The frequently cited axiom of M&A litigation that no Delaware court has ever found a material adverse event (MAE) is no longer true. On October 1, 2018, the Court of Chancery (Laster, VC) ruled in favor of a buyer that had terminated a merger agreement and, in doing so, concluded that the target had suffered an MAE under the stringent standards of Delaware law.[1] While the high burden for establishing an MAE did not change as a result of this decision, prospective buyers and sellers should both be aware that Delaware courts will carefully analyze whether an MAE has occurred when presented with drastically changed and unexpected circumstances between signing and closing.

Background

On April 24, 2017, Fresenius Kabi AG, a German multi-segment pharmaceutical company with operations around the world, signed a merger agreement to acquire Akorn, Inc., a United States generic pharmaceutical company. Soon after signing, Akorn reported that, year-over-year, second-quarter revenue declined 29%, operating income declined 84%, and earnings per share declined 96%. Akorn’s business continued to underperform by significant margins for each of the following three quarters.

Compounding these business declines were whistleblower letters Fresenius received in the fall of 2017 drawing attention to FDA compliance issues at Akorn. Fresenius initiated its own investigation, which uncovered serious data integrity issues that threatened Akorn’s overall regulatory compliance and put at risk Akorn’s Abbreviated New Drug Applications pending with the FDA for products in Akorn’s pipeline. In addition, Akorn submitted a presentation to FDA that Fresenius claimed — and the court found — to be misleading.

Fresenius had seen enough. In a letter sent six days before the merger agreement termination date, Fresenius informed Akorn it believed Akorn had breached various provisions of the merger agreement, and it was prepared to terminate the merger agreement. As its bases for terminating, Fresenius cited Akorn’s representations and warranties related to regulatory compliance; Akorn’s covenants to operate in the ordinary course of business; and the existence of a general MAE based on the sharp decline in Akorn’s business. Fresenius offered to extend the closing deadline by six weeks if Akorn believed that further investigation into the FDA compliance issues would show that Akorn had fully performed. Akorn declined and filed suit seeking specific performance one day after Fresenius officially terminated the merger agreement.

The Court’s Ruling

After granting Akorn’s motion for expedited proceedings, the court conducted a five-day trial less than three months from the date the action was filed. In its post-trial opinion, after a detailed discussion of the types of economic risks contemplated by MAE clauses and how those types of risks are generally allocated between the parties, the court cited and re-affirmed the “heavy burden” a party faces when trying to prove an MAE in Delaware under cases such as Hexion Specialty Chemicals Inc. v. Huntsman Corp.[2] and In re IBP, Inc. Shareholders Litigation.[3] Under that test, an MAE must “substantially threaten the overall earnings potential of the target in a durationally-significant manner [and] should be material when viewed from the longer-term perspective of a reasonable acquiror”; “the important consideration . . . is whether there has been an adverse change in the target’s business that 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.”

(i) Occurrence of an MAE

The court held that Fresenius had carried its “heavy” burden and proved that Akorn’s business decline was unexpected, material, specific to Akorn, and durationally significant (i.e., that it would persist significantly into the future).

In so holding, the court did not set firm quantitative thresholds for materiality, but favorably cited treatises, Chancery Court dictum, and out-of-state cases to support its materiality conclusions. The court noted that, for the four quarters following execution of the merger agreement, Akorn experienced year-over-year declines in revenue of 27% to 34%, declines in operating income of 84% to 292%, and declines in EPS of 96% to 300%, and that, for 2017, Akorn reported a year-over-year decline in EBITDA of 86%. The court noted that these declines were a “departure from [Akorn’s] historical trend,” which had shown consistent growth in revenue, EBITDA, EBIT, and EPS for the past five years and, “[n]otably,” that performance in the quarter just before the merger agreement was signed did not exhibit such a downturn.

In ruling that this was not a case of buyer’s remorse, the court noted that by the time Fresenius terminated the merger agreement the declines had “persisted for a full year,” they “show[ed] no sign of abating,” and the reasons for the declines, including the FDA compliance issues, entry of competitors, and the loss of a key contract, were both unexpected and likely “to have durationally significant effects.”

Akorn advanced a number of arguments against finding an MAE, each of which the court rejected. The court declined Akorn’s bid to consider an MAE in the context of the anticipated combined entity (including expected synergies) based on the plain language of the merger agreement’s MAE definition. The court also rejected Akorn’s argument that there can be no MAE if the buyer can still make a profit off the deal, and drew a distinction between the common law doctrine of “frustration of purpose” and the lower bar of the parties’ MAE clause.

Finally, Akorn argued that the business decline was a result of “industry headwinds” that applied to the whole market and were, therefore, covered by an exception to the definition of MAE for systemic risks generally affecting the industry. The court disagreed, finding that, on the facts, the reasons for the decline were problems specific to Akorn or, in the alternative, even if they were industry factors, the factors disproportionately affected Akorn compared to the rest of the industry.

(ii) Breach of Regulatory Representations and Reasonable Expectation of an MAE

The court held Fresenius proved that Akorn’s regulatory-compliance representation was not true, given the significant problems uncovered by the data-integrity investigation. The court found that the cost to remediate those compliance issues that went to the core of Akorn’s business was approximately $900 million, or about 21% of the equity value of Akorn implied by the merger price, and so would “reasonably be expected to result” in an MAE, even for a strategic buyer.

(iii) Material Breach of Interim Operating Covenants

The court found that Akorn had materially breached its covenant to use commercially reasonable efforts to operate in the ordinary course of business between signing and closing, because Akorn — without advising Fresenius — canceled audits and ceased work on compliance improvements and data-integrity initiatives after signing. The court noted that compliance with FDA regulations is “essential” to a pharmaceutical company like Akorn. The court also repeatedly criticized Akorn for not properly investigating the compliance failures and submitting a regulatory filing to the FDA that relied on fabricated data, which “cost Akorn a year of what could have been meaningful remediation efforts.”

An appeal seems certain, and so this story is likely not yet over. As all cases do, this one turned on its facts. The undisclosed and unexpected regulatory problems that triggered a sharp financial decline that was expected to last for an extended period of time called into question the value of the seller in ways Delaware courts have not seen before. Time will tell if this decision stands, if it is an outlier, or if it is the beginning of a shift in the general reluctance of courts to entertain cases of claimed MAEs.