Akorn v. Fresenius Kabi: Delaware Court of Chancery Finds Target Company Suffered MAC Allowing Buyer to Terminate Merger Agreement

Practical Law Legal Update w-016-9166 (Approx. 14 pages)

Akorn v. Fresenius Kabi: Delaware Court of Chancery Finds Target Company Suffered MAC Allowing Buyer to Terminate Merger Agreement

by Practical Law Corporate & Securities

Background

The dispute arose out of the merger agreement between Fresenius Kabi AG, a German pharmaceutical company, and Akorn, Inc., a Louisiana specialty generic pharmaceuticals company. The consideration under the merger agreement was set at $34 per share, implying an equity value for Akorn of $4.3 billion and a total purchase price of $4.75 billion including the assumption of debt. For a summary of the merger agreement, see What's Market, Fresenius Kabi AG/Akorn, Inc. Merger Agreement Summary. The agreement was signed on April 24, 2017, and selected Delaware governing law for all matters except the procedures of the merger and the Akorn board's fiduciary duties. As the issues in the case revolved around contractual interpretation, Delaware law governed.

Several provisions in the merger agreement, all drafted in typical, market language, are implicated in the decision, including:

A regulatory-compliance representation given by Akorn, in which Akorn represented that it was in compliance with all rules and regulations promulgated by the FDA (as well as other government agencies), except where noncompliance would not reasonably be expected to have a Material Adverse Effect.
An operating covenant under which Akorn committed to use commercially reasonable efforts to carry on the business between signing and closing in all material respects in the ordinary course of business.
An efforts covenant in which both parties committed to use reasonable best efforts to take whatever actions necessary to satisfy the closing conditions to the merger, as well as a hell-or-high-water covenant obligating Fresenius to take all actions necessary to secure antitrust approval for the merger.
A no-MAE closing condition that conditioned Fresenius's obligation to close the merger on Akorn not having suffered a Material Adverse Effect. Failure of this closing condition would not itself authorize Fresenius to terminate the merger agreement, but if the outside date for closing (April 24, 2018) were to pass, Fresenius could terminate the agreement as long as its own breach was not a principal cause of the failure of the closing condition.
A bring-down closing condition requiring that Akorn's representations and warranties (including, for purposes of the litigation, the regulatory-compliance representation) be true and correct both at signing and at closing, except where the failure to be true and correct would not reasonably be expected to have a Material Adverse Effect. Failure of this condition would allow Fresenius to terminate the merger agreement if the failure could not be cured by the outside date, unless Fresenius were in material breach of its own obligations under the merger agreement (including, for purposes of the litigation, the efforts and hell-or-high-water covenants).
A covenant-compliance closing condition requiring that Akorn have complied in all material respects with its obligations under the merger agreement (including, for purposes of the litigation, the operating covenant). As with the bring-down closing condition, failure of this condition would allow Fresenius to terminate the merger agreement if the failure could not be cured by the outside date, unless Fresenius were in material breach of its own obligations under the merger agreement (including, for purposes of the litigation, the efforts and hell-or-high-water covenants).

The decision contains 105 pages of factual background, describing in painstaking detail the downturn that Akorn experienced shortly after the signing of the merger agreement. In broad terms, two sets of bad facts plagued Akorn simultaneously, each of which would have qualified as an MAE under a relevant provision in the merger agreement without having to resort to the other set of facts.

The first set of bad facts was that Akorn's financial performance "fell off a cliff" shortly after the signing of the merger agreement. Fresenius had asked Akorn to reaffirm its guidance for 2017 when the parties announced the transaction, which Akorn did. Yet on July 21, 2017, less than three months after signing and two days after the stockholders of Fresenius approved the merger, Akorn notified Fresenius that it would be reporting $199 million in revenue for the second quarter of 2017 compared to a business plan of $243 million, representing a year-over-year decline of 29%. The drop in operating income was even more stark, declining 84% year-over-year. Management also significantly lowered its forecasts for the rest of the year.

Akorn attributed the decline to two major factors:

Unexpected new market entrants who competed with Akorn's top three products and a new competitor for another important Akorn product.
The unexpected loss of a key contract to sell an Akorn drug.

