Contingent Payment Installment Sales - A Seller's Dilemma
Kristian A. Werling | Richard B. Smith
More than 80 percent of all deals in the pharmaceutical, medical device and biotech industries include an earnout structure that provides some type of contingent or delayed payment of proceeds to the sellers (2012 SRS Life Sciences M&A Study). Trends vary widely, but in many transactions, the earnout consideration can far exceed the up-front payment to the sellers. This earnout consideration is frequently contingent on post-closing achievement of certain clinical study results, product approvals, reimbursement or sales. As a result, sellers during transaction negotiations intensely focus on the obligations of buyers to use corresponding “diligence” to achieve the goals that will trigger the contingent payment to the seller. This focus frequently comes to rest on the obligation of a buyer to use “commercially reasonable efforts” and the related definition of this obligation in transaction documentation. This article reviews the common approaches to defining “commercially reasonable efforts” and analyzes several recent cases interpreting the definitions in deal documentation.
Common Approaches to Defining Commercially Reasonable Efforts
Outward Facing Definition
An outward facing definition of commercially reasonable efforts applies an industry-standard requirement or looks to other participants in the industry to define the diligence obligations of the buyer. An example of this type of definition is:
“Commercially Reasonable Efforts” means the efforts consistent with the past practice of similarly situated pharmaceutical companies with respect to similarly situated pharmaceutical products.
This definition is generally viewed as more favorable to the seller of a technology, as it enables the seller to point to other industry standards that would have the buyer take additional steps to achieve the goal that would result in a payout on the earnout.
Inward Facing Definition
In contrast, an inward facing definition applies the buyer’s own standard for undertaking research, regulatory approvals, and sales and marketing efforts. An example of an inward facing definition of commercially reasonable efforts is:
“Commercially Reasonable Efforts” means efforts consistent with the past practice of Buyer related to research and development, regulatory approval, commercialization, sales and marketing of similar oncology therapeutic products with similar market potential at a similar stage in its development.
This definition is more favorable to a buyer because it allows the buyer to point to its own investment thresholds and decision processes. Buyers can typically point to a similar situation where a step or expenditure of funds would not have been taken.
An option for buyers and sellers is to leave the term undefined. In the event of a dispute, a judge or mediator would look to case law and the facts of the situation to determine whether the appropriate level of diligence was utilized. It should be noted, however, that some states’ courts (most notably, Illinois) have interpreted terms such as “best efforts” and “commercially reasonable efforts” to be so vague as to be unenforceable. (See Kraftco Corp. v. Kolbus, 274 N.E.2d 153, 156 (Ill. App. Ct. 1971).) For an excellent discussion of courts’ varying interpretations of different due diligence standards, including commercially reasonable efforts requirements, see Kenneth A. Adams’ article.
Many transaction documents incorporate mandatory arbitration provisions. In fact, sophisticated buyers understand that there are frequently dramatic changes post-closing related to medical products and, therefore, include a variety of structures to amicably settle earnout related disputes outside the courtroom. As a result, most disputes related to diligence obligations are handled out of court, which results in a limited number of cases that directly address the interpretation of commercially reasonable efforts obligations. Two recent cases, however, have given insight to judges’ review of these obligations.
In Banas v. Volcano Corp., the former owners of CardioSpectra, Inc. challenged whether Volcano Corporation used appropriate diligence to develop and sell CardioSpectra’s medical device system. Banas v. Volcano Corp., 2014 WL 1309720 (N.D. Calif. 2014) The merger agreement required Volcano to use “commercially reasonable efforts” and to “act in good faith” when working to achieve the goals that would result in additional merger consideration payable to the former shareholders of CardioSpectra. The merger agreement defined commercially reasonable efforts as:
… the use of efforts, sales terms, expertise and resources normally used by [Volcano] for other products, which, as compared with the OCT Products; are of similar market potential at a similar stage in its development or product life, taking into account all reasonable relevant factors affecting the cost, risk and timing of development and the total potential of the applicable OCT Products, all as measured by the facts and circumstances at the time such efforts are due …
The definition used in the CardioSpectra merger agreement was inward facing and required the sellers to demonstrate that commercially reasonable efforts were not used compared with efforts made for other similarly situated Volcano products. The court granted summary judgment to Volcano because the sellers failed to present any evidence that demonstrated Volcano’s efforts with similarly situated products. The judge determined that without such evidence, the sellers could not make claim for breach of the merger agreement.
In addition to addressing commercially reasonable efforts, the judge examined whether Volcano failed to act in good faith in development efforts. The merger agreement did not define act in good faith, so the court looked to case law to determine the standard. Examining the evidence, the court found that Volcano had expended significant resources, hired sufficient personnel and had not willfully abandoned the development of the CardioSpectra system. As such, it determined that Volcano had not breached the merger agreement by failing to act in good faith.
