Earlier this month, in Akorn, Inc. v. Fresenius Kabi A.G., the Delaware Court of Chancery sustained a would-be buyer’s termination of a merger agreement because, among other things, the target company had suffered a material adverse effect (MAE). The 246-page decision is notable for several reasons:
- First, although MAE clauses (also called “MAC” clauses, for material adverse change) are ubiquitous in merger agreements and litigation of MAE clauses is not uncommon, only rarely has a party been successful in terminating a merger agreement in reliance on an MAE clause alone. In fact, Akorn is the first time that a Delaware court has permitted a buyer to rely upon a MAE to walk away from a deal.
- Second, the Court’s reasons provide useful guidance about the qualitative and quantitative factors that should be taken into account in determining whether a MAE has occurred.
- Third, while the Akorn decision is not binding on any Canadian court, it could become influential on this side of the border.
Arguably, although the result may be unprecedented, the decision in Akorn did not create any new law. The facts of this case were extraordinary. The decision’s greatest significance may be in illustrating that MAC clauses are not theoretical: on the right (or wrong) facts, a court will step in and permit a bidder to walk away from an agreed transaction.
Fresenius is a German healthcare company and Akorn is a NASDAQ-listed specialty generic drug manufacturer. In April 2017, following completion of a lengthy due diligence process and iterative negotiations, Fresenius reached an agreement to acquire Akorn for US$34 per share (US$4.3 billion) in cash.
The merger agreement contained customary closing conditions, which relieved Fresenius of its obligation to complete the acquisition if, among other things and prior to closing, (a) Akorn breached its representations and warranties and the magnitude of the breach would reasonably be expected to result in an MAE (the “bringdown condition”) or (b) Akorn suffered an MAE (the standalone “general MAE”).
Despite Akorn having reiterated its previous full-year earnings guidance at the time of announcing the merger agreement, “…immediately after the signing of the Merger Agreement, Akorn’s performance dropped off a cliff.” Soon after Akorn’s stockholders approved the merger, Akorn announced its second quarter results, with year-over-year revenues down by 29%, year-over-year net operating income down by 84% and year-over-year earnings per share down by 96%. Although Akorn’s CEO reassured Fresenius that the downturn was temporary, Akorn’s management was forced to adjust the company’s earnings guidance downward and Akorn’s financial performance continued to deteriorate. In November 2017, when Akorn announced its third quarter results, year-over-year revenues were down by 29%, year-over-year net operating income was down by 89% and year-over-year earnings per share were down by 105%.
Akorn’s difficulties didn’t end there. During Akorn’s third quarter, Fresenius received two anonymous whistleblower letters that raised concerns with Akorn’s product development and quality control processes and regulatory compliance. The letters triggered investigations by Fresenius and Akorn and, in reviewing the results of those investigations, the Delaware court found evidence of numerous instances of altered, missing and false data that were used in some of Akorn’s regulatory applications and new product approval processes. Taken together, these findings raised concerns about the integrity of Akorn’s internal controls and its regulatory compliance.
After these financial and compliance concerns surfaced, and despite its senior management team’s misgivings, Fresenius maintained its public support for completing the merger until at least January 2018. In February 2018, tensions between the parties escalated as their respective legal counsel squabbled over the scope of the internal investigation and how their respective findings should be presented to Akorn’s regulators. On April 18, 2018, Fresenius wrote to Akorn, asserting that Akorn had breached various provisions in the merger agreement, including regarding regulatory compliance, but offered to extend the outside date for closing to provide Akorn an opportunity to rebut Fresenius’s assertions. Akorn declined that offer.
On April 22, 2018, Fresenius gave notice of termination of the merger agreement, citing both Akorn’s inability to satisfy the bringdown condition and the occurrence of a standalone MAE. The following day, Akorn commenced an action seeking specific performance of the merger agreement. While the litigation was ongoing, Akorn announced its financial results for the first quarter of 2018, reporting that year-over-year revenues were down by 27%, year-over-year net operating income was down by 134% and year-over-year earnings per share were down by 170%.
