Until Vice Chancellor Laster’s decision last week in Akorn Inc. v. Fresenius KABI AG,[1] no Delaware court had released an acquiror from its obligation to close a transaction as a result of the occurrence of a “Material Adverse Effect.”[2]  The cases previously adjudicated in Delaware all had required the acquiror to close, often despite a significant diminishment in target value and, in some, the court criticized the acquiror for seeking to avoid its obligations based on little more than buyer’s remorse.  Against this weight of precedent, the Vice Chancellor found that the grievous decline of generics pharmaceutical company Akorn, Inc. after it agreed to be acquired by Fresenius constituted a MAC.  While Akorn presents a stark set of facts and the Delaware Supreme Court has yet to have the final word in the case,[3] the decision nonetheless provides useful guidance to practitioners in shaping and navigating MAC clauses and related contractual provisions.

  • MACs remain difficult to establish. The outcome in Akorn was driven by its particularly unhappy facts.  Despite “extensive representations” made to Fresenius that it was operating in compliance with law and applicable FDA regulations, Akorn lacked credible compliance and quality control functions and, according to the court, was “in persistent, serious violation of FDA requirements with a disastrous culture of non-compliance.”  The  court found that, as a result of the breaches of the regulatory and compliance representations, $900 million in value had been lost (out of a $4.75 billion purchase price).  In addition to its regulatory shortcomings, not long after the transaction was announced and it had reaffirmed its earnings guidance, Akorn’s financial performance “fell off a cliff.”   Among many other dismal metrics cited by the court, 2017 year-over-year EBITDA and EBIT declined by 55% and 62%, respectively, after growth in each year from 2012 to 2016, and, as of trial, the situation showed no signs of improving.  It will be the rare case in which the deterioration in the target’s financial performance is as unexpected and dramatic or the alleged malfeasance as pervasive and clear-cut as it was in Akorn.  We thus expect the conventional wisdom to continue to hold true – it is extremely difficult for an acquiror to establish the occurrence of a MAC.
  • What constitutes a MAC? Consistent with previous Delaware cases, Akorn notes that to give rise to a MAC the adverse effect must substantially impact the overall earnings potential of the target in a durationally-significant manner measured in years rather than months.  Not surprisingly, the Vice Chancellor was careful not to draw a hard-and-fast line as to how much value must be lost.  He considered, among other factors, the magnitude of the effect both qualitatively and quantitatively – as measured against the target company’s historical results, recent earnings guidance and pricing expectations – viewed from the perspective of a reasonable acquiror.  The court concluded that Akorn’s regulatory violations, increased competition from new market entrants and loss of a significant contract together resulted in a downturn in performance that was durationally-significant.  The court further found that, on the facts presented in Akorn, a 21% decline in the company’s standalone equity value was sufficient to constitute a MAC.
  • Breach of the Interim Operating Covenant.
    • The court held that Akorn’s failure to use sufficient effort to remedy its compliance and quality control failures – considered relative to what a reasonable, hypothetical generics pharmaceutical company would do under the circumstances – was a breach of its obligation to operate in the ordinary course of business “in all material respects” between signing and closing. As a result, Fresenius would have been able to terminate the transaction even if a MAC had not occurred.  Importantly, the materiality standard applied to Akorn’s breach was whether it was “significant in the context of the parties’ contract” and “a deviation from the buyer’s reasonable expectations regarding what it would receive at closing.”  Thus, Akorn counsels that a target’s failure to respond reasonably to an unexpected development could allow an acquiror to terminate a transaction even if the resulting damage is not sufficiently severe to constitute a MAC.
    • In light of this holding, it is clear that in addition to assessing whether the MAC clause is implicated by a post-signing development, a target must also consider the interim operating covenant and develop a response in light of how a reasonable, similarly situated company would be expected to react. The target’s response should not be colored by the pending transaction – absent the acquiror’s consent (which should be formally documented).   It is also worth noting that the outcome in Akorn was influenced by the court’s view that the company concealed the extent of its regulatory violations from Fresenius.