Sekisui/America Diagnostica, Inc.
Also in the first quarter of 2014, a judge examined counterclaims in a lawsuit brought by Sekisui America against the former shareholders of America Diagnostica, Inc. (ADI). Sekisui America Corp. v. Hart, 2014 WL 687222 (S.D. NY 2014). In counterclaims against Sekisui, the former shareholders of ADI alleged that Sekisui America had breached the stock purchase agreement by failing to use “commercially reasonable efforts” and omitting actions “with the intent of preventing [ADI] from meeting … revenue targets …” The term commercially reasonable efforts was not defined in the stock purchase agreement.
The court found that the sellers had failed to prove a breach of the diligence obligations because they did not present evidence establishing the objective standard for commercially reasonable efforts in the regulatory context of the U.S. Food and Drug Administration, nor did they explain how Sekisui America deviated from that standard. Further, the court found that there was no evidence demonstrating that Sekisui America intentionally omitted actions to prevent the revenue targets from being met.
Tips and Takeaways
Inward Facing Definitions Add Hurdles for Sellers
As demonstrated by Volcano, an inward facing definition of commercially reasonable efforts adds significant hurdles for the sellers attempting to prove that diligence requirements were breached.
Additional Requirements to Use “Good Faith” Should Be Defined
Sometimes drafters will toss in additional references or requirements to use good faith in the diligence obligation section of an M&A document. Such terms should be cautiously used because, as seen in both Volcano and Sekisui America, this allows a seller to further attack the buyer’s effort. If good faith is an obligation of the buyer, consider defining the requirement further.
Define the Impact of a New Technology Acquisition
Acquisition documentation frequently fails to address the impact of newly acquired technology. If it is not specifically addressed in the document, courts will be left to discern the intent of the parties if a new acquisition is made that impacts existing diligence or milestone obligations. Ideally, a buyer would have a clear statement that the acquisition of a new technology involving the same therapeutic area is permitted.
Business Teams Should Be Aware of Implications of “Shelving” the Acquired Technology
Although not examined in either Volcano or Sekisui America, other litigation and mediation involving diligence obligations have shown that sellers can win large damage awards if the buyer’s business team “shelves” or otherwise abandons an acquired technology where the acquisition documentation included a diligence obligation. It is worth the additional time and effort to avoid protracted litigation to establish strong documentation as to why development, regulatory or sales efforts related to a technology were shelved.
Consider the Impact of Specific Diligence Milestones
In addition to requiring a buyer to use commercially reasonable efforts, sellers will often require a buyer to meet certain specific diligence milestones, regardless of whether buyer is using commercially reasonable efforts. The diligence milestones are typically key product development or commercialization events, and will often trigger one or more earnout payments. A buyer’s failure to achieve a milestone may result in breach of its obligations to a seller, even in the event that a buyer was otherwise using commercially reasonable efforts to meet such milestone.
Buyers Should Consider the Benefit of Safe Harbor Provisions
In the event that the buyer satisfies a specified milestone in a timely manner, a safe harbor provision can deem a buyer to have used commercially reasonable efforts in achieving such milestone. This will relieve the buyer of all or part its obligation to use commercially reasonable efforts. Such milestones may include development achievements, regulatory approvals or financial events such, as net sales achievements. Preferably, a buyer will want to negotiate optional safe harbor events that, if met, will demonstrate the buyer’s use of commercially reasonable efforts without creating mandatory obligations.
Consider Third Party Diligence Obligations
Buyer should be aware that, to the extent that it acquires intellectual property through a sublicense issued by a seller (i.e., seller has in-licensed intellectual property from a third-party licensor), the seller may have its own diligence obligations it owes to its third-party licensor that will need to be satisfied to retain its in-license. It is also likely that, with respect to the technology sublicensed to the buyer, the seller will rely on the buyer’s diligence to satisfy the seller’s obligations to its licensor. Therefore, the seller’s hands may be tied when it comes to negotiating a buyer’s diligence obligations and remedies. If such diligence obligations and remedies are unacceptable to the buyer, the only acceptable alternative may be for the seller to renegotiate its diligence obligations with the third-party licensor.
Define Specific Circumstances Under Which Buyer Will Be Excused
Despite good faith intentions, events can occur that make unreasonable the continued use of commercially reasonable efforts. In addition to force majeure, such events can include failure to obtain regulatory approval as expected, unexpected safety concerns, unexpected market shifts or unfavorable commercial circumstances that adversely affect product viability, and inability to obtain commercially viable reimbursement levels. It is best to anticipate the possibly of such events and provide reasonable tolling and other remedial provisions.
