Delaware Superior Court Distinguishes Between Affirmative and Negative Covenants in Earnout Dispute
Under Delaware law, parties may structure covenants in an earnout agreement as affirmative (mandating action) or negative (prohibiting action). Given the important differences in the obligations these types of covenants impose, as illustrated by this decision, parties should carefully consider the contractual language in drafting.
Several years ago, Mitchell International, Inc. purchased a company that developed review and approval processes for reimbursement and insurance claims. Mitchell and the Sellers entered into an earnout agreement that allowed Sellers to earn additional compensation for two years after the sale. The earnout agreement included a covenant that required Mitchell to “avoid” taking actions that would reasonably be expected to materially reduce the amount of the earnout to Sellers. One of the Sellers (Quarum) entered into a two-year employment agreement with Mitchell to assist with the post-closing marketing and business. After Mitchell terminated Quarum and Quarum brought suit alleging that Mitchell had breached the earnout covenant, Mitchell moved to dismiss.
The Superior Court upheld aspects of Quarum’s earnout claim but dismissed others. Specifically, the Court found that the plain language of the relevant covenant created a negative covenant prohibiting positive action. In doing so, the Court declined to read the operative term “avoid” in a manner that would convert the negative covenant into an affirmative one. The Court’s reasoning turned on the plain meaning of the term “avoid” as well as the entirety of the relevant provision, which gave Mitchell the sole authority to direct the company’s strategy and business decisions. Accordingly, the Court only sustained those parts of Quarum’s claim concerning prohibited actions by Mitchell (such as allegedly sabotaging development efforts or diverting customers), but dismissed those parts based on alleged business decisions and strategies that Mitchell did not pursue.Share