Key takeaways

• These two recent cases, whilst different in their legal approach to address the issues, reflect a similar theme. They illustrate how what appears to have been drafting imprecisions can lead to disputes (and presumably anxiety in the interim on behalf of the ultimately successful party).
• The cases also demonstrate that parties should hesitate before seeking to take advantage of such drafting imprecisions, as courts are prepared to exercise a discretion to achieve outcomes they consider to be appropriate in all of the circumstances.
• Disputes between transaction parties after completion sometimes occur. Earn-out disputes are a good example of this. Accordingly, earn-out drafting should be approached with care.

In depth

Earn-outs and other deferred consideration mechanisms can operate as a means of "bridging the valuation gap" between buyers and sellers.

They are also a source of potential disputes between the transaction parties following completion of a deal. Drafting to reflect a fair outcome adds complexity, which in turn can give rise to points of dispute.

Earn-out payment where target's assets could change

In Wilson v. QBT Pty Limited,¹ part of the purchase price under a share sale agreement was to be paid at a later date based on a formula, because it was unknown at the time of signing whether the target company would retain an interest it held in a joint venture and the value of the target was uncertain.

Background

The target company to be sold to the buyer held 40% of the shares in an incorporated joint venture (JV). Under the terms of the JV, the change of control of the target resulting from its sale to the buyer was an event of default, which gave the other JV party the right to purchase the target’s shares in the JV.

To address the possible impact of this situation on the target's value, the share sale agreement required the buyer to pay part of the purchase price as a "Deferred Amount" to the sellers. This was expected to be around AUD 4 million, but would vary depending on whether (a) the JV partner gave written consent to the change of control and the target retained its JV shares, or (b) the JV partner did not consent and elected to purchase the JV shares. The "Deferred Payment Date" was a number of days after the earlier of (a) the JV partner giving its written consent, or (b) the JV partner paying for the JV shares.

In the event, none of these provisions were triggered: the JV partner did not expressly consent to the change of control, did not elect to purchase the JV shares and therefore did not pay for the shares. The target retained its shares in the JV, but without the express consent of the JV partner. So, if the definitions of Deferred Amount and Deferred Payment Date were read strictly as drafted, neither limb of either definition applied. The buyer therefore argued that no Deferred Amount was payable.

Decision

The Court found in favour of the sellers and ordered the buyer to pay the Deferred Amount plus interest.

This was not a result of rectifying the terms of the share sale agreement, or finding that additional terms were implied, but simply a decision as to the proper interpretation of the contract, based on well established principles: "The meaning of the terms of a commercial contract is to be determined by what a reasonable businessperson would have understood those terms to mean. … The contract must be construed as a whole."

The Court first noted that the language of the clause appeared to be clear when taken in isolation – that is, it seemed to support the buyer's argument. However, it was difficult to reconcile that language with other terms of the agreement, including terms that the buyer "must" pay the Deferred Amount, without qualifying words such as "if any", and an obligation to pay AUD 4 million into a quarantined account to be used only for payment of the Deferred Amount.

These other terms strongly suggested that the parties intended that an amount of deferred consideration would be paid in all circumstances. The Court found that the buyer's interpretation "produces commercially absurd results. … it makes no commercial sense for the [sellers] to receive nothing if [the target] retains its shares in the JV Company other than as a consequence of written consent from [the JV partner], when the obvious purpose of the Deferred Amount was to compensate the [sellers] for the value of the shares [the target] held in the JV Company”.

The Court held that the definitions of Deferred Amount and Deferred Payment Date should be given effect by "ignoring" the references to whether the JV partner consented to the target's change of control – instead, the amount and timing of the deferred consideration depended only on whether the target retained the JV shares or not. Although this interpretation involved “some violence to the language”, it avoided "commercial absurdity" and was consistent with what the Court considered to be the broader agreement.

Earn-out to address differing performance expectations

In SSABR Pty Ltd v. AMA Group Ltd,² part of the purchase price under a business sale agreement was an earn-out amount to be paid two years after completion based on the target businesses' earnings before interest and tax (EBIT) in that period, namely the "EBIT for the Businesses for the Earn-Out Period".

Background

The sellers argued that this drafting referred to the total EBIT over the two-year Earn-Out Period. The buyers argued that it should be interpreted to mean the average annual EBIT for that period – in other words, half of the amount claimed by the sellers.

Decision

The Court found in favour of the buyer and ordered that the business sale agreement be rectified by adding the words "average annual" before "EBIT" in the earn-out formula.

As in Wilson v. QBT above, the Court first noted that the drafting of the earn-out formula was not ambiguous and meant total EBIT for the two calendar years, not the average EBIT for each year in that period. However, the Court found that it was apparent from the history of negotiations and drafting that this is not what the parties meant.

Unlike Wilson v. QBT, this was not an error that could be remedied simply as a matter of interpretation: the literal meaning of the contractual words was not absurd, and the "objective intention" of the parties as to some other interpretation was not self-evident.

Nevertheless, it is open to a court to rectify an agreement as a matter of equity if there is convincing proof of the parties' actual common intention and proof that this intention is not correctly recorded in the written document. In this case, the parties' common intention was evidenced by an earlier binding heads of agreement that provided for an earn-out based on average annual EBIT, and further evidence suggested that this remained their intention up to the execution of the business sale agreement.

Accordingly, the Court was prepared to exercise its discretion to rectify the agreement to refer to average annual EBIT to accurately record what it considered to be the parties' bargain.

Conclusion

These two recent cases, whilst different in their legal approach to address the issues, reflect a similar theme. They illustrate how what appears to have been drafting imprecisions can lead to disputes (and presumably anxiety in the interim on behalf of the ultimately successful party).

The cases also demonstrate that parties should hesitate before seeking to take advantage of such drafting imprecisions, as courts are prepared to exercise a discretion to achieve outcomes they consider to be appropriate in all of the circumstances.

It is interesting to note that the two cases were decided by different judges in the same Court at a similar time to each other, and the slightly later case did not seem to have had regard to the slightly earlier one. Given the different legal approach adopted to address their issues, not much turns on this, despite the coincidences of their subject matter and their timing.

We understand that appeals have been lodged against both of these decisions, and it will be interesting to continue watching this space.

1 Grant Reid Wilson atf G&L Wilson Family Trust v. QBT Pty Limited [2023] NSWSC 1255.
2 SSABR Pty Ltd v. AMA Group Ltd [2023] NSWSC 1551.