If a buyer and seller agree that no specific diligence standard will be required (i.e., the buyer will not be required to use commercially reasonable efforts, or any other level of efforts for that matter), the agreement should include a disclaimer on point. It is otherwise too easy for a court to imply at least some level of good faith efforts into the agreement that were never intended or agreed to by the parties.
Identifying and Mitigating Liabilities in Medical Device M&A
Parties have increasingly looked to earnouts or contingent payments to bridge any gap in value between the buyer and seller and to incentivize target owners who continue to work in the business post-closing. Subject to certain exceptions, if these earnouts or contingent payments are to be received in a taxable year after the sale year, they are viewed as a form of deferred consideration, which may be eligible to be reported for U.S. federal income tax purposes on the “installment method.” We address how the tax rules treat contingent payment sales that are reported on the installment method and highlight a few important considerations for sellers as they analyze whether to elect out of the installment method or otherwise take affirmative actions to structure the deal to avoid application of the installment method.
The Installment Method
The installment method is an option for certain sellers to defer reporting taxable gain until payments are received in connection with the sale of certain types of property. A seller may elect out of the installment method and recognize gain in the year of the sale in an amount equal to the excess of (i) the total consideration received, including the full fair market value of any installment obligation received (including the fair market value of the right to receive any contingent payments), over (ii) the seller’s basis in the property sold. If a seller elects out of the installment method and does not receive the full amount estimated as the fair market value of the installment obligation (including any right to receive contingent payments), the seller is not permitted to recompute the amount of income recognized in the year of sale. Instead, the seller may only take a loss (generally, a capital loss) when it is ultimately determined that the installment obligation is worthless.
The installment method generally provides that each payment received by the seller in a taxable year subsequent to the sale year is comprised of three parts: a partial return of the seller’s basis in the property sold, a portion of the gain recognized on the sale and interest. When a seller reports a transaction on the installment method, the timing of the basis recovery is dependent upon the terms of the deferred consideration. When either the selling price of the property or the time period over which the deferred payments are to be received is fixed, the seller generally recovers its basis in the property sold ratably and reports the associated income in the year in which the payments are received. The rules are significantly more complex, however, when both the timing and the amount of any deferred payments is not known.
Contingent Payment Installment Sales
If a seller can compute the maximum possible amount that could be received in an installment sale (e.g., when an earnout is capped at a fixed dollar amount), the seller is required to compute the taxable gain when a payment is received based upon an assumption that the seller will actually receive the maximum possible amount under the agreement. If less than the stated maximum selling price is received, this method defers the seller’s recovery of basis, as compared to a scenario where the full payment schedule is known.
If there is no stated maximum selling price but the time period during which payments will be received is fixed (e.g., when an uncapped earnout is scheduled to be paid following each of the three fiscal years following closing), a seller may only recover the basis in the property sold in equal annual increments during the scheduled time period of payments. In a typical situation where the payments received by the seller are front loaded, this method can result in a significant acceleration of taxable gain.
Finally, if there is no stated maximum selling price nor a fixed time period during which payments will be received (e.g., when an uncapped earnout is contingent on the achievement of certain milestones rather than payable during a fixed time period), the seller may only recover basis in the property sold in equal, annual increments over 15 years. Once again, when the payments received by the seller are front loaded, this method of basis recovery may result in a significant acceleration of taxable gain.
If the gain recognized with respect to a particular sale pursuant to the application of these rules will distort the seller’s income over time, the seller may seek a ruling from the Internal Revenue Service (IRS) to permit an alternative means of basis recovery or apply an “income forecast” method, with respect to the sales of certain types of property (e.g., mineral property, motion picture film, television film or taped television show).
Interest Charge on Installment Obligations in Excess of $5 Million
If, at the end of a particular taxable year, a seller holds installment obligations that, in the aggregate, exceed $5 million, the seller is required to pay an additional tax akin to an interest charge on the tax liability deferred as a result of the installment method. If an installment obligation is not contingent, interest is generally payable at the federal short-term rate (currently 0.32 percent) plus 3 percent on the product of (i) the maximum capital gains rate in effect for the seller and (ii) the amount of gain deferred with respect to the portion of the installment obligation that exceeds $5 million. Thus, if a seller sold property with a basis $800,000 in exchange for an $8 million installment obligation, for each taxable year during which such installment obligation remained outstanding, the seller would be required to pay interest on the product of (i) maximum capital gains rate applicable to the seller, currently 20 percent for individuals and 35 percent for corporations, and (ii) $2.7 million (three-eighths of the total $7.2 million gain). Depending on how the deferred consideration is structured, this interest charge can significantly reduce the present value of the seller’s net after-tax cash proceeds.
