In most M&A transactions, material adverse effects (MAE) clauses, are utilized in representations and warranties and closing conditions as a risk allocation tool and to narrow diligence issues. MAEs are rarely expected to be operative or used by one party to terminate a merger or acquisition agreement. One former colleague, an experienced M&A attorney, routinely waved away MAEs as largely irrelevant, saying, “I’ve never seen Bigfoot, and I’ve never seen an MAE,” emphasizing that we should save our dry powder for more important negotiated points.
However, the Delaware Court of Chancery recently found Bigfoot. In Akorn, Inc. v. Fresenius Kabi AG, C.A. No. 2018-0300-JTL (Del. Ch. Oct. 1, 2018), the Court held for the first time that a buyer properly terminated an acquisition agreement on the basis of an MAE and refused the seller’s request for specific performance of the merger agreement. In a one-page ruling on December 7, 2018, the Delaware Supreme Court affirmed the lower Court’s Akorn decision. In this article, we describe the background of Akorn, analyze the Court’s decision and provide some key takeaways for negotiating future M&A transactions under Delaware law.
On April 24, 2017, Fresenius Kabi AG, a German pharmaceutical company, agreed to acquire Akorn, Inc., an Illinois-based publicly traded specialty generic pharmaceutical company, in an all-cash deal where each share of Akorn stock would be converted into the right to receive a cash payment of $34 at closing. As is customary, Fresenius’s obligation to close was conditioned on Akorn’s representations having been true and correct both at signing and closing, except where failure to be true and correct would not reasonably be expected to have an MAE. Fresenius’s obligation to close was also conditioned on Akorn not having suffered an MAE in the interim period between signing and closing. Akorn also agreed to use commercially reasonable efforts to continue to operate its business in the ordinary course after signing.
In the quarter after signing, Akorn’s business performance quickly deteriorated. Akorn announced year-over-year declines for the quarter of 29% in revenue, 84% in operating income and 96% in earnings per share. Akorn’s executives attributed the poor results to unexpected new market entrants competing with Akorn’s key products. This competition exceeded Akron’s projections in its 2017 forecast. Fresenius executives met with Akorn management to understand the nature of the decline and began to explore Fresenius’s options under the merger agreement, including possible termination of the agreement. Akorn management assured Fresenius that the downturn was only temporary, but Akorn’s performance continued its downward trajectory in July and August of 2017.
Regulatory Compliance Issues
In late 2017, Fresenius received several letters from anonymous whistleblowers asserting that Akorn’s product development process failed to comply with regulatory requirements, including with respect to FDA regulations. Akorn was an FDA-regulated company, so these allegations were particularly concerning and called into question the accuracy of Akorn’s regulatory compliance representations and warranties and whether Akorn had breached its covenant to operate in the ordinary course of business. Fresenius began investigating the allegations and uncovered serious and pervasive data integrity problems. Fresenius concluded that Akorn’s representations and warranties about its regulatory compliance would reasonably be expected to result in an MAE and that Akorn had failed to conduct its business in the ordinary course.
Akorn also made fundamental changes to its quality control and information technology processes without the consent of Fresenius. As the Court noted, employees in Akorn’s quality and IT functions were informed that some of the 2017 quality control initiatives would cease as a result of the pending acquisition. This included replacing certain regular internal audits with “verification” audits, which were less stringent and focused only on addressing prior audit findings as opposed to identifying any potential new issues.
Fresenius Demands Out
In April 2018, Fresenius sent Akorn a letter stating that the conditions to closing could not be met and identifying Fresenius’s contractual bases for terminating the merger agreement. In an effort to help resolve the issues, Fresenius offered to extend the outside date by which the merger could be closed if Akorn believed further investigation could help Akorn resolve its difficulties. Akorn declined, however, and Fresenius gave notice it was terminating the merger agreement shortly thereafter. Fresenius terminated the merger agreement on three grounds:
- Akorn’s representations regarding regulatory compliance were so incorrect as would reasonably be expected to result in an MAE;
- Akorn had suffered a general MAE; and
- Akorn failed to use commercially reasonable efforts to operate in the ordinary course of business.
