United States: Significant 2018 Decisions Affecting Private Company M&A

This newsletter is our fifth annual review of significant state court decisions relevant for private company M&A transactions and related governance matters and disputes. The summary includes the landmark Akorn v. Fresenius decision, which is the first Delaware M&A decision to uphold a buyer's termination right on the basis of an MAE. A few of the decisions concern drafting points, a few concern overall deal process and planning points, and two of the decisions concerned fiduciary duty breaches in contested situations (one was a public company decision that has relevance to the private M&A context).

Akorn, Inc. v. Fresenius Kabi AG, 2018 WL 4719347 (Del. Ch. Oct. 01, 2018), aff'd, 198 A.3d 724 (Del. 2018)

Delaware Court of Chancery provides important interpretive guidance on the meaning of material adverse effect (MAE) clauses and is the first Delaware decision to hold that an acquirer was justified in terminating a merger agreement as a result of the occurrence of an MAE.


Akorn v. Fresenius is a major decision regarding MAEs in the M&A context, and builds on prior guidance of Delaware courts issued in IBP and Hexion.1 Akorn involved the proposed acquisition of Akorn, Inc. (Akorn), a generics pharmaceutical company, by Fresenius Kabi AG (Fresenius), for $34 a share pursuant to a reverse triangular merger. The deal was signed on April 24, 2017, and had a drop dead date of April 24, 2018 (the Outside Date). At the time of announcing the deal, Akorn reaffirmed its full year guidance for 2017. Akorn's financial results for the second quarter of 2017 declined precipitously, which Akorn attributed to unexpected competition and loss of a key customer. Akorn's financial results continued to deteriorate in the third quarter of 2017. In October and November 2017, Fresenius received two anonymous whistleblower letters containing allegations about Akorn's product development process and quality compliance programs failing to comply with FDA regulations. Invoking its information access rights under the merger agreement, Fresenius conducted an investigation that uncovered "serious and pervasive data integrity problems," which called into question whether Akorn's representations and warranties under the merger agreement were sufficiently inaccurate as to reasonably be expected to result in a MAE. In a meeting with the FDA in March 2018, Akorn understated its regulatory issues and overstated its remedial efforts. Akorn's financial performance continued to deteriorate throughout this time.

On April 22, 2018, Fresenius delivered notice that it was terminating the merger agreement on two grounds: (i) an uncurable breach of Akorn's regulatory representations and warranties, which gave rise to an MAE, and (ii) an uncurable breach of Akorn's pre-closing covenants. Fresenius also alleged that the stand-alone MAE closing condition was not satisfied. Akorn filed suit, seeking a decree of specific performance to compel Fresenius to close. Fresenius filed a counterclaim, seeking a declaration that it validly terminated the merger agreement. In a post-trial decision, the Court of Chancery ruled in favor of Fresenius, holding that it validly terminated the merger on both of the two grounds that it invoked, and that Fresenius properly relied on the fact that Akorn had suffered an MAE in refusing to close (although this did not give rise to a termination right under the merger agreement). The Delaware Supreme Court affirmed the Court of Chancery's decision.

Key Merger Agreement Provisions

Section 6.02 of the merger agreement set forth Fresenius' conditions to closing. Section 6.02(a)(ii) set forth the Akorn representation and warranty bring-down, and provided that Akorn's general representations and warranties must be true and correct (disregarding materiality and MAE qualifiers) as of the merger agreement date and as of the closing date except where the failure to be true and correct would not, individually or in the aggregate, reasonably be expected to have an MAE (the Bring-Down Condition). Section 6.02(b) provided that Akorn shall have complied with or performed in all material respects its obligations required to be complied with or performed by it prior to the effective time of the merger (the Covenant Compliance Condition). Section 6.02(c) provided that there shall not have occurred or be continuing an MAE (the General MAE Condition). The failure of the Bring-Down Condition and the Covenant Compliance Condition gave Fresenius a termination right if the failure was incapable of being cured by the Outside Date, so long as Fresenius was not then in material breach of its representations, warranties, covenants or agreements under the merger agreement.

