Implied Covenants in Earn-Outs -- Lady Duff-Gordon Rides Again
Where earn-out compensation represents a significant portion of the seller’s consideration in a purchase transaction, the buyer is required to use reasonable efforts to achieve the purposes of the earn-out. That is the law in Massachusetts, as per a recent Federal appeals court decision, and any other State where Justice Cardozo’s memorable opinion in Wood v. Lucy, Lady Duff-Gordon is still quoted.
PerkinElmer, a publicly traded lab equipment company, acquired the business and assets of Sonoran Scanner, a private company engaged in the computer-to-plate (CTP) printing business. Sonoran’s main product was a $500,000 machine that offered a high-speed digital alternative to the costly and time-consuming analog process required by conventional plate technology printing. Like many good ideas, this one ran low on funding. The founder had invested $3.5 million of his own funds, but the company had no sales. Out of cash, the founder sought a purchaser to undertake the continued development and marketing of the CTP technology.
PerkinElmer paid $3.5 million at closing (most of which went to creditors) and agreed to certain earn-out payments if sales targets were met over a 5 year period. PerkinElmer would pay $750,000 if at least three CTP machines were sold in the first year following closing, $1.5 million (less any previously paid earn-out amounts) if at least ten machines were sold by the end of the second year, and additional amounts if certain gross margin targets on sales of CTP machines were met. The additional earn-out payment (over and above the $1.5 million) during the five year payout period was a maximum of $2 million.
Sadly, the CTP business, as operated by PerkinElmer, was a failure. Only one CTP unit was sold and there were no earn-out payments. The founder blamed the failure on PerkinElmer. Unfortunately, the purchase agreement contained no express covenants regarding how the business was to be run during the earn-out period.
The Court of Appeals held that the acquisition agreement contained an implied contractual term requiring that PerkinElmer use reasonable efforts to develop and promote the CTP technology, citing the famous 1917 case from the pen of then Judge Cardozo known as Wood v. Lucy, Lady Duff Gordon. In this case, Otis F. Wood, a New York advertising agent, signed on Lucy, Lady Duff-Gordon, otherwise known as "Lucile" (her couture label), to market garments and other products bearing her endorsement for a period of one year. The contract was exclusive, and gave Duff-Gordon half of all revenues that Wood was able to generate. Wood's only duties under the contract were to account for monies received and secure patents as necessary - there was nothing requiring him to exert any efforts (although if he did nothing, there would be no revenues to share). Around the same time, Duff-Gordon came up with an idea to market a line of clothing "for the masses," and she broke the exclusivity provision by endorsing products sold by Sears Roebuck. Wood sued, and Duff-Gordon defended on the grounds that no valid contract existed with Wood since he had not made an express promise to do anything. The issue for Judge Cardozo was whether to find that Wood had made an implied promise to exert efforts to achieve revenues, thereby making the contract enforceable. Cardozo held that Wood did make such an implied promise:
We are not to suppose that one party was to be placed at the mercy of the other. . . . [The] promise to pay the defendant one-half of the profits and revenues resulting from the exclusive agency and to render accounts monthly was a promise to use reasonable efforts to bring profits and revenues into existence.
Although the context was different (the Cardozo case was an exclusive representation agreement), the First Circuit in Sonoran Scanner held that PerkinElmer had made a similar implied promise to use reasonable efforts to achieve the earn-out, even though the contract had no such language. The court was swayed by the fact that the potential earn-out compensation was “substantial” (potentially $3.5 million) in relation to the up-front payments made by PerkinElmer (also $3.5 million). Also relevant was the fact that most of the $3.5 million closing payment was paid to creditors and did not benefit the founder. Finally, there was no language in the agreement negating an obligation by PerkinElmer to use reasonable efforts or conferring absolute discretion on it as to the operation of the business.
Drafting tip: if you are representing the buyer, and don’t want to get hit with an implied obligation to use reasonable efforts to achieve an earn-out, be sure to put in a clause giving your client full discretion as to the operation of the business during the earn-out period.
