Source: Daily Journal
You’ve recently closed a merger, representing the seller in a deal that netted your client — and you — a good bit of cash. And you clink glasses a second time because there is, potentially, much more coming: in addition to the up-front payment your client received for the sale of the company, your client could receive a hefty sum in the future if the buyer achieves certain milestones. You like your chances: not only does the buyer have a direct interest in making enough sales to reach that milestone, but even if the buyer decided it no longer had such an incentive, it is still required to use “commercially reasonable efforts” to try to achieve that milestone.
You had insisted on the inclusion of an “efforts” provision to protect your client’s interest, and, two months after the deal, you are glad you did — the buyer has suddenly abandoned all efforts to achieve the milestone, and appears to have diverted its resources into a different project that it believes will be more lucrative. Your client sues for breach of the efforts provision, seeking the milestone payment as damages. The breach is so glaring that the buyer barely tries to dispute it at trial. But you lose! Your client recovers zero damages because you failed to prove causation — that, had the buyer used commercially reasonable efforts, achievement of the milestone would have been “reasonably certain” (the standard for proving that a breach caused damages in California — see US Ecology, Inc. v. California 129 Cal. App. 4th 887, 909-10 (Cal. Ct. App. 2005).
The nature of “efforts” clauses (“best efforts,” “reasonable efforts,” “best commercial efforts,” “commercially reasonable efforts,” etc.) is that they often support milestones that are far from guaranteed, or even that might pose a significant challenge. In such situations, your “efforts” clause could actually be a blank check for the buyer to abandon efforts altogether, confident in the improbability of your proving actual damages at trial. It seems odd to call the basic causation element of a contract claim a “loophole,” but that’s what it becomes in the context of “efforts” provisions that support any moderate-to-difficult milestones that are not yet close to being achieved when the breach occurs.
It seems in patent bad faith for a buyer to knowingly dilute or abandon its efforts in breach of an obligation not to do so, but that claim — breach of the implied covenant of good faith and fair dealing — also requires damages to be proven to a reasonable certainty. Vu v. California Commerce Club, Inc., 58 Cal. App. 4th 229, 233 (Cal. Ct. App. 1997). Your client may be stuck in a painful — and likely avoidable — situation.
The simplest way to avoid the issue is to eschew efforts clauses altogether. If you valuate your milestone events up front ([value if the milestone is achieved] X [probability of achievement]), you can include it in the up-front purchase price while avoiding the expensive down-the-road headache of litigating contingent payments, “efforts,” and causation, and your clients receive the full present value of their property.
Some transactional attorneys may resist this option, arguing that practical realities requiring expeditious deal-closing often preclude up-front valuation of milestones, the speculative nature of which may cause an impasse where the parties dispute probability of achievement. But this retort highlights the very problem that efforts clauses cause — that same speculative nature is what makes proving the causation element on the back end so difficult if, for example, the buyer abandons efforts to achieve the milestone altogether.
If practical realities require contingent payment obligations, then another solution (depending on your operative law) is to contract around causation by liquidating the damages of a breach of the efforts provision. California’s liquidated damages law seems particularly suited for this. The Civil Code was amended in 1978 to render reasonable liquidated damages enforceable by default (with some codified exceptions) (CC Section 1671) on the recommendation of the California Law Revision Commission. The CLRC noted in its report that, when damages are liquidated, “troublesome problems involved in proving causation and foreseeability are avoided…. [A party] may fear that, without an enforceable provision liquidating the damages, the other party will lack incentive to perform since any damages he causes will not be sufficiently provable to be collected.” Annual Report, 13 Cal. L. Revision Comm’n Reports 1601, 1740 (1976).
Another solution is to use per-unit royalties instead of threshold milestones. While this won’t work for milestones that can’t be measured on a gradation (such as obtaining regulatory approvals), it works for sales- or revenue-based milestones. For example, instead of a clause requiring a buyer to use best efforts to sell a million widgets, and if it does so, the buyer pays the seller $1 million, the contract instead requires the buyer to use best efforts to maximize widget sales, and the seller receives a $1 royalty on each widget sold, with royalties capped at $1 million. That way, if the buyer breaches the efforts provision, your client won’t walk away with nothing — you’ll have your battle of the experts about how many widgets would have been sold had best efforts been expended, the factfinder decides on a number, and your client recovers its damages (once the fact of damages is proven by reasonable certainty, they won’t be denied simply for lack of “mathematical precision” in their estimation. Milton v. Hudson Sales Corp., 152 Cal. App. 2d 418, 434-35 (Cal. Ct. App. 1957)). However, do consider how a royalty may incentivize the buyer to favor its products with better margins (i.e., those without a royalty) — this could push sales of your product down even if the seller doesn’t go so far as to commit actionable breach of the efforts provision. You might partially protect against this outcome by setting a guaranteed minimum total royalty, as the plaintiff did in Citri-Lite v. Cott Bevs., Inc., 1:07-cv-01075 OWW DLB (E.D. Cal. Sept. 30, 2011), aff’d, 546 Fed. Appx. 651 (9th Cir. 2013) (no breach of the “efforts” provision, but plaintiff had protected itself with a guaranteed minimum royalty).
The plaintiff in 1L Contracts staple Bloor v. Falstaff Brewing Corp., 601 F.2d 609 (2nd Cir. 1979) protected himself by combining both a per-widget royalty and, as a backstop against total abandonment, liquidated damages. The buyer of a beer brand was obligated to use best efforts to sell the beer, and would pay the seller $0.50 per case sold for six years. 610. But if the buyer “substantially discontinue[d]” distribution of the brand, it would pay a liquidated sum based on the amount of time left in the royalty period when the breach occurred. 610. The court found that the buyer breached the best efforts requirement, and awarded the seller his lost royalties (although it did not find that the liquidated damages were triggered). 614-16.
In considering a potential efforts provision during contract negotiations, consider what would happen if the buyer breached it before most of the goal had been achieved. Would your client actually be protected? If it turns out your efforts provision looks less like an iron shield and more like Swiss cheese, alternative contract arrangements may be more protective of your client’s interests.