Failure of the General MAE Condition

Fresenius argued that it was not obligated to close because Akorn had suffered an MAE. In considering whether this General MAE Condition was satisfied, the Court of Chancery considered the structure and rationale of a typical MAE provision. The Court of Chancery noted that the typical MAE clause, through the basic provision and numerous exceptions, allocates industry (or systemic) risk to the buyer and company-specific risks on the seller. Relying on Hexion, the Court of Chancery noted that for a buyer to satisfy the heavy burden it faces when demonstrating the existence of an MAE, the important consideration is whether the adverse change in the target's business "is consequential to the company's longterm earnings power over a commercially reasonable period, which one would expect to be measured in years rather than months." A decline in company performance should be evaluated against the company's results during the same quarter of the prior year. The Court of Chancery noted that in Hexion, a 3% decline in 2007 EBITDA from the prior year, and projected 7% (or 11% using conservative projections) decline in EBITDA for the next year, did not give rise to an MAE. The Court of Chancery noted that one treatise found that most courts required a decrease in profit of at least 40% in order to find an MAE. In dictum in a prior decision, Chancellor Allen noted that an earnings decline of more than 50% over two quarters would probably constitute an MAE.2 In IBP, a 64% drop in quarterly earnings was found not to give rise to an MAE. However, in that case, then Vice Chancellor Strine noted it was a close call, and buyer's arguments were undermined by buyer's failure to provide expert evidence.

Financial Performance Downturn Constituted an MAE

In contrast to IBP, the Court of Chancery found that Fresenius had submitted credible and persuasive expert testimony that Akorn's financial performance had declined materially since the signing of the Merger Agreeent and that the underlying causes of the decline were durationally significant. The court noted that year-over-year declines in quarterly revenue for each quarter from the second quarter 2017 until the first quarter 2018, and in annual revenue for fiscal year 2017, ranged from 25% to 34%. Declines in operating income for the same periods ranged from 84% to 292%, and declines in earnings per share for the same periods ranged from 96% to 300%. Full year EBITDA declined 86%, and full-year adjusted EBITDA declined 51%. The Court of Chancery noted that Akorn's dramatic fall in performance during 2017 was a reversal of the yearly growth it experienced during the five year period ended in 2016. The Court of Chancery found that the downturn in performance was durationally significant because it had persisted for a full year and showed no sign of ceasing. Management had attributed the performance decline to factors such as new market entrants and loss of a key contract, which the Court of Chancery found created a situation that was likely to persist. The Court of Chancery noted that analysts had slashed estimates of 2018, 2019 and 2020 EBITDA by more than 62.6%, 63.9% and 66.9%, respectively, between the date of signing the merger agreement and the closing date, and had only decreased forward EBITDA estimates for peer companies by 11%, 15.3% and 15%, respectively. The Court of Chancery held that this was strong evidence of an MAE. The Court of Chancery rejected Akorn's argument that the decline in performance should be measured not against its performance as a standalone entity, but should also factor in the synergies to Fresenius. In looking at the MAE definition, which referenced a material adverse effect with respect to Akorn and its subsidiaries and carved out the effect of the consummation of the merger, the Court of Chancery held that the analysis should be based on the performance of Akorn as a stand-alone company.

MAE Exceptions Did Not Apply

Having found that Akorn had suffered a general MAE, the Court of Chancery considered whether any of the exceptions to the MAE applied. Akorn argued that its performance deterioration was due to known "industry headwinds," such as a consolidation of buyer power leading to drug price reductions, the FDA's efforts to approve generic drugs, and legislative attempts to reduce drug prices. The Court of Chancery noted that while industry risks were allocated to Fresenius under the MAE definition, the risk allocation reverted to Akorn if the industry headwinds had a disproportionate effect on Akorn relative to other industry participants. Rejecting Akorn's argument that an exception applied, the Court of Chancery noted that the primary drivers of Akorn's bad performance were new market entrants and loss of a key contract, which were specific to Akorn. But even if you viewed them as industry effects, they disproportionately impacted Akorn relative to other industry participants.

Fresenius did Not Assume the Risk Through Industry Knowledge

Relying on language in IBP that MAEs protect against unknown risks, Akorn argued that Fresenius could not claim an MAE based on risks that it learned of in due diligence or was on notice of because of industry knowledge. Rejecting Akorn's argument, the Court of Chancery noted that the argument would introduce a tort-like concept of assumption of the risk, and run counter to Delaware courts' promotion of freedom of contract.

The Court of Chancery distinguished IBP on several grounds. First, the Court of Chancery noted that the MAE in IBP did not contain lengthy exclusions, and neither IBP nor Hexion should be viewed as setting forth rules that apply to all MAEs, including that in Akorn. Second, while the analyses in IBP and Hexion were framed in terms of known versus unknown risks, both cases involved buyers being unable to rely on consequences of widely known systemic risks. IBP involved cyclical effects in the meat industry, and Hexion involved macroeconomic challenges, such as increases in crude oil and natural gas prices and changes in foreign exchange rates. Thus, both decisions should properly be viewed as consistent with the view that buyers cannot invoke MAEs for known systemic risks, which is different from the situation in Akorn. Third, even if IBP and Hexion could be read as applying a blanket rule that turns on known versus unknown risks, the analysis would not apply in Akorn, because the events that gave rise to the bad performance were unanticipated.