The Court ruled that Fresenius validly terminated the merger agreement on all three grounds, and that Fresenius had not been in material breach of its own obligations under the agreement.
Regulatory Compliance MAE
The Court conducted a qualitative and quantitative analysis of Akorn’s compliance with its regulatory representations and warranties. The standard analysis for determining if an MAE has occurred is whether the alleged violation would be considered “material when viewed from the longer-term perspective of a reasonable acquirer.”
In its qualitative analysis, the Court determined that compliance with FDA regulatory requirements was essential to Akorn’s business because the value of Akorn’s products and its developing products depended on its ability to meet FDA requirements.
In its quantitative analysis, the Court extensively reviewed the financial impact of Akorn’s pervasive regulatory compliance issues. The Court concluded that $900 million was the most credible estimate of the financial impact of Akorn’s data integrity issues, or 21% of the implied $4.3 billion equity value of Akorn under the terms of the merger agreement. After a lengthy discussion of what would be considered “material” under Delaware law and in the broader corporate context, the Court concluded that “an expense amounting to 20% of Akorn’s value would be material to a reasonable acquirer,” and that, as a result, the regulatory issues would reasonably be expected to result in an MAE. However, the Court took great pains to emphasize that 20% under no circumstances should be viewed as establishing a bright-line test or that revenue and profitability metrics are determinative to an MAE analysis.
The Court described general MAE clauses as a risk allocation device, typically allocating general market or industry risk to the buyer and target-specific risks to the seller. As noted above, with respect to a general MAE, the standard is whether the MAE is “material when viewed from the longer-term perspective of a reasonable acquirer.” The Court explained that a buyer “faces a heavy burden when it attempts to invoke a material adverse effect clause in order to avoid its obligation to close,” and “a short-term hiccup in earnings should not suffice.” In order for an MAE to exist, the effect in question should substantially affect the overall earnings potential of the target in a “durationally-significant manner,” which requires an intensive fact-based inquiry accounting for many variables, including seasonality, industry trends and a detailed analysis of the target’s business.
The Court analyzed the decline in Akorn’s business and found it to be durationally significant due to the decline in revenue, operating income and earnings per share in each of five straight quarters. The Court also noted that the decline showed “no sign of abating” based on contemporary analyst valuations of Akorn at between $5 and $12 per share, a far cry from the $34 per share offered by Fresenius. Akorn’s peers had not endured a similar decline, which supported Fresenius’s case.
Akorn presented a counterargument asserting that its decline in performance should be assessed against its synergistic value to Fresenius as opposed to as a standalone entity. The Court flatly rejected this argument and cited the language of the merger agreement that the MAE referred to the “results and operations of the Company and its Subsidiaries, taken as a whole.” In the Court’s view, if the parties wanted the MAE to apply to the synergistic value of Akorn to Fresenius, it would have said so and referenced the combined company.
The Court also rejected Akorn’s argument that it was the victim of an industry-wide decline, which was a risk assumed by Fresenius under the terms of the merger agreement. According to the Court, Akorn’s decline was disproportionate to its peers and a specific business risk that should be borne by the target company. Major contributors to Akorn’s decline were new market entrants and the loss of a key customer contract, both of which were specific to Akorn and not industry-wide concerns.
Ordinary Course Covenant Failure
In the merger agreement, Akorn committed to use “commercially reasonable efforts to carry on its business in all material respects in the ordinary course of business.” The Court broke this obligation down into its component parts and determined that Akorn had breached this covenant leaving Fresenius free to validly terminate the merger agreement.
First, the Court discussed what “in all material respects” means when considering the breach of a covenant. The Court relied on a formulation familiar in securities law and held that “in all material respects” requires only a “substantial likelihood that the…[breach] would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information.” The Court noted, however, that this was a lower standard than the MAE built into the regulatory compliance representation.
Second, the Court discussed what “commercially reasonable efforts” entail. The Court summarized the common distinctions M&A attorneys make between different efforts standards, including “best efforts,” “reasonable best efforts,” “reasonable efforts,” “commercially reasonable efforts,” and “good faith efforts.” The Court found these distinctions essentially meaningless and not supported by case law. Instead, the Court reaffirmed the Delaware Supreme Court’s view that efforts covenants in general “impose obligations to take all reasonable steps” in order to accomplish the applicable action. In the case of Akorn, the covenant required that Akorn “‘take all reasonable steps’ to maintain its operations in the ordinary course of business.”
