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M&A practitioners have long advised boards of directors that the Delaware courts have never found that the events or circumstances in a particular transaction met the contractual standard of having a material adverse effect (or MAE) as defined in a merger or acquisition agreement. Therefore, the board should have a high degree of confidence in deal certainty. We can no longer give this advice. In its decision in Akorn, Inc. v. Fresenius Kabi AG, C.A. No. 2018-0300-JTL (Del. Ch. Oct. 1, 2018), the Delaware Court of Chancery found, following a trial, that the acquirer Fresenius properly terminated its merger agreement with the public company target, Akorn, due to the target’s breach of representations and warranties relating to its regulatory compliance that constituted an MAE and due to the target’s failure to comply in all material respects with its pre-closing covenant to use commercially reasonable efforts to operate in the ordinary course of business. The court also found that Fresenius was justified in not closing the transaction before the end date because of the occurrence of an MAE. In reaching these holdings, the court found that:
- the target’s business experienced a “dramatic, unexpected and company-specific downturn” shortly after signing due in part to “serious and pervasive data integrity problems” that adversely impacted the target’s regulatory compliance
- the adverse change in the target’s business was consequential to the target’s long-term earnings power over a commercially reasonable period measured in years rather than months
- the adverse change constituted an MAE as defined in the merger agreement
- the target failed to use commercially reasonable efforts to operate in the ordinary course of business in all material respects as a result of its numerous regulatory compliance failures
This decision does not fundamentally alter the fact that MAE is a high standard, but it provides acquirers with a better roadmap for terminating or renegotiating an agreement on the grounds of an alleged MAE and provides meaningful teeth to the pre-closing affirmative operating covenants.
The Merger Agreement
In April 2017, Fresenius agreed to acquire Akorn, a US-based, Nasdaq-listed specialty manufacturer and marketer of generic prescription and over-the-counter pharmaceutical products, for $35 per share or approximately $4.75 billion. Akorn’s business model is based on offering generic products with complex manufacturing processes or alternative dose forms from the branded drugs. Akorn’s primary regulator is the Federal Food and Drug Administration, and Akorn made representations and warranties about its regulatory compliance in the merger agreement.
The merger agreement permitted Fresenius to terminate the agreement if any of Akorn’s representations or warranties were not true and correct at signing or at closing, except, in the case of certain representations and warranties, where “the failure to be true and correct would not individually or in the aggregate, reasonably be expected to have a Material Adverse Effect.” Additionally, Fresenius’ obligation to close the merger agreement was conditioned on the absence of “any effect, change, event or occurrence that, individually or in the aggregate, has had or would reasonably be expected to have a Material Adverse Effect.” The merger agreement also contained a standard closing condition that the target comply in all material respects with its covenants in the merger agreement. Fresenius had the right to terminate the merger agreement if the target failed to perform its covenants in all material respects and the breach was incapable of being cured. Among other obligations, the merger agreement included an obligation for Akorn to use its “commercially reasonable efforts to carry on its business in all material respects in the ordinary course of business.”
“Serious and Pervasive” Problems
Two days after the announcement of the execution of the merger agreement, Akorn notified Fresenius that it was experiencing dismal second quarter results (despite Akorn having reaffirmed its full-year guidance for 2018 at Fresenius’ request on the date that the parties signed the merger agreement). Akorn’s CEO assured Fresenius that the downturn would be temporary, but Akorn’s business performance continued to suffer throughout the summer and into the fall of 2017. To make matters worse, in October and November 2017, Fresenius received letters from an anonymous whistleblower who first alleged that Akorn’s product development process failed to comply with regulatory requirements and subsequently raised troubling concerns about Akorn’s quality compliance programs for its pharmaceutical product manufacturing.
