According to a recent study by SRS of recent private life sciences deals, disputes over earn-outs arose in about one-third (36%) of all milestones that were expected to be hit by September 2016. While most disputes were not about contract interpretation issues regarding whether an event triggered the milestone or not, one recent dispute in the Delaware Court of Chancery illustrates the potentially significant value at stake when these interpretation issues do occur.
In Gilead vs. SRS, the Delaware Court of Chancery recently held that Gilead Sciences was not required to pay former stockholders of Calistoga Pharmaceuticals a $50 million milestone payment under the terms of a 2011 merger agreement in which Gilead acquired Calistoga for an upfront payment of $375 million and potential milestone payments of up to $225 million.
As drafted, the milestone payment at issue was triggered upon “the receipt of Regulatory Approval of CAL-101 in the United States or the European Union, whichever occurs first, as a first-line drug treatment . . . for a Hematologic Cancer Indication.” In September 2014, the European Commission approved CAL-101 as a first-line treatment in combination with another drug for patients with chronic lymphocytic leukemia (CLL) who have a genetic abnormality with respect to chemo-immunotherapy (a sub-population of patients with CLL). Following the approval, the former stockholders claimed that the milestone was achieved and that payment was required. Gilead, which had already paid the former Calistoga stockholders $175 million in satisfaction of the first two milestones, disagreed. Gilead contended that the term “indication” in the milestone trigger required approval of the drug as a first-line therapy for all patients with the disease, and not just a first-line therapy for a sub-population of patients with the CLL disease who had a genetic abnormality that made them immune to chemo-therapy.
The court agreed with Gilead, based primarily on a review of the parties’ drafting and negotiating history, which was corroborated by the parties’ contemporaneous statements made after the European Commission approved the deal. The court also held that Gilead’s interpretation was supported by the overall structure and operation of the milestone provision, which suggested that only a potentially large commercial application should trigger the milestone. In reaching this conclusion, the court reviewed the plain terms of the contract and found that the word “indication” was ambiguous and thus that extrinsic evidence could be used to interpret the milestone payment trigger. It then turned to the extrinsic evidence to determine that the word “indication” meant “disease” in this context and that the overwhelming weight of the evidence proved that the parties had agreed that the milestone would be triggered only by a disease-level approval. It then found that the European Commission’s approval of the drug was not a disease-level approval, but rather an approval for a sub-population of people with a genetic predisposition that made them immune to chemo-therapy, and held that the milestone was not triggered.
Though not essential to the court’s decision, the court also found that contemporaneous statements made in separate emails by the former CEO and the former chairperson of Calistoga stating that the European Commission approval did not trigger the milestone payment demonstrated that they, themselves, believed the milestone was based on regulatory approval for a broader population. The court also found that the structure and operation of the milestone provision further corroborated that the regulatory approval must be at the disease level. It noted that the high value of the milestone as a percentage of the overall deal consideration suggested that the milestone was intended to affect a large population. The court found that only a regulatory approval that would have provided a high “value inflection” such as a significant commercial reward for treatment of a large population (and not just a subgroup of the relevant patients) must have been intended. The court thus concluded that Gilead was not required to pay the third milestone.
Some key takeaways include:
Defining milestones. It is common for an earn-out to be based on the achievement of marketing approval for a drug because of the substantial value creation and alignment of party interests that result from achieving this event. However, this litigation highlights that despite this alignment of interests and relatively objective drafting exercise, there is still a possibility of ambiguity and risk of a significant dispute in this context. A marketing approval is often based on the indication, or specific use case, being pursued at the time of the sale in on-going clinical trials for the potential product. For example, for an oncology drug, the approval may be based on its use as a first-line vs. refractory treatment, the treatment of a particular sub-type of a disease, or a specific cohort with a combination of illnesses or conditions. The possibilities are endless and must take into account the possibility that the regulatory approval strategy for a drug candidate may change over time based on clinical trial results, feedback from regulatory agencies, competitive developments and other factors. Because of these technical aspects, milestones based on marketing approval of a drug need to be defined very carefully. This same observation holds true for milestones based on successful completion of clinical trials in “Phase 2” or “Phase 3” stages as the parties may have different perspectives on what constitutes successful completion of a trial or even the number and type of trials that must be conducted in these later stages. It is therefore imperative for those who are drafting the provision to coordinate closely with industry and business experts to ensure that the description of the technical specs for a regulatory milestone is precise, objective and comports with the parties’ shared understanding of the business deal.
Avoid terms of art. In this decision, the court determined that the word “indication” had multiple meanings in the oncology industry that are context specific. Throughout the trial, it was evident that the word had various meanings during the negotiations. The term “indication” is often used in the biotech/pharmaceutical industry as a term of art, and to describe both developmental as well as commercial milestone events in an acquisition agreement. Because of its ambiguity, the case cautions against using the term in describing an earn-out, or if it is used at all, to provide as much objective clarity as possible regarding its contextual meaning.
Anticipate a dispute. Disputes involving an earn-out are fairly common, which is not surprising given the highly fact-specific nature of an earn-out and the significant possibility of changed circumstances. Many milestone disputes are renegotiated (SRS Study: 20% of all milestones were renegotiated) or settled, with few disputes resulting in trial and a judgment or an arbitration. While the particular strategy of a defendant will depend on the specific facts and circumstances, in this case, Gilead opted to go the distance, was able to obtain favorable evidence during discovery and won at trial. Regardless of a party’s litigation risk tolerance, however, any party to an earn-out should anticipate that a dispute could arise and price this factor into the deal accordingly. Parties should carefully consider, and not treat as boilerplate, the provisions in the agreement that pertain to dispute resolution such as notice and information rights, submission to arbitration, jurisdiction and venue, payment of expenses and defense costs, and the mechanics and adequacy of the stockholder representative defense fund.
Contemporaneous communications. The case also serves as a reminder that a court is willing, and indeed required, to look beyond the four corners of an agreement to resolve contractual disputes to determine the parties’ shared intent when the plain terms of the agreement are ambiguous. Here, the court reviewed blacklines of prior versions of the merger agreement as well as other forms of contemporaneous communications, such as internal notes and emails by the participants. The court gave great weight to contemporaneous emails by representatives of the former stockholders, particularly where their statements contradicted their personal financial interests. It is worth reminding that emails and communications are discoverable in a litigation if a dispute should later arise regarding the parties’ intent. Transaction parties should therefore keep this in mind throughout any negotiation, and should consider taking this opportunity to review their firm-wide communication policies and protocols, including standard record retention policies, in light of these risks.
See a copy of Shareholder Representative Services LLC v. Gilead Sciences, Inc., C.A. No. 10537-CB (March 15, 2017)
 SRS Acquiom’s 2016 Life Sciences M&A Earnout Achievement Update, December 2016 (SRS Study).
 According to the SRS study, most disputes involved major disagreements over lack of progress of acquired programs or changed plans that increased the risk that milestones wouldn’t be paid. Others involved very near misses of the milestone that was being challenged by the sellers, for example, by auditing revenue numbers. Of the deals that had a dispute, 42% of them had at least one milestone that was eventually paid.