Ambiguous drafting of earnout provisions in M&A agreements is a perennial source of post-closing disputes. What may have seemed clear to parties in the heat of negotiations can often become less so as time passes, particularly where expectations are not met, or the relationship otherwise degrades. As demonstrated in ARO inc. c. Polard, 2024 QCCA 546, however, Québec civil law’s principles of contractual interpretation offer a distinct approach for addressing these disputes.

To those who have spent long hours negotiating the finer points of a complex M&A agreement, Article 1425 of the Civil Code of Québec may initially seem puzzling. This article, which is the cornerstone of contractual interpretation in Québec, states, “The common intention of the parties rather than adherence to the literal meaning of the words shall be sought in interpreting a contract.” Why then would sophisticated buyers and sellers of businesses, who see eye to eye on a deal they’ve struck, spend so much time working with their lawyers on hundreds of pages of those words? Fortunately, Québec case law has long made clear that it is only once a court has determined that the written words are unclear that this preeminence of subjective intentions over written words comes into play. In other words, you only apply the rules of interpretation if there is something that is ambiguous that requires interpreting.^[1] This is what happened in ARO inc. c. Polard (“ARO”).

Facts

In ARO, the Polard family had sold their collection agency business to ARO Inc., a Québec-based competitor, for $6 million, plus up to $1.5 million by way of an earnout payable in three annual installments. The earnout was calculated using a combination of revenue and retention performance targets.

The detailed trial level decision (Polard c. ARO Inc., 2022 QCCS 3443) suggests that the relationship between the parties quickly deteriorated after closing. Notably, three members of the Polard family who were employed by the purchaser following the transaction were terminated and employment-related litigation ensued. A disagreement also arose over the calculation of the earnout amount.

As is typical for earnouts, the agreement between ARO and the Polards specified that the buyer was to deliver annual statements comparing the actual results to the performance targets. This was coupled with a mechanism for submitting disputes to an independent accountant. In this case, after protracted proceedings, the independent accountant calculated the earnout amount at 90% of the potential maximum. Eventually the parties came to agree that this determination was binding, but the buyer still refused to pay on the ground that a further condition specified in the agreement had not been met.

Key Issue

This further condition was the crux of the litigation that ensued. The condition, included in the section of the agreement dealing with payment of the earnout amount, specified that:

Payment of each of the annual payments is conditional upon ARO’s compliance, in all material respects, with the financial ratios set out in Schedule “B” attached hereto, such compliance to be determined based on the audited financial statements of ARO.

The agreement also specified that interest would be paid by ARO on the adjusted earnout amount from the Closing Date until payment in full at a rate of 5% per annum.

It was uncontested that the buyer faced financial difficulties after closing and failed to comply with the Schedule “B” financial ratios throughout the three-year earnout period. The consequences of this non-compliance on the earnout payment were hotly contested, however:

• The buyer argued that non-compliance on the relevant date extinguished each obligation to pay the applicable portion of the earnout – i.e., interpreting “payment” in the clause to mean the very obligation to pay.
• The sellers argued that the consequence was instead the deferral of the payment obligation with interest continuing to accrue thereon – i.e., interpreting “payment” as the simple act of payment.

Ruling

The trial judge found, and the appeal court agreed, that the provision in question was ambiguous in that it did not “specifically address the consequences” of failure to comply with the financial ratios. As such, having found an ambiguity, the rules of interpretation in articles 1425 through 1432 of the Civil Code were applied, with the court seeking to determine the common intention of the parties, reading the contract as a whole and taking into account its nature, the circumstances of its formation and any interpretation the parties may have already given to it, as well as common usage.

Ultimately the trial judge agreed with the sellers’ interpretation, and further specified that failure to meet the financial ratios would defer the payment for a maximum of three years. This was based in part on the negotiation history and related communications between the parties, in particular:

• that the sellers had insisted that the shareholder of the buyer provide a personal guarantee of the payment obligation (i.e., why ask for a guarantee if the buyer’s impecunity would result in the extinguishment of the obligation?); and
• that while the earnout performance targets were heavily negotiated, there was no negotiation of the financial ratios, which were presented as simply being a requirement of the buyer’s lender.

The court looked closely at how the buyer reflected the earnout obligation on its own financial statements following the transaction and also relied on the testimony of the sellers’ expert witness regarding market practices with respect to earnouts (effectively that that the buyer’s interpretation would make for a very off-market earnout structure).

Conclusion

In the end, the interpretation favoured by the court here seems to make commercial sense and align with the extrinsic evidence, at least as compared to the interpretation proffered by the buyer. However, the court effectively read a maturity date into the payment obligation that does not appear to have been reflected anywhere in the text of the agreement, and other reasonable interpretations of the clause in question certainly seem possible. While perhaps a just result, this case demonstrates how far Québec’s rules of contractual interpretation can allow a court to depart from the text of the agreement in the face of ambiguity,^[2] even in the context sophisticated commercial transactions.

Earnout provisions and other financial adjustment clauses in M&A agreements can, by design, be quite complicated. However, given that their implementation has a direct and significant impact on the financial consequences of a transaction, it is particularly important for the parties and their counsel to ensure that these provisions are drafted clearly and in manner that properly reflects their intentions. Leaving any ambiguity in the terms of a contract, even if you think it is likely be read in your favour, means that any future dispute could invite a wide-ranging examination of extrinsic evidence that could lead to unexpected results.

[1] See Uniprix inc. v. Gestion Gosselin et Bérubé inc., 2017 SCC 43 at para. 34: "a judge must defer to a clear contract." Notably though, seemingly clear words can be found to be ambiguous when read in the context of the agreement as a whole or the circumstances in which it was concluded.

[2] While this approach may seem surprising, it should be noted that, in result, it is not all that different from the approach to contract interpretation in Canada's common law provinces, particularly since Sattva Capital Corp. v. Creston Moly Corp., 2014 SCC 53, where the Supreme Court recognized that common law contractual interpretation had evolved towards a practical, common-sense approach that interprets contracts within their surrounding circumstances or "factual matrix".

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