In a first-of-its-kind post-trial opinion, the Court of Chancery ruled on October 1 in Akorn, Inc. v. Fresenius Kabi AG, C.A. No. 2018-0300-JTL, that German pharmaceutical company Fresenius Kabi AG had properly terminated its agreement to purchase U.S. drug maker Akorn, Inc. because Akorn had suffered a material adverse effect (MAE). No prior Chancery rulings have found a buyer was justified in terminating a merger agreement on the basis of a claimed MAE.

The parties entered into a merger agreement in April 2017. In the merger agreement, Akorn made various representations and warranties about its compliance with applicable regulatory requirements and committed to use commercially reasonable efforts to operate in the ordinary course of business. Fresenius’s obligation to close the deal was conditioned upon Akorn’s not having suffered an MAE between signing and closing, and upon Akorn’s material compliance with its obligations under the merger agreement.

The court found that, within months of signing, “Akorn’s business performance fell off a cliff.” Akorn’s year-over-year EBITDA declined 86 percent in the quarter after the merger agreement was signed, and, despite assurances from Akorn’s management that things would improve, they only got worse.

Akorn’s problems were not only financial. Fresenius received letters from multiple anonymous whistleblowers accusing Akorn of regulatory breaches. In response, Fresenius conducted its own investigation under a cooperation provision of the merger agreement. Fresenius’s investigation uncovered “serious and pervasive data integrity problems,” none of which Akorn had disclosed to Fresenius. Among its primary concerns, Fresenius learned that Akorn had been misleading the U.S. Food and Drug Administration, its primary regulator.

In the following months, Akorn’s business continued to deteriorate, and Fresenius eventually terminated the merger agreement, asserting, among other things, that Akorn’s regulatory compliance representations were “so incorrect that the deviation would reasonably be expected to result in a Material Adverse Effect.” Akorn brought suit to compel Fresenius to close. Following an expedited trial, the court made three key findings:

First, Fresenius validly terminated the Merger Agreement because Akorn’s representations regarding its compliance with regulatory requirements were not true and correct, and the magnitude of the inaccuracies would reasonably be expected to result in a Material Adverse Effect.

Second, Fresenius validly terminated because Akorn materially breached its obligation to continue operating in the ordinary course of business between signing and closing.

Third, Fresenius properly relied on the fact that Akorn has suffered a Material Adverse Effect as a basis for refusing to close.

With respect to its first and third findings, the court held that Akorn had suffered an MAE because, among other things, (i) it had suffered an 86 percent decline in EBITDA from the prior year, (ii) its stock price was estimated to have dropped from $32.13 per share just before signing to between $5.00 and $12.00 per share after signing, and (iii) testimonial and documentary evidence demonstrated that Akorn’s sudden economic downturn was likely to continue, given the recent emergence of unexpected new market competitors.

With respect to its second finding, the court found that Akorn had failed to use commercially reasonable efforts to operate in the ordinary course of business post-signing. The court determined that as soon as the parties signed the merger agreement, Akorn canceled regular audits, assessments and inspections of known problems specifically because of the pending merger. Akorn also failed to maintain its data integrity system and submitted regulatory filings that contained inaccurate data, all of which were deviations from the ordinary course of Akorn’s business. The court found that these violations were material because, among other reasons, they cost Akorn “a year of what could have been meaningful remediation efforts” and only led to the further deterioration of numerous existing shortcomings.

The court differentiated this case from other MAE claims in which buyers have second thoughts or “buyer’s remorse” about an acquisition after “cyclical trends or industrywide effects negatively impacted their own businesses, and who then filed litigation in an effort to escape their agreements without consulting with the sellers.” In the Akorn case, the court concluded, Fresenius responded to “a dramatic, unexpected, and company-specific downturn in Akorn’s business” and “whistleblower letters that made alarming allegations about data integrity issues at Akorn.” The cumulative impact of Akorn’s deficiencies warranted Fresenius’s exercising its contractual right to terminate the merger agreement on the basis of an MAE.

This ruling opens a new page in MAE litigation and provides important guidance to acquirers and targets. Buyers that are considering relying on an MAE to terminate a merger agreement must ensure that their concerns are specific to the target company rather than the industry as a whole and that the seller’s overall conduct was so detrimental and pervasive as to constitute a deviation from the ordinary course of business. Sellers must ensure that their post-signing operation of the company is sufficiently consistent with their pre-signing conduct to be ordinary course, lest they leave themselves vulnerable to potential MAE claims.