Delaware Supreme Court Reaffirms the Limits of the Implied Covenant of Good Faith and Fair Dealing

Summary

On January 12, 2026, the Delaware Supreme Court vacated in part what had been the largest earnout-related damages award in Delaware history. The Court held that the implied covenant of good faith and fair dealing — a narrow doctrine permitting courts to imply terms where a contractual gap threatens the parties’ reasonable expectations at signing — did not itself obligate the buyer to pursue an alternative regulatory approval pathway after the regulatory approval pathway specified in the merger agreement (and tied to earnout milestones) became unavailable. The decision makes clear that the implied covenant cannot be used to rescue parties from drafting choices where the relevant regulatory risk was foreseeable at signing. In those circumstances, Delaware courts will hold parties to the bargain they struck and will not read in additional contractual obligations through the implied covenant that the parties could have, but did not, negotiate.

Background

In 2019, Johnson & Johnson acquired Auris Health (“Auris”) for $3.4 billion in upfront cash, plus up to $2.35 billion in contingent earnouts tied primarily to milestones requiring FDA 510(k) premarket notification. Four months after closing, the FDA confirmed that first-generation robotic-assisted surgical devices would no longer be eligible for 510(k) clearance and instead would require a more rigorous De Novo review.[1] Johnson & Johnson treated the FDA’s regulatory shift as excusing its earnout obligations.

Fortis Advisors, acting as Auris’s stockholders’ representative, filed a lawsuit against Johnson & Johnson, alleging that Johnson & Johnson (1) had breached its contractual efforts obligations and (2) had fraudulently induced Auris to accept a contingent payment instead of additional upfront consideration. Following a 10-day trial, the Court of Chancery ruled in favor of Fortis on both theories and awarded more than $1 billion in contract and fraud damages, plus pre-judgment interest. Among other findings, the Court found that the implied covenant of good faith and fair dealing required Johnson & Johnson to pursue an alternative regulatory pathway to approval after the FDA foreclosed the 510(k) pathway.

The Delaware Supreme Court’s Decision

The Delaware Supreme Court affirmed in part the Court of Chancery’s decision regarding the fraud-based allegations, but importantly reversed the court’s application of the implied covenant of good faith and fair dealing.[2] The Supreme Court reiterated well-settled Delaware law that the implied covenant “inheres in every contract and ensures that neither party acts arbitrarily or unreasonably to frustrate the fruits of their bargain.”[3] As the Court explained, the implied covenant applies primarily in two circumstances: (1) when a contract allocates discretionary authority to one party over a central aspect of the contract, and (2) when a true contractual gap exists as to unforeseen developments that threaten the parties’ bargained-for economic expectations. The Court emphasized that this gap-filling power is a narrow remedy reserved for exceptional circumstances.

Here, the Court held that the implied covenant had no role to play because there was no genuine contractual gap for it to fill. The Court pointed to the merger agreement’s repeated and express conditioning of the regulatory milestone earnouts on obtaining FDA 510(k) premarket notification, as opposed to obtaining regulatory approval more generally. The Court viewed that drafting choice as reflecting the parties’ recognition that FDA developments could affect the value and achievability of the earnouts, as well as the parties’ deliberate allocation of regulatory risk to Auris’s stockholders.

The Court of Chancery also had held that the implied covenant had required Johnson & Johnson to pursue De Novo approval from the FDA because a shift from the 510(k) pathway to the heightened De Novo pathway would not have had a material effect on the time and cost of FDA clearance. The Supreme Court, however, rejected that view. As the Court explained, “[i]mmateriality bears on comparative burden; it does not rewrite a contractual requirement that the parties expressed in unambiguous terms.”[4] Because De Novo approval is not the same as a 510(k) premarket notification, the Court held that it could not be treated as contractually equivalent.

The Supreme Court also was unpersuaded by Fortis’s argument that the FDA’s prior acceptance of 510(k) submissions for similar devices meant that the 510(k) regulatory pathway had been the “only logical” one for the parties to consider in negotiating the merger agreement.[5] The Court held that although the parties had believed at the time that 510(k) clearance was the most likely pathway to approval, the FDA’s shift from the 510(k) pathway to De Novo review was not unforeseeable at the time of signing. The Court pointed to Johnson & Johnson’s and Auris’s prior experiences operating in a heavily regulated environment, as well as the fact that Auris, having navigated the FDA approval process for prior devices, understood that heightened regulatory scrutiny was always a possibility for novel, first-generation devices.

Importantly, the Court clarified that the implied covenant does not ask whether the parties expected a particular risk to materialize at signing or whether one result seemed the most “logical”; rather, it asks whether the possibility of a different outcome fell within the range of risks that reasonable parties in their position could have anticipated and bargained over. As such, it did not matter that the FDA had previously granted 510(k) approval for similar devices: That line of inquiry goes to likelihood, not foreseeability. The implied covenant does not permit courts to reallocate regulatory risk that was foreseeable at signing, even if it was viewed as unlikely.

Implications

The Court’s decision underscores the limits of the implied covenant of good faith and fair dealing. When structuring earnouts, particularly in transactions in highly regulated industries, precision in drafting is critical. Delaware courts will not invoke the implied covenant to reallocate foreseeable regulatory risk, even if the parties believed that such risk was unlikely to materialize.

• Sellers need to clearly specify obligations with respect to alternative regulatory pathways if they wish later to have rights with respect to those pathways. Where earnout milestones are tied to regulatory approval, parties should expressly state whether the buyer has an obligation – and, if so, the applicable efforts standard – to pursue alternative regulatory pathways if the initially contemplated pathway becomes unavailable. Absent such express language, Delaware courts are unlikely to use the implied covenant to read in an obligation to pursue alternative regulatory pathways.
• Do not draft only for “likely” outcomes. Prior regulatory approvals for similar products or devices may indicate that a particular regulatory pathway is likely to be available or successful, but they do not establish whether a shift in the regulatory pathway was foreseeable at signing. Parties should therefore explicitly allocate regulatory risks that may affect the timing, achievability or economics of an earnout. If a different regulatory pathway may change the transaction’s economic terms, parties should unambiguously allocate that risk.
• Expect Delaware courts to apply the implied covenant narrowly. The Court emphasized that the implied covenant is a “tool of last resort,” reserved to address “developments that could not be anticipated, not developments that the parties simply failed to consider.”[6] It cannot be used to rewrite or supplement contractual provisions to address regulatory risks that were foreseeable at signing. As the Court reiterated, the implied covenant is “a scalpel, not a brush.”[7]