Interest Charge on Contingent Payment Installment Obligations
When the installment obligation does not provide for the payment of a fixed amount, the application of this interest charge is not clear. The Internal Revenue Code directs the U.S. Secretary of the Treasury (Secretary) to prescribe regulations as may be necessary to carry out the interest charge provisions in the case of contingent payments. However, the Secretary has not yet proposed or promulgated any such regulations in the 26 years that have passed since the provisions were enacted.
Assuming that contingent payment installment obligations are subject to the interest charge provisions (despite the fact that no regulations have been issued) a seller could assert that the formula to compute the amount of the interest charge yields zero because the face amount of a wholly contingent installment obligation is undefined. The IRS, however, has asserted that even without any regulations, contingent payment installment sales are subject to the interest charge provisions. In support of its position, the IRS has argued that failing to apply the interest charge provisions to contingent payment installment obligations would result in sellers who elect out of the installment method and are required to value and report contingent payments in the year of sale paying more tax than sellers who use the installment method to defer their tax liability.
Informal IRS Guidance on Contingent Payment Installment Obligations
Although the IRS has been clear in its position that the interest charge provisions should apply to contingent installment obligations, it has been much less clear in defining how the provisions should apply. In the absence of regulations, the IRS has asserted that sellers may use any reasonable method of calculating the deferred tax and interest on the deferred tax liability with respect to contingent payment installment obligations.
In informal guidance, the IRS has indicated that sellers may report (and pay on a current basis) the interest charge based on an assumption that the maximum amount will be received under the installment obligation. Alternatively, sellers may simply wait and use the amounts actually received to calculate the actual amount of tax deferred and use that amount as the basis upon which the interest is computed and paid (the look-back method). Paying the interest charge on a current basis, while assuming that the full amount of any contingent consideration will be received, accelerates payments to the IRS when cash may not be available from the sale and could also result in interest being paid on amounts never received. This could significantly reduce the present value of the after-tax proceeds to the seller; hence, the remainder of this discussion focuses upon the application of the look-back method.
Application of the look-back method should account for the benefit of the $5 million threshold amount that is excluded from the interest charge provisions. Because the total “face amount” of a contingent payment installment obligation cannot be determined for purposes of determining the amount by which the face amount of the installment obligation exceeds $5 million, the IRS suggested that a seller treat the first $5 million of payments received after the year of sale as exempt from the interest charge provisions. The tax liability attributable to the gain on payments received in the year(s) subsequent to the year of sale in excess of $5 million is subject to the interest charge.
With respect to these subsequent payments, the deferred tax liability is determined by multiplying the portion of the payments received that represents gain (the total amount of the payments received less any imputed interest and the amount of the basis in the property sold that is allocable to the taxable year) by the maximum capital gains rate applicable to the seller. This deferred tax liability is then multiplied by the relevant rate in effect for the month with or within which the taxable year ends to obtain the amount of interest due. Additional interest on the interest is calculated for the period beginning on the due date of the seller’s return for the taxable year in which the sale occurred and ending on the due date for the seller’s return for the taxable year immediately preceding the taxable year in which the relevant principal payment was received (the interest period).
Although arguably this method for applying the interest charge provisions to contingent payment installment obligations is reasonable, it has only been discussed by the IRS in informal non-precedential guidance. As a result, sellers should be wary as they consider applying it to their own circumstances because there is nothing that binds the IRS to this method.
Takeaway—Choosing a Method
A seller who accepts contingent consideration should carefully consider the manner in which the seller intends to report the transaction for tax purposes. If the seller elects out of the installment method and takes into income any deferred consideration in the year of sale, the seller must be prepared to report as income the fair market value of any right to receive contingent payments. By electing out of the installment method, however, the seller will not be subject to the interest charge provisions. If the amount reported as income with respect to the contingent consideration is not ultimately received, the seller should understand that the only recourse may be to report a capital loss when the installment obligation is ultimately determined to be worthless.
If, on the other hand, the seller decides to report the transaction on the installment method, the fair market value of the right to receive the contingent payments does not need to be determined. The seller must instead evaluate the application of the interest charge provisions. If the seller does not apply an interest charge with respect to the contingent consideration, the IRS could challenge that position. If the seller takes a more conservative approach and uses the look-back method to apply the interest charge provisions, the IRS should be less likely to challenge the approach because it has acknowledged the reasonableness of the look-back method in informal guidance. Nevertheless, the seller should be aware that there is no precedential guidance authorizing the look-back method.
As sellers agree to accept contingent consideration, they should be aware of the options available to report any income associated with the sale and ensure that, regardless of the manner in which they intend to report the transaction for income tax purposes, the structure does not give rise to any unanticipated tax risk. There may be alternative structures for the transaction that result in greater certainty as to the present value of the seller’s after-tax proceeds.