In November 2017, Fresenius confronted Akorn about these allegations and informed Akorn that it was invoking its right of access and information under the merger agreement to conduct its own investigation of the allegations. Fresenius’ subsequent investigation uncovered serious and pervasive data integrity problems in its IT and other systems that raised the question of whether Akorn was complying with applicable law and regulations, including in its data submissions to the FDA. In mid-April 2018, Fresenius sent Akorn a letter outlining the contractual bases for terminating the merger agreement and offering to extend the outside date of the merger agreement to facilitate further investigation of the regulatory deficiencies uncovered by Fresenius’ investigation. Akorn declined, and on April 22, 2018, Fresenius gave Akorn a notice of termination of the merger agreement. In relevant part, Fresenius alleged that the failure of Akorn’s regulatory compliance representations to be true and correct was severe enough as to make it reasonably likely to cause an MAE and that Akorn failed to use commercially reasonable efforts to operate in the ordinary course of business in all material respects while the transaction was pending. Shortly thereafter, Akorn brought an action in the Delaware Court of Chancery seeking a declaratory judgment to invalidate Fresenius’ attempt to terminate and specific performance compelling Fresenius to close the merger.
A Finding of a Material Adverse Effect
In finding that Fresenius validly terminated the merger agreement, Vice Chancellor Laster examined both (i) whether Fresenius had a right to terminate the agreement on the grounds that the inaccuracy of the target’s regulatory compliance representations was reasonably expected to have an MAE and the target’s failure to comply in all material respects with its covenants in the merger agreement where the failure could not be cured by the end date, and (ii) whether Fresenius was precluded from exercising its termination right because it was then in material breach of any of its representations, warranties or covenants in the merger agreement.
Failure of the General MAE Condition
On the question of whether the MAE closing condition had been satisfied, Vice Chancellor Laster found that the sudden and sustained drop in Akorn’s business performance was sufficiently large and durationally significant to constitute a general MAE. Vice Chancellor Laster noted that, while precedents have indicated that a decline of business in the range of 40% to 50% was likely to indicate the presence of an MAE, a buyer can show that percentage changes of a lesser magnitude can constitute an MAE (and, conversely, that percentage changes of a greater magnitude could fail to prove the existence of an MAE). In Akorn’s case, Vice Chancellor Laster found that Akorn had experienced a 25% decline in revenue and a 55% decline in EBITDA in fiscal 2017 (as compared to fiscal 2016) and a change from positive operating income to operating losses, as well as a departure from its historical trend of consistent revenue and earnings growth over a five-year period, and concluded that that the magnitude of this decline was material to Akorn’s business. Vice Chancellor Laster also concluded that, because the changes in Akorn’s business had persisted for a year at the time of trial and showed no sign of abating, the decline was also durationally significant. The court found additional support for this conclusion in recent analyst valuations of Akorn based on post-merger agreement signing performance, including the dramatic reduction in analysts’ forward-looking estimates.
At trial, Akorn argued that the changes in its business were the result of industry headwinds, but in view of Akorn’s performance relative to its industry peers, Vice Chancellor Laster concluded that Akorn had been uniquely and disproportionally affected due to company-specific factors. Akorn also argued that Fresenius assumed the risk of the events that caused Akorn’s business performance to decline, but this too was rejected as the events were deemed to have been unexpected. Vice Chancellor Laster closely examined the allocation of risks built into the MAE definition (and the exceptions and exclusions therefrom) and concluded that Akorn, and not Fresenius, had borne the risk of the unexpected events that led to the decline in its business performance.
Because the magnitude and duration of Akorn’s business decline were material, Vice Chancellor Laster found that Akorn had suffered a general MAE and that Fresenius could not be forced to close.
Failure of the Bring-Down Condition and a Right to Terminate
On Fresenius’ right to terminate due to the failure of the bring-down condition, Vice Chancellor Laster found that Akorn’s regulatory compliance representations were sufficiently inaccurate such as would reasonably be expected to result in an MAE. In reaching this conclusion, Vice Chancellor Laster examined whether the inaccuracy of Akorn’s regulatory compliance representations were qualitatively and quantitatively significant “from the longer-term perspective of a reasonable acquirer.” The inaccuracies were found to be qualitatively significant because “Akorn has gone from representing itself as an FDA-compliant company with accurate and reliable [FDA] submissions from compliant testing practices to a company in persistent, serious violation of FDA requirements with a disastrous culture of non-compliance.” The court noted that the regulatory problems existed at signing and got worse during the period between signing and termination of the merger agreement. The court cited specific findings in third-party audits of the target’s data integrity systems, including testimony from an expert that the target’s data integrity issues were among the top three worst of the 120+ pharmaceutical companies they assessed, which the court characterized as “a notorious status” because the expert’s practice only involves assessing companies that have data integrity problems.