Fresenius's chairman told Akorn's CEO the drop was "the most embarrassing personal or professional thing" that had happened to him. He also asked his executive team if they had been defrauded. They did not yet think so, and also explained to him that there was not yet a way to cancel the deal. With that understanding, Fresenius set about trying to figure out how to salvage the deal by finding new synergies, but also hired outside counsel to guide it on a litigation strategy were Fresenius to decide to terminate the deal on the basis of an MAE.

Akorn's business performance only worsened with each passing quarter. For the full-year 2017, Akorn's revenue declined 25% year-over-year, its operating income declined 105%, and its EBITDA declined 86%. All three declines steepened in the first quarter of 2018. The declines also represented a departure from Akorn's historical trend: in each of the five previous years, Akorn had grown consistently in terms of revenue, EBITDA, and other financial measures.

The second set of bad facts was the revelation of serious and pervasive data-integrity issues at several Akorn locations. Anonymous whistleblower letters made detailed allegations concerning Akorn's culture of noncompliance with FDA regulations. The company's senior quality-control official submitted a false Complete Response Letter to the FDA and the company made a separate presentation to the FDA that was misleading in several significant ways. A total of no less than four individuals at Akorn were known to have been involved in data fabrication. A facility-inspection firm found a slew of critical and major nonconformities at Akorn sites; the firm's expert testified that Akorn's data-integrity issues were among the top three worst of the 120+ pharmaceutical companies that he had assessed. The expert added that Akorn's problems were so fundamental that he would not expect to find them "at a company that made Styrofoam cups," let alone at a pharmaceutical company.

On April 13, 2018, senior executives at Fresenius decided to recommend terminating the merger agreement. They based their decision on the data-integrity problems at Akorn, the costs of remediation, and the decline in Akorn's business performance. Fresenius still offered Akorn the choice of extending the outside date for the merger to the end of August to facilitate further investigation into the data-integrity issues. Akorn declined the offer.

On April 22, 2018, Fresenius gave notice that it was terminating the agreement. Fresenius cited its right to terminate based on:

Akorn's breaches of representations and warranties, including those related to regulatory compliance.
Akorn's breaches of its covenants, including its obligation to operate in the ordinary course of business.
Its right not to close because Akorn had suffered a general MAE, which would give rise to a right to terminate two days later, on April 24, 2018, when the outside date would pass.

Akorn brought suit in Delaware, seeking a declaration that Fresenius's attempt to terminate the agreement was invalid and an order of specific performance requiring Fresenius to close. Fresenius counterclaimed seeking a declaration that it had validly terminated the agreement.

Outcome

The Chancery Court ruled in favor of Fresenius, holding that the downturn in Akorn's business performance represented an MAE that would cause a failure of the no-MAE closing condition and that the gap between Akorn's representation of its regulatory compliance and the reality of its noncompliance also represented an MAE that could not be cured by the outside date. The court also found that Akorn had failed to satisfy its operating covenant in material respects and that the covenant-compliance condition would therefore not be satisfied either.

The court also held that Fresenius did not breach its efforts covenant at all, and that while it did breach its hell-or-high-water covenant, the breach was too short-lived to be considered material. Fresenius therefore did not lose its contractual right to terminate the merger agreement.

The Definition of Material Adverse Effect

The Chancery Court began its analysis with the general no-MAE closing condition, the most straightforward of the three closing conditions at issue.

The court walked through the prevailing market practice for MAE definitions, which is to define MAE circularly: an MAE is a change that has a material adverse effect on the target business. Most of the negotiation between the parties revolves around the stated exceptions to the definition of an MAE. The practice is to use the exceptions to allocate general market or industry risk to the buyer while allocating company-specific risk to the seller. Carveouts for general risks borne disproportionately by the target business reallocate general risks that affect the seller severely back to the seller.

In the immediate aftermath of the wave of busted M&A deals during the 2007-2008 financial crisis, many observers suggested that adding specific financial thresholds to MAE definitions could help avoid the litigation that had entangled many dealmakers. However, the Chancery Court acknowledged the justifications for leaving the MAE definition deliberately murky. Citing to leading treatises on M&A contract drafting, the court noted that it can be difficult during deal negotiations to reach agreement on a particular percentage or dollar decrease that the target business must suffer to be considered an MAE. Giving examples in the contract itself also raises the risk that anything short of the example will not be considered an MAE. On the other hand, ambiguity preserves an incentive for the parties to renegotiate between themselves when the target business seems to have suffered an MAE, rather than go through the uncertainty of litigation.