The MAE Clause
MAE clauses are essentially risk allocation tools and, unsurprisingly, not all unfortunate events that may occur after signing a merger agreement and before closing will entitle a prospective buyer to walk away from a bad deal. In general terms, in a typical MAE clause (as was the case in Akorn):
- the buyer assumes all risks associated with any adverse material change in the general economic environment, laws, accounting principles and the industry in which the target company operates (“exogenous or systematic risks” that are “beyond the control of all parties”), except to the extent that any exogenous or systematic risk has a disproportionate adverse effect on the target company; and
- the target assumes all risks associated with any adverse material change that is specific to the target company (“endogenous risks”), as well as any exogenous or systematic risk that has a disproportionate adverse effect on the target company.
As is customary, the merger agreement in Akorn did not define what is “material.” In part, that is because it can be exceedingly difficult (although not impossible) for parties to agree on precise, quantifiable metrics (eg., a decrease in sales or earnings, a prescribed decrease in stock price, a loss of a specific contract, etc.) against which to measure materiality when they are negotiating a merger agreement. In part, it might also be because the uncertainty of leaving materiality undefined creates “productive opportunities for renegotiation” should an unfortunate event occur before closing.
In considering the application of the MAE clause in Akorn against the factual context, the Court made two important findings:
- Akorn had breached the bringdown condition, because its representations and warranties concerning regulatory compliance were not true and correct and the magnitude of the inaccuracies would reasonably be expected to result in an MAE; and
- The sudden and sustained drop in Akorn’s business performance following execution of the merger agreement constituted a general MAE.
In its lengthy reasons, the Court identified at least five factors that supported the buyer’s proper termination of the merger agreement:
- The suddenness of Akorn’s downturn – the Court noted that, beginning in the quarter right after the merger agreement was announced, “Akorn’s business performance fell off a cliff, delivering results that fell materially below Akorn’s prior-year performance on a year-over-year basis,” even though Akorn had re-affirmed its full-year earnings guidance at the time of announcement.
- The magnitude of Akorn’s downturn - after considering expert testimony from both parties, the Court concluded that Akorn’s financial performance had declined materially, with five consecutive quarters of double or triple digit, year-over-year declines in its revenue, operating income and earnings per share. Also, the Court noted that, in the five years ended 2016, Akorn had reported annual increases over the previous year’s EBITDA of between 10% and 147%, as compared to a 55% decline in EBITDA for 2017 – which represented a “departure from its historical trend.
- The durational significance of Akorn’s downturn - the Court found that the underlying causes of Akorn’s decline went beyond a short-term hiccup in earnings and were material when company’s overall earnings potential in a durationally-significant manner, noting that “[I]t has already persisted for a full year and shows no sign of abating.” Additional support for that conclusion was found in analyst estimates that were published during the months following the announcement of the merger agreement, which had been revised downwards by double digits. As such, the Court concluded that the decline in Akorn’s performance was “material when viewed from the longer-term perspective of a reasonable acquirer, which is measured in years.”
- The disproportionate effect of industry headwinds on Akorn’s downturn – the Court rejected Akorn’s argument that its financial downturn was caused principally by “industry headwinds,” including by a prevailing consolidation of buyer power and by the FDA’s efforts to approve more generic drugs, resulting in lower prices. First, the Court found that the primary drivers of Akorn’s dismal performance were internal and company-specific, which risks are allocated to the target in the MAE definition. Second, the Court found that, to the extent there were industry headwinds, Akorn suffered disproportionately, and systemic risks that have a disproportionate effect are likewise allocated to the target in the MAE definition. Specifically, the Court took note of expert evidence that showed that Akorn’s percentage declines in reported quarterly EBITDA and analysts’ forward EBITDA estimates were markedly sharper than the medium and mean of its peers.
