Implied Duties in Commercial Contracts: Impact on Earnout Arrangements

Business or share sale transactions often include an ‘earnout mechanism’ for addressing the uncertainty regarding the future performance of a business or assets being acquired. Earnouts typically link part of the consideration (purchase price) to the future performance of the target company following completion, with payment based on pre-agreed metrics or targets. While these arrangements provide a flexible way in which parties may overcome a perceived ‘valuation gap’ in relation to the sale of a business or shares, they can also give rise to legal issues, particularly in relation to the implied duties under commercial contracts.

Earnout drafting is considered well after completion of a transaction and often by people (accountants, lawyers and executives) who were not involved in drafting the provisions. Courts have looked at interpreting earnout provisions relatively pragmatically. Cases provide good guidance on what is uncertain commercial territory and an unsettled area of law.

An earnout is a provision in a sale agreement where part of the consideration (purchase price) for the business is contingent upon the future performance of the target business (often assessed with reference to a financial metric). Earnouts are commonly used when the buyer and seller have differing views on the value of the business or its future prospects, and they seek to bridge this gap by deferring a portion of the purchase price.  They can be particularly attractive to a buyer when purchasing a business that has been valued on a future maintainable earnings basis, to provide some protection if the representation made by the seller as to the ‘maintainability’ of earnings is not substantiated following completion.

Earnout structures can vary but typically involve targets such as revenue, EBITDA or other objective performance indicators (retention of clients / renewal of key contracts). Earnouts may last for a few years following completion of a business or share sale transaction and can be structured in a variety of ways,  including fixed payments, a sliding scale payment arrangement or payments based on the percentage of the relevant target achieved.

Implied duties are obligations that are not explicitly stated in the terms of a contract but are assumed to be part of the agreement due to the nature of the relationship between the parties. These duties can be read into a contract by courts in order to give effect to the parties’ reasonable expectations or to ensure fairness in the execution of the agreement, so that neither party is restricted from being able to reasonably achieve that which they have bargained for.

In the context of commercial contracts, including earnout arrangements, implied duties may arise even where specific terms are not detailed. Two critical implied duties that are often relevant to earnout agreements are:

1. Duty of Good Faith

The duty of good faith is implied in most commercial contracts in Australia.  It is also common to expressly include a general obligation of the parties to act in good faith under the terms of a commercial contract.  In earnout arrangements, this duty obliges both the buyer and seller to act honestly and fairly in the execution of the contract.

For example,  an earnout clause may include a duty that the buyer is expected to continue operating the business in a manner that does not deliberately undermine the agreed earnout metrics.  Of course, business operations are subject to change and there could be legitimate reasons behind a decision to alter business operations in a way that affects the ability of a party to achieve a pre-agreed earnout metric.  In the absence of specific drafting contemplating this situation and the corresponding impact on the value of the earnout consideration, disputes may arise.

In Australia, courts have emphasised that parties to a commercial contract should not act in a way that deprives the other party of the benefit of the bargain. This duty can also require both parties to cooperate in the achievement of the earnout targets and not take steps that would frustrate the achievement of the agreed performance metrics.

The NSW Court of Appeal in Bundanoon Sandstone Pty Ltd v Cenric Group Pty Ltd [2019] NSWCA 87 considered the duty of good faith regarding a show cause notice issued by a principal to a subcontractor, in the context of a termination clause in a construction contract.  Despite having the ability under the contract to issue the show cause notice, the Court held that the show cause notice was not issued in good faith because the issuer had a closed mind when the notice was issued.  Gleeson JA (at [154]) commented on the duty of good faith as follows:

…  where a contractual power is given to one party for a purpose but in terms wider than necessary for the protection of its legitimate interests, the exercise of the power may be constrained by implied obligations of reasonableness and good faith…

While the judgment provides guidance on the application of the implied duty of good faith, each case will necessarily involve an analysis of the facts and the underlying motivation of the party exercising its contractual power to determine whether the duty of good faith applies and if so, whether that duty has been breached.

2. Duty to Cooperate

The duty was described as follows: In Butt v M’Donald (1896) 7 QLJ 68:

It is a general rule applicable to every contract that each party agrees, by implication, to do all such things as are necessary on his part to enable the other party to have the benefit of the contract.

This extract is generally regarded as the foundation authority on the implied duty to cooperate, however subsequent decisions limit the circumstances in which the duty may be implied.  The statement in Butt was endorsed and expanded on by the High Court in Secured Income Real Estate (Australia) Ltd v St Martins Investments Pty Ltd [1979] HCA 51; (1979) 144 CLR 596, at [607-608]:

It is easy to imply a duty to co-operate in the doing of acts which are necessary to the performance by the parties or by one of the parties of fundamental obligations under the contract. It is not quite so easy to make the implication when the acts in question are necessary to entitle the other contracting party to a benefit under the contract but are not essential to the performance of that party’s obligations and are not fundamental to the contract. (emphasis added)

In practice, parties need to be aware that it may be difficult for a party to establish that a duty to cooperate is implied because:

• the duty will not be implied if doing so would be inconsistent with the express terms of the contract; and
• where the duty is implied, it is restricted to only the “fundamental obligations” under the contract and is also limited with reference to the concept of reasonableness.

