Chancery Provides Further Clarity Regarding Material Adverse Effect Clauses in Merger Agreements
Material adverse effect clauses provide a form of buy-side protection in merger agreements. These often are complex provisions permitting the buyer to avoid closing under the right circumstances, usually involving an actual or reasonably expected serious business deterioration. Channel Medsystems represents the latest decision from the Delaware courts interpreting and applying a material adverse effect clause. Here, the Court of Chancery held that a buyer’s termination of a merger agreement was invalid because the fraudulent conduct of an officer of the seller, which rendered certain contractual representations materially false, did not have, nor was reasonably expected at the time of termination to have, a material adverse effect on the seller.
Under the merger agreement, termination was only appropriate if one or more of the seller’s representations were materially inaccurate, and that inaccuracy had, or could reasonably be expected to have, a materially adverse effect on the seller. In examining the material falsity of the seller’s representations, the Court applied the disclosure-based standard for “material” set forth in Frontier Oil v. Holly Corp., 2005 WL 1039027 (Del. Ch. Apr. 29, 2005), and subsequently endorsed in Akorn, Inc. v. Fresenius Kabi AG, 2018 WL 4719347 (Del. Ch. Oct. 1, 2018). Under this standard, a contractual misrepresentation is material if it “would have been viewed by the reasonable investor as having significantly altered the total mix of information.” Finding some of the seller’s false representations material using this standard, the Court turned to the effect of those false representations on the seller.
On that issue, the merger agreement’s definition of a material adverse effect did not itself define materiality. Accordingly, the Court looked to Delaware precedent, including its decision in Akorn, which defines a material adverse effect as one that “substantially threaten[s] the overall earnings potential of the seller in a durationally-significant manner.” In doing so, the Court rejected the buyer’s argument that the same disclosure-based standard for “material” misrepresentations should apply, explaining that, with respect to merger agreements, the concepts of “material adverse effect” and “material” are “analytically distinct even though their application may be influenced by the same factors.” The Court concluded that the falsification of certain documentation by an officer of the seller did not substantially objectively threaten the seller’s overall earnings potential in a durationally-significant manner and thus did not qualify as a material adverse effect. The Court reasoned that the evidence presented at trial demonstrated that the extensive remediation efforts undertaken by the seller neutralized the effects of the fraudulent conduct on potential earnings. Accordingly, without the prospect of a material adverse effect at the time of termination, the conduct did not support the buyer’s attempt to terminate the merger agreement. Based on this and other findings, the Court ordered the buyer to specifically perform the parties’ agreement and close the merger.Share