The Delaware Court of Chancery’s October 1, 2018 decision in Akorn Inc. v. Fresenius KABI AG (“Akorn”) marked the first time that any Delaware court has determined that a buyer should be released from its obligation to close an M&A transaction because of the occurrence of a Material Adverse Effect (“MAE”). In a terse three-page order dated December 7, 2018 in which the Delaware Supreme Court specifically declined to address “every nuance of the complex record” and largely confined itself to affirming the main findings of law by the Court of Chancery, the court upheld the Court of Chancery’s decision. However, the Court of Chancery’s opinion emphasized the seller’s (Akorn) egregiously bad post-signing conduct, which indicates the holding was very fact-specific and casts some doubt on its precedential value. The court’s exhaustive 246-page opinion nevertheless provides a number of important takeaways for M&A practitioners and their clients on the current state of the law regarding enforceability of MAE clauses under Delaware law.
The Evidentiary Bar for Establishing a MAE under Delaware Law Remains High. Notwithstanding the court’s holding in Akorn, because of the uniquely bad facts of the case, we expect that as a general matter it will continue to be extremely difficult for a buyer to establish the occurrence of a MAE under Delaware law. As described in the Court of Chancery’s opinion, these bad facts include, among other things, that Akorn lacked credible compliance and quality control functions and was “in persistent, serious violation of FDA requirements with a disastrous culture of non-compliance,” despite “extensive representations” that it was operating in compliance with applicable laws and FDA regulations. The court also found that, due to Akorn’s breach of the various regulatory and compliance representations in the merger agreement, Akorn had lost approximately $900 million of its value against an original purchase price of $4.75 billion. In addition, the court found that Akorn’s financial performance had fallen “off a cliff” and experienced a “sudden and sustained drop” after Akorn’s stockholders approved the merger. The initial revenue target miss of approximately 25 percent was followed by a sustained decline in Akorn’s business and, as of the trial, Akorn’s financial picture showed no signs of improvement. We expect that future disputes over similar provisions will be very fact-intensive, and only rarely will a case present itself in which the target’s financial performance deteriorates so dramatically and for such a sustained period and in which the target’s actions that contributed to the deterioration are so egregiously bad. Thus, Akorn will likely be viewed as consistent with the general understanding that there is and will continue to be a high bar for establishing the occurrence of a MAE under Delaware law.
A One-Time Dip in Earnings Potential of the Target Does Not Constitute a MAE. The Court of Chancery’s opinion reaffirmed that only a sustained and severe business decline, not due to general economic or industry factors merely, is necessary to find a general MAE; a mere temporary downturn in financial performance is insufficient. Although the court was careful not to draw a bright line as to how much value must be lost, it found that a 21% decline in the target company’s standalone equity value, when taken together with the other circumstances presented to the court (including loss of a significant contract and increased competition from new market entrants) suggesting a low probability of recovery in the near term, was sufficient to trigger a MAE.
Materiality Standard Applicable to Breach of an “Ordinary Course” Covenant. The opinion clarified that a seller’s failure to respond reasonably to an unforeseen adverse development affecting its business could allow a buyer to terminate an acquisition agreement even in the absence of a finding that a MAE occurred. Among its other findings, the court found that Akorn committed a material breach of the covenant to operate its business in the ordinary course “in all material respects” between signing and closing by failing to use sufficient efforts to remedy its compliance and quality control failures relative to what a reasonable pharmaceutical company would have done under similar circumstances. The materiality standard applied by the court was whether the breach was “significant in the context of the parties’ contract” and “a deviation from the buyer’s reasonable expectations regarding what it would receive at closing.” The court indicated that Akorn’s failure to meet this standard provided Fresenius with an independent basis to terminate the transaction, even if the court had determined that a MAE had not occurred.
Absent Specific Carveouts, Pro-Sandbagging Clauses Remain Generally Enforceable by Delaware Courts. The court rejected the “anti-sandbagging” argument by Akorn that Fresenius should be deemed to have assumed the risk of loss in connection with any issue that Fresenius knew or should have known about through its due diligence examination of Akorn. The court found that the decline in Akorn’s business was unexpected. However, even had it been foreseeable, since the parties did not include within the MAE clause an exception for “matters disclosed during due diligence” and did not define MAE to include only “unforeseeable effects, changes, events, or occurrences,” the buyer could not be deemed to have assumed the risk of problems that it knew or should have known about through its due diligence process. The court’s opinion therefore serves as a reminder that in seeking to allocate known risks through a MAE clause, parties should draft the risk allocation language with specificity.
Delaware Law Does Not Recognize Differences Among the Various “Efforts” Standards. Akorn also reaffirmed that, under Delaware law, all “efforts” clauses are treated as being substantially identical, such that language calling for a party to use “best efforts” or “reasonable best efforts” or “commercially reasonable efforts” all are deemed under Delaware law to require the party to take “all reasonable steps” to fulfill its obligations. In view of the court’s stance, a party desiring a different or clearer standard for determining what “all reasonable steps” means should consider drafting a covenant that details the specific steps that the parties are required to take.
Importance of Buyer’s Good Faith Response to a MAE or Breach. Akorn made clear that it is vitally important that a buyer responds to a potential MAE or other seller breach in good faith by continuing to perform its contractual obligations under the acquisition agreement. The court credited Fresenius with demonstrating its commitment to proceed with the transaction, notwithstanding its mounting concerns regarding Akorn’s financial condition, by continuing to seek antitrust clearance, proceeding with integration planning, offering Akorn an opportunity to correct any inaccuracies in Fresenius’ understanding of its financial and regulatory issues, and even offering to extend the drop-dead date of the merger to allow Akorn to right its problems. The court suggested that had Fresenius materially breached its obligation to use reasonable best efforts to close the transaction, the court might have ruled differently. It cannot be overstressed, therefore, that a party seeking to establish the occurrence of a MAE as a basis for terminating an acquisition agreement should bring “clean hands” to the court by demonstrating that it used reasonable best efforts to close the transaction, notwithstanding the occurrence of the MAE.