The Magnitude of the Decline Was Material

As the Chancery Court explained, the first step in analyzing whether a general MAE has occurred is to determine whether the magnitude of the downward deviation in the company's performance is material. This, as virtually all M&A practitioners know, is a heavy burden for buyers to carry. A short-term hiccup in the company's earnings does not count as an MAE (In re IBP, Inc. S'holders Litig., 789 A.2d 14, 68 (Del. Ch. 2001)). Rather, the drop-off must be material from the long-term perspective of a reasonable buyer. Such a perspective would be expected to be measured in years, not months (Hexion Specialty Chems., Inc. v. Huntsman Corp., 965 A.2d 715, 738 (Del. Ch. 2008)). As the IBP decision put it, the change must be one that substantially threatens the overall earnings potential of the target in a "durationally significant manner."

In assessing whether such a downturn has taken place, the Hexion court taught that the company's results should be evaluated against the same quarter of the previous year, to minimize the effect of seasonal fluctuations (965 A.2d at 742). The court noted that the Kling and Nugent treatise on M&A has given a decrease in profits in the 40%-or-higher range as a guideline for finding an MAE. However, this does not foreclose the possibility that a lesser decline could still constitute an MAE. Similarly, an even steeper decline might have reason to not be considered durationally significant if it was due to a seasonal fluctuation or some other temporary event, as was held in IBP.

In the case at hand, the court held that Akorn's financial performance had declined materially since the signing of the merger agreement and that the decline was durationally significant. The company's performance had drastically declined using every relevant financial metric in every year-over-year comparison beginning with the second quarter of 2017. For the full-year 2017, Akorn's revenues declined by 25%, its operating income declined by 105%, and its EBITDA declined by 86%.

The court held that the decline was durationally significant as it had already persisted for a full year and shown no signs of abating. Indeed, the company's results for the first quarter of 2018 continued the decline observed for the full-year 2017. Given that the company had blamed the downturn on new and unexpected competition, there was good reason to think the downturn will persist, as the competition was not about to disappear nor was there any meaningful plan for Akorn to win back the key contract it had lost.

The court also found additional support for the durational significance of Akorn's decline in recent analyst valuations of the company. In connection with the Akorn board's approval of the transaction, the board's financial advisor had submitted a discounted cash flow valuation for Akorn with a midpoint of $32.13 per share. Yet analysts now estimated that Akorn's standalone value is between $5.00 and $12.00 per share. Analysts also have dramatically reduced their forward-looking estimates for Akorn. Analysts thus perceive that Akorn's difficulties are durationally significant.

Value to Synergistic Buyer Not Relevant

In response to the evidence of a significant downturn that rather plainly made the case for a finding of an MAE, Akorn argued that any assessment of the decline in Akorn's value should be measured not against its performance as a standalone entity, but rather against its value to Fresenius as a synergistic (strategic) buyer.

The court rejected this defense for two contractual reasons:

The definition of MAE in the agreement only made reference (as is typical) to a material adverse effect on the business, results of operations, or financial condition of the company and its subsidiaries, taken as a whole. This language contemplates a review of only the company's performance, not its performance as a unit of the buyer.
One of the (typical) exceptions to the definition is for effects resulting from the merger itself. The generation of synergies is an effect that results from the merger itself.

Ability to Still Generate a Profit Not Relevant

Akorn also argued that as long as Fresenius can make a profit from the acquisition, an MAE cannot have occurred. The court rejected this theory as well, noting that the MAE definition concentrates only on the value of the target business without saying anything about profitability of the deal to the buyer. The parties could have bargained for a profitability standard, but they did not.

The Decline Did Not Fall Within an MAE Exception

With the downturn in Akorn's business constituting a material adverse effect, Akorn argued that its performance was due to industry-wide conditions, the risks of which were assumed by Fresenius in the form of an exception in the MAE definition. Akorn highlighted several industry headwinds, including:

Consolidation of buyer power, leading to large price reductions.
FDA attempts to approve additional generic drugs, leading to new market participants and more downward pressure on pricing.
Legislative attempts to reduce drug prices.

