In a decision with implications for M&A deal structuring, the Delaware Superior Court’s Complex Commercial Litigation Division, in Prosser, et al. v. Pharmalogic Holdings Corp., allowed sellers to proceed with a breach of contract claim alleging that a buyer deliberately manipulated operations to avoid triggering a $6.6 million earnout payment. The decision underscores that courts may look beyond the face of routine business decisions when the timing and circumstances suggest possible bad faith. This is especially true at the pleading stage, where the court is required to accept the plaintiffs’ allegations as true and draw reasonable inferences in their favor.

The Deal and the Dispute

The founders of a nuclear pharmacy business (the “Sellers”) sold their company to PharmaLogic (the “Buyer”) under a securities purchase agreement (the “SPA”) that included a contingent payment: if the business’s EBITDA reached a specified threshold during the earnout period, the Sellers would receive an additional $6.6 million. The agreement required the Buyer to operate the business in good faith and to refrain from actions designed or intended to impede EBITDA.

The Buyer ultimately delivered an earnout statement to the Sellers reporting an EBITDA of $6.8 million—just $200,000 below the earnout threshold. Following months of dialogue and exchanges of information among the parties, the Sellers alleged a pattern of suspicious changes in the business during the applicable earnout period: increased bad-debt charges tied to altered accounting practices, expenses incurred in implementing a new 401(k) matching program, sales bonuses, and a costly supplier switch. These changes, the Sellers alleged, were designed to depress EBITDA just enough to avoid the earnout payment. After years of attempting to resolve the dispute, certain of the Sellers sued the Buyer for: (i) breach of Section 2.6(e) the SPA (the provision providing that the Buyer would operate the business in good faith and not interfere with its EBITDA); (ii) a declaratory judgment that the Buyer breached the SPA and that breach relieved Sellers of the obligation to follow an independent auditor provision in the agreement, and that Sellers were entitled to certain additional financial information; and (iii) breach of the implied covenant of good faith and fair dealing or unjust enrichment in connection with allegedly retaining tax returns for pre-closing overpayments.

The Court’s Holding

Breach of contract claims survived. The court refused to dismiss the Sellers’ core breach of contract claim in favor of the SPA’s independent auditor provision, finding that the Sellers adequately pleaded a breach of the earnout covenant to operate the business in good faith. The court emphasized that the real question was why the Buyer took certain actions—a question of intent that belongs before a judge, not an auditor, and should be assessed with the benefit of discovery.

Dispute resolution clause read narrowly. The agreement’s auditor clause covered only disputes over “amounts” in the earnout statement. The court held that questions about the Buyer’s state of mind, whether the Buyer supplied adequate information supporting the earnout calculation, and operational decisions which allegedly impacted EBITDA, fell outside the narrow delegation to an auditor and, under these circumstances, were legal questions for the court.

Discovery was necessary for statute of limitations analysis. Buyer argued that the Sellers’ breach of contract claim was barred by Delaware’s three-year statute of limitations, while Sellers argued that the statute of limitations was tolled by the inherently unknowable injury doctrine.  The court found that factual issues prevented resolution, at the motion to dismiss stage, of whether the Sellers were on inquiry notice of the Buyer’s breaches before Sellers received the earnout statement.

Declaratory judgment claim was dismissed in part. The court found that the Sellers were not entitled to a declaration that the auditor provision in the SPA no longer bound them because they continued to operate as though the SPA was still in effect. In so doing, the Sellers waived any power to seek to have their obligations under the SPA lifted (including terminating the same) by reason of the Buyer’s alleged breach. The court further found that the only portion of the Sellers’ declaratory judgment claim it could address is the question of whether the Buyer’s failure to provide certain financial information constituted a breach of the SPA; however, such a declaration could not provide Sellers with any substantive remedy because Sellers’ claim was not styled as breach claim for damages. The court ordered the parties to meet and confer regarding how Sellers’ declaratory judgment claim should proceed.

Implied covenant and unjust enrichment claims were dismissed. In a separate dispute over tax refunds, the court dismissed the Sellers’ implied covenant and unjust enrichment claims. Because the agreement contained detailed tax provisions and thus indicated the parties anticipated tax issues, the court found that tax overpayments were foreseeable and should have been addressed explicitly. The implied covenant does not fill gaps the parties should have anticipated. With respect to unjust enrichment, the court found that because the SPA comprehensively addressed the treatment of pre-closing taxes, it could not fail to adequately address the parties’ rights and duties regarding tax issues. The unjust enrichment claim failed for the same reason as the implied covenant claim: the parties could have included a tax refund provision but did not do so.

Key Takeaways

• Intent matters more than form. Even facially legitimate operational changes—new benefits, supplier decisions, and accounting adjustments—can support a breach of contract claim if they are made during an earnout period with suspicious timing and motive, at least at the pleading stage.
• Draft ADR clauses with precision. Courts will read dispute resolution provisions, particularly independent auditor or accountant provisions, narrowly. If a contract sends “amount” disputes to an independent auditor or accountant, do not expect that mechanism to necessarily cover broader claims concerning good faith, intent, and entitlement to books and records. Consider whether operational and intent-based disputes need separate resolution paths.
• The implied covenant will not save foreseeable omissions. If a contingency is reasonably anticipatable, such as a tax overpayment or refund, address it explicitly in the contract. Delaware courts will not use the implied covenant to fill gaps the parties should have seen coming.
• Continuing to perform after breach may constitute waiver. Sellers who learn of a potential breach but continue performing under the contract risk waiving their right to terminate it or otherwise avoid their contractual obligations. They should act promptly and preserve rights expressly.
• Statute of limitations questions may survive early dismissal. Courts are reluctant to resolve statute of limitations issues at the pleading stage when inquiry notice turns on facts that require discovery, particularly where the plaintiffs had limited post-closing access to information.