DILIGENT REQUIREMENTS FOR LIFE SCIENCES DEALS AND EARN-OUTS
Contingent payments (a.k.a. earn-outs in transactions among private companies, and contingent payment rights (CPRs) in transactions among listed companies) are a very common and valuable component of purchase price constructs in today’s life sciences and healthcare M&A deals.
It is indeed common practice in the life sciences sector, more than in other industries, to have a contingent payment subject to the occurrence of non-financial milestones (such as the approval of a new drug application by the relevant authority, or the success of clinical trials). Nevertheless, life sciences players often also tie the contingent payment to the achievement of financial milestones such as the net sales of a specific drug/product or, more generally, the revenues or EBITDA generated by one or more business unit (e.g. the business unit related to the promotion and commercialization of dietary supplements as opposed to the pharma division of the same company, etc.).
In this regard, one of the main issues that arises among the parties of a M&A transaction is the level of effort that a buyer should comply with in order to achieve the agreed milestones and to maximize the value of the contingent payment post-closing. This is a particularly sensitive topic if the parties are not dealing with a fixed lump sum payable upon the occurrence of a single milestone but with a percentage to be calculated upon the financial results of the target company within a certain period. After the closing the buyer would manage the target company and therefore would be in the best position to cause the target company to achieve, or to fail to achieve, the contractual milestones. As a consequence, the seller might blame the buyer in case of failure and decide to bring the matter before a court.
What are the legal consequences if a buyer has failed to invest enough funds or to dedicate enough resources and employees to the R&D of a new drug, making it impossible for the seller to achieve the milestone requiring the approval of said new drug by the FDA? Can a seller make a claim against the buyer for breach of contract if the buyer has failed to pursue business opportunities or have operated the target company in a disruptive way, causing the failure to achieve the target EBITDA or other financial parameters triggering an earn-out?
Over the years, from a contractual standpoint this issue has been addressed in different ways, providing mixed results from a case law standpoint in terms of different decrees of diligent requirements applicable to the buyer in case of an earn-out construct.
1. Statistics on diligent requirement
Below is a chart from the 2015 Life Sciences M&A Updated study issued by SRS Acquiom , showing the application percentage of diligent requirements for the buyer in the context of an earn-out construct.
According to this chart, 84% of the transactions apply a “commercially reasonable efforts” standard with regard to the achievement of development and regulatory milestones and a slightly lower percentage (78%) to commercial and sales milestones. Furthermore, the study highlights that in several cases the parties agree to apply the “commercially reasonable efforts” standard for a pre-agreed period of time after closing (two years on average) and an “express buyer discretion” standard for the following years. This data confirms the experience we have had with our clients, so far, with regard to the extensive use of such diligent standards.
The other interesting outcome of this study is that almost all of the milestones that have been paid by the buyer to the seller as of the date of the analysis were associated with a diligent requirement on the buyer to use commercially reasonable efforts (or more specific and stringent requirements) to achieve the milestones. In 17 deals with less-stringent diligence requirements of the buyer (such as an express good faith effort or an express no bad faith action), “three (18%) have seen at least one payment, compared to 48% across all deals” and “US$158 million has been paid out of US$536 million (29%) in milestones come due to date, compared to 41% across all deals”.
On the opposite end of the spectrum, only a few transactions (9% in the case of regulatory milestones and 5% in the case of financial milestones) do not contain any diligent requirement.
1. “Commercially reasonable efforts” standard in the US
As highlighted in the chart above and confirmed by our experience, in most of the cases, the parties agree to apply a “commercially reasonable efforts” standard to achieve milestones triggering the payment of earn-outs/CPRs and in fewer cases a “best efforts” standard. Generally speaking, a “best efforts” standard is considered to impart the most onerous and strictest obligation on the promisor while a “commercially reasonable efforts” standard is thought to impart a lesser obligation on the promisor .
However, the use of such a standard, especially if it is not defined in the acquisition contract and/or is not used on a consistent basis throughout the contract, may generate confusion and may lead to uncertain outcomes in case of litigation.