The court rejected this theory, finding that the primary drivers of the downturn in Akorn's business were Akorn's new market competitors and its loss of a key contract. These were Akorn-specific issues based on its product mix.

In the alternative, even if allowing that the downturn in Akorn's business was attributable to general industry conditions, the court held that they disproportionately affected Akorn. Fresenius presented evidence that Akorn's decline was disproportionate to its industry peers by every relevant financial measure during every relevant period of time. These disproportionate effects were carved out of the industry-conditions exception and reallocated to Akorn.

Failure to Be Allowed to Grow Through Acquisitions Not a Defense

Akorn offered another theory for why its decline fell within an exception to the definition of MAE. Akorn argued that its poor performance resulted from the restrictions the merger agreement imposed on its ability to grow through acquisitions. Because the MAE definition excluded effects resulting from performance of the merger agreement, Akorn contended that the risk of its decline had been assumed by Fresenius.

The court rejected this theory on several grounds, including that:

The finding of an MAE is measured by reference to the existing business that the buyer contracted to acquire. The target company does not have a contractual right to try to make up for its losses by buying growth.
Acquired companies take time to integrate and Akorn's downturn happened too quickly to have been fixable through acquisitions.
Nothing in the merger agreement forbade Akorn from seeking to do acquisitions; it was simply required to ask Fresenius for consent. It never did.

Fresenius Did Not Assume the Risks that Led to the MAE

Akorn argued that Fresenius cannot claim an MAE based on any risks that Fresenius learned about in due diligence or generally was on notice about because of its industry knowledge that it did not thoroughly investigate in due diligence. Akorn relied for its position on the observation in IBP that MAE provisions are "best read as a backstop protecting the acquiror from the occurrence of unknown events that substantially threaten the overall earnings potential of the target in a durationally-significant manner" (789 A.2d at 68). If the MAE functions only as a backstop for unknown (and unknowable) events, then Fresenius cannot invoke an MAE if it should have known of the possibility of the downturn that Akorn went on to suffer.

The court rejected this broad reading of IBP, explaining that it amounted to replacing the enforcement of a bargained-for contractual provision with a tort-like concept of assumption of risk. Because Delaware favors a contractarian approach, in which parties are allowed to order their affairs voluntarily through a binding contract, Delaware law is strongly inclined to respect an arm's-length, negotiated agreement. The court therefore does not ask what the buyer did or should have known after it has negotiated a provision that allows it to terminate the agreement when certain stipulated conditions are met.

In the merger agreement here, the parties negotiated the allocation of risk between them. The MAE definition could have excluded certain specific matters that Akorn thought might come up between the signing and closing, but they did not. Nor did they negotiate an exception for matters disclosed during due diligence or even risks identified in public filings. In a footnote, the decision cites to the 2017 Nixon Peabody MAC survey, which found that 28% of deals valued at $1 billion or more included an exception for developments arising from facts disclosed to the buyer or in public filings. Having chosen not to include such an exception in their agreement, the court declined to exercise such an exception on Akorn's behalf.

The court added that even if IBP should be read as broadly as Akorn advocated, the decision still only calls the MAE a backstop for unknown events, not for contemplated risks. The events that gave rise to Akorn's dismal performance were unexpected and the court would not have expected Fresenius to have anticipated them.

The Failure of the Bring-Down Closing Condition

The Chancery Court next analyzed whether Fresenius validly terminated the merger agreement because the bring-down closing condition could not be met. The bring-down condition permitted Fresenius to refuse to close if Akorn's representations are not true at closing, except where the deviation from Akorn's representation would not reasonably be expected to constitute a Material Adverse Effect.

To defeat the bring-down condition, Fresenius focused on Akorn's regulatory-compliance representation. The analysis therefore boiled down to whether the deviation between Akorn's as-represented condition of its compliance with FDA regulations and the true condition of its compliance would reasonably be expected to constitute a Material Adverse Effect. If Akorn would be expected to suffer an MAE, thereby causing a breach of its regulatory-compliance representation, the follow-up contractual questions would be whether the breach was curable by the outside date (a question the court had little trouble concluding that it was not) and whether Fresenius itself was in material breach of the merger agreement (see Fresenius Did Not Breach its Efforts Covenant).