Finally, the Court applied the standards above to the facts and determined that Akorn had indeed breached the ordinary course covenant. The Court focused on Akorn’s most egregious actions, including its departure from its regular audit assessments, failure to maintain data integrity and submission of FDA regulatory filings based on fabricated data. The Court concluded that Fresenius would not have agreed to buy Akorn if it understood that Akron would not address these issues in the interim period between signing and closing, which altered the total mix of information available to Fresenius at the time of the merger agreement and which made the breach material. The Court also doubted that the breach was curable since Akorn estimated it would take three years to cure its regulatory issues, well beyond the bounds of the outside date for completion of the merger.
MAEs Remain a Fact-Intensive Inquiry
Despite the Court’s ruling, it seems unlikely that we will see a marked increase in MAE terminations in the future. Buyers still bear a heavy burden to prove an MAE has occurred, and the Court emphasized that it was not setting any bright-line standards or blazing a new trail. Any dispute over an MAE will be fact-intensive and require egregious circumstances for the Court to determine that an MAE exists. As noted, a temporary dip in financial performance is insufficient to trigger an MAE. The decline must be serious and sustained. Therefore, buyers should not begin looking for an exit based on a single quarter of poor target financial results, and sellers likewise should not worry if poor results are seasonal or cyclical or if the seller’s performance fluctuates consistent in magnitude with a broader industry trend.
MAEs Can Be Operative, but Buyers Should Monitor Their Conduct
Buyers can take comfort that MAEs, under the right circumstances, are enforceable and operative under Delaware law. If the facts are egregious enough, buyers may be able to validly terminate an agreement based on an MAE. However, buyers should take care to monitor their own conduct between signing and closing to ensure they are not vulnerable to a seller counterclaim that the buyer is merely experiencing buyer’s remorse or looking for any way to exit the deal. The Court took special note of Fresenius’s conduct throughout the process and emphasized that Fresenius attempted to cooperate and work with Akorn while Akorn experienced business and regulatory difficulties, largely of Akorn’s own making. Fresenius also explored its options under the merger agreement but continued to publicly affirm the transaction and perform its obligations. It may be a fine line between exploring termination rights under the merger agreement and actively trying to scuttle a deal, so buyers would do well to consult with legal counsel early and often if they believe there is the possibility of an MAE or a violation of an MAE-qualified representation in the interim period between signing and closing.
Sellers Shouldn’t Count Their Chickens
Sellers should be cognizant that MAEs are not a get out of jail free card. The Court in Akorn determined that a 20% decline in the target’s total equity value based on a violation of a representation resulted in an MAE. While the Court emphasized this was in no way a bright-line test, this threshold is the only guidepost we have under Delaware law and will be one baseline for future MAE-related litigation. Additionally, Akorn did itself no favors here. It attempted to paper over the cracks in its compliance regime and actively departed from its prior internal audit procedures, practically inviting the Court to make its ruling. A seller may help avoid a similar outcome by operating as if it would continue to be a standalone company in the future, including adapting to changing business environments, as opposed to halting certain compliance functions due to a major pending transaction. If major changes are contemplated, communication with the buyer is essential and a seller should err on the side of requesting consent from the buyer to make such changes.
One Effort Standard
The Court also indicated that the traditional hierarchy of efforts standards employed by M&A attorneys (“best efforts,” “reasonable best efforts,” “reasonable efforts,” “commercially reasonable efforts,” etc.) may be irrelevant. It did not distinguish between the various efforts standards and instead applied a single standard that requires a party to “take all reasonable steps” to adhere to its obligations. This may save buyers and targets some time and fees in the future as M&A attorneys may no longer have to spend the time (and brain damage) arguing over the various efforts distinctions.
However, the Court did recognize that hell-or-high-water clauses were a separate standard and still required Fresenius to “take all actions necessary” to secure antitrust approval of the transaction. Therefore, it seems we may be moving to a two-tier standard comprised of reasonable efforts on the one hand and a hell-or-high-water clause on the other.