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Delaware Chancery Court Relies on Extrinsic Evidence to Resolve Merger Agreement Ambiguity

$50 Million Earn-Out Payment Denied

Corporate and Securities Alert | March 28, 2017
By: Lori Smith, Bridget Henwood and Michael Psathas

In a post-trial opinion issued on March 15, 2017, the Delaware Court of Chancery considered extrinsic evidence to resolve an ambiguous term in a merger agreement in order to determine whether a $50 million earn-out payment provision had been triggered. Shareholder Representative Services LLC v. Gilead Sciences Inc. et al. provides useful insight into the circumstances and manner in which Delaware courts will look to evidence outside the four corners of a contract to determine parties’ intent and analyze disputed contract terms.

Case Background

In 2011, Gilead Sciences, Inc. (Gilead) entered into a merger agreement (Merger Agreement) with Calistoga Pharmaceuticals, Inc. (Calistoga) in which the shareholders of Calistoga agreed to merge with Gilead for an initial payment of $375 million. Additionally, Gilead was required to make three “milestone payments” to the former shareholders of Calistoga if Calistoga’s cancer drug compound, CAL-101, achieved certain regulatory milestones. Gilead refused to make the third milestone payment of $50 million, claiming that the necessary approvals triggering that particular payment provision had not been obtained.

Pursuant to the Merger Agreement, the third payment was to be due upon “the receipt of Regulatory Approval[1] of CAL-101 in the United States or European Union, whichever occurs first, as a first-line drug treatment (i.e., a treatment for patients that have not previously undergone systemic drug therapy therefor) for a Hematologic Cancer Indication” (emphasis added). Although the drug had been approved in 2014 by the European Commission as a first-line treatment for patients with chronic lymphocytic leukemia (CLL), a type of hematologic cancer, the approval was limited to treatment of patients possessing a certain genetic abnormality.

The parties’ dispute essentially centered on the meaning of “indication”—specifically, whether approval of treatment for a limited subset of hematologic cancer patients satisfied the “treatment for a hematologic cancer indication” requirement. Both parties agreed that the term “indication” has multiple meanings in the oncology industry depending upon the context in which it is used. In this context, Plaintiff Shareholder Representative Services LLC (SRS) (the appointed agent for the former shareholders of Calistoga) contended that “indication” as used in the Merger Agreement meant “the approved use of a drug in a population of patients with a particular disease” and, therefore, that the third milestone was triggered upon approval by the European Commission for CLL patients with the specified genetic mutation. Gilead, on the other hand, argued that “indication” meant “disease” and that only disease-level approval (i.e., a broad approval covering all patients for a particular disease) of CAL-101 could trigger the third payment. Both parties argued that the Merger Agreement was unambiguous and that the plain language of the contract supported their respective interpretations.

The Court’s Analysis

The Ambiguity of the Term “Indication”

The court began its analysis with a recitation of basic contract interpretation principles, explaining that a contract’s express terms provide the starting point for analyzing a disputed contract. If the contract is unambiguous on its face, extrinsic evidence may not be used to interpret the intent of the parties or vary the terms of the contract. If, however, the contract is ambiguous (i.e. reasonably susceptible to different interpretations or multiple meanings), a court may consider extrinsic evidence, including evidence of prior agreements and communications between the parties, trade usage or course of dealing. In evaluating extrinsic evidence, “the court should uphold, ‘to the extent possible, the reasonable shared expectations of the parties at the time of contracting. In giving effect to the parties’ intentions, it is generally accepted that the parties’ conduct before any controversy has arisen is given great weight.’” (citing Rhone-Poulenc Basic Chems. Co. v. Am. Motorists Ins. Co., 616 A.2d 1192, 1196 (Del. 1991)).

The court first examined the plain language of the Merger Agreement and emphasized that, contrary to the parties’ respective arguments, the word “indication” was ambiguous when construed within the four corners of the Merger Agreement. The court noted that witnesses from both sides had testified that “indication” is a highly context-specific term within the oncology industry, meaning anything from a single tumor to a disease depending on how and where it appears. The court was not convinced by SRS’s surplusage argument that substituting “disease” for “indication” in the phrase “hematologic cancer indication” would result in a repetitive nonsensical phrase “hematologic cancer disease” not used within the oncology industry. The court noted that variations of the phrases “hematologic cancer diseases” and “cancer diseases” appear in industry publications and journals and were referenced at trial numerous times.

