On October 1, in Akorn v. Fresenius Kabi, the Delaware Court of Chancery for the first time found that a material adverse effect — or MAE — had occurred in a merger transaction, which, combined with other breaches of the merger agreement, allowed the buyer to terminate the merger agreement and walk away from the transaction. While Akorn is notable in that Fresenius achieved what was heretofore the unprecedented, and seemingly insurmountable, task of establishing that an MAE had occurred, the careful and thorough analysis by the Court of a relatively standard public-company merger agreement highlights that the result was driven by specific — and oftentimes egregious — facts rather than any drastic re-interpretation of MAE clauses under Delaware law. Nonetheless, the case is replete with practical lessons for buyers and sellers alike in negotiating M&A transactions.
The dispute in Akorn arose from the proposed sale of U.S. generic drug manufacturer Akorn to German pharmaceutical company Fresenius Kabi. After the parties signed a merger agreement in April 2017, and following a precipitous and sustained decline in Akorn’s financial performance, Fresenius invoked the MAE clause under the merger agreement, asserting that Akorn had suffered an MAE that relieved Fresenius of its obligation to close the transaction. Fresenius separately asserted its right to terminate the merger agreement on the basis that Akorn’s regulatory compliance representations and warranties were so inaccurate as would reasonably be expected to result in an MAE, and that Akorn failed to comply in all material respects with its obligation to use commercially reasonable efforts to operate in the ordinary course pending consummation of the merger.
Fresenius’ arguments were based principally on (1) the dramatic and sustained decline in Akorn’s financial performance, (2) Akorn’s failures to comply with U.S. Food and Drug Administration data integrity and other regulatory requirements (which were flagged for Fresenius in two whistleblower letters from an Akorn employee) and (3) Akorn’s failure to take reasonable actions to rectify such regulatory deficiencies. The Court, in its October 1 decision, while reaffirming the heavy burden that Delaware courts place on a buyer asserting that an MAE had occurred, found that Fresenius had indeed met this burden.
Material Adverse Effect
The Court in Akorn analyzed MAE in two separate contexts: (1) in the “stand-alone” MAE closing condition, which entitled Fresenius not to close if an MAE had occurred and (2) in the “representation bring-down” closing condition, which entitled Fresenius not to close, and to terminate the merger agreement, if any of Akorn’s representations (here, the regulatory compliance representations) were so inaccurate as to reasonably be expected to result in an MAE. (These provisions were drafted in the typical manner for public-company merger agreements.)
The Court’s analysis of the stand-alone MAE followed the standard established in prior precedents: An alleged MAE must “substantially threaten the overall earnings potential of the target company in a durationally significant manner” (i.e., “measured in years,” not months) and cannot be a “short-term hiccup.” For the four quarters following the signing of the merger agreement, Akorn’s financial results “fell off a cliff”: revenues declined 29%, 29%, 34% and 27%, respectively, and operating income declined 84%, 89%, 292% and 134%, respectively, in each case compared to the same quarter in the prior year. This stood in stark contrast to Akorn’s consistent growth over the time period preceding the signing of the merger agreement. After determining that none of the contractually agreed-upon MAE exceptions applied — most notably that the decline in performance was not the result of “industry-wide effects” — the Court found that a stand-alone MAE had occurred.
While Fresenius was excused from closing based on the stand-alone MAE, the affirmative ability to terminate the merger agreement required Fresenius to show, among other things, that (1) Akorn’s representations in the merger agreement were inaccurate as of the time that the closing would have occurred and (2) the degree of such inaccuracy was so substantial that it would reasonably be expected to result in an MAE. The Court reviewed Akorn’s representation that it was in compliance with all applicable regulatory (i.e., FDA) requirements, and analyzed the materiality of the alleged inaccuracies, from both a qualitative and quantitative perspective, against a previously articulated Delaware standard: “material when viewed from the longer-term perspective of a reasonable acquiror.” As to qualitative factors, the Court noted that FDA compliance for Akorn, as a generic pharmaceutical company, is “an essential part of Akorn’s business,” and most notably cited a former Akorn consultant’s testimony that the company’s regulatory deficiencies were so fundamental that he would not expect to see them “‘at a company that made Styrofoam cups,’ let alone a pharmaceutical company.” As to the quantitative factors, the Court analyzed estimates of the cost of remediating Akorn’s regulatory noncompliance, and determined that such costs would reduce Akorn’s value by approximately $900 million, a decline of 21%. The Court held that Akorn’s regulatory issues would reasonably be expected to result in an MAE, from either a qualitative or a quantitative perspective.
While M&A legal advisors can no longer counsel that no Delaware court has ever found an MAE, Akorn reaffirms the long-standing guidance of Delaware courts that buyers will continue to bear an extremely heavy burden in establishing a stand-alone MAE to avoid their obligations to close.
However, we expect the Court’s discussion of MAE in the context of the bring-down closing condition to garner more attention, and in particular the quantitative analysis that concluded that an issue that would result in a 21% decline in Akorn’s overall valuation would reasonably be expected to result in an MAE. Notwithstanding the Court’s express admonishment that “[n]o one should fixate on a particular percentage as establishing a bright-line test,” Akorn provides the only data point to date in favor of an MAE finding, and will therefore necessarily feature in legal advisors’ counsel going forward. That said, the Court’s articulated test — that an effect must be “material when viewed from the longer-term perspective of a reasonable acquirer” — will remain a necessarily fact-intensive inquiry.
Other Implications and Practical Considerations
Aside from the headline MAE issue, the opinion offers a number of other practical lessons for M&A practitioners.