While an analysis of the express terms of the contract is relatively straightforward, answering the question “what are the ‘fundamental obligations’ under a contract” may not be as simple, particularly where contingent consideration (in the context of an earnout) is involved.

The Victorian Court of Appeal, in Adaz Nominees Pty Ltd v Castleway Pty Ltd [2020] VSCA 201, has also considered the implied duty to cooperate and the closely related implied term framed as a negative covenant which required a party “not to hinder or prevent the fulfilment of the purpose of the express promises” under the contract (citing Peters (WA) Ltd v Petersville Ltd (2001) 205 CLR 126, 142 [36] (Gleeson CJ, Gummow, Kirby and Hayne JJ)).

In Adaz Nominees, the Court ultimately held that payment of a large charitable donation that significantly impacted the remuneration payable to the other party to a contract was a breach of an implied term to do all things necessary to enable the other party to have the benefit of the contract. This had the effect of seriously undermining the value of the contract.  However, in dissent McLeish JA concluded that the duty to cooperate had not been breached because the fundamental contractual promise to pay a service fee had been fulfilled and the contract did not stipulate that the profits or service fee were required to be maximised.

The differing opinions in the Adaz Nominees case highlights the difficulty faced by the Courts  when considering the implied duty to cooperate, particularly in the context of matters which may be considered an “anticipated benefit” under the contract, in contrast to those matters which are considered “fundamental obligations” under the contract.

The duty to cooperate will not be implied info all commercial contracts, and whether the duty can be implied will depend on the express terms of the contract, the fundamental obligations under the contract and whether it is reasonable in the circumstances to imply the duty.

Parties contemplating an earnout arrangement need to be aware of the duties which may be implied under the contract, as earnout arrangements necessarily involve the assessment of future performance and typically require some level of cooperation and good faith of both the buyer and the seller. Below are some common legal issues that arise concerning implied duties in earnout provisions:

• Ambiguity in Performance Metrics
  Earnout provisions often require precise performance targets to trigger payments, but disagreements over how these targets should be measured or achieved can arise. When performance metrics are unclear or ambiguous, Courts may imply a duty to cooperate depending on the circumstances and nature of the fundamental obligations under the contract and clarify the interpretation of these metrics to reflect the true intentions of the parties. If a dispute arises, a court might be more inclined to apply a reasonable interpretation of the earnout clause based on implied obligations of good faith.

• Buyer’s Conduct Affecting the Earnout
  One of the most common areas of dispute in earnout arrangements is the conduct of the buyer post-transaction. If the buyer changes the business’ operations, reduces capital investment, or otherwise acts in a manner that negatively impacts the business’s ability to meet the earnout targets, the seller may argue that the buyer has violated the implied duty of good faith or failed to honour the earnout terms. Without explicit provisions contemplating the change to operations of the business post Completion, if the buyer’s actions are seen as deliberately undermining the performance targets,  it could be argued that this conduct may constitute a breach of the implied duty of good faith.

• Seller’s Conduct in Achieving the Earnout
  On the other hand, the seller may also be subject to implied duties that require them to act in a way that does not artificially inflate the business’s performance to achieve earnout targets. This includes avoiding fraudulent or deceptive practices such as manipulating accounting records or misrepresenting the business’s financial status.  Practically, this is less likely to occur in circumstance where the buyer has control of the business post Completion.

To minimise the risk of legal disputes arising from implied duties in earnout arrangements, parties negotiating a business or share sale agreement that contains an earnout component should consider the following:

• Clear and Specific Earnout Terms: Ensure that the performance metrics and calculation methodologies for earnout payments are clearly defined. Ambiguity can lead to disputes. The importance of concise drafting to include detailed, measurable criteria to reduce uncertainty should not be understated.
• Explicit Provisions for Changes in Operations: Buyers and sellers should address in the agreement the potential for operational changes. Specifically, the parties should outline whether the buyer can alter the course of business post-sale having regard to the agreed earnout metrics and the circumstances under which such changes may ultimately impact the earnout payments.
• Dispute Resolution Mechanisms: To resolve any disputes that might arise, including those related to implied duties, parties should consider including arbitration or mediation clauses in their agreement. These mechanisms can help resolve conflicts more efficiently and avoid prolonged litigation.
• Worked Example: It may be appropriate for the parties to agree upon an example calculation (which may be included as a schedule to the transaction document) which confirms the relevant line items that are to be included in calculating a target or threshold (e.g. what is considered ‘revenue’), sets out how the financial metric is assessed and the basis on which any earnout consideration will be payable.

Implied duties, particularly the duties of good faith and the duty to cooperate, play a crucial role in ensuring the fairness and enforceability of earnout provisions in business and share sale agreements. These duties seek to protect parties from unfair practices that could, in the context of an earnout arrangement, undermine the purpose of the earnout or the value of the transaction. When drafting or negotiating these arrangements, it is essential to clearly define the terms of the earnout,  anticipate potential changes in business operations that could impact performance metrics and clearly set out what these changes mean in the context of the earnout provisions.

This article is not legal advice.  It is intended to provide commentary and general information only.  Access to this article does not entitle you to rely on it as legal advice.  You should obtain formal legal advice specific to your own situation.  Please contact us if you require advice on matters covered by this article.