Representation Breached Based on Objective Standard for Finding an MAE

The representation at issue contained an exception for inaccuracies that would not reasonably be expected to have a Material Adverse Effect. The court explained that the "reasonably be expected to" standard is objective. When this phrase is used, future occurrences qualify as material adverse effects, meaning that an MAE can have occurred without the effect on the business being felt yet. Even so, a mere risk of an MAE cannot be enough. Rather, the buyer must have a basis in law and in fact for the serious adverse consequences that it predicts to occur. When evaluating this prediction, the court must consider "quantitative and qualitative aspects" (Frontier Oil Corp. v. Holly Corp., , at *37 (Del. Ch. Apr. 29, 2005)).

Akorn's Noncompliance Was Qualitatively Significant

The court held that the qualitative dimension of the MAE analysis strongly supported a finding that an MAE would reasonably be expected to occur. In so holding, the court reviewed the salient facts of Akorn's pervasive noncompliance and widespread regulatory violations. These included the testimony of experts that Akorn's noncompliance was among the worst ever encountered, critical deficiencies that went ignored, fabricated data submitted to the FDA, and other major shortcomings. The court considered the regulatory situation at Akorn qualitatively material when viewed from the long-term perspective of a buyer.

A 20% Decline in Valuation for Remediation Was Quantitatively Significant

The question of the quantitative significance of the inaccuracy of Akorn's regulatory-compliance representation concerned the two parties' competing estimates of the cost of remediation of Akorn's compliance failures. Akorn estimated direct outlays of $44 million with no other effect on the company's value. Fresenius's estimate contemplated direct outlays of $254 million plus a valuation hit of up to $1.9 billion from suspending on-market products and pushing out pipeline products while Akorn's data would be verified.

The court rejected Akorn's estimation. The court noted that the estimate unrealistically assumed that consultants would complete a limited process to correct Akorn's protocols and confirm that everything is in order, but where nothing else would be uncovered, no data would need to be revalidated, and no products would need to be withdrawn or deferred. Fresenius's estimate, on the other hand, took these likely costs into account.

The court settled on a valuation hit of $900 million, representing a decline of 21% from Akorn's implied equity value of $4.3 billion. Here the court lamented the lack of assistance from the parties as to whether a 21% decline in valuation would be considered material to a reasonable buyer when viewed from a long-term perspective. The court concluded that a 20% decline ought to be considered material. By its own admission, this was mostly a matter of intuition for the court, supported by the fact that Akorn had extracted top dollar from Fresenius in their negotiations, leaving little room for Fresenius to absorb significant unexpected losses.

To help bolster its conclusion, the court pointed out the following indicia that a 20% reduction in value would generally be considered material from a long-term perspective:

The general magnitude of a 20% change. A 20% fall in the stock market is considered a bear market. A single-day decline of 20% in the Dow Jones Industrial Average would make for the second-largest drop ever, surpassed only by Black Monday in 1987.
A study found that when parties renegotiate a deal after a target-specific MAE, they reduce the price by 15% on average. A 20% drop would therefore be considered material.
Two studies of pricing collars in public stock deals found, on average, a lower bound for the collar at a price 10% below the initial deal consideration. (For more information about pricing collars, see Practice Note, Pricing Collars: Mitigating Market Risk in Public Mergers.)
Reverse break-up fees that cap a buyer's damages for breach and, if unaccompanied by a remedy of specific performance, are the seller's sole remedy against the buyer, are generally priced between 6% and 7%. (For the latest information on reverse break-up fee pricing, see Reverse Break-Up Fees and Specific Performance: A Survey of Remedies in Leveraged Public Deals (2018 Edition).)

Fresenius Did Not Knowingly Accept the Risk of a Regulatory MAE

As it did when arguing against the existence of an MAE for purposes of the no-MAE closing condition, Akorn contended that Fresenius could not claim that its regulatory issues would be reasonably likely to result in a Material Adverse Effect because Fresenius knew about the risk of potential issues and signed the Merger Agreement anyway. The court rejected this argument on similar grounds as before, explaining that Fresenius's general knowledge about potential regulatory issues, or questions about the extent to which it conducted due diligence into these issues, did not mean that Fresenius could not rely on the representation it obtained from Akorn.