Along with its MAE findings, the Court determined that Fresenius was also entitled to terminate the merger agreement because Akorn failed to conduct its operations between signing and closing in the “ordinary course of business.” Among the factors cited by the Court in reaching this finding were: a failure to continue regular audits and remediate compliance deficiencies, refusal to maintain company data integrity systems, submission of fabricated data to the FDA and inadequately investigating allegations of wrongdoing submitted in multiple whistleblower letters. Under Akorn, the target company is required to operate as a reasonable company would in the same industry under similar circumstances. In other words, a requirement to operate “in the ordinary course of business” does not mean merely maintaining status quo — a target company must react to new circumstances reasonably and appropriately, without regard to the fact that a merger agreement has been entered into.
All “Efforts” are the Same
The Court noted that while deal lawyers will often recite a hierarchy of efforts standards (namely, “best efforts” > “reasonable best efforts” > “commercially reasonable efforts”), those distinctions are not supported by Delaware law. Putting aside the lowest rung in the spectrum (“good faith efforts”), the Court expressly equated the other efforts-based standards and held that each standard simply requires that the applicable party “take all reasonable steps” to fulfill the applicable obligation. In practice, this should lead deal lawyers to spend less time negotiating such standards.
Meaning of “In All Material Respects”
The Court analyzed whether Akorn complied “in all material respects” with its obligation to conduct its operations between signing and closing in the ordinary course of business. Akorn, as expected, proposed a high standard: that a breach must “touch the fundamental purpose of the contract that defeats the object of the parties in entering into the contract.” The Court disagreed, and applied a lower standard: a breach will be material if there is a “substantial likelihood that the… fact [of breach] would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information.”
Meaning of “Executing”
Akorn argued that Fresenius had breached the parties’ confidentiality agreement because Akorn’s confidential information could only be used “for the purpose of evaluating, negotiating, and executing” a transaction, and not in furtherance of Fresenius’s investigations leading to the litigation to terminate the merger. The Court instead agreed with Fresenius that its investigation fell within the definition of “executing” because it was part of “carrying out” the transaction, which necessarily includes the ability to evaluate one’s rights and obligations under the agreements governing the transaction. To attempt to foreclose this result, we would expect target companies to seek to eliminate a prospective buyer’s ability to use confidential information to “execute” the transaction, or potentially include an express prohibition on the use of such information in litigation against, or to investigate, the target company. We expect prospective buyers to resist conceding their ability to enforce rights they have not yet negotiated.
Importance of Information Access Rights
A buyer’s pre-closing information access rights in an M&A transaction are common, and generally not controversial. However, this case highlights the critical role such rights play when a transaction goes sideways. Without them, it seems unlikely (notwithstanding the whistleblower letters) that Fresenius would have been able to uncover the degree of regulatory non-compliance that led it to conclude it could terminate the merger agreement. Following Akorn, we expect to see a renewed focus by buyers and target companies to expand or restrict these provisions, respectively.
Delaware Remains “Pro-Sandbagging”
Akorn attempted to argue that Fresenius had assumed the risk of Akorn’s regulatory non-compliance because Fresenius knew about the risk of potential issues (through its pre-signing due diligence and its own industry experience), and because the relevant representations carried an MAE qualifier. In rejecting this argument, the Court seemed to reaffirm Delaware’s consistent “pro-sandbagging” posture, which favors parties’ express contractual risk allocation over a “more amorphous and tort-like concept of assumption of risk.” Sophisticated parties will remain aware that courts in different jurisdictions in the United States (e.g., California) take a different view, and the absence of express contractual language may lead to very different outcomes.
Buyer’s Clean Hands
The Court seriously considered Akorn’s argument that Fresenius was motivated by buyer’s remorse, and should have been barred from exercising its right to terminate based on its own failure to use reasonable best efforts to close the transaction. Fresenius was able to rebut this argument by showing that it continued its efforts to close the transaction until it terminated the merger agreement, for example, by repeatedly and publicly stating that it was committed to the transaction, offering Akorn additional time to cure the problems identified in Fresenius’s investigation and maintaining its efforts to obtain antitrust approval for the transaction. Accordingly, even in the context of considering a potential termination, a buyer should not cease its efforts to obtain regulatory approvals or comply with other affirmative pre-closing covenants, and instead should proceed on a “dual track” in which it continues its efforts to satisfy all closing conditions while also investigating its ability to terminate the agreement prior to closing.
Fresenius agreed to “take all actions necessary” to secure antitrust approval of the transaction, including agreeing to divest its overlapping assets, or any other remedies required by regulators. Fresenius’s compliance with this “hell-or-high-water” provision was critical to the Court’s analysis, as a material breach by Fresenius would have affected its ability to terminate the transaction (although it still could have refused to close so long as the stand-alone MAE was not cured). The Court ultimately found that Fresenius had breached this high standard by briefly pursuing a strategy that would have delayed antitrust approval, but because it reversed course after just a week the breach was deemed immaterial, and therefore Fresenius’s termination right was not disqualified. The Court’s finding appeared colored by the fact that, while the merger agreement obligated Fresenius to comply with a regulator’s demands, it also allowed Fresenius to control the overall antitrust strategy with the regulators, which afforded Fresenius considerable leeway in setting a strategy that would have resulted in FTC approval within the timeframe prescribed by the merger agreement. To obtain the full benefit of the bargain in a hell-or-high-water provision, target companies should seek some level of control or input on antitrust strategy, or at least limit a buyer’s discretion in formulating strategy.