In Akorn, the Court of Chancery held that the buyer, German pharmaceutical company Fresenius Kabi AG, validly terminated a $4.75 billion merger with the seller, generic pharmaceutical company Akorn, Inc., based on three grounds in their merger agreement. The court initially noted the “heavy burden” under Delaware law that buyers face when they seek to terminate a merger based on an MAE provision. But Akorn presented extraordinary facts that distinguished this case from many prior Delaware MAE cases, in which buyers have second thoughts post-signing “after cyclical trends or industrywide effects negatively impacted their own businesses” and then seek to escape their bargain based on a purported MAE on the seller’s business under the merger agreement.
Extraordinary Circumstances MAE Allow a Buyer to Break a Bad Deal
The State of Delaware’s policy is to give maximum effect to the principle of freedom of contract. Delaware courts seek to enforce the language in an agreement negotiated by the parties and will not rewrite the agreement after the fact to reallocate risks, especially in an agreement between sophisticated parties that was bargained for at arm’s length. This includes risks allocated through “material adverse effect” (MAE) provisions in a merger or acquisition agreement. The Delaware Court of Chancery’s recent decision in Akorn, Inc. v. Fresenius Kabi AG, No. 2018-0300-JTL, 2018 WL 4719347 (Del. Ch. Oct. 1, 2018) (Laster, V.C.), illustrates how the court applies Delaware’s policy of freedom of contract. While this is the first time that the court has found that an MAE on the seller’s business justified a buyer’s termination of a merger agreement, this decision presented an exceptional set of facts regarding the utter deterioration of Akorn’s business and widespread company regulatory compliance issues affecting its pipeline of new generic drugs. Accordingly, the court’s ruling merely represents the application of a well-known principle to enforce the language of a merger agreement, allocating the risks bargained for by sophisticated parties, to an egregious set of facts.
First, the court found that “the dramatic downturn in [Akorn’s financial] performance” after execution of the merger agreement and its causes were “durationally significant” to establish an MAE on Akorn’s business that justified Fresenius’s refusal to close on the merger. The court explained that Akorn’s financial performance “dropped off a cliff” post-signing with a year-over-year decline in quarterly earnings before interest, tax, depreciation, and amortization of 86 percent that was attributable to competition from new generic drug companies in the market, the loss of a key contract, supply interruptions, and price erosion. The court noted that all of these factors were specific to Akorn’s business, had persisted for a year, and showed no signs of abatement. Notably, the court rejected Akorn’s contention that Fresenius could not rely on a decline in Akorn’s business to support an MAE because Fresenius had allegedly learned about these business risks in the course of due diligence. The court reasoned that the MAE provision “turned on whether the effect, change, event, or occurrence occurred after signing and constituted . . . an MAE.” The court emphasized that this language is “forward-looking and focuses on events. It does not look backwards at the due diligence process and focus on risks.” In sum, the court adhered to the plain language of the MAE provision bargained for by the parties, and the court was unwilling to rewrite their agreement to exclude matters or risks disclosed in due diligence from the MAE definition in their merger agreement.
Second, the court found that Akorn’s representations concerning its regulatory compliance were inaccurate and that the magnitude of the inaccuracies regarding the widespread company compliance issues “would reasonably be expected to result in a Material Adverse Effect.” The court noted that both “qualitative and quantitative” aspects must be evaluated to determine whether the regulatory failures would reasonably be expected to result in an MAE. From a qualitative standpoint, the court explained that there was overwhelming evidence of pervasive data integrity and compliance problems that prevented Akorn from being able to meet Food and Drug Administration (FDA) requirements for data integrity. Akorn had “gone from representing itself as an FDA-compliant company with accurate and reliable submissions from compliant testing practices to a company in persistent, serious violation of FDA requirements with a disastrous culture of noncompliance.” Similarly, the quantitative aspect of an estimated decline in Akorn’s value of 21 percent to remediate these regulatory problems also supported a finding that these problems would reasonably be expected to result in an MAE. These problems would also affect Akorn’s ability to move its pipeline of new generic drugs to market.
Last, the court found that Akorn’s failure to address its regulatory compliance problems constituted a breach of its contractual covenant to operate its business in the ordinary course of business after execution of the merger agreement. The court explained that Akorn’s conscious failure to remediate regulatory deficiencies, to maintain its data integrity system in compliance with FDA requirements, and to conduct investigations into these issues were departures from the ordinary course of business that a generic pharmaceutical company would follow. Accordingly, Akorn had failed to use “commercially reasonable efforts to operate in the ordinary course [of business].”
While this is the first time that the Delaware Court of Chancery has permitted a buyer to terminate a merger agreement based on a “material adverse effect” on the seller’s business, the Akorn decision simply represents an application of Delaware’s policy of freedom of contract to an egregious set of facts. The lesson from Akorn is that in drafting MAE provisions, practitioners should carefully define and allocate responsibility between the buyer and seller for systematic, financial indicator, merger agreement, and business risks that affect the seller’s business after execution of the merger agreement. In sum, a clear manifestation of the parties’ reasonable expectations will reduce the risk of a judicial interpretation that negates objectives to allocate such risks under a merger or acquisition agreement. Stay tuned for whether the decision is affirmed by the Delaware Supreme Court on appeal.
American Bar Association, November 16, 2018