In support of this point of law, the court borrowed from the private M&A context, particularly the issue of sandbagging that arises when negotiating remedies for breach in a private acquisition agreement. Quoting at length from Cobalt Operating, LLC v. James Crystal Enterprises, LLC, the court explained that under Delaware law, reliance is not a necessary element for a breach of contract claim. Rather, representations serve an important risk-allocation function that a seller cannot get around by claiming that the buyer should have uncovered the representations' falsity (, at *28 (Del. Ch. July 20, 2007), aff'd without op., 945 A.2d 594 (Del. 2008); for more on the Cobalt decision and sandbagging in general, see What's Market Analytics: Sandbagging Provisions (2017)).

The Failure of the Covenant-Compliance Condition

The Chancery Court next analyzed whether Fresenius had validly terminated the merger agreement because Akorn had failed to satisfy the closing condition that it comply with its covenants in all material respects. Here Fresenius focused on Akorn's failure to comply with its operating covenant, which required Akorn to use commercially reasonable efforts to carry on the business between signing and closing in all material respects in the ordinary course of business. If Akorn were found to have breached its operating covenant, the follow-up contractual questions would be whether the breach was curable by the outside date (a question the court again had little trouble concluding that it was not) and whether Fresenius itself was in material breach of the merger agreement (see Fresenius Did Not Breach its Efforts Covenant).

The "All Material Respects" Standard

The parties debated the meaning of the "all material respects" standard of the operating covenant and closing condition. (The court acknowledged the double materiality here, but held that its only import was to emphasize that a breach cannot be immaterial.) Akorn argued that the phrase gives significant latitude by adopting the common law doctrine of material breach. A breach is material if it goes to the root or essence of the agreement between the parties, or touches the fundamental purpose of the contract and defeats the object of the parties in entering into the contract.

The court cited to several treatises in support of the idea that the phrase implies a lower bar. Parties use the "all material respects" language simply to exclude small, nitpicky foot faults from counting as a breach of the agreement. A breach more serious than that would cause a failure of the covenant. Fresenius also borrowed from the public-disclosure context to argue that the phrase requires only a substantial likelihood that the breach would be viewed by the reasonable investor as having significantly altered the total mix of information. The court accepted that this more or less captured what is meant by the phrase "in all material respects."

The "Commercially Reasonable Efforts" Standard

Owing to the language of the operating covenant, the court also had to define the meaning of the "commercially reasonable efforts" standard. Here the court noted that conventional wisdom among practitioners departs somewhat from Delaware precedent. Practitioners tend to image a hierarchy of efforts standard in which the most onerous standard is the "best efforts" standard, the only standard that requires a party to do anything it can to perform its obligation. Below that standard would be the "reasonable best efforts" standard, while significantly below that is the "commercially reasonable efforts" standard, in which it is imagined that a party does not have to take any action that would be commercially detrimental to it.

This hierarchy is unfounded under Delaware law. In Williams Companies v. Energy Transfer Equity, L.P., the Delaware Supreme Court rejected any difference between "reasonable best efforts" and "commercially reasonable efforts." Both standards impose obligations to take all reasonable steps to solve problems and close the transaction (159 A.3d 264, 272 (Del. 2017); for more on the Williams v. ETE decision, see Legal Update, Delaware Supreme Court Affirms Chancery Court Ruling in The Williams Companies v. ETE).

Akorn Breached the Operating Covenant

Under the "commercially reasonable efforts" standard (which requires significant efforts) and the "in all material respects" standard (by which a breach is not hard to find), the Chancery Court held that Akorn had breached the operating covenant. The court essentially recast Akorn's major regulatory deficiencies as breaches of the covenant, in that:

A generic pharmaceutical company operating in the ordinary course of business is obligated to conduct regular audits and to take steps to remediate deficiencies. Yet Akorn cancelled regular audits at four sites in favor of verification audits that would not look for additional deficiencies. Fresenius also cancelled an assessment of one facility and never allowed completion of another, even though Akorn had planned for both to take place before the merger agreement was signed.
A generic pharmaceutical company operating in the ordinary course of business is obligated to maintain a data-integrity system that enables the company to prove to the FDA that the data underlying its regulatory filings and product sales is accurate and complete. Akorn did not do this.
A generic pharmaceutical company operating in the ordinary course of business does not submit regulatory filings to the FDA based on fabricated data. Yet Akorn's senior quality-control official did just that.
Akorn also failed to act in the ordinary course of business in the way it responded when Fresenius provided it with the whistleblower letters. Akorn should have conducted an investigation using counsel with experience in regulatory matters, but it instead decided to have its deal counsel front-run the investigation that Fresenius intended to conduct and head off any problems that Fresenius otherwise might uncover.