Failure of the Bring-Down Condition

One of Fresenius' bases for terminating the merger agreement was that the Bring-Down Condition was not satisfied because of the inaccuracy of Akorn's representations in Section 3.18 of the merger agreement relating to regulatory compliance. For the Bring-Down Condition not to be satisfied, Fresenius would have to show that the difference between the actual condition of Akorn and the condition as represented was great enough that it would reasonably be expected to result in an MAE. The Court of Chancery held that the "reasonably be expected" standard was an objective one that required a qualitative and quantitative analysis.

Qualitative Analysis

The Court of Chancery held that the "overwhelming evidence of widespread regulatory violations and pervasive compliance problems at Akorn" strongly supported a finding of an MAE. The Court of Chancery noted that Akorn had "pervasive data integrity and compliance problems" that prevented it from meeting FDA data integrity requirements. The Court of Chancery invoked numerous examples of Akorn's failures. For example, one of Akorn's own consultants testified that data integrity failures were so bad he would not expect to see them "at a company that made Styrofoam cups," and that its integrity issues were among the three worst of the more than 120 pharmaceutical companies he had assessed. The Court of Chancery noted that evidence showed that Akorn was aware of the issues but ignored them. After the merger agreement was signed, the head of Akorn's quality function exacerbated the problem by submitting false data to the FDA. Akorn also submitted misleading information to the FDA regarding its efforts to investigate problems. Counsel retained by Fresenius to investigate the problems also identified "serious fundamental flaws" in Akorn's management of data. An expert witness retained by Fresenius also tested that he had "rarely seen integrity issues that exist at the scope and scale we see" at Akorn.

Quantitative Analysis

The Court of Chancery held that the quantitative aspects of the MAE analysis also supported the finding that Akorn's regulatory issues would reasonably be expected to result in an MAE. Akorn estimated expenses of $44 million to remediate its data integrity problems, with no other impact on valuation. Fresenius estimated remediation expenses of $254 million, plus a valuation hit of up to $1.9 billion due to suspension of products being marketed and delays in new products. The Court of Chancery found that the valuation impact would be somewhere between the two, at approximately $900 million. The court of Chancery compared this to the standalone valuation of Akorn when the merger agreement was signed of approximately $3.9 billion, and arrived at a valuation decrease of approximately 21%.

Looking at various anecdotal sources, the Court of Chancery held that a 21% valuation decrease satisfied the test of being "material when viewed from the longer-term perspective of a reasonable acquiror." The court first noted that during diligence and negotiation of the transaction, Fresenius was willing to close despite identifying a high risk of potential exposures of approximately $200 million in value, and that the valuation impact of Akorn's regulatory failures was four to five times greater. The Court also noted that a bear market is deemed to occur when stock prices fall at least 20%, and that one unpublished study found that the average negotiated price reduction following the occurrence of an MAE is 15%. The Court of Chancery considered academic studies and market practice and observed that upper and lower bounds for collars generally fall within 10% to 20% of deal consideration at signing, which indicated that parties viewed a 10% value change as material. The Court of Chancery noted a 2011 law firm study that found that median reverse termination fees equaled 6.36% of transaction value.

Fresenius' Knowledge of Regulatory Risks Did Not Foreclose an MAE Finding

The Court of Chancery rejected Akorn's argument that Fresenius could not claim the existence of a regulatory MAE because it knew about the risk of potential issues when it signed the merger agreement. The Court of Chancery noted that Delaware cases have held that "a breach of contract claim is not dependent on a showing of justifiable reliance."3 Allowing parties to allocate risk under the acquisition agreement serves the important purpose of not forcing acquirors to undergo extensive and costly due diligence.

Akorn argued, relying again on IBP, that the MAE provision changes the analysis because it should be understood as backstop protection from unknown events. Rejecting Akorn's argument, the Court of Chancery reasoned that adding an MAE qualifier does not change the nature of the representation, but merely addresses the permissible degree of deviation from the representation before the representation is deemed inaccurate. Whether the buyer had concerns about regulatory compliance matters was irrelevant—the mere existence of the representation demonstrates some level of concern by the buyer. But what is important is how the parties allocated the risk of inaccuracy of the representation under the acquisition agreement. Akorn's approach would turn an MAE-qualified representation into an expansive knowledge-based qualification of the representations based on everything the buyer knew or should have known. In dictum, the Court of Chancery noted that its reasoning did not necessarily mean that a buyer who knew about a specific risk should be permitted to close and then sue for damages, because that has different public policy implications.