This is because the “commercially reasonable efforts” standard is not regulated or defined under the laws of US states and the main case law does not provide clear and settled guidance on what this standard precisely means in a given context. In other words, the scope of obligations under this standard is vague and a judge would engage in a highly fact-specific enquiry on a case-by-case basis to ascertain whether the relevant party has met such a standard or not.
Taking into consideration the laws of New York and its relevant case law for the purposes of this contribution, a seller claiming a breach of contract based on a buyer’s failure to comply with the “commercially reasonable efforts” standard shall first establish what such a standard in the relevant industry is.
Since the “commercially reasonable efforts” standard is considered an objective standard of conduct , the courts would verify the compliance with such a standard based on what is usually considered a reasonable behavior in the applicable industry.
In addition, the New York courts would generally place the burden on the claimant to provide evidence that demonstrates not only what constitutes a “commercially reasonable standard” but also that the other party has failed to meet such a standard and that the party’s conduct has been commercially unreasonable. To this purpose, the courts would generally take into consideration and evaluate factors such as industry standards, the party’s available resources, expertise, and good faith efforts.
As a consequences, the legal meaning to be given to a “commercially reasonable efforts” standard would strongly vary depending on, among other factors, (i) the industry, the type of business of the target company (e.g. managing the lifecycle of a new drug, the marketing and commercialization of a new wearable, etc.), and the parties involved, and (ii) the activities that a buyer should carry out post-closing to achieve the earn-out benchmarks (e.g. obtaining a FDA approval, launching a new product in the market, achieving a target amount of sales or revenues, etc.).
By way of example, if the seller shall achieve a certain amount of revenue generated by the sale of a certain drug or shall launch a new drug in the market, the courts would verify whether the buyer has conducted all R&D and marketing efforts that other companies in the same industry would generally and typically take to successfully develop or sell such a drug. Evidence such as this would most likely require an expert testimony.
In Sekisui America Corporation v. Hart, Sekisui America Corporation and Sekisui Medical Co., Ltd. (together Sekisui), acquired America Diagnostica, Inc. (ADI), a corporation engaged in the discovery, manufacture and marketing of medical diagnostic products. In the litigation proceeding bought by Sekisui against Richard Hart, the former president and CEO of ADI, and his wife Marie Louise Trudel-Hart (together the Harts), the Harts asserted a counterclaim against Sekisui for breach of contract for failing to use “commercially reasonable efforts to market Femtelle [(i.e. a breast cancer prognosis assay)] and omitting to take actions to obtain FDA approval for Femtelle, thereby preventing ADI from maximizing Femtelle revenues” .
In this case, the Harts failed to present evidence of what a “commercially reasonable efforts” standard should be in the medical and diagnostics devices industry and in the FDA regulatory context without explaining in concrete terms how Seksui deviated from such a standard . According to the court, Sekisui undertook considerable efforts to bring Femtelle to market and “Sekisui diligently strived for Femtelle clearance until 2011 when it realized that the necessary studies would be prohibitively expensive and time-consuming. Even if Sekisui had paid for the studies, they would not have been completed until 2014 – a year after the earn-out period had ended”.
The court found that Seksui pursued FDA approval as long as it practically could since Sekisui undertook considerable efforts to bring Femtelle products to market but, given the cost of the studies, the uncertainty of ever receiving FDA clearance, and the increased competition in the breast cancer diagnostic market, Seksui decided not to submit another 501(k) to the FDA for the pre-market approval. At the same time, the Harts did not present any “evidence that Sekisui omitted to take any actions with the intent of preventing AD from meeting Femtelle reached the targets”. Indeed, according to New York case law, the “commercially reasonable efforts” standard should not require a party to act against its own interests on the assumption that such a party has the right to exercise its business judgment and on such a basis action should be evaluated as commercially reasonable or not.
