Drafting Guidance from Delaware Supreme Court on Earnouts, Efforts Obligations, and Fraud

In Johnson & Johnson v. Fortis Advisors (Jan. 12, 2026), the Delaware Supreme Court reversed the Court of Chancery’s decision that, based on the implied covenant of good faith and fair dealing, Johnson & Johnson breached its efforts obligations with respect to the first earnout payment under the Merger Agreement pursuant to which, in 2019, it acquired Auris Health, Inc., a medical robotics company. In a 2024 decision, the Court of Chancery had awarded Auris damages of over $1 billion ($300 million of it attributed to the breach with respect to the first earnout payment).

The Merger Agreement called for upfront consideration of $3.4 billion, which J&J paid at closing, and an additional up to $2.35 billion in earnout payments, none of which was paid. Each earnout payment was conditioned on J&J obtaining “510(k) approval” from the U.S. Federal Drug Administration—in the case of the first payment, to use Auris’ robot, “iPlatform,” in general surgery; and, in the case of the other payments, to use iPlatform or certain other Auris robotic-assisted surgical devises (RASDs) for various types of more complex surgeries.

The 510(K) pathway has been the fastest and least burdensome path to FDA approval of new devices, as it depends on a showing that the device is substantially similar to a “predicate” device (that is, a device already legally marketed). The parties anticipated that iPlatform would obtain 510(k) approval for general surgery based on Auris’ already marketed “Da Vinci” robot as the predicate device; and then the 510(k) approvals for Auris’ other RASDs would be obtained based on iPlatform as the predicate device. When, post-closing, the FDA eliminated the 510(k) pathway for first-generation devices (like iPlatform) for general surgery, J&J viewed the entire earnout as unachievable and it ceased all efforts to achieve the regulatory milestones.

The Court of Chancery had held that, based on the implied covenant of good faith and fair dealing, when the FDA eliminated the 510(k) pathway for general surgery indications, J&J was obligated to seek approval for iPlatform for general surgery through a different pathway—“De Novo approval,” which would have had the same result and not have been significantly more burdensome to obtain. The Supreme Court reversed that ruling, however, holding that the unexpected post-closing regulatory development did not create a “gap to be filled” by the implied covenant, as the Merger Agreement plainly required that J&J seek “510(k) approval,” and only that approval, for use of iPlatform for general surgery. Therefore, the Supreme Court held, J&J did not breach its efforts obligations with respect to the first earnout payment.

The Supreme Court upheld the Court of Chancery’s other rulings, including that J&J breached its efforts obligations with respect to the remaining earnout payments. Ironically, the Supreme Court concluded that J&J’s obligation to use reasonable efforts to achieve the later 510(k) approvals (for indications for which the FDA did not eliminate the 510(k) pathway) included obtaining De Novo approval for iPlatform for general surgery so that iPlatform could be used as the predicate device for the later approvals. As J&J did not pursue De Novo approval for iPlatform for general surgery, it breached its efforts obligations with respect to the remaining earnout payments.

Key Points

• The Delaware Supreme Court emphasized a narrow interpretation of the implied covenant of good faith. Generally, the implied covenant of good faith has been invoked to “fill gaps” in an agreement where a situation arises post-signing that was unforeseen by the parties, so they did not expressly cover in their agreement what should happen if the development occurred, but their expectations can be inferred from the agreement. In J&J/Auris, the Supreme Court stressed that the implied covenant cannot be invoked simply because the parties failed to consider a development that then occurred post-signing, but only if they could not have anticipated the development. The Supreme Court wrote: “If a development could have been anticipated, even if it was unlikely to occur, the implied covenant cannot be invoked to provide protections that easily could have been drafted at the bargaining table.” Clearly, parties to an agreement cannot address every development that they could foresee as a possibility. Parties should consider carefully which developments may be sufficiently likely to occur, and/or sufficiently significant if they do occur, that they should be expressly addressed in the agreement.
• When drafting a regulatory approval provision, consideration should be given to the possibility (even if remote) that the regulator might eliminate, replace or modify the specified regulatory approval. In J&J/Auris, the Supreme Court emphasized that the parties “anchored their milestones to a specific regulatory category and nothing more”—and that drafting choice “foreclose[d] any claim that the contract is silent about what form of FDA clearance would suffice.” The Supreme Court observed that Auris and J&J “neither defined the milestones by reference to ‘regulatory approval by 510(k) or any successor or alternative pathway (emphasis added)’ nor provided that the earnouts would adjust if the FDA closed the 510(k) route or extended its review.”
• The Supreme Court’s decision may be distinguishable from other situations on the basis that the parties in this case actually had foreseen and considered the regulatory development that occurred. The Supreme Court noted that Auris had received information from the FDA that indicated the 510(k) pathway might not be available for iPlatform for the general surgery indication. Also, it had been publicly announced that the FDA was in the midst of overhauling the 510(k) pathway. Yet, the Supreme Court emphasized, Auris and J&J nonetheless “chose to explicitly tie every regulatory milestone—totaling hundreds of millions of dollars—to ‘510(k) [approval],’ and only to that pathway.” Thus, this case may be distinguishable from cases where the parties did not actually foresee and consider the development and make a choice not to address it.
• The Supreme Court’s decision also highlights certain drafting considerations with respect to (i) efforts obligations and (ii) anti-reliance provisions. With respect to efforts obligations, where the parties set a standard for the required efforts (such as, in this case, “commercially reasonable efforts comparable to J&J’s other priority medical products”), and they also preserve some discretion for the obligated party (in this case, a list of ten factors that J&J could “take into account” when determining what efforts to take), the drafting should be clear as to whether the discretionary factors are subject to, or instead independent of, the specified efforts standard. With respect to anti-reliance provisions, where the agreement includes an earnout, the buyer should consider seeking an express disclaimer from the seller as to its non-reliance on the buyer’s extra-contractual statements relating to the likelihood of achievement of all or any part of the earnout.