Fresenius Did Not Breach its Efforts Covenant

The final issue for the court was whether Fresenius was barred from exercising its termination right because of its own material breaches of the merger agreement. Akorn contended that Fresenius could not terminate the agreement because it had breached both the reasonable best efforts covenant and the hell-or-high-water covenant. (Note that Akorn only had to prove that Fresenius was in material breach of its own covenants, not that Fresenius's breach was related to the failure of the closing conditions giving rise to the termination right.)

In so arguing, Akorn attempted to paint Fresenius as a recalcitrant buyer, not unlike the buyer in Hexion, trying to concoct a narrative in which an MAE frustrated its goal of closing the merger when it really was experiencing buyer's remorse and just wanted out of the deal.

The dilemma that arises for any buyer in this scenario is that on the one hand it has a termination right that it should be allowed to exercise when the conditions for termination are met, yet on the other hand it is bound by a covenant requiring it to exercise reasonable best efforts to close. Somewhere before termination there must come a point where the buyer decides to terminate; at that point, it can no longer be said to still be attempting to close. The question is how a buyer can navigate around this contractual pitfall.

The key for the Chancery Court, as shown in IBP and Hexion, is that the buyer show that it:

Had reasonable grounds to take the action it did.
Sought to address problems with the seller.

In IBP and Hexion, the Chancery Court criticized parties who did not raise their concerns before filing suit, did not work with their counterparties, and appeared to have manufactured issues solely for purposes of litigation. For example, in Hexion, the buyer, perhaps realizing that its MAE argument was not strong, attempted to build a case on the basis of the target company's insolvency.

In this case, by contrast, Akorn’s dismal post-signing performance gave Fresenius good cause to evaluate its rights and obligations under the merger agreement. The fact that Fresenius also consulted with legal counsel to better understand its rights under the agreement does not serve as evidence of an intent to manufacture an excuse to terminate the agreement. The Hexion court observed that a company can always seek expert advice to rely on when evaluating its contractual alternatives.

Another important distinction here is that Fresenius communicated directly with Akorn about its performance. The evidence also showed that even as Fresenius was evaluating its contractual rights, it still worked hard to figure out how the deal could still work. Fresenius therefore did not breach its efforts covenant.

Fresenius Did Not Materially Breach its Hell-or-High-Water Covenant

A somewhat closer call was whether Fresenius had breached its hell-or-high-water covenant relating to antitrust approval. There was no serious dispute that for the six months following signing, Fresenius diligently pursued antitrust approval, including by working with advisors and proposing a divestiture plan to the FTC.

Somewhat problematic for Fresenius was that for approximately a week in February 2018, Fresenius contemplated a path for obtaining FTC clearance that would have delayed closing by two or three months. Internal communications revealed that the motivation for delaying closing was to give more time to develop a legal position vis-à-vis Akorn's regulatory failures and the possibility of terminating the agreement.

The Chancery Court held that this week-long divergence of focus constituted a breach of the hell-or-high-water covenant. However, because Fresenius changed course and dropped this plan after one week, the court considered the breach immaterial. Fresenius therefore did not lose its right to terminate the merger agreement.

Practical Implications

The decision in Akorn, Inc. v. Fresenius Kabi AG will long be remembered as the first decision in Delaware to have allowed termination of a merger agreement due to a Material Adverse Effect. The decision proves, if nothing else, that it is not impossible to convince a Delaware court that an MAE has occurred. The decision will be cited at length in any future MAE claim by buyers wishing to prove to the court that their situation resembles that in Akorn v. Fresenius.