2. Tips on how to address this issue from a contractual standpoint
In order to reduce the risks arising from the ambiguity of a “commercially reasonable efforts” standard whose interpretation relies strongly on case law, it would be advisable for a seller to include in the transaction documents a defined term of such a standard. Specifically, the parties may adopt a wide range of solutions providing a more or less strict definition. In a recent deal in the pharmaceuticals and biotechnology sector, the parties agreed to use the following definition for the standard:
“Commercially Reasonable Efforts as used in Section […] means those commercially reasonable efforts and resources that are substantially similar to the level of effort and resources used by a pharmaceutical company of similar size and resources to Buyer to accomplish a similar objective under similar circumstances with respect to drugs or drug candidates of similar commercial potential and is at a similar stage of development or product lifecycle, taking into consideration all relevant factors at the time such efforts are expended, which may include, as applicable, issues of safety and efficacy, projected costs to Develop such Transferred Product, the competitiveness of alternative Third Party products to such Transferred Product, the patent and other proprietary position of such Transferred Product, the freedom to operate or other patent or intellectual property infringement concerns, the likelihood of Regulatory Approval, and the expected pricing, sales, reimbursement, financial return, commercial potential and profitability of such Transferred Product. Notwithstanding anything to the contrary, for purposes of determining Commercially Reasonable Efforts hereunder, Buyer shall not be entitled to take into account any amounts due to Seller pursuant to this Agreement, the License and Collaboration Agreement, […] or any other Related Agreement .”
Furthermore, instead of relying on a “commercially reasonable efforts” standard that even if defined may leave room for interpretation by the courts, the parties may add buyer’s post-closing obligations to meet specific diligent requirements, such as an obligation to comply with an agreed development or marketing plan, to invest a minimum amount of funds, to dedicate a minimum number of employees to certain experimentation, to continue the R&D or commercialization activities relating to a specific drug, etc.
In the TransUnion Healthcare, Inc. acquisition of the stock of RTech Healthcare Revenue Technologies, Inc. dated September 21, 2016, the parties did not provide for a definition of “commercially reasonable efforts” but agreed to the following specific diligent requirements:
“(h) Conduct of Business. […] from the Closing until the last day of the Customer Retention Contingent Purchase Price Determination Period:
(i) Purchaser shall operate the Business of the Company in good faith, in the Ordinary Course of Business, including not increasing or decreasing customer pricing as set forth in the Company’s customer Contracts […] and using the Company’s historical accounts receivable collection practices described on Schedule […], and otherwise using its commercially reasonable efforts to promote, develop, market, and distribute the Company Products;
(ii) Purchaser shall not and shall cause the Company to not take any action that is intended to circumvent the ability of the Company to recognize Actual Revenue from any or all Selected Customers during the Customer Retention Contingent Purchase Price Determination Period;
(iii) Purchaser shall maintain separate books and records with respect to the computation and verification of the Actual Revenue from the Selected Customers; and
(iv) Purchaser shall not, prior to the last day of the Customer Retention Contingent Purchase Price Determination Period, consummate the sale of all or substantially all of the equity or assets of the Company, on a stand-alone basis, to an unaffiliated third party.”
In addition to the inclusion of detailed diligent obligations, it would be advisable to add veto rights in favor of the seller and negative post-closing covenants on the business operations of the target company by the buyer.
Finally, if the buyer is not be subject to any diligent standard, it would be advisable to include an appropriate disclaimer to avoid the application of the so-called “implied covenant of good faith and fair dealing”.
The implied covenant principle applies to every contract and it is recognized under the laws of most states in US, although with different gradations. The implied covenant doctrine “requires a party in a contractual relationship to refrain from arbitrary or unreasonable conduct which has the effect of preventing the other party to the contract from receiving the fruits of the bargain”.  In other words, according to the implied covenant of good faith and fair dealing, the buyer cannot purposely interfere with the achievement of the seller’s earn-outs/CPRs and shall use reasonable efforts to achieve the relevant milestones.
Therefore, even if a contract does not qualify in any way the level of diligent efforts that the buyer shall comply with and the seller deems that the lack of payment of the contingent consideration for having failed to meet a milestone is to address to the buyer’s behavior, the seller could claim a breach of the implied covenant of good faith and fair dealing.