- The qualitative harm done to Akorn’s business as a result of its poor regulatory compliance, which was unknown to Fresenius when it signed the merger agreement. Qualitative harm changes the nature of what the buyer had agreed to buy. The Court, after noting that Akorn’s compliance with the FDA’s regulatory requirements was an “essential part of Akorn’s business,” found that, during the period following the signing of the merger agreement, “Akorn [had] gone from representing itself as an FDA-compliant company… to a company in persistent, serious violation of FDA requirements with a disastrous culture of non-compliance.” Moreover, there was no quick fix for this qualitative harm: “The evidence at trial demonstrated that Akorn had pervasive regulatory issues that would take years to fix.”
At first blush, the Delaware court’s decision in Akorn might seem like a departure from its precedents. In two earlier prominent decisions, the Delaware Court had refused to sanction a buyer’s termination of a merger agreement in purported reliance on MAC clauses:
- In a 2001 decision, IBP v. Tyson Foods1, Tyson had attempted to terminate a US$1.6 billion merger with IBP because, after signing the merger agreement, IBP announced a 64% year-over-year drop in quarterly sales and a US$60 million accounting restatement due to a fraud uncovered in a subsidiary. The Court specified a three-part test for finding an MAE: (i) the occurrence of unknown events that (ii) substantially threaten the overall earnings potential (iii) in a durationally-significant manner. While accepting that Tyson had valid concerns about IBP’s earnings prospects and management credibility, the Court declined to find that a MAC had occurred, in part because of Tyson’s state of knowledge about the risks associated with IBP’s business prior to signing the merger agreement, and because Tyson’s public statements to analysts and the media to the effect that its motivation for acquiring IBP was driven more by a desire to achieve synergies than to benefit from IBP’s expected financial performance. In the result, the Court concluded that the main reason for Tyson’s desire to terminate the merger agreement was “buyer’s regret,” which was not sufficient to invoke a MAC clause.
- In 2008, just as the world was starting to come to terms with the global financial crisis, a buyer tried terminating a merger agreement when the target company experienced consecutive quarters of poor financial performance, repeatedly missing the financial forecasts that it had shared during due diligence. In deciding Hexion Specialty Chemicals v. Huntsman2 against the buyer, the Court held that, because the target had specifically excluded the missed forecasts from its representations, the failure to achieve them could not constitute a MAE. Moreover, the Court stated that, to validly rely upon a MAC, the buyer must show that the adverse change “is consequential to the company’s long-term earnings power over a commercially reasonable period, which one would expect to be measured in years rather than months.” In the result, the Court concluded that a few awful quarters of financial performance was not sufficient to invoke a MAC clause.
At least arguably, the magnitude and duration of Akorn’s post-announcement difficulties exceeded those of the target companies in both IBP and Huntsman. And, unlike the buyer in IBP, there was no evidence that the buyer in Akorn had any foreknowledge of those difficulties. Moreover, the potential long-term detrimental impact of Akorn’s serious regulatory compliance issues appeared to exceed the likely duration of the challenges faced by the target companies in IBP and Huntsman. In addition, in Akorn, the court took notice that Fresenius was careful not to overreact to Akorn’s deterioration and refrained from making any public (and few private) statements that were inconsistent with working towards completing the agreed transaction.
A conventional MAE clause does not typically offer the buyer a successful escape from a bad deal, but is instead used as leverage to renegotiate price. Several previous Delaware decisions had placed a heavy burden on buyers seeking to avoid a deal. Without an occasional win by a buyer on an MAE litigation, that leverage can wane. Akorn may have breathed new life into the leverage, but it would be wrong for buyers to take too much comfort from this decision. MAE litigation tends to be highly fact-specific, and the facts in Akorn were extraordinary.
Moreover, in Canada (in part because our securities regulators do not require parties to pre-clear proxy materials), we often close M&A transactions more quickly than in the United States. At the same time, our civil litigation process sometimes takes longer and an expedited application may afford less opportunity to surface extraordinary facts. Taken together, while a MAC clause does afford a bidder with more than theoretical leverage, these factors could make it more challenging for a bidder to demonstrate sufficient “durational significance” in a Canadian litigation.