The Court of Chancery noted that even if you accepted Akorn's argument, while Fresenius did identify regulatory risks in diligence, it did not know about Akorn's data integrity issues, and could not have known about the actions that Akorn took after signing the merger agreement that increased the risk further.

The Court of Chancery then considered whether the regulatory compliance representations were capable of being cured prior to the Outside Date. The Court of Chancery held that no such cure was possible, noting that Akorn's own witnesses believed that the regulatory failures would take three years to cure.

Failure of the Covenant Compliance Condition

A second basis for Fresenius' termination of the merger agreement was that Akorn breached its covenant to use commercially reasonable efforts to carry on its business in all material respects in the ordinary course of business, and that such breach could not be cured prior to the Outside Date. The Court of Chancery first considered Akorn's argument that the "all material respects" language adopted the common law standard for material breach of contract. Rejecting the argument, the Court of Chancery held instead that it required a less onerous standard, akin to that used to assess materiality for purposes of disclosure, which it described as a "substantial likelihood that the fact of breach would have been viewed by the reasonable investor as having altered the total mix of information."

The Court of Chancery next considered the "commercially reasonable efforts" language. The Court of Chancery noted that while practitioners generally consider it as the fourth in a hierarchy of five efforts standards, ranging from "good faith efforts" to "best efforts," case law has interpreted "commercially reasonable," "reasonable best," and "best" similarly. The Court of Chancery held that it required Akorn to "take all reasonable steps" to maintain operations in the ordinary course of business.

The Court of Chancery framed the test whether Akorn had taken all reasonable steps to maintain operations in the ordinary course of business as an objective one, as opposed to considering what historically constituted the ordinary course of business for Akorn. The Court of Chancery held that Akorn failed to comply with this standard in several respects, including through conducting regular audits and taking steps to remediate deficiencies, failing to maintain adequate data integrity systems, submitting fabricated regulatory filings to the FDA, and failing to conduct responsible and credible investigations when provided with the two whistleblower letters. The Court of Chancery held that Akorn's breach of the ordinary course covenant was material, because the record indicated that Fresenius would not have agreed to buy Akorn if it had known that Akorn would fail to comply with the ordinary course covenant in the way that it did. The Court of Chancery held that the Covenant Compliance Condition could not have been cured by the Outside Date, and thus Fresenius was justified in invoking it as a basis for termination.

No Fresenius Material Breach

The Court of Chancery considered whether Fresenius was in material breach of the merger agreement, which would have barred it from exercising its termination right on both of the two grounds. The court first considered whether Fresenius breached its covenant to use reasonable best efforts to close. The court noted that this did not impose an obligation to merge at all costs, but should be considered in light of Akorn's representations, and Fresenius' conditions and termination rights under the merger agreement. The court held that the analysis required a consideration of whether Fresenius "(i) had reasonable grounds to take the action it did and (ii) sought to address problems with its counterparty." In finding that Fresenius did not breach its reasonable best efforts covenant, the Court of Chancery found that Fresenius was justified in undertaking the investigation of Akorn that it did after learning of regulatory issues and receiving the whistleblower letters. The court held that Fresenius acted reasonably before it decided to terminate the merger agreement, and even offered to extend the Outside Date, which Akorn refused. The court rejected Akorn's efforts to depict Fresenius as having "buyer's remorse," similar to the buyers in IBP and Hexion, noting "the difference between this case and its forebearers is that the remorse was justified."

The Court of Chancery held that Fresenius breached its covenant regarding efforts required to obtain antitrust approval, but that the breach only lasted for about a week and was not material. Accordingly, Fresenius was able to validly terminate the merger agreement.


Akorn is a major decision that provides guidance on a number of topics, including the following:

MAE Definition: The decision provides guidance on the nature and magnitude of a deterioration in financial performance that is required in order to constitute an MAE. The typical MAE allocates industry/systemic risks to the buyer, so risks that are general industry risks, and that don't disproportionately impact the seller relative to other industry participants, will not trigger an MAE. The deterioration has to be durationally significant, typically over years and not months, and is measured relative to corresponding periods in prior years. In Akorn, the deterioration was significant by any measure, and the hurdle is therefore likely to remain very high after this decision.

