"Earn out" clauses - buyer's duty of loyalty

Earn out mechanisms are a common feature in M&A transactions, used to make a portion of the purchase price contingent on the target company's future performance. <br><br>Negotiating and operating an earn out-structure is complicated, since the buyer takes control of both the operations and the accounting of the target after closing and therefore also has the ability to influence the size of the seller's earn out payment.

The Norwegian Supreme Court has in a recent case for the first time ruled that earn out clauses in a share purchase agreement impose a heightened duty of loyalty on the buyer towards the seller.

The ruling provides useful guidance on how to navigate and negotiate earn out clauses in a Norwegian law M&A transaction.

Background

The case arose from the sale by Mira Mare AS of its stake in Propcap AS. Under a share purchase agreement signed in June 2021, the purchase price included an earn out element equal to 19.75% of Propcap's net profit for the financial years 2021 and 2022. A shareholders' agreement entered into on the same date required Propcap to continue running the business "as it has been run to date", with no material changes to ongoing operations, financing or accounting policies, and no changes to the existing bonus scheme.

Mira Mare received NOK 7.6 million in earn out for 2021 and NOK 2.1 million for 2022. The dispute centred on a claim for additional earn out for 2022, arising from two transactions which Mira Mare argued had reduced the net profit in breach of the shareholders' agreement and the implied contractual duty of loyalty: (i) the sale of two equity holdings to Propcap's own shareholders at 80% of cost; and (ii) the write-down of another equity holding.

The legal framework

The Supreme Court confirmed that earn out clauses are interpreted using the ordinary principles applicable to commercial contracts – objectively, with significant emphasis on the text itself, but also having regard to the purpose, structure and context of the agreement, and with loyalty considerations capable of being taken into account. Referring to another recent decision, the Supreme Court emphasized that the duty of loyalty is not merely a tool of interpretation but can itself be an independent source of rights and obligations. At its core, the duty of loyalty imposes on the parties a certain degree of care for the other's interests, even at some cost to their own.

The Supreme Court’s ruling highlights the following key principles:

• Earn out clauses give rise, as a matter of principle, to a duty of care owed by the buyer to the seller, which translates into a strengthened duty of loyalty. The rationale is the structural imbalance between the parties: the seller can no longer influence how the business is run, while the buyer may have a direct financial interest in taking steps that reduce the earn out payable.

• The duty of loyalty functions primarily to fill gaps in the agreement where it is silent. It cannot require a party to override obligations imposed by public law or company law – such as liquidity requirements or accounting standards – or commitments already made to third parties. Parties are expected to identify and expressly address the key rights and obligations themselves.

• As a general rule, the party alleging a breach bears the burden of proof, in this case the seller. However, considerations of evidential fairness may shift that burden to the buyer. Where unusual transactions occur during the earn out period, the duty of loyalty requires the buyer to keep clear records of what was done and why – and any remaining doubt will be resolved against the buyer.

The Supreme Court's analysis of the two transactions

The sale of Propcap's equity holdings to its own shareholders at 80% of cost was not, in the Court's view, a continuation of normal business operations. The sale was carried out to generate liquidity for bonus payments, not for any commercial reason related to the investments themselves. The Court also found that it had not been established that the shares were sold at market value – a burden that rested on the buyer. Additionally, the bonus payments themselves – made partly within the same financial year as the earn out period and partly in breach of section 15-4 of the Financial Institutions Regulations (Nw.: finansforetaksforskriften) – constituted a breach of the shareholders' agreement's prohibition on changes to the bonus scheme. Mira Mare was accordingly awarded additional earn out of NOK 574,781.

The Supreme Court did, however, reject the seller's claim regarding the write-down. Mira Mare had relied solely on the duty of loyalty as basis for its claim, without alleging breach of the shareholders' agreement. The Court found that Propcap had demonstrated a sufficient accounting basis for the write-down, pointing to market conditions in 2022 and the fact that another shareholder had made a corresponding write-down. Propcap also pointed to discussions with its auditor and a net asset value report. The fact that the write-down was partly motivated by the interests of the other shareholders did not make it wrongful towards Mira Mare, provided there was a proper accounting justification for it.

Key takeaways for transaction parties

• Sellers: Earn out clauses carry implied protections that go beyond the contract's express wording. Even where the agreement says nothing about remedies, a buyer can be held liable for actions that unjustifiably reduce the earn out. That said, sellers should not rely on the duty of loyalty as a backstop – the key protections should be expressly set out in the agreement.

• Buyers: During the earn out period, extraordinary or unusual transactions should either be avoided without the seller's consent or, at minimum, thoroughly documented – particularly where the transaction affects the figure on which the earn out is calculated, or involves related parties. Inadequate documentation may result in the buyer bearing the risk of any resulting uncertainty. Buyers should also use the contract negotiations to expressly carve out any transactions or actions they anticipate needing to take, so that those are not later subject to challenge based on implied loyalty obligations.

• Both: As the duty of loyalty only applies to the extent the earn out-provisions do not regulate the respective situation, the Supreme Court’s decision once again highlights the importance of precise, well-considered earn out clauses. These should set clear standards for how the business is to be run during the earn out period, how assets are to be valued in related-party transactions, which accounting policies apply, and how any disputes about the earn out calculation are to be resolved.

• Both : The earn out in this case was pegged to Propcap's net profit. When negotiating an earn out mechanism, the parties should think carefully about whether to link it to revenue, EBITDA or net profit (as here) – since the choice of metric directly affects the risk profile of the arrangement and the degree to which the buyer's freedom of action needs to be contractually constrained.  

AGP is a law firm specialising in transactions, capital markets and corporate law. Advising on transactions – including the structuring of earn out mechanisms and settlement clauses – is one of our core practice areas.

This article is for marketing purposes only and does not constitute legal advice.

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