Background. The Court of Chancery, in a decision issued by Vice Chancellor Lori W. Will, had held that J&J (i) breached its efforts obligations with respect to the earnout set forth in the Merger Agreement; and (ii) fraudulently induced Auris to agree to one of the milestones by overstating the likelihood of its achievement. The Court of Chancery awarded Auris over $1 billion in damages—$300 million attributable to the breach with respect to the first earnout payment; $600 million to the breach with respect to the remaining earnout payments; $61 million with respect to the fraud; and the remainder for pre-judgment interest. The Supreme Court held that J&J (i) did not breach its efforts obligations with respect to the first earnout payment; (ii) breached its efforts obligations with respect to the remaining earnout payments; and (iii) fraudulently induced Auris to agree to one of the milestones. The case has been remanded to the Court of Chancery for re-determination of the damages award in light of the Supreme Court’s holding that J&J did not breach its obligations with respect to the first earnout payment.

Discussion

The Supreme Court held that the implied covenant could not be used to fill the gap in the Merger Agreement that arose when the FDA eliminated 510(k) approval for first-generation devices for general surgery. The Supreme Court stressed that the implied covenant can be invoked only in “limited and extraordinary” circumstances. It concluded that in the case the Court of Chancery’s use of the implied covenant improperly “rewr[ote] the parties’ bargain.” The parties had specified “510(k) approval,” and only 510(k) approval, as the milestone condition for the first earnout payment. The parties could have foreseen the possibility of the FDA eliminating the 510(k) approval pathway, and could have provided in the agreement for that possibility, even though they may have considered it highly unlikely to occur.

The Supreme Court noted that the parties actually did foresee and consider the possibility that the 510(k) pathway might be unavailable to them. The Supreme Court viewed as evidence that the parties “could have foreseen” this regulatory development the fact that they in fact had foreseen it as a possibility. First, the parties knew that it was entirely within the FDA’s discretion whether the 510(k) pathway would be available for iPlatform, and knew that the FDA requires De Novo approval instead of 501(k) under various circumstances. Second, Auris had consulted with the FDA about the likelihood of 510(k) being available for iPlatform for the general surgery indication and had received “pointed feedback” that it might not be because of certain technological differences from the predicate product. Third, the FDA had publicly announced that it was “modernizing” the 510(k) pathway and had proposed a new rule to discourage “inappropriate” 510(k) submissions for novel devices. Although the parties thus clearly could have anticipated (as they in fact did anticipate) the unavailability of the 510(k) pathway, they nonetheless chose not to provide for an alternative approval to be obtained in that event.

The Supreme Court viewed certain standard provisions in the Merger Agreement as implicitly allocating to Auris risks associated with regulatory developments. As further support for its view that the regulatory development that occurred “could have been foreseen” by the parties, the Supreme Court noted that various provisions in the Merger Agreement “acknowledged differing possible regulatory scenarios.” The Supreme Court pointed to the “carefully negotiated definition of ‘commercially reasonable efforts’ [that] expressly permitted J&J to calibrate its efforts in light of ‘guidance or developments from the FDA’ and the ‘likelihood and difficulty of obtaining FDA or other regulatory approval’; and to provisions that “warn[ed] that the milestones were subject to a variety of factors and uncertainties, including many outside of J&J’s control, and [that] as a result, some or all of the Earnout Payments may never be paid.”