3. The Italian perspective
The importance of adding a definition of “commercially reasonable efforts” would be even stronger in contracts governed by Italian law. The reason being that there are no specific case-law guidelines on diligence requirements in connection with earn-out payment mechanics.
The absence of precedents would induce Italian courts to apply Italian law general principles. According to such principles , the parties to an agreement must act based on “good faith” standards (esecuzione secondo buona fede) in the performance of their contractual obligations.
The “good faith” standard requires a party to (i) protect the interest of the other party regardless of a specific contractual obligation, and (ii) carry out any action aimed at such purpose to the extent that the relevant action does not trigger a significant prejudice to the party’s self-interest.
It is easily understandable that, given the broadness of the “good faith” standard and the absence of specific case-law guidelines (Italian judicial precedents on the issue at stake focus mainly on insurance agreements, employment agreements, leasing agreements, public procurement agreements, etc.), it would be strongly advisable to include specific diligent requirements as those mentioned under section 4 above and, secondly, a definition of “commercially reasonable efforts” so as to reduce the uncertainty that could arise from the application of Italian law general principles by Italian courts in case of earn-out constructs.
From a different, but strictly related, angle, it should be noted that, according to certain Italian commentators , when in a post-closing scenario, the operation of the target company is totally under the buyer’s control, earn-out constructs could be deemed as “purely arbitrary CPs” (condizioni sospensive meramente potestative) since the achievement of the contractual milestones would depend only on the buyer’s management decisions. As a result of this interpretation, from an Italian law standpoint the earn-out constructs would be deemed null and void and the seller would be entitled to claim for the payment of the residual amount of the purchase price even if the milestones are not achieved.
Although the above interpretation of Italian law general principles is rather extreme, the inclusion of specific post-closing obligations, veto rights in favor of the seller, and negative post-closing covenants, would help to reduce the risks arising from it.
 This study dated September, 2015, was based on a limited but meaningful number of M&A deals, where SRS Acquiom served as a post-closing shareholder representative (58 recent deals with a total value of US$29.2 billion).
 Lou R. King & Eileen T. Nugent, Negotiated Acquisitions of Companies, Subsidiaries and Divisions, §13.06 n.3.2 (2003); Charles M. Fox, Working with Contracts 88 (2002).
 See Sekisui America Corp. v. Hart, 15 F.Supp.3d 359, 381 (S.D.N.Y. 2014); MBIA Ins. Corp. v. Patriarch Partners VIII, LLC, 950 F. Supp. 2d 568, 617
 According to Section 2.6 of the Purchase and Sale Agreement executed by the parties on March 5, 2009, “[Sekisui] shall undertake commercially reasonable efforts to market or sell, or to cause the marketing and sale of the Femtelle Product, including […] submitting to the FDA […]. submissions and filings for uses of the Femtelle Product that are reasonably related to those provided for in the Femtelle Clearance . . . [and] (B) not willfully take any actions, or omit to take any actions, with the intent of preventing the Business from meeting the Femtelle Revenue targets […] or that could reasonably be expected to impair the ability of [ADI] to maximize Femtelle Revenues […]”.
 See also MBIA Ins. Corp. v. Patriach Partners VIII, LLC, 950 F. Supp. 2d 568, 617 (S.D.N.Y. 2013) (requiring evidence to define the “commercially reasonable efforts” standard for a particular industry); B.D.G.S., Inc. Balio, 8 N.Y.3d 106, 113 (2006) (relying on expert testimony regarding bank practices on check endorsement for purposes of commercial reasonableness analysis).
 Asset Purchase and Sale Agreement entered into by and between Ipsen S.A. and Merrimack Phamaceuticals, Inc. on January 7, 2017.
 Dunlap v. State Farm Fire & Cas. Co., 878 A.2d 434, 442 (Del.2005).
 Section 1175 and 1375 of the Italian Civil Code.
 G. De Nova, Il Sale and Purchase Agreement: un contratto commentato, Section 8.3, pages 139 and following, Turin, 2014.