New standard imposed in contracts

A 1st U.S. Circuit Court of Appeals ruling has created a “reasonable efforts” common-law contract standard that imposes new duties on corporate parties who purchase other companies’ assets, according to several practitioners familiar with the case.

“This decision is really a head’s up for corporate lawyers … that courts are going to recognize the existence of an implied contract at summary judgment and trial,” said plaintiffs’ counsel Edward T. Dangel III of Boston. “The concept is very well established; it’s just that it hadn’t been applied in a case of this magnitude for a while.”

Christopher M. Lefebvre, a federal practitioner in Pawtucket, R.I., agreed that it is highly unusual for a court to recognize the existence of an implied right in a contract dispute.
“Shocking is the word that comes to mind, because courts generally frown upon implied rights and implied remedies, particularly when they are dealing with sophisticated transactions involving corporate litigants,” he said. “I am dumbfounded by the concept because I had always read and understood that if something is not spelled out in a commercial contract, the courts typically will find against the drafters of the agreement.”

In Sonoran Scanners, Inc., et al. v. PerkinElmer, Inc., the 1st Circuit held that a Massachusetts company had breached an implied covenant in an asset purchase agreement when it failed to develop and promote a plate-printing technology product.
At a recent hearing, U.S. District Court Judge William G. Young in Boston, who is presiding over the underlying dispute, told the lawyers involved in the case that members of the bar have deemed the 1st Circuit’s ruling “somewhat groundbreaking.”
“[I]f they have accurately predicted it, … this is now an implied covenant for all contracts in Massachusetts and one would think, perhaps, the 1st Circuit,” Young said. “That’s not insignificant.”

The defendant company argued that it had paid $3.5 million in consideration for the plaintiff’s assets and that courts can imply a reasonable efforts duty only when there are no other factors supporting the existence of a contract.

But Judge Timothy B. Dyk, sitting by designation in the 1st Circuit, disagreed and reversed Young’s summary judgment ruling.

“Given that [the defendant] had an implied obligation to exert reasonable efforts towards promoting sales of the [plaintiffs’ products], the factual question remains whether [it] breached this obligation,” he wrote.

Profit maximizing

The defendant’s Boston counsel, T. Christopher Donnelly, said the only implied covenants that had been recognized before Sonoran were for good faith and fair dealing.
While Donnelly agreed that the court made new law by imposing the reasonable efforts standard, he suggested its holding would not impact all contract cases.

“[Our] position is that the ruling was limited to contracts involving the acquisition of business assets,” he said. “I think the impact of the 1st Circuit’s decision is potentially broad in the context of mergers and acquisitions, but whether it goes further remains to be seen.”
Although the reasonable efforts concept has been recognized in California and other parts of the country, Dangel said Massachusetts has not addressed the issue in more than 60 years.

However, Dangel said Judge Dyk clearly found the defendant owed an implied duty to his client to maximize the profit potential of the technology it had purchased.

“When there are payout provisions written into a contract and much of the consideration is left to those provisions, both sides need to understand there is going to be a duty to try to achieve those payments,” he said. “That duty is defined today as reasonable efforts.”
Dangel said the 1st Circuit interpreted reasonable efforts to mean diligent, appropriate efforts under all the circumstances to make the technology profitable.
“Lawyers must understand that they need to draft into their contracts the level of efforts that are going to be anticipated under the contract, rather than just leaving it open, which is what we were dealing with in this case,” he said.

Terms of the deal

The plaintiff, Sonoran, was an Arizona corporation that developed and marketed a high-speed computer-to-plate technology (CTP) used in the newspaper and graphic arts industries. As of 2000, Sonoran had created a prototype CTP machine but had not made any sales.
Although there was interest in the product, Sonoran was running out of cash despite the fact that its founder, plaintiff Joseph Donahue, had invested $3.5 million of his own money.
As a result, Sonoran approached defendant PerkinElmer to see if it was interested in purchasing the CTP business. In 2001, PerkinElmer executed an asset purchase agreement in which it purchased Sonoran’s business. Under the agreement, PerkinElmer paid $3.5 million, a significant portion which went directly to Sonoran’s creditors.

Under the agreement, PerkinElmer was obligated to pay Sonoran more money on an annual basis if a certain number of CTP products were sold between 2001 and 2006.
PerkinElmer also entered into an agreement with Donahue, under which he was to serve as general manager of the CTP business. The agreement stated that Donahue would be eligible to receive bonuses over a five-year period based on CTP sales.

It was undisputed that the business was a failure. Between 2001 and 2004, only one unit was sold and no additional money was paid out under the contract.

The plaintiffs alleged that the CTP failure was due to a series of unreasonable and bad-faith decisions by PerkinElmer.

In September 2004, PerkinElmer sold its CTP assets to another company, which quickly closed the business. The plaintiffs then filed suit in U.S. District Court, arguing in part that PerkinElmer had breached the implied terms of its deal by failing to make reasonably competent efforts to develop and market Sonoran’s products.

In 2008, Judge Young granted summary judgment to PerkinElmer on all claims, holding that its agreement contained no implied “obligation to continue operating the CTP Business” in the face of the losses.

Implicit terms

In reversing Young, Dyk found that the contingent nature of the plaintiffs’ compensation terms demonstrated that a reasonable efforts requirement was implicit in the agreement.
He said the plaintiffs’ future compensation payouts were substantial in comparison to the up-front payments made by the defendant.

A significant portion of the up-front money was paid to the plaintiffs’ creditors, the judge added, and did not benefit the shareholders directly.

Dyk wrote that the purchase agreement also contemplated a campaign to market the plaintiffs’ technology over the next five years.

“There was no language in the agreement negating an obligation by PerkinElmer to use reasonable efforts or conferring absolute discretion on PerkinElmer as to the operation of the business,” he said. “Under these circumstances, we find that PerkinElmer had an implied obligation to use reasonable efforts to develop and promote Sonoran’s technology.”