Ironically, the Supreme Court nonetheless held—for other reasons—that J&J had been obligated to pursue De Novo approval to use iPlatform for general surgery. The FDA did not eliminate 510(k) approval for the devices and surgical indications that were the subject of the earnout payments following the first earnout payment. The Supreme Court upheld the Court of Chancery’s ruling that the Merger Agreement still plainly required that J&J use reasonable efforts to obtain those 510(k) approvals. Although J&J was not obligated under the implied covenant to seek De Novo approval of iPlatform for the general surgery indication, the Supreme Court held that seeking De Novo approval of iPlatform for general surgery was within the reasonable efforts J&J was required to use to obtain the remaining 510(k) approvals (as, with such approval, iPlatform could serve as the predicate product for the remaining 510(k) approvals).

The Supreme Court upheld the Court of Chancery’s methodology for calculating damages for breach of the earnout efforts obligation. The Chancery Court had calculated damages, for each milestone payment, based on the amount of the payment multiplied by the parties’ estimated probability of the milestone’s achievement at the time of the merger (using 75% probability for the first milestone and 85% for the remaining milestones).

The Supreme Court upheld the Court of Chancery’s interpretation of the parties’ definition of “commercially reasonable efforts.” The Merger Agreement provided that J&J had to use “commercially reasonable efforts” to achieve the earnout milestones, which was defined as efforts comparable to those it used for its other priority medical devices. The Merger Agreement then listed ten issues that J&J could “take into account” in determining the efforts to be used: safety and efficacy issues, inherent development risks, market competitiveness, patent position, regulatory difficulty, pending legal matters, risk of recalls, regulatory input and guidance, and the product’s expected profitability and return on investment. Further, the Merger Agreement prohibited J&J from acting “with the intention of avoiding” any earnout payment or from factoring the cost of an earnout into post-closing business decisions. The Court of Chancery had rejected J&J’s argument that the list of ten issues expressly “preserve[d] J&J’s discretion to make the sorts of business judgments that any acquiring company would insist on….” The Court of Chancery wrote that the list could not be “elevate[d]…over the definition that precedes it,” as that would “reduce to little more than surplusage the [Merger Agreement’s] ‘priority’ language and the express instruction…that efforts be directed to achieve each of the Regulatory Milestones.” The Supreme Court agreed, explaining that the list’s function was to “leave J&J room to calibrate its efforts within the ‘priority medical device’ baseline.”

The Supreme Court upheld the Court of Chancery’s holding that J&J fraudulently induced Auris to agree to one of the milestones. J&J’s CEO told Auris that one of the near-term milestones was “highly certain” to be achieved, so much so that J&J was considering it to be part of the upfront payment. However, at the time, the CEO knew, but did not tell Auris, that a patient in J&J’s relevant clinical study had recently died, triggering a for-cause FDA inspection that risked, at a minimum, substantial delay in obtaining regulatory approval. J&J’s deal team had been briefed on these developments and was in the midst of running a sensitivity analysis “to understand the impact to the milestone’s valuation.” The Supreme Court rejected J&J’s argument that there was no fraud because the CEO truly believed that the milestone was highly certain to be achieved. The Supreme Court noted that scienter is satisfied if the defendant knew its representation was false or made it with reckless indifference to the truth. “In light of th[e] undisputed facts, presenting the milestone as ‘highly certain’ permitted the reasonable inference that J&J at least acted with reckless indifference to the statement’s truth.” While the Merger Agreement included standard exclusive remedy and anti-reliance provisions, they (as would be usual) covered only the buyer (not Auris), and so did not bar Auris’ fraud claim based on J&J’s extra-contractual statements relating to achievability of the milestone.

