J&J’s Billion-Dollar Appeal Aims Spotlight at ‘Litigation Trap’

Johnson & Johnson’s bid to erase a record $1 billion court loss is spotlighting a deferred-payment transaction structure that continues to tempt dealmakers despite its tendency to spawn high-stakes litigation.

The decision set for review Wednesday by Delaware’s supreme court held the pharmaceutical giant liable for breaching a pledge to prioritize surgical robots it acquired when it bought Auris Health Inc. for $3.4 billion. The ruling was the largest ever in a dispute over the contingent payments known as “earnouts,” the focus of a litigation wave flooding the state’s elite business tribunal.

The provisions are designed to help close transactions stalled on the 1-yard line over divergent valuations, particularly toward startups with untested products that could shoot the moon or fizzle out.

It “sounds like a great idea at 3 a.m.,” according to Boston College law professor Brian Quinn. But putting the fate of the payments in the hands of the party responsible for them is a recipe for a court battle, he said. The sentiment echoed a 2009 quip by a Delaware Chancery Court judge who said earnouts convert “today’s disagreement over price into tomorrow’s litigation.”

“My general advice for anyone thinking of doing an earnout is to run away,” Quinn said.

‘Weird Incentives’

Recent earnout decisions include a $181 million ruling against an AstraZeneca Plc affiliate and a $50 million loss by Arthur J. Gallagher & Co., while earnout lawsuits filed this year alone cover a popular video game, a tequila brand associated with George Clooney, and Vanguard Group Inc.'s first ever acquisition.

The provisions were traditionally geared toward the biotech sector, where the difference between a blockbuster and a money pit is rarely clear in advance.

They’re now finding their way into all manner of transactions as shortcuts to “bridge the valuation gap"—between buyers and sellers—driven by interest rates, inflation, supply chain concerns, and President Donald Trump’s trade wars.

Earnouts are useful for pharma deals, which are “more about the uncertainty on all sides—is this product going to be a home run?” said Haynes & Boone LLP partner Zachary Jacobs. “But it’s becoming a bit of a litigation trap.”

The clauses are appearing in run-of-the-mill transactions without the valuation challenges of pre-clinical drugmakers, according to Ambrose Lazarow PLLC partner Jonathan Lazarow. In those instances, the stakes are low enough that disagreements usually settle out of court, said Foundation Law Group LLC partner Armen Martin.

The structure can create “weird incentives,” according to Quinn: Satisfied sellers may view earnouts as gravy, while buyers sometimes pay them—despite missed milestones—to avoid alienating stockholding employees.

Those dynamics explain why the earnouts that prompt court fights—the J&J case, a lawsuit filed in December seeking $450 million from Bristol-Myers Squibb Co., litigation over a $1.5 billion Nestlé SA deal—usually involve big numbers. There’s enough money on the table “to offset litigation costs, and both sides have dug in,” Martin said.

Earnout deals also often involve founders bidding farewell to “a labor of love,” said Widener University law professor Geeta Kohli. “It’s partly financial,” but if a conglomerate buys a lifesaving invention just to bury it, “there’s going to be some anger there,” she said.

Commercially Reasonable Efforts

The J&J lawsuit said it misled Auris about how it would allocate resources between the deal’s flagship product and a rival robot. J&J allegedly held a rigged “faceoff” between the two, then cannibalized funds it had pledged to the Auris platform.

Vice Chancellor Lori W. Will sided with Auris last year. Although $2 billion-plus hinged on the regulatory process, J&J “almost immediately” breached its promise to pursue approvals with “commercially reasonable efforts,” she said. Will also ruled J&J breached the implied covenant of good faith and fair dealing—a doctrine meant to stop parties from exploiting contract loopholes—and committed fraud involving a second Auris device.

“Efforts” clauses, a recurring theme of earnout deals, function as a form of insurance for buyers, an enforceable guarantee that payment milestones aren’t empty promises, according to Martin. Although there are two major subspecies of earnout disputes—buyer’s remorse and fraud—breaches of an efforts clause often form the basis for liability.

Corporate directors, investment bankers, and attorneys devote significant energy to parsing commercial best efforts, reasonable best efforts, commercially reasonable best efforts, and so on. Delaware’s judges, however, may see those permutations as distinctions without a difference.

Drafters are “very passionate about their hierarchy of efforts,” Will said earlier this year in New Orleans, but “for the most part we view the efforts standards as exactly the same. It’s heartbreaking, right?”

Flexible Approach

While Delaware’s judges “respect the ability of sophisticated parties to agree to a specific standard,” Jacobs said, they’ll seek “creative routes to liability” if they suspect milestone sabotage.

The judges are applying the flexibility they’re famous for—honed in the fact-intensive fiduciary duty context—to efforts clauses that can be just as slippery.

J&J has argued Will’s misinterpretations of the efforts clause “infected” her entire ruling. In citing the implied covenant, meanwhile, she “rewrote” the contract, threatening deals across the board by sowing “doubts that courts will enforce earnout provisions,” the company says.

But an approach focused on “the spirit of the deal” has already begun to sink in with corporate planners, who are now “putting more meat on the bones” of efforts clauses “to limit future reading-between-the-lines,” Jacobs said.

Buyers are starting to insist on terms restricting what they have to consider when deciding how vigorously to pursue milestones, while sellers are negotiating for guardrails against competing products.

Still, while specificity never hurts, “it’s impossible to cover every single unexpected scenario,” Kohli said.

Will, too, has warned against taking the details too far. “When you’re writing these two-page-long clauses, think about me,” she said in New Orleans. “Short sentences, plain English, and everything will go much more smoothly.”