Buyer's Knowledge: Many practitioners read IBP as indicating that MAEs would be evaluated in light of the knowledge that a buyer possessed when entering into the agreement. Akorn suggests that is incorrect, and that the buyer in IBP assumed the risks at issue there not because the buyer knew of them, but because they were industry/systemic risks that buyers typically assume under MAE definitions. The Akorn decision adopts much more of a pro-contractarian approach, where the court deferred to the parties' risk allocation under the merger agreement, as opposed to reliance on notions of what a buyer knew or should have known at the time of contracting.

Sandbagging: Practitioners typically view Delaware as a pro-sandbagging jurisdiction, which means that buyers are not foreclosed from bringing claims from breach of representations and warranties even if they knew they were inaccurate at signing. The Akorn court noted in dictum that while it was pro-contractarian in that it would not inquire into what a buyer knew or should have known for purposes of the closing conditions, different policy considerations apply with respect to claims for breach of representations and warranties. Thus, the court called into question whether Delaware really is a pro-sandbagging jurisdiction. It is worth noting that in an unrelated 2018 decision, Justice Valihura noted that whether Delaware courts permit sandbagging is an unresolved issue, and Chief Justice Strine cast doubt on whether Delaware courts would permit it.4

MAE Bring-Down: The Akorn decision provided guidance on how to evaluate whether inaccuracies of representations would reasonably be expected to result in an MAE. Given its prospective nature, this is different from the analysis of a general MAE, which is more of a financial analysis. The MAE Bring-Down analysis involves a qualitative and quantitative review of the inaccuracy. The qualitative analysis in Akorn involved particularly egregious facts which are unlikely to be present in many situations. The quantitative analysis suggests that a valuation decrease of 20% is likely to be sufficient to support an argument that the representation inaccuracy gave rise to an MAE. A decrease of between 10% and 20% is likely to fall in a grey area.

Interim Operating Covenant: The decision provides interpretive guidance on covenants to use commercially reasonable efforts to operate the business in the ordinary course between signing and closing. As in several other decisions, the Akorn court minimized the significance of the difference among the various efforts standards, such as "commercially reasonable efforts," "best efforts," and "reasonable best efforts." The applicable test was whether Akorn had taken "all reasonable steps" to maintain operations in the ordinary courts of business. Practitioners should note that this was an objective standard, which involved a comparison of what Akorn did against what a typical company in its industry would do. Thus, implicitly, Akorn would have been unable to rely on its conduct prior to the merger agreement signing date as setting a benchmark.

Reasonable Best Efforts Covenant: For deal parties concerned about a potential condition failure that may give rise to that party having a termination right, the decision provides useful guidance on how the party should conduct itself in order to avoid a breach of its obligation to use the requisite degree of efforts to close. The Akorn court held that the applicable test was whether the applicable party "(i) had reasonable grounds to take the action it did and (ii) sought to address problems with its counterparty." Parties are not obligated to close at all costs, but should continue to push forward in light of their contractual rights to investigate circumstances giving rise to condition failures and termination rights. As was the case in Akorn, a buyer's compliance with its efforts obligations is typically a prerequisite to the buyer being able to invoke a termination right. The consequences of failing to comply can therefore be much more significant than simply giving rise to a damages claim for breach of contract.

Delaware's Pro-contractarian Approach: Throughout the decision, the Court of Chancery advocated following the language and structure of the merger agreement and eschewed Akorn's attempts to impart bright line rules that may significantly change the contractually agreed allocation of risk. The decision therefore serves as a useful reminder that if an issue or interpretation is significant to a party, the party should draft appropriate language in the acquisition agreement. For example, if a target company wants the acquiror to assume known risks, it should expressly carve them out from the MAE definition.

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1. See In re IBP, Inc. S'h'holders Litig., 789 A.2d 14 (Del. Ch. 2001); Hexion Specialty Chems., Inc. v. Huntsman Corp., 965 A.2d 715 (Del. Ch. 2008).

2. Raskin v. Birmingham Steel Corp., 1990 WL 193326, at *5 (Del. Ch. 1990).

3. Citing Cobalt Operating, LLC v. James Crystal Enterprises, LLC, 2007 WL 2142926 (Del. Ch. July 20, 2007), aff'd, 945 A.2d 594 (Del. 2008).

4. See Eagle Force Holdings, LLC v. Stanley, C.A. No. 10803-VCMR (Del. 2018).

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