Practice Points

• Based on J&J/Auris, parties to earnouts should consider the following drafting points:
  • Regulatory approval. Where a specific regulatory approval is a condition to a milestone payment, state whether an alternative regulatory approval does (or does not) have to be sought if the regulator eliminates, replaces, or modifies the specified approval. Parties could consider providing, for example, that any alternative approval must be sought that would produce a similar result and would not be significantly more burdensome to obtain in terms of timing, efforts, or costs.
  • Efforts obligation. Where the parties set forth a standard of efforts the buyer must use to seek to achieve milestones, and also set forth discretionary factors the buyer can take into account, be explicit as to whether the discretionary factors are subject to, or instead independent of, the efforts standard.
  • Anti-reliance. A buyer agreeing to an earnout should consider seeking to include an express disclaimer from the seller as to reliance on any extra-contractual statements made by the buyer relating to achievement of the earnout. A seller should consider whether there are statements the buyer has made relating to achievability of the earnout that should be included as representations in the agreement. Care should be taken when commenting on the likelihood of achievement of milestones, as overstating it can lead to fraud charges, particularly where one party has negative information not shared with the other.
• Earnouts should be drafted as bespoke provisions, tailored to the specific product, business, company, industry, science, regulators, and situation. Careful, specific, business-contextualized consideration of potential issues that may arise relating to the earnout is critical. The drafting and negotiation process should involve not only lawyers, but also the business people and experts who best understand the product and the potential issues. Also, it should be made clear how the earnout provisions relate to other provisions of the merger agreement (such as the buyer’s level of discretion to run the acquired business post-closing). For clarity, the parties may wish to specify in the agreement how they intend that the efforts standard provided (or other provisions) will be interpreted, including by providing examples of hypothetical situations and how the standard would work in those circumstances.
• Sellers agreeing to an earnout should consider seeking to include the J&J/Auris Merger Agreement’s unusually seller-friendly provisions.
  • “Inward-facing” efforts standard. J&J was required to use efforts comparable to those it used for its own other priority medical devices. An inward-facing standard can be advantageous to the seller when the buyer is a top company in the industry and so would have higher standards, and would have exerted greater efforts for its products, than others in the industry. At the same time, an inward-facing standard may provide greater flexibility to a buyer. For example, depending on the facts and circumstances, a buyer may be able to adjust its efforts for its other products if beneficial for its efforts obligations with respect to the earnout product. Also, particularly where there is a long earnout period, an inward-facing standard may better accommodate unique corporate needs or objectives that may develop over time (i.e., needs that would not necessarily apply to other companies).
  • “In furtherance of” the earnout. J&J’s efforts had to be “in furtherance of achieving each of the Regulatory Milestones.” The Court of Chancery stressed this language when concluding that J&J’s efforts in furtherance of the company’s robotics program generally, or its other corporate goals, did not satisfy its efforts obligation with respect to the earnout.
  • “Not with an intention to avoid” the earnout and “not taking into account cost” of the earnout. J&J was prohibited from acting “with the intention of avoiding” payment of the earnout, and from making decisions “based on taking into account the cost of making any Earnout Payment(s).” The Court of Chancery found this to be “more restrictive” language than the typical requirement that a buyer not act “for the purpose of thwarting” an earnout.
  • Buyer discretion. The Merger Agreement did not include the typical provision stating that the buyer would have “complete discretion” over decisions relating to the acquired company’s business. The Court of Chancery found that the absence of this language supported its rulings limiting J&J’s discretion with respect to its efforts obligations.
• In selecting between an inward- or outward-facing efforts standard, the parties should consider which comparators would be applicable under each standard—and then consider which comport best with how the buyer intends to proceed, or the seller expects the buyer to proceed, as the case may be. (Notably, in some decisions, the Court of Chancery has stated that there may be no outward-facing comparators for a company developing pharmaceuticals, given the inherently unique circumstances for every drug development process.) If an inward-facing standard is selected, the parties may wish to identify by name particular products that will be used as the comparators—rather than characterizing the comparators (for example, “priority products”), which could lead to disputes as to which products meet that characterization. A seller may wish to consider seeking a hybrid standard, providing for either an inward- or outward-facing standard, whichever, at the time an action is considered, provides for a higher standard of efforts—although such a standard could create an additional layer of complexity with more issues for dispute, and could be difficult to monitor.
• Before a buyer takes action that may affect a product subject to an earnout, the buyer should review the agreement to determine whether the action is permitted under the efforts standard. Determining whether such actions would violate the efforts standard will require close analysis of the specific language of the earnout provisions and their interrelationship with other merger agreement provisions, as well as developments since the agreement was signed. As highlighted in the Court of Chancery’s J&J/Auris opinion, such actions might include, for example: causing the acquired product or business to compete with any of the buyer’s existing products; failing to identify and pursue alternative regulatory strategies when others are foreclosed; revising the incentive program for, or making comments that may negatively affect the motivation of, the employees working on the acquired product; changing the reporting structure for the employees working on the acquired (such as by having them report to a person without experience with the specific type of product); significantly decreasing the funding or other corporate support for the acquired product; and significantly increasing the investment in other businesses (perhaps, even if significant funding is still being provided for the acquired product).
• A buyer should monitor compliance with the efforts standard on an ongoing basis during the earnout period. If an inward-facing standard applies, the buyer should monitor the efforts it is making with respect to its own products or businesses that are the comparators, and benchmark its earnout efforts against those efforts. If an outward-facing standard applies, the buyer should monitor the efforts its peers (or other companies that are the comparators) are making, and benchmark its efforts against those efforts.
• Parties should pay attention to the special issues that may arise where the buyer has, or may acquire, products that compete, or potentially will compete, with products subject to the earnout. The parties should consider providing explicitly in their agreement how the competing products will be treated in relation to one another with respect to the earnout and whether they can be combined.