With respect to quantitative significance, Vice Chancellor Laster reviewed the remediation plans and estimates of both the target (that estimated only $44 million in remediation costs) and Fresenius (that estimated $254 million in out-of-pocket costs, plus a loss of valuation of $1.9 billion from suspending on-market products and pushing out pipeline products until data is verified). The court noted that it was not possible to define with precision the financial impact of the data integrity issues on Akorn’s value and ultimately determined that the valuation decline was roughly $900 million or 21% of the target’s standalone value. The court then used a number of external sources as a cross-check or proxy for determining materiality of this cost/loss in value in the context of the transaction as a whole. These methods included a comparison of the magnitude of the anticipated remediation costs/loss of value against (i) how a 20% decline in value of the Dow Jones Industrial Average would be viewed in a cultural sense, (ii) studies indicating that on average there was a 15% reduction in purchase price negotiated by parties in transactions where a buyer asserted an MAE, (iii) the 10% to 20% ranges that parties generally use for upper and lower bounds of collars in transactions involving stock consideration, and (iv) the magnitude of reverse termination fees. The court concluded that these indicators also supported its conclusion that the 21% decline in Akorn’s value due to the data integrity issues was quantitatively material.
In view of the qualitative and quantitative significance of the regulatory deficiencies, and in view of the fact that the inaccuracies could not be cured by the outside date and that Fresenius itself was not in material breach of the merger agreement, Vice Chancellor Laster found that Fresenius had a right to terminate the merger agreement because its regulatory compliance representations were inaccurate in a manner that would be reasonably expected to have an MAE.
But Isn’t This Just Buyer’s Remorse?
Akorn argued at trial that Fresenius assumed the risk of a downturn in its business and that Fresenius’ attempt at termination was merely an example of buyer’s remorse in the mold of the buyers in Hexion Specialty Chems., Inc. v. Huntsman Corp., 965 A.2d 715 (Del. Ch. 2008) and In re IBP, Inc. S’holders Litig., 789 A.2d 14 (Del. Ch. 2001). Vice Chancellor Laster distinguished Akorn from Hexion and IBP, noting that in those cases “the buyers had second thoughts because of problems with their own businesses spurred by broader economic factors.” Here, Fresenius terminated the merger agreement only after Akorn’s business suffered a general MAE and after Fresenius conducted a legitimate investigation of the potential regulatory problems and uncovered pervasive regulatory compliance failures. While conducting this investigation, Fresenius continued to act in good faith to satisfy its closing conditions. These factors led Vice Chancellor Laster to conclude that, in this case, the buyer’s remorse was justified.
Breach of the Covenant Compliance Condition
In finding that Fresenius validly terminated the merger agreement, Vice Chancellor Laster also determined Akorn breached its pre-closing covenant to use its “commercially reasonable efforts to carry on its business in all material respects in the ordinary course of business.” The parties disputed the meaning of both the “commercially reasonable efforts” and the “all material respects” qualifiers of the covenant.
With respect to commercially reasonable efforts, Vice Chancellor Laster found that the standard required Akorn to take all reasonable steps in maintaining its operations in the ordinary course of business of a specialty pharmaceutical company manufacturing and selling generic drugs. Akorn failed to do so in several ways, including by (i) failing to conduct regular audits and take steps to remediate deficiencies, (ii) failing to maintain data integrity systems and instructing its IT department not to devote any resources to such systems, (iii) submitting regulatory filings to the FDA based on fabricated data, and (iv) failing to conduct its own investigation in response to the whistleblower letters and instead relying on its deal counsel (as opposed to experienced regulatory counsel) to front-run Fresenius’ investigation and head off any problems that Fresenius’ investigation might uncover.
With regard to materiality, the ordinary course covenant in the merger agreement was qualified by compliance in all material respects. Vice Chancellor Laster found that this standard limits the operation of the covenants to “issues that are significant in the context of the parties’ contract, even if breaches are not severe enough to excuse a counterparty’s performance under a common law analysis.” In this case, not only did Akorn’s violations of the ordinary course covenant cost Akorn a year of what could have been meaningful remediation efforts, it also made matters significantly worse in its attempted cover-ups by submitting fraudulent data to the FDA and subsequently failing to be completely transparent in meetings with the FDA. These failures led Vice Chancellor Laster to the conclusion that Akorn’s violations of the ordinary course covenant were material and that Fresenius would not have agreed to buy Akorn if Fresenius understood that Akorn would not continue conducting its business in the ordinary course of business of a pharmaceutical company.
