Zenix was a manufacturer of high-frequency microwave components for the defense, aerospace, and telecommunications industries. In 1998, Zenix entered into an asset purchase agreement with EDO under which EDO purchased substantially all of the assets of Zenix for $800,000, and assumed certain Zenix liabilities. The Asset Purchase Agreement required EDO to pay Zenix a 5% royalty on sales of Zenix products after the closing until such time as the aggregate amount of royalty payments equaled $1,200,000.
Six months after the closing, EDO closed one of the Zenix plants and moved equipment to another plant that Zenix alleged was not equipped to manufacture Zenix products. Zenix further alleged that EDO changed production formulas and disposed of equipment and inventory necessary for the continued production of Zenix products, resulting in lost sales, and a corresponding reduction in royalties.
In 2005, after EDO did not resume manufacture of Zenix products, Zenix demanded payment of $1,154,000 in royalty payments. EDO rejected Zenix’s demand. Zenix sued EDO alleging, among other things, breach of contract, breach of the implied covenant of good faith and fair dealing, and fraud. EDO filed a motion to dismiss all of Zenix’s claims.
As to its claims for breach of contract and breach of the implied duty of good faith and fair dealing, Zenix alleged EDO was required to make royalty payments totaling $1,200,000, and EDO breached its contractual duties by failing to take steps necessary to generate sales of Zenix products after the closing.
EDO argued that royalty payments were not mandatory and that EDO had no duty to use reasonable efforts to sell the Zenix product line. EDO noted that the Asset Purchase Agreement included no language that EDO must use best or reasonable efforts and that such a duty could not be inferred.
While the court agreed that royalty payments were not mandatory, the court held that under New York law EDO had a duty to use reasonable efforts to sell Zenix products and that Zenix had alleged facts sufficient to state a claim for breach of that duty. The court further noted that if EDO’s interpretation of the Asset Purchase Agreement were adopted, EDO could have shut down the Zenix product line immediately after the closing, rendering the royalty provisions illusory.
This case illustrates that in the absence of express provisions in an acquisition agreement governing the parties’ obligations with respect to an earnout, actions by the purchaser that allegedly frustrate the seller’s ability to receive earnout payments may give the seller a sufficient basis to allege fraud and breach of the implied covenant of good faith and fair dealing.