By Gardner Davis and Danielle Whitley
In a recent decision, the Delaware Chancery Court allowed a buyer to terminate a merger agreement and walk from the deal because the target suffered a material adverse effect or "MAE". Akorn, Inc. v. Fresenius Kabi AG is believed to the first case of its kind in Delaware, which is the leading source of law governing M&A transactions.
Almost all acquisition agreements today provide the buyer with some type of walk right for an MAE. However, the overwhelming majority of acquisition agreements offer no definition for the key term "material". In practice, most buyers and sellers find it very difficult to agree on a particular percentage or dollar amount as constituting the grounds to call off the deal and therefore by not doing so they essentially punt and leave the difficult issue to the court's discretion.
Until the Akorn decision, the M&A community has been operating largely in the dark when it comes to an objective standard for what constitutes an MAE under Delaware law.
The Merger Agreement
Akorn involved the merger agreement signed in April 2017 by Fresenius Kabi AG, a German pharmaceutical company, and Akorn, Inc., an American generic pharmaceutical company,providing for Fresenius to acquire Akorn for $ 4.75 billion.
The merger agreement contained customary terms and in light of the nature of Akorn's business as a pharmaceutical company, Akorn also made extensive representations about its compliance with applicable regulatory requirements.
The merger agreement conditioned the buyer's obligation to close 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 a contractually defined "Material Adverse Effect". This type of provision is typically referred to as the "bring-down condition".
In addition, the buyer's obligation to close was conditioned on Akorn not having suffered any change, event or occurrence that, individually or in the aggregate, has had or would reasonably be expected to have a contractually defined Material Adverse Effect. This type of provision is often referred to as the "general MAE condition".
The general MAE condition is not tied to a particular representation about a specific issue.However, the bring-down condition examines the inaccuracy of specific representations and uses as a measuring stick whether the deviation between the as-represented condition and actual condition constitutes an MAE.
The merger agreement contained a relatively standard, albeit convoluted definition of "Material Adverse Effect". The agreement defined the termto include "any effect, change, event or occurrence that, individually or in the aggregate . . . has a material adverse effect on the business, results of operations or financial condition of the Company and its Subsidiaries, taken as a whole".
Target's Business Falls Off A Cliff
After the signing of the merger agreement, Akorn's business performance deteriorated dramatically, or as Vice Chancellor J. Travis Laster colorfully put it -"fell off a cliff".
Akorn's full-year EBITDA showed an 86% decline. Akorn's full-year adjusted EBITDA declined 51%. These declines represented a departure from Akorn's historical trend. Over the prioe five-year span, Akorn grew consistently, year over year, when measured by revenue.
After signing the merger agreement, Fresenius discovered serious and pervasive data integrity problems that rendered Akorn's representations regarding its regulatory compliance inaccurate.
Fresenius concluded that the merger was a bad deal and sought to terminate the merger agreement. Fresenius asserted that Akorn's representations regarding regulatory compliance were so inaccurate that the deviation could reasonably be expected to result in a material adverse effect. Fresenius also cited the section in the merger agreement that conditioned Fresenius' obligations to close on Akorn's not having suffered a material adverse effect.
Akorn responded by filing an action in the Delaware Chancery Court seeking a declaration that Fresenius' attempt to terminate the merger agreement was invalid and a decree of specific performance compelling Fresenius to close.
In prior cases, the Delaware Chancery Court consistently ruled against buyers who sought to back out of acquisitions on the grounds of the MAE provision in the contract.
Court Examines Buyer's Claim of MAE
Vice Chancellor Laster found that Fresenius made the necessary showing to establish a general MAE. He also found the bring-down condition was not satisfied because the inaccuracy of Akorn's regulatory compliance representation constituted an MAE.
The Delaware Chancery Court's decision in Akorngives the M&A community new guidance regarding what will constitute an MAE under Delaware law:
- In order to constitute a general MAE, the decline in business performance must be durationally-significant from a long term perspective. A short term hiccup will not qualify. A minimum of two bad quarters, measured on a year-over-year basis, is probably required.
- In order to constitute a general MAE, the decline in business performance must be greater than 10%.A decline of 40% or more will probably be a general MAE. Although Akorn does not provide specific guidance in the intermediate range of declines, a decline resulting in the loss of 20% of the target's value may be the threshold. However, Akorn cautioned the reader not to fixate on a particular percentage as establishing a bright-line test.
- In order to constitute an MAE for purposes of a bring-down condition, the breach of the representation must be both qualitatively and quantitatively significant when viewed from the longer-term perspective of a reasonable acquiror.
- In order to constitute an MAE for purposes of a bring-down condition, the difference between the as-represented condition of the company and the actual condition at closing probably must represent a decline in value equal to approximately 15% to 20% of the target's equity value.