The pitfalls of poorly drafted earn-out provisions

Earn-out contracts generally contain provisions allowing the purchase price to be paid by an initial payment with the balance by way of adjustable installments.

But what happens if the purchaser frustrates the process of determining the installments by tampering with or putting the data for calculating those installments beyond the seller’s reach?

This situation went to court recently when Macpherson Kelley acted for an insurance client that sold its book to a purchaser who disputed the purchase price calculations in the earn-out contract.

The purchaser paid the initial purchase price of $1.9 million but said it was not liable to pay the balance of a further $1 million, arguing the adjustment determination had not occurred.

It produced evidence from an expert which said – unsurprisingly – that it was not liable to pay any more. By issuing subpoenas to various underwriters, and critically scrutinising the methods used by the purchaser’s expert, Macpherson Kelley was able to discredit the purchaser’s data.

The County Court of Victoria found the earn-out provision was to be interpreted in a way which avoids commercial nonsense, in circumstances where only the purchaser (who controlled the data post-transfer) could avoid paying the purchase price in full, by failing to engage in the determination process in a timely manner or at all, and then effectively putting the data which would enable the process to occur, out of reach.

That commercial imbalance is avoided when the contract was interpreted to include a default mechanism which in effect provided that unless and until the adjustment determination occurs, the subsequent installments are calculated by reference to the initial purchase price calculation appearing in the sale agreement.

The decision was upheld on appeal to the Court of Appeal, where Macpherson Kelley also successfully assisted the client to obtain security for costs and to resist the appellant’s application to stay the effect of the initial judgment pending appeal (which is often granted). Macpherson Kelley then also successfully wound up the purchaser company despite the last-minute appointment of a voluntary administrator by the purchaser in a final attempt to thwart recoveries.

This case highlights that earn-out clauses should be carefully drafted to ensure information required is not controlled entirely by one party.

It also points out the importance of having clear “fall back” positions making earn-out amounts undeniably due and payable where one party is in clear breach of disclosure and reporting requirements and other material post-completion obligations.

This article was written by Nathanael Kitingan, Principal Lawyer, Victoria Nomikos, Principal Lawyer and Daniel Teoh, Associate – Litigation and Dispute Resolution.