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An ‘earn-out’ tale revisited

10 May 2019 - By John Horner

As a sequel to the article entitled “A tale of two earn-outs” (LawTalk 922, October 2018, page 22) this article considers The Malthouse Ltd v Rangatira Ltd [2018] NZCA 621 in which the Court of Appeal overturned the High Court ruling ([2018] NZHC 816).

Although the High Court was prepared to consider “commercial common sense” to assist in correcting an apparent drafting oversight, the Court of Appeal insisted on applying the disputed clause as written. The relevant aspects of the disputed clause read: “If … [an exit event] … occurs … then the [additional amount] shall become immediately due and payable.”

Rangatira argued that the exit event was required to occur within a certain time period, referred to elsewhere in the agreement as “prior to the Contingent Sunset Date”. Those words were not included in, or otherwise incorporated into, the disputed clause. Churchman J in the High Court found the most sensible commercial interpretation was that the parties intended the temporal limitation to apply even though the disputed clause did not include it.

Images of a building exit sign

Miller J, in his reasons for a unanimous judgment of the Court of Appeal, summarised the current law on contractual interpretation in New Zealand. In doing so he noted that where there is a natural and ordinary meaning to the term in issue, departing from it for reasons of commercial common sense should only occur “in the most obvious and extreme cases”.

From this, the key issue for the Court of Appeal to determine was if the absence of any reference to the Contingent Sunset Date in the disputed clause was so obvious and extreme that it justified a “commercial interpretation” (as opposed to a literal interpretation). If the answer to that question was positive, the court would then need to determine what the commercial interpretation should be.

The Contingent Sunset Date was a defined term in the agreement and used for the purpose of determining if the additional amount (the earn-out payment) was payable or not having regard to the financial performance of the business. The disputed clause was a secondary provision concerning payment of the additional amount in the event that the business was sold, or similar. In that clause the Contingent Sunset Date was not used.

Relevance of drafting note

In engaging in the interpretation exercise, both courts considered the relevance of a drafting note made alongside the disputed clause by a lawyer in the course of negotiations. The drafting note read “not anticipated but inserted for completeness”.

The High Court found that it was the likelihood of a sale of the business in the short term that was ‘not anticipated’ whereas the Court of Appeal found the “obvious explanation” was that the drafter of the note considered the primary trigger of the earn-out would be satisfied and so the secondary trigger would not be relevant.

In the author’s view this finding is both unnecessary and speculative. It would have sufficed to say that the drafting note simply did not add clarity or meaning to how the disputed clause should be interpreted and so little or no evidential weight should be given to it.

The Court of Appeal also disagreed with the High Court’s finding that the purpose of the disputed clause was to establish an agreed value at a particular date and not at an indefinite time in the future. As a consequence, the earn-out amount was held to be payable by Rangatira no matter when in the future the exit event occurred, dismissing any concern about an open-ended contractual obligation.

Finally, the Court of Appeal swiftly rejected the argument that the temporal limitation should be an implied term. This conclusion was reached through consideration of the impact on the balance of the bargain struck. The natural meaning of the disputed clause required no additional interpretive machinery and any implied term was far from being so obvious as to go without saying.

Drafting earn-out clauses

As any transactional lawyer can attest, drafting earn-out clauses requires a level of foresight about what eventualities may or may not affect the future payment obligations of a purchaser or investor, having regard to the relevant circumstances.

The objective is to address all reasonably likely scenarios, including any future sale or disposal of the business. There is an inevitable conflict of interest between the investor or purchaser’s interest in operating and owning (or on selling) the business they have invested in or purchased, and the ongoing interest of the founding shareholders or vendor in the earn-out payment.

In the author’s experience a provision that requires the investor or purchaser to pay an earn-out amount beyond the agreed earn-out period is highly unusual. In this judgment, the Court of Appeal has put the onus squarely on the parties and their lawyers to get the drafting right to give effect to what is intended. It is clear that the willingness of courts to look beyond the words of the contract has its limits, regardless of how unusual the outcome might be.

John Horner johnhorner@quiggpartners.com is a partner at Quigg Partners, specialising in mergers and acquisitions. He was assisted in writing this article by Julia Marshall-Mead.

Last updated on the 10th May 2019