Material adverse effect (MAE) or material adverse change (MAC) clauses are common in acquisition agreements, and yet until recently, no Delaware court has determined that a buyer had ever validly terminated a merger agreement pursuant to such a clause. That all changed on October 1, 2018, when the Delaware Court of Chancery in Akorn, Inc. v. Fresenius Kabi AG, a blockbuster, 246-page opinion, determined for the first time that such a clause was properly evoked.
Due to “overwhelming evidence of widespread regulatory violations and pervasive compliance problems” as well as the fact that target’s financial performance “dropped off a cliff,” the court ruled that a MAE occurred. Although the Akorn decision, as the first decision applying Delaware law that found an MAE warranting a buyer’s exercise of merger termination rights, may embolden future buyers to test the power of their own provisions, commentators are cautioning that the court decided Akorn based on extraordinary facts and that it awaits review by the Delaware Supreme Court.
MAC or MAE clauses appear in merger agreements in several locations. They may be embedded in a representation or warranty, appear as a condition precedent to closing, or sometimes even be a condition to exercise termination rights. Regardless of where they appear, merger agreements usually define the MAC or MAE vaguely as events materially adverse to the business of the seller. The intended purpose of these clauses is to protect the buyer against unanticipated changes in the target’s business between signing and closing.
Moreover, when buyers do try to evoke these provisions, they rarely proceed to litigation. The vagueness of the MAE and MAC provision itself provides incentive for the parties to negotiate and reprice the deal. After all, who knows what a court would hold? (Although with MAE’s and MAC’s judicial track record, one would think that this incentive would favor the target during negotiations).
When the MAE or MAC provision does come before a court determining whether a MAE or MAC occurred, the issue turns on “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.” Hexion Specialty Chemicals v. Huntsman, 965 A.2d 715, 738 (Del. Ch. 2008). The Huntsman standard has been historically tough to meet. In Huntsman itself, the seller’s six-month decline in EBITDA, repeated failure to meet EBITDA forecasts, and an increase in debt contrary to projections were all, even in totality, insufficient to meet the standard. It seemed like only a true catastrophe would lead a Delaware court to find a MAC or MAE clause correctly evoked.
Akorn was that catastrophe. Akorn’s conduct and financials were so bad that although the conclusion that an MAE occurred is unprecedented in Delaware, it was not surprising.
On April 24, 2017, Fresenius Kabi AG, a German pharmaceutical company, agreed to acquire Akorn, Inc., an Illinois pharmaceutical manufacturer. Fresenius agreed to buy Akorn in a $4.75 billion transaction, subject to the satisfaction of customary closing conditions. Akorn made the usual representations and warranties about its business and compliance with applicable regulatory requirements. Fresenius’s obligation to close was conditioned on Akorn’s representations being true and correct both at signing and at closing, except where the failure to be true and correct would not reasonably be expected to have an MAE.
Then, during the post-signing period, Akorn experienced consecutive year-over-year declines in quarterly revenue. Akorn’s operating income was down 84, 89, 292, and 134 percent, respectively, in the four quarters after it signed the merger agreement. Akorn’s revenue was down 29, 29, 34, and 27 percent, and earnings per share were down 96, 105, 300, and 170 percent. Akorn’s stock price dropped from $32.13 per share before signing to between $5.00 and $12.00 per share after signing. Commenting on Akorn’s financial decline, Chancellor Stine remarked:
Akorn’s dramatic downturn in performance is durationally significant. It has already persisted for a full year and shows no sign of abating. More importantly, Akorn’s management team has provided reasons for the decline that can reasonably be expected to have durationally significant effects.
Not only had Akorn’s financial situation “dropped off a cliff,” Fresnius soon also learned of serious deficiencies in Akorn’s data integrity processes. Dramatically, these issues were first identified in an anonymous whistleblower letter. Upon review of the letter, Fresnius performed its own investigation. Fresnius discovered that Akorn was “in persistent, serious violation of FDA requirements” and had “a disastrous culture of noncompliance.” The investigation by Fresenius also uncovered the possible use of fabricated data in Akorn’s FDA submissions. Additionally, as soon as the parties signed the merger agreement, Akorn had canceled regular audits, assessments, and inspections of known problems.