In order for Fresenius to validly terminate because of Akorn’s material failure to operate in the ordinary course of business, Akorn’s failures must have been incapable of being cured by the outside date of April 24, 2018. By that date, Akorn has just begun in earnest its efforts to remediate its data integrity problems and, even if the outside date had been extended (as was proposed by Fresenius in its penultimate communication to Akorn prior to Fresenius’ termination of the merger agreement), Akorn would not have been able to cure the problems. Accordingly, because Akorn had breached the ordinary course covenant and because such breach could not have been cured by the outside date, Vice Chancellor Laster held that Fresenius could validly terminate the merger agreement.
- Buyers still have a heavy burden in order to prove that an MAE has occurred.
Vice Chancellor Laster reiterated the fact that it is a heavy burden for a buyer to show that an MAE has occurred. Buyers will have to demonstrate a significant decline in business (based on revenue, EBITDA, earnings and other metrics) that has continued or is reasonably likely to continue for a duration of at least a year. The decline must also result from company-specific problems rather than industry-wide conditions. Any lesser showing is unlikely to persuade the Delaware Court of Chancery that an MAE has occurred.
- Buyers seeking to invoke an MAE must nevertheless continue to work to close the transaction in good faith.
A key aspect of Vice Chancellor Laster’s decision was Fresenius’ continued efforts to close the merger while exploring whether an MAE had occurred. Even after discovering Akorn’s regulatory deficiencies and after instructing its counsel to explore its legal options, Fresenius consulted with Akorn about the regulatory compliance issues and invoked its information and access rights under the merger agreement to conduct a thorough investigation. In doing so, Fresenius was able to distinguish itself from other buyers who failed to prevail in establishing an MAE in prior court proceedings. Indeed, had Fresenius failed to do so, it is possible that Vice Chancellor Laster would have found such failure to constitute a material breach of the reasonable best-efforts covenant in the merger agreement, and Fresenius’ right to terminate would have been suspended per the terms of the merger agreement.
- Pay attention to compliance with the covenant to conduct business in the ordinary course, because it could be the basis for a renegotiation or failure to close a transaction.
In finding that Akorn materially failed to operate in the ordinary course of business, Vice Chancellor Laster used an objective standard comparing Akorn’s post-signing conduct to the conduct of a specialty generic drug company operating in the ordinary course of its business rather than Akorn’s own past conduct of its business. Under this reasoning, companies that are operating below industry standards may be viewed as failing to operate in the ordinary course of business even if the consequences of the substandard conduct does not constitute an MAE. Because the typical closing condition in an acquisition agreement for compliance with covenants is generally an “in all material respects” standard – not an MAE standard – sellers may be subject to greater deal certainty risk than they may realize. Buyers, who still will have a heavy burden to establish the existence of an MAE, may instead pursue a renegotiation or termination of an acquisition agreement on the basis of covenant non-compliance. Sellers who have leverage in negotiating the transaction agreement might want to consider asking for a higher standard than “in all material respects” on the covenant compliance closing condition.
- The Delaware Court of Chancery will honor the allocation of risk built into the MAE definition.
Vice Chancellor Laster closely examined the parties’ MAE definition to determine which party had borne the risk of the events that led to the decline in Akorn’s business and reaffirmed that the “proper way to allocate risks in a contract is through bargaining between the parties.” Accordingly, in negotiating MAE definitions, parties should ensure that they carefully allocate risks, including:
- systemic risks (risks which are beyond the control of the parties and affect companies generally)
- indicator risks (risks that might signal an MAE, such as a drop in stock price, a credit rating downgrade or a failure to meet financial projections)
- agreement risks (risks arising from the announcement of the merger, including the loss of key customer or supplier contracts or employee flight)
- business risks (risks arising from the ordinary operation of the party’s business)
Sellers that are aware of specific risks to the business should seek to address them specifically in the MAE definition by adding appropriate exceptions. Conversely, buyers should closely examine the exceptions and exclusions of an MAE definition to ensure they are not taking risks that they intend to be borne by the seller.
As of the time of this writing, Akorn has appealed the Delaware Chancery Court ruling.