Acceleration of an earn-out in a M&A transaction

The decision of the Ontario Superior Court of Justice (the Court) in Project Freeway Inc v. ABC Technologies Inc provides important guidance for parties involved in M&A transactions. Specifically, the decision highlights the importance of clear drafting in preliminary and definitive documents, the significance of initial negotiations and the impact of the parties' conduct on the Court's interpretation of a contractual provision.

Project Freeway Inc. (Seller) sold all its shares of certain companies pursuant to a share purchase agreement (the SPA) to ABC Technologies Inc. (Purchaser), for a base price at closing along with an earn-out payable over the following two years. The earn-out provision required the Purchaser to pay up to an additional US $26 million if the acquired companies met certain specified financial targets. The earn-out provision also included an acceleration clause which stipulated that the full earn-out would become payable if the Purchaser sold a "material portion of the assets" of the acquired companies without the written consent of the Seller.

The Purchaser completed the following two transactions (collectively, the Transactions)

 during the first earn-out period without the Seller's prior written consent:

• The sale leaseback (SLB) transactions: The land and buildings of the acquired companies were sold to arm's length entities which leased them back to the Purchaser
• The factoring arrangement: The Purchaser sold essentially all the accounts receivable of the acquired companies

The only issue for the Court to consider was whether the acceleration clause had been triggered as a result of either of the Transactions. The Seller argued that the Transactions constituted a sale of a "material portion of the assets of the Business" and on a plain reading of the earn-out provision, the acceleration clause had been triggered. The Purchaser argued that within the context of the earn-out provision "material" meant material to the calculation of the earn-out. The Court sided with the Purchaser's interpretation that, in the context of the earn-out, "material portion of the assets of the Business" refers to a sale that would be material to the earn-out and concluded that the Transactions did not impact the operation of the business and therefore were not material. The following three key factors were important to its decision.

First, the Court relied on a non-binding letter of intent (LOI) in considering the surrounding circumstances at the time the SPA was entered into. This was despite an "entire agreement" clause in the SPA which explicitly referenced the LOI. The terms in the LOI that related to the earn-out were consistent with the Purchaser's interpretation.

Second, in the Court's view, language in two other provisions supported the interpretation that "material" meant material within the context of the earn-out regime. One provision permitted the Purchaser to consolidate or merge the acquired companies' facilities with its existing facilities, provided the earn-out targets could still be calculated. The other provision provided the Purchaser with the right to complete mergers or other internal reorganizations without the Seller's consent. The Court concluded that it would be a "commercially absurd" result if the Purchaser was prohibited from completing ordinary course financing transactions, but could complete mergers and other internal reorganizations, or close and consolidate facilities without the Seller's consent.

Third, the Seller was aware of the Purchaser's intent to enter the SLB transactions prior to closing but only raised an objection after the first earn-out target was not met. The Court noted that the parties were sophisticated, and if there was a concern that the full earn-out may be triggered, presumably one of the sophisticated parties or counsel would have raised it when the Purchaser proceeded with these ordinary course financing transactions.

1. Context matters: The Court considered evidence of all surrounding circumstances, including initial negotiations of the parties, when interpreting the purpose of the earn-out provision. In addition, "entire agreement" clauses in the definitive agreement may be ineffective in precluding preliminary deal documents being used as interpretive aids
2. Conduct matters: Knowledge of a transaction and an inaction or delay by a party to raise an issue may impact the Court's interpretation of a provision
3. Consider the effect of negotiations on contract interpretation: Preliminary deal documents may be used by courts as an interpretive aid regardless of any additional phrases included in "entire agreement" clauses. Document the purpose and demonstrate deliberate intention when changing language from earlier negotiations in the definitive agreement
4. Commercial sense matters: Courts will not be receptive of arguments that lead to a significant windfall or a commercially absurd interpretation
5. Draft carefully: To reduce uncertainty and litigation risk, define important terms, clearly specify conditions, and ensure the intention of all parties is consistently drafted throughout various sections of a definitive agreement, especially when drafting provisions that contain triggering events or materiality thresholds. For example, the parties could have added additional language to specify certain transactions that would trigger the acceleration clause under the earn-out provision
6. Add to "entire agreement" clauses: Defend against a court ignoring your intention to exclude preliminary documents as interpretive aids by including additional language in the preliminary documents precluding reliance on the preliminary document in a future dispute. Additionally, include language in the definitive agreement's "entire agreement" clause that reiterates this intention and expressly excludes the preliminary documents.