Selling with an Earn-out? Who is (Really) Buying? The Seventh Circuit Offers A Reminder.

The U.S. Court of Appeals for the Seventh Circuit offers good reminders for structuring earn-out agreements. In Northbound Group, Inc., v. Norvax, Inc., et al., No. 14–1651 (July 28, 2015), the Seventh Circuit held that a corporate parent cannot be held contractually liable for breach of a specially-formed and wholly-owned subsidiary’s earn-out provision absent evidence of fraud or injustice. Northbound generates and sells life insurance leads under the brand name “Leadbot.” Northbound was in financial distress when Defendant Norvax, Inc. agreed to purchase Northbound Group through a specially-formed and wholly-owned LLC called “Leadbot LLC.” The entire purchase price was via an earn-out calculated as a percentage of the monthly net revenue of newly-formed Leadbot LLC. When Leadbot sued for breach of the earn-out, it discovered that Leadbot had no assets to recover and the parent company, Norvax, was not party to any agreements. Leadbot sued Norvax for breach of the earn-out contract, arguing that although it was not a party to the asset purchase agreement, it was a “direct participant” or an “alter ego” of its subsidiary. The Seventh Circuit affirmed summary judgment in favor of Norvax. The Court recognized precedent imposing potential tort or statutory liability upon a parent company, but refused to read such an expansive policy into contracts with an earn-out “where parties may choose which individuals or companies will be bound.” In rejecting the alter ego theory, the Court conceded that the subsidiary may be a “mere instrumentality” of Norvax. But, it refused to disregard Leadbot LLC’s “separate corporate existence” via the alter ego doctrine without some demonstration that a “fraud or injustice” would arise without such extraordinary measures. The potential breach of an earn-out was not enough.

Cutting through the legalese– The ruling offers a good reminder of the importance of choosing corporate parties in deals with earn-out provisions.  If the company agreeing to pay the earn-out has no assets, you may not have a remedy if you are not paid.

Conversely, if you are a buyer of distressed companies, even on a no-cash basis, you must recognize corporate formalities and potential pitfalls concerning fraud or injustice claims or risk becoming an unwitting guarantor in earn-out contracts of your subsidiaries.