The court also pointed to the definition of “Hematologic Cancer Indication” provided in the Merger Agreement as further evidence that the parties likely intended that “indication” would mean “disease.” The Merger Agreement defined “Hematologic Cancer Indication” as “any hematologic cancer indication specifically identified in Part 1 of Section 1.1 of the Company Disclosure Schedule.” Part 1 defined “Hematologic Cancer Indications” to include “[a]ny Specified Hematologic Cancer Indication listed in Part 2 of this Schedule 1.1.” Notably, Part 2 of Schedule 1.1 consisted only of a list of specific diseases (not of any subpopulations of disease sufferers). The court found that “Specified Hematologic Cancer Indications” clearly meant any of the listed diseases, suggesting that “indication” was likely defined at the disease level as well. However, it deemed “indication” within the “Hematologic Cancer Indication” term to be sufficiently ambiguous to necessitate further analysis extending beyond the Merger Agreement itself.

Evaluation of Extrinsic Evidence

In light of the ambiguity, the court turned to extrinsic evidence to guide its interpretation of “indication,” focusing primarily on the parties’ negotiation history and the evolution of the terms “Hematologic Cancer Indication” and “Specified Hematologic Cancer Indication” during the course of negotiations.[2] The court examined evidence such as draft merger agreements and emails among the negotiators and colleagues on both sides, both before and after closing.

Importantly, this evidence demonstrated that the parties had discussed only disease-level regulatory approvals throughout their negotiations over the milestones. Further, there was no evidence to suggest that the parties had ever discussed approvals for subpopulations of disease patients. Calistoga had even used “indication” to refer to “diseases” in some of its own presentations and regulatory materials that it had sent to Gilead during negotiations, and some of Calistoga’s own trial witnesses’ testimony supported the “disease” meaning. Several of the emails examined were from Calistoga’s founder and chairman and its CEO following the European Commission approval stating that there was “no milestone” hit, but “good progress” had been made and that the third milestone would “most likely” be triggered at some specified point in the future. The court articulated that, although these discussions came several years after the Merger Agreement had been executed, they still had probative value in terms of evaluating the parties’ shared intentions and expectations.

Conclusion

The court concluded that the overwhelming weight of the evidence demonstrated that the parties mutually understood when they entered into the Merger Agreement that “indication” was to mean “disease.” Therefore, the European Commission approval for the subpopulation of CLL patients was insufficient to trigger the third milestone payment of $50 million. This case serves as a useful reminder that courts may consider extrinsic evidence to determine parties’ intent in order to resolve ambiguous contract terms, which can have significant implications for post-closing payments to sellers. Therefore, when drafting key provisions such as triggers for milestone or earn-out payments, it is important to be precise in order to avoid ambiguity, particularly where a term may be used imprecisely in practice throughout a particular industry.  

If you have questions or would like additional information, please contact Lori Smith (smithl@whiteandwilliams.com; 212.714.3075), Bridget Henwood (henwoodb@whiteandwilliams.com; 212.631.4421), Michael Psathas (psathasm@whiteandwilliams.com; 212.868.4833) or another member of our Corporate and Securities Group.

[1] “Regulatory Approval” is defined, in relevant part, in the Merger Agreement to mean “with respect to a particular country or jurisdiction, all approvals, licenses, registrations or authorizations by any Regulatory Authority necessary to market a Company Product in such country or jurisdiction, but excludes agencies or authorities regulating Environmental Laws.”

[2] It is important to note that the Merger Agreement contained an integration clause, stating in relevant part: “This Agreement and the documents and instruments delivered pursuant hereto, including the exhibits hereto, the Company Disclosure Schedule and the other schedules hereto . . . together constitute the entire agreement among the parties with respect to the subject matter hereof and supersede all prior agreements and understandings, both written and oral, among the parties with respect to the subject matter hereof, except for the Confidentiality Agreements . . . .” Although the court in this case does not directly address this point, we note that courts may look to parol evidence to resolve ambiguous term(s) in a contract, even where the agreement contains an integration or “entire agreement” clause. See Vianix Del. LLC v. Nuance Communs., Inc., 2010 Del. Ch. LEXIS 171 (Del. Ch. Aug. 13, 2010); Klein v. Handley, 47 A.3d 524 (Del. Super. Ct. 2012).

This correspondence should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult a lawyer concerning your own situation and legal questions.
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