Upon these findings, Fresnius attempted to terminate the merger agreement. Akorn argued that the merger agreement should be specifically enforced. Fresnius counterclaimed, seeking a ruling that it properly terminated the merger agreement. The rest, as they say, is history.
The court determined that the unexpected and nonstop drop in Akorn’s business performance constituted a “general MAE” (that is, the company itself had suffered an MAE), and that because Akorn’s representations of regulatory compliance were not true and correct, the deviation between the as-represented condition and its actual condition would also result in an MAE.
Parsing the court’s analysis shows that a buyer claiming that a representation given by the target at closing fails to satisfy the MAE standard must demonstrate such failure, both qualitatively (i.e., the suddenness of the financial decline, whether in revenue or EBITDA, and/or the presence of factors suggesting “durational significance”) and quantitatively (i.e., the magnitude and length of the downturn). Merely showing qualitative failure without quantative failure, or vice versa, would not be enough given the court’s discussion in Akorn. Throughout the opinion, the court cautioned buyers in regard to evoking a MAE or MAC clause. The court emphasized the steep climb and heavy burden faced by a buyer in establishing an MAE or MAC.
The court reaffirmed that “short-term hiccups in earnings” do not suffice; rather, the adverse change must be “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.” Akorn’s data integrity problem was not directly relevant upon the court’s finding of a MAE, but it most certainly informed the court’s overarching conclusion that this was not a case of buyer’s remorse. The compliance issues in effect presented the qualitative failure the court was looking for.
As previously stated, the conclusion that an MAE occurred in Akorn was not that surprising given the facts, and although significant, the decision is unlikely to lower the already high bar to proving a MAC or MAE had occurred. Yet, Akorn importantly shows that, yes, such a bar could be met, and that MACs or MAEs are not mere hypotheticals over which lawyers spend hours negotiating. Moreover, Akorn provides some additional lessons.
Akorn tried to advance the argument that an MAE could not have occurred because the purchaser would have generated synergies through the combination, which would have generated profits from the merger. The court rejected this argument, finding that the MAE clause itself was focused on the results of operations and the financial condition of the target and its subsidiaries, instead of the results of operations and financial condition of the surviving corporation or the combined entity. The court determined that the MAE clause in Akorn carved out any effects arising from the “negotiation, execution, announcement or performance” of the merger agreement or the merger itself, including “the generation of synergies.” The drafting lesson learned is that buyers going forward should consider including express references to synergies in defining the concept of an MAE in their merger agreements.
Next, Akorn tried to claim that it faced “industry headwinds” that caused its decline in performance. Akorn pointed to heightened competition and pricing pressure as well as regulatory actions that increased costs. The court rejected this argument as well. However, the court’s rejection was not due to the argument itself, but rather the fact that evidence was provided showing that Akorn’s EBITDA decline vastly exceeded its peers. Presumably, if Akorn’s decline were similar to its competitors, the court would have accepted that Akorn’s failure was an industry-wide failure, which would not have been a MAE. The drafting lesson learned from this is that buyers should think of including “disproportionate effects” qualifications in MAE carve-outs with respect to industry-wide events.
Finally, less of a drafting lesson and more of a philosophical lesson, the court seemed to conceive of the MAE clause as a negotiating tool. The court delved into existentialism and examined why MAE or MAC clauses exist. Vice Chancellor Laster wrote:
Despite the attention that contracting parties give to these provisions, MAE clauses typically do not define what is “material.” . . . [P]arties find it efficient to leave the term undefined because the resulting uncertainty generates productive opportunities for renegotiation. . . . What constitutes an MAE, then, is a question that arises only when the clause is invoked and must be answered by the presiding Court.
The court essentially determined that MAE or MAC clauses exist in order to create incentives for both sides to reprice the deal and stay out of court. MAE and MAC clauses essentially recognize that mergers are less about strict legal rights and more about relationships. The drafting of a MAE or MAC should keep that in mind.