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Akorn, Inc. v. Fresenius Kabi AG: Delaware Court of Chancery Finds Material Adverse Effect Allowing Buyer to Terminate Merger Agreement

October 2, 2018

In Akorn, Inc. v. Fresenius Kabi AG, C.A. No. 2018-0300-JTL (Del. Ch. Oct. 1, 2018), the Court of Chancery issued what is believed to be the first decision of a Delaware court allowing a buyer to terminate a merger agreement due to the occurrence of a material adverse effect.

The dispute arose from Fresenius Kabi AG’s agreement to acquire Akorn, Inc. in April 2017. Soon after the agreement was reached, “Akorn’s business performance fell off a cliff” due largely to increased market competition that affected Akorn significantly more than its competitors. Additionally, Fresenius received a series of letters from anonymous whistleblowers calling into question Akorn’s compliance with FDA data integrity regulations. Fresenius informed Akorn of the letters and, after conducting an independent investigation revealing serious FDA compliance issues, questioned the appropriateness of Akorn’s response and remediation efforts. In April 2018, Fresenius terminated the merger agreement with Akorn.

The Court upheld the validity of Fresenius’s termination of the merger agreement on several bases. First, the Court found that Akorn had breached its representations relating to regulatory compliance. As a result, the Court found that Akorn was unable to satisfy the closing condition requiring that all of its representations be true and correct as of the closing date except where the failure “would not, individually or in the aggregate, reasonably be expected to have a Material Adverse Effect.” In so holding, the Court determined that the regulatory compliance issues—expected to take at least three to four years to remedy—were durationally significant and gave rise to estimated remediation costs of approximately 20% of Akorn’s standalone value. The Court accordingly found that the issues resulted in a material adverse effect under the merger agreement. Second, the Court found that Akorn, in failing to take appropriate action in response to these regulatory compliance issues, failed to satisfy its interim covenant to use “commercially reasonable efforts to carry on its business in all material respects in the ordinary course of business,” thereby giving Fresenius additional grounds to terminate the merger agreement. Finally, the Court held that the significant drop-off in Akorn’s performance, which included a 55% drop in annual EBITDA in 2017 after Akorn’s annual EBITDA had grown consistently over the preceding years, constituted a general material adverse effect. Although the merger agreement did not provide Fresenius with a separate right to terminate the agreement upon a general material adverse effect, it did entitle Fresenius to refuse to close the merger on that basis.

In addition to its findings relating to the occurrence of a material adverse effect, the Court’s 247-page opinion provides insight into a number of issues relevant to M&A negotiations.

Material Adverse Effect Provisions

  • While the Akorn Court was careful to caution against the inference that it was making any per se rule, and warned readers not to “fixate on a particular percentage as establishing a bright-line test” or to construe its “decision as suggesting that there is one set of percentages for revenue and profitability metrics and another for liabilities,” its opinion indicates that events giving rise to a 20% decrease in a target’s value, when considered with other factors, could constitute a material adverse effect.
  • The Court indicated that, in most cases, a seller will not be able to overcome the finding that a material adverse effect had occurred on the basis that the buyer should have known about the risks. The Court further indicated that parties may allocate these risks by contract. The Court noted, for example, that the material adverse effect definition at issue could have excluded (but did not exclude) specific matters that the seller believed would, or were likely to, occur during the interim period, or matters disclosed during due diligence, or risks identified in public filings. The Court also suggested that the parties could have defined (but did not define) the term to include only unforeseeable effects, changes, events, or occurrences.
  • The Court highlighted the distinction between actions or factors causing a material adverse effect, on the one hand, and actions or factors that could “reasonably be expected to” cause a material adverse effect, on the other. The latter formulation is not satisfied through the “mere risk” of a material adverse effect, but it does allow for “future occurrences [to] qualify as a material adverse effect” such that a material adverse effect “can have occurred without the effect on the target’s business being felt yet.”
  • Although the material adverse effect provision at issue included a carve-out for general industry risks, the carve-out contained an exception that applied to the extent that Akorn was disproportionately affected by those risks. In this case, the increased market competition giving rise to the general material adverse effect on Akorn did not similarly affect its competitors.

Representations and Warranties

  • Despite finding a representation with a material adverse effect qualifier to have been breached, the Court observed that representations couched with a material adverse effect qualifier are more forgiving than those requiring that the representation be true in “all material respects.” The Court indicated that a representation subject to a material adverse effect qualifier will not be breached unless it gives rise to material and durationally significant qualitative and quantitative damage to the target. By contrast, the Court found that an “all material respects” qualifier operates in a manner similar to the test used to determine materiality under disclosure law and looks to whether a reasonable buyer would have viewed the representation’s inaccuracy to “significantly alter the ‘total mix’ of information.”
  • Without directly addressing the issue, the Court articulated a number of policy arguments that could be read to support the position that Delaware law is “pro-sandbagging.” The Court of Chancery’s statements should be viewed, however, in light of the Delaware Supreme Court’s recent decision in Eagle Force Holdings, LLC v. Stanley, in which it declined to affirmatively decide the issue, but questioned the view that Delaware was pro-sandbagging. 187 A.3d 1209, 1236 n.185 (Del. 2018); id. at 1247 (Strine, C.J. & Vaughn, J., concurring in part and dissenting in part).

Interim Covenants

  • Citing the Supreme Court’s holding in Williams Cos. v. Energy Transfer Equity, L.P., 159 A.3d 264 (Del. 2017), the Akorn Court found that covenants to use “commercially reasonable efforts” and “reasonable best efforts” effectively impose identical requirements to “take all reasonable steps.”
  • The Court found that Fresenius had breached the merger agreement’s “hell-or-high-water” covenant (albeit immaterially) in seeking antitrust approval of the merger, but its analysis on this issue was colored by the fact that the merger agreement vested Fresenius with the right to control the strategy for obtaining antitrust approval. To avoid potential dilution to the strength of a hell-or-high-water provision, sellers negotiating for such provisions should seek to obtain some level of input on antitrust strategy or limit the buyer’s discretion to formulate antitrust strategy in a way that could delay antitrust approval.
  • As the regulatory issues underlying Fresenius’s termination rights were largely uncovered through its own independent investigation, the Akorn opinion underscores the importance of the buyer’s contractual information rights. Buyers should strive to secure the type of information rights secured by Fresenius, which gave Fresenius reasonable access to Akorn’s “officers, employees, agents, properties, books, [c]ontracts, and records.”

Termination

  • The merger agreement at issue in Akorn did not allow Fresenius to exercise either of the termination rights it ultimately relied upon if it was in material breach of any of its own obligations under the merger agreement. It is not uncommon for a merger agreement to only limit a party’s termination right to the extent that such party’s breach was the cause of the conditions giving rise to the termination right. If Fresenius’s unrelated breach of the merger agreement had been found to be material, the merger agreement’s use of the former approach could have been significant.

Confidentiality Agreements

  • The Court found that outside counsel engaged by Fresenius to investigate Akorn’s alleged regulatory violations was entitled to use the information originally furnished to Fresenius in connection with its due diligence. Although the confidentiality agreement between the two parties provided that such information “could be used ‘solely for the purpose of evaluating, negotiating, and executing’ a transaction,” the Court determined that the outside counsel’s investigation formed part of the process of executing the transaction. As a result, in confidentiality agreements with prospective buyers, sellers should consider further limiting the permissible uses of confidential information provided during the course of due diligence and including express prohibitions on the use of such information in connection with any litigation brought against or investigations of the seller.