(Article from Securities Law Alert, September/October 2018)
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One of the key terms in an acquisition agreement is “Material Adverse Effect,” which essentially defines when a buyer does not have to complete an agreed-upon acquisition as a result of an adverse change to a target’s business during the period between signing and closing. Despite all of the attention given to this term by M&A practitioners, until the recent decision in Akorn, v. Fresenius Kabi, 2018 WL 4719347 (Del. Ch. Oct. 1, 2018) (Laster, V.C.), the Delaware Court of Chancery had never found that a buyer was justified in terminating a public company merger agreement on the basis that a Material Adverse Effect occurred.
Delaware courts to consider this issue have found that a Material Adverse Effect requires that “unknown events” threaten earnings potential in a “durationally-significant manner.” IBP v. Tyson Foods, 789 A.2d 14 (Del. Ch. 2001). In IBP, for example, the Delaware Chancery Court held that a 64% quarterly decline in year-over-year sales did not constitute a Material Adverse Effect because the decline was only in a single quarter and the target’s business was cyclical by nature.
In Akorn, the buyer terminated the merger agreement on the grounds that (1) significant declines in the target’s performance amounted to a Material Adverse Effect (and therefore, a failure of the standalone MAE condition), and (2) serious FDA compliance failures breached the target’s regulatory compliance representations in a manner that constituted a Material Adverse Effect (and therefore, a failure of the target’s ability to “bring-down” its representations and warranties at closing). During the four quarters following execution of the merger agreement, the target’s year-over-year EBITDA declined by 86% due to competitors entering the market, loss of a material contract and other issues. In the same period, the target experienced year-over-year quarterly revenue declines of more than 25%, operating income declines of more than 80%, and net income declines of more than 90%. Moreover, a whistle-blower came forward raising allegations concerning the target’s FDA compliance practices, and further investigation uncovered significant FDA compliance issues which the court determined reduced the target’s equity value by 21% and would take up to four years to remedy.
The court held that the buyer-had satisfied its “heavy burden” to demonstrate that a Material Adverse Effect had occurred based on both the severe decline in the target’s performance and its myriad FDA compliance issues. With respect to the target’s business performance, for example, the court found that the year-over-year decline was material and durationally significant as “[t]here is every reason to think that the additional competition will persist and no reason to believe that [the target] will recapture its lost contract.” Additionally, while cautioning that a 20% decline in a target’s equity value is not necessarily sufficient to show a Material Adverse Effect, the court found that the 21% decline coupled with the need for up to four years to remedy the compliance issues meaningfully contributed to satisfying the Material Adverse Effect standard. The target argued that its decline in performance and FDA compliance issues could not result in a Material Adverse Effect because the buyer knew of the potential for competition and was aware of some FDA compliance issues from its due diligence. The court rejected this argument, and explained that risks that a buyer discovers in its diligence will not preclude the buyer from showing that a Material Adverse Effect has occurred based on problems that arose as a result of those risks. Rather, the court looks to the terms of a contract and its allocation of risks between the parties to determine whether the parties specifically agreed to exclude items uncovered in due diligence or unforeseen events from the definition of Material Adverse Effect.
It does not appear that Akorn represents a sea change in Delaware law on what constitutes a Material Adverse Effect. The court reaffirmed its prior decisions requiring an adverse change to threaten earnings potential in a “durationally-significant manner.” The Akorn ruling is also specific to the facts and circumstances of the transaction. Nonetheless, the decision will likely be heavily scrutinized by practitioners as the only concrete example to date of a Delaware court finding a Material Adverse Effect. The target has appealed the Akorn ruling.