When parties can’t agree on a fixed price for the sale of a business, they often use an earn out arrangement whereby some of the price is dependent on how the business performs or whether certain milestones are achieved after the business is sold.
Earn out arrangements are usually beneficial to both the vendor and the purchaser. For instance, if the business performs well, that is a good result for the purchaser plus it also usually means that the vendor gets paid more for the business. However, earn outs can generate tensions. For example, if the purchaser, as the new owner of the business, wishes to pursue a strategic path that might ultimately be the best way forward for the business in the long term, this can be detrimental to the interests of the vendor if it means that the short term earn out targets are not achieved.
From a vendor’s perspective, earn outs also carry the risk that the purchaser may manipulate the way the business is operated or delay certain actions with a view to ensuring that the earn out targets are not achieved so as to avoid having to pay any more for the business. A recent case considers this scenario and finds that the purchaser failed to act in good faith.
Who needs to know?
Vendors and purchasers who have or are considering entering into any earn out arrangements.
Recent Case
The recent decision of the Court of Appeal of the Supreme Court of Victoria in Trampoline Enterprises Pty Ltd v Fresh Retailing Pty Ltd[2019] VSCA 74 arose from the sale of the ‘Trampoline’ ice-cream retailing business. It involved the sale of 6 owned stores and 6 franchised stores.
As part of the sale arrangements, an earn out of $140,000 was payable if a franchisee commenced operating a new store within 180 days of completion of the sale.
The sale completed on 30 September 2013 and the 180 day earn out period therefore expired on Saturday, 29 March 2014.
As it eventuated, a new store commenced operating on Monday, 31 March 2014.
The vendor claimed that the purchaser deliberately delayed opening the new store so as to avoid paying the earn out amount. In this regard, the earn out arrangements included an express clause requiring the purchaser to “act in good faith and not unreasonably or intentionally delay the signing of documentation or the performance of any other act required to recruit a new franchisee to open a new Trampoline store”.
The New Store
The new store required a fit out and, in order for it to open, an occupancy certificate had to be issued.
The fit out was completed during January and February 2014. An application for the occupancy certificate was prepared. The application was dated 18 February 2014. At this time, the original target date for opening the store was Friday, 21 February 2014.
Around this time, but before the store opened, the purchaser’s business development manager told the project manager undertaking the fit out to “put the occupancy certificate on hold”. The business development manager subsequently told the project manager that there was “a legal issue that they couldn’t take handover due to … purchasing of the Trampoline from previous owners, so they weren’t able to … operate the store until a certain date” about one month later.
Following the “put it on hold” conversation, relatively little happened to progress the store until about 18 March 2014 when the purchaser announced internally that the new target date for opening the store would be 31 March 2014.
The project manager issued its ‘practical completion certificate’ for the fit out to the purchaser on 3 March 2014. The purchaser countersigned this certificate to acknowledge that the works were in good order except for a few specified items (none of which apparently had anything to do with why the store did not open until later). Even though practical completion was achieved in early March, the occupancy certificate was not issued until 21 March 2014.
Innocent Explanations
In the Court of Appeal, the purchaser argued that there was an ‘innocent explanation’ as to why it gave the ‘put it on hold’ direction. It argued that it should be inferred that the direction was given so as to delay the commencement of rent (or at least the rent free period) under the lease between the purchaser and the landlord of the new store. It argued that this motivation had nothing to do with the earn out and therefore it could not be held to have acted in bad faith.
The purchaser also argued that there could not have been any lack of good faith because the purchaser’s business development manager who gave the ‘put it on hold’ direction was apparently unaware of the purchaser’s earn out payment obligations. This evidence about awareness was not challenged by the vendor, yet it is unclear whether the trial judge actually accepted or rejected this evidence. The vendor nevertheless pointed out that the purchaser had not adduced at trial any evidence to support other explanations for why the ‘put it on hold’ direction was given. The vendor argued that the ‘natural inference’ from the direction was that the purchaser wished to delay the opening so as to avoid paying the earn out amount. Moreover, the vendor argued that the mere fact that the purchaser did nothing to progress the opening of the new store for nearly one month of itself meant that the purchaser failed to act in good faith.
Decision
The Court of Appeal accepted the inferences argued for by the vendor. In doing so, the Court of Appeal rejected the purchaser’s ‘innocent’ explanation as being ‘fundamentally flawed’ because the rent free period had in fact already commenced on 26 February 2014.
The Court of Appeal held that while the purchaser’s business development manager may not have known, with precision, the nature of the “legal issue”, the only reasonable conclusion in the circumstances was that the business development manager was aware that, in the legal arrangements between the vendor and the purchaser, it was disadvantageous to the interests of the purchaser to have the store opened before the end of March.
In those circumstances, the Court of Appeal found that there was sound and cogent evidence to support the conclusion that the intentional delay constituted a failure to act in good faith as required by the express clause in the earn out arrangements.
Interestingly, the Court of Appeal also found that the mere lack of activity during the hiatus period itself constituted a breach of the requirement to act in good faith. Therefore, even if the ‘put it on hold’ direction had not been given, the purchaser had still breached its obligations. The lack of activity could not “sensibly be regarded as being merely coincidental”. The Court of Appeal found it was “well-nigh inevitable” that the reason for the otherwise inexplicable period of inactivity by the purchaser, was the same as the reason for the ‘put it on hold’ direction.
Practical Points to Take Away
- Deliberately delaying things or simply doing nothing so as to avoid an earn out payment will not be acting in good faith.
- If there is an ‘innocent’ reason for a delay or period of inactivity, then this should clearly be supported by the evidence (including contemporaneous notes, emails and consistent statements) so as to reduce the prospect of bad faith motivations being inferred.
- Even if a sale agreement does not contain an express clause requiring the purchaser to act in good faith, an obligation of this type may well be implied.
- Vendors should ensure that the sale agreement obliges the purchaser to use best or similar endeavours to achieve the earn out targets.
- Vendors should ensure that the sale agreement requires the purchaser to provide regular reports on its progress during the earn out period. This may help to identify at an earlier stage if the purchaser is delaying things or operating the business in an unusual way.