Beyond the headline fact of the finding of an MAE, the decision contains many useful guidelines:

Losses due to unexpected competition. If a target loses business due to the unexpected entry of new competitors, the court may take the new competition as evidence of the durational significance of the downturn. Entry of new market participants is not taken to be a merely seasonal change.
Year-over-year results. The decision endorses and follows Hexion for the principle that in assessing whether a decline in performance is durationally significant, performance should be measured on a year-over-year basis to avoid seasonal effects.
Expected 20% decline in value is material from a long-term perspective. The court seems relatively comfortable with the idea that a 20% decline in target value due to expected losses stemming from a material adverse change is enough to qualify for an MAE. This is not a hard-and-fast rule but works as a guideline.
Analyst estimates reliable. The court is willing to look to analyst estimates of current and future value for supporting evidence of the durational significance of a downturn in the target business. A valuation significantly below the pre-signing valuation evidences an expectation that the suffered losses are not temporary.
Target business assessed on own. The fact that the target business may still retain synergistic value for the buyer is of no consequence if the business has itself suffered an MAE.
Language suggestions for MAE definitions: Certain findings in the decision raise interesting suggestions for the language of MAE definitions. For one, sellers can negotiate a profitability exception, in which no MAE is deemed to have occurred in spite of a downturn in the target business if the buyer will still be able to turn a profit with the target business under its helm. Another drafting suggestion, already observed between a quarter and a third of the time, is to add an exception for developments arising from facts disclosed to the buyer or in public filings.
Pro-sandbagging view possibly restored. The decision contains a robust defense of the view that Delaware takes a contractarian approach and allows contractual parties to order their affairs as they see fit. As such, Delaware law allows a party to rely on the representation it has obtained from its counterparty, regardless of what it knew or should have known through its own due diligence. This passage may come as a relief to some practitioners who have highlighted a footnote in a recent Delaware Supreme Court decision that implied that Delaware may not be the pro-sandbagging state it had been assumed to be (Eagle Force Holdings LLC v. Campbell, 187 A.3d 1209, 1236 n.185 (Del. 2018)). Pro-sandbagging is shorthand for a view that a buyer can claim a breach of contract regarding a matter that the buyer knew about before signing the agreement. The Supreme Court in the footnote at issue acknowledged the debate around the subject of sandbagging and said the issue has yet to be decided in Delaware—not a definitive pullback from pro-sandbagging, but not a ringing endorsement either. The discussion in Akorn v. Fresenius Kabi of the Cobalt decision might help restore Delaware's previous reputation on the subject. (The Chancery Court here did not mention Eagle Force at all; one can read into that any way one pleases.)
"In all material respects" standard. The court held that the phrase "in all material respects" when used in representations and covenants is meant only to avoid arguments over de minimis breaches, but it otherwise constitutes a relatively low bar for breach. It certainly contemplates a stricter standard than an MAE carveout, which requires far more fundamental breaches.
"Commercially reasonable efforts" standard. The court reiterated the lesson of Williams Companies, namely that practitioners should not make the mistake of thinking a "commercially reasonable efforts" standard implies a lower level of obligation than does a "reasonable best efforts" standard. The Delaware judiciary treats them both essentially the same way and in both cases requires the obligor to take all reasonable steps to close the transaction.
Buyers may discuss termination options with counsel. A buyer concerned the target business has suffered an MAE has every right to discuss its options with counsel and eventually reach a decision that it must terminate. A buyer will not risk breach of its efforts covenant so long as it discusses its concerns with the target company and does not concoct plans for getting out of the transaction if the MAE argument is weak. Ultimately the best defense against an argument that the buyer breached its efforts covenant is that an MAE actually occurred.
Post-signing investigation under confidentiality agreement. This issue is ancillary to the main issues at the heart of the decision, but still worth highlighting. In November 2017, Fresenius decided to hire outside regulatory counsel to help investigate the data-integrity issues at Akorn. Counsel determined that Fresenius did not require special consent from Akorn for counsel to begin reviewing diligence materials available in the data room because the confidentiality agreement authorized "representatives" to review Evaluation Material for the purpose of evaluating, negotiating, and executing a transaction. Counsel concluded that its investigation was part of the process of executing (that is, carrying out) the transaction and that it could therefore use the Evaluation Material in its investigation. The court agreed with that interpretation and did not limit the word "executing" to "signing." This means that post-signing, counsel can be brought in for (legitimate) investigative purposes without requiring special consent if the confidentiality agreement contains similar (typical) language.

Akorn v. Fresenius Kabi: Delaware Court of Chancery Finds Target Company Suffered MAC Allowing Buyer to Terminate Merger Agreement | Practical Law