  • Sandbagging in MAC Clauses. In the seminal IBP case decided in 2001,[4] then-Vice Chancellor Strine stated that the purpose of a MAC provision is to protect the acquiror from the occurrence of “unknown events.”  This led some practitioners to speculate that MAC clauses implicitly include an “anti-sandbagging” principle that would prevent an acquiror from invoking the clause in response to developments arising out of “known or contemplated risks” in addition to the specifically negotiated carve-outs (which often occupy half a page or more of an acquisition agreement).  The Akorn court declined to find such an implicit anti-sandbagging principle; rather, according to Vice Chancellor Laster, the touchstone is the scope of the MAC clause as explicitly drafted and not what risks the acquiror may or may not have known about or contemplated at the time of signing.  Akorn thus serves as a reminder that in seeking to allocate known risks through the MAC clause parties should consider drafting such allocation into the contract with specificity.
  • All Efforts Standards Are Created Equal. The Akorn court reiterated that, under Delaware law, there is no hierarchy among efforts clauses.  In the court’s eyes, provisions requiring “best efforts” or “reasonable best efforts” or “commercially reasonable efforts” all require the party to take “all reasonable steps” to fulfill its obligation.  If contracting parties seek a higher (or lower) standard or simply desire greater certainty as to what “all reasonable steps” entails, they should consider crafting a covenant that details the specific actions the parties are required (or are not required) to take.
  • Access Covenants and Use Restrictions. After receiving a series of anonymous whistleblower letters detailing some of Akorn’s myriad regulatory violations, Fresenius relied on the merger agreement’s access covenant to launch an extremely detailed and wide-ranging investigation of Akorn’s compliance efforts, including site visits, interviews and forensic audits.  The court noted that the access covenant “enable[s] a buyer to investigate issues that arise between signing and closing,” and in thoroughly investigating Akorn, Fresenius used the covenant “for its intended purpose.”  The court also found that Fresenius’s use of the information it uncovered to evaluate Akorn’s compliance with the merger agreement and eventually terminate the transaction was consistent with the confidentiality agreement’s requirement that Akorn’s confidential information be used only to “execute” the transaction.  In light of Akorn, we expect that going forward targets may seek to further limit access covenants as well as the use of information provided to the acquiror between signing and closing.
  • The Acquiror’s Response to a MAC or Breach.
    • Following signing, despite its growing concerns as to the economic viability of the transaction, the court found that Fresenius remained committed to the transaction and continued to materially perform its obligations under the merger agreement. For instance, Fresenius continued to seek antitrust clearance, proceeded with integration planning, offered Akorn an opportunity to correct any inaccuracies in Fresenius’ understanding of the company’s financial woes and regulatory issues and offered to extend the drop-dead date if Akorn felt it could rectify the situation.  This proved to be extremely important as Fresenius would have been prohibited from terminating the transaction if it had materially breached its obligation to use its reasonable best efforts to close the transaction, or if the failure of the transaction to close otherwise had been proximately caused by Fresenius’ material breach of the merger agreement.
    • The lesson here is clear – an acquiror’s response to a potential MAC or other target company breach is crucial.  A well-advised acquiror will keep (or at the very least evince) an open mind and continue to perform its contractual obligations while the investigation of a potential MAC or other target company breach unfolds.  The message of continued commitment to the transaction should be clearly communicated to the target and throughout the acquior’s organization.  It also may be advisable for the acquiror to consider implementing additional prophylactic measures to limit the risk that it will be considered in breach of its obligations, such as creating a separate team to investigate the potential MAC or other non-compliance to ensure the investigation doesn’t taint the deal team’s apparent motives or otherwise detract from efforts to close the transaction.

[1] C.A. No. 2018-0300-JTL (Del. Ch. Oct. 1, 2018).

[2] In this note we use the typical shorthand “MAC” to refer to a “Material Adverse Effect.”

[3] Shortly after the Delaware Court of Chancery rendered its decision, Akorn announced that it intended to appeal.

[4] In re IBP, Inc. S’holders Litig., 789 A.2d 14 (Del. Ch. 2001).