In the recent case of Glidepath Limited v. Beumer Corporation, the Delaware Court of Chancery considered the case of whether a court could apply equitable principles to reform the dates in a purchase contract for measurement of an earn-out period. The court held that reformation was not appropriate because the sellers were unable to establish by clear and convincing evidence that because of either fraud or mutual mistake, the contract did not reflect the actual intention of the parties.
The case involved a Membership Interest Acquisition Agreement dated January 16, 2014 and effective as of January 1, 2014 (the acquisition agreement). The acquisition provided for an initial period through March 31, 2016 when Beumer Corporation (the buyer) would control 60% of Glidepath LLC (the company), but there would be shared management. At the end of that period, the buyer had an option to purchase the sellers’ remaining 40% of the company, or the sellers could exercise an option to put their remaining interest to the buyer. Part of the consideration for the 60% interest consisted of an earn-out payment which would be based on the performance of the company during the period beginning on April 1, 2013 and ending on March 31, 2016. The sellers were also entitled to a distribution equal to 40% of the profits of the company during the earn-out period.
When the parties first negotiated the acquisition agreement and the operating agreement for the company, they expected the sale of the 60% membership interest to close on April 1, 2013 so that the periods noted above would correspond with the period of shared control and the then applicable fiscal years for the company. However, in the course of the negotiations, the buyer sought to postpone the closing and the sellers did not object. Therefore, the transaction did not close until January 2014. Despite the delayed closing, the parties did not revise the acquisition agreement or the operating agreement to adjust the earn-out period or any other provisions that were tied to the March 31, 2016 date.
The company failed to perform as anticipated, and as a result, as early as November 2014 the buyers informed the sellers that they would not receive any earn-out payments as they were unlikely to be able to produce the cumulative performance targets set in the acquisition agreement. There were ongoing meetings, some quite heated, in which the sellers blamed the buyer for poor performance, but the buyer claimed that the company was not in the shape it believed it was in when they made the acquisition.
The sellers objected asserting that the parties always contemplated that the earn-out would begin at closing and last a full three years. They argued it made no sense for the earn-out period to commence prior to the closing. They also argued that the buyer always intended to change the company from a March 31 fiscal year to a standard calendar year fiscal year. The sellers sought reformation of the contract on equitable principles in an attempt to extend the earn-out period through December 31, 2016 and to change the date when the buyer could exercise its call option and acquire the balance of the sellers’ shares.
The court held that the sellers had the burden of proving their reformation claim by clear and convincing evidence and found that they “failed to carry the burden of proof regarding either (i) the existence of mutual mistake of fact during the negotiation that resulted in an erroneously drafted agreement or (ii) a unilateral mistake of fact by the sellers, coupled with knowing silence by the buyer.”
The court considered that the buyer’s counsel had used a precedent from a prior deal and circulated several iterations of the agreements. Also, the buyer had a delayed closing in that prior year but did not adjust dates based on the delayed closing. There had also been discussions whether to change the company’s fiscal year to a standard calendar year. In fact, in June 2013, the buyer’s accountants reviewed the acquisition agreement and commented on the fact that the agreement referred to fiscal years and that they thought the intent was to change to a 12/31 calendar year end. However, the parties never changed the dates in the draft agreement.
The court also noted that there were several delays, but eventually the parties targeted a January 2014 closing. During this period, they reviewed the documents and reopened and renegotiated a few points, including other points on the earn-out, but the sellers did not at that time make any comments on the dates for the earn-out period. Throughout this period, the buyer used outside counsel, but the sellers decided to negotiate without formally involving outside counsel and without retaining U.S. counsel. They consulted with their New Zealand solicitor but “he did not play a meaningful role in the negotiations.”
The court stated that the party seeking reformation must show “that it was mistaken about the contents of the final, written agreement” and that “either its counterparty was similarly mistaken (mutual mistake) or that its counterparty “knew of … [the] mistake and remained silent” so as to take advantage of the error. The court held that while the sellers had a mistaken belief as to how the earn-out period and put-call period mechanism would be measured, the sellers did not prove that the buyer was similarly mistaken. While the sellers testified that they believed the dates would be updated to run for three years from closing, they never attempted to actually update the dates. The buyers testified that they believed they had always agreed to specific dates and not a three year period from closing. They argued that they assumed the dates would not change despite the delayed closing because they had priced the deal based on the situation in early 2013. While the sellers did prove that the buyer came to understand that the sellers had made a mistake, this did not happen until the dispute arose over the earn-out period and not during the negotiations or at signing.
Finally, the court said that “regardless of whether the plaintiff was relying on mutual mistake or unilateral mistake”, the sellers needed to prove by clear and convincing evidence that the parties came to a specific prior understanding that differed materially from the written agreement. The only evidence that the court had of a prior understanding was a term sheet that referred to fiscal years 2014, 2015 and 2016 which at the time of the term sheet would have meant the then effective fiscal year end of March 31. Therefore, there was no prior understanding for the court to enforce.
Earn-outs are always a potential source of difficult negotiations and often result in disputes in an acquisition as the party relying on the earn-out is rarely in control of the business operations during the earn-out period. This generally leads to extensive and detailed negotiations of measurement periods, milestones or targets, and provisions for controls or acceleration triggers to protect the selling parties. Parties should not negotiate these types of arrangements without advice from counsel or other third parties with significant experience in dealing with the practical implications of implementation of the formulas and terms of the agreement. This case should be a warning for parties to pay particular attention to these matters before finalizing any agreement, especially in the case where there are delays or other modifications to the deal that could impact the originally contemplated parameters.
