Material Adverse Effect After the Akorn Decision
The Anatomy of a Deal Newsletter May 24, 2019
Each month, Eric Duffee looks at a different piece of The Anatomy of a Deal – a series of easy-to-digest articles that break down complicated aspects of business transactions – helping you better understand terms + processes that can shape the direction of your business.
For those of you who regularly read The Anatomy of a Deal (hi Mom and Dad!), you may remember this strong statement I made in the very first installment of the series discussing material adverse effects (MAE): ”In fact, Delaware courts – the gold standard of corporate law (yes, seriously) – have never found a MAE/MAC that excuses a Buyer from closing on a deal.”
Well, it turns out that the Delaware judges must also read AoD. Their apparent response after reading such a bold assertion: Challenge accepted!
While I hoped that I would never have to cite another court case after graduating law school, the Delaware Court of Chancery forced my hand. In its decision in Akorn v. Fresenius Kabi AG , the court arrived at the unprecedented conclusion that a MAE existed and permitted the buyer (Fresenius) to abandon its proposed merger transaction with Akorn, a generic drug manufacturer.
I’ll spare you all of the details that only a law student could love, but what do we make of this decision and how does it change our understanding of the mystical MAE? Here’s my take:
- The basic rule remains the same – Although the MAE finding in this case is notable, it’s important to stress that the court reaffirmed the long-standing Delaware law that a MAE requires both a substantial threat to the overall earnings of the target company and that it be “durationally significant” (i.e., we’re talking years, not months). In this case, Akorn’s earnings did indeed take a precipitous dive over a period of several quarters with no hope for a substantial rebound in sight.
- The case involves extreme facts – In addition to the nosedive in Akorn’s earnings as noted above, a whistleblower revealed appalling concerns regarding Akorn’s compliance with FDA requirements. Additionally, the evidence showed that Akorn covered up compliance issues and misrepresented the situation to both the FDA and to Fresenius in an effort to get the deal closed without scrutiny. The court determined that rectifying these issues and repairing the long-term damage would cost about $900 million – representing a 21% decline in Akorn’s value.
- The MAE in question only involved a closing condition – Like most of the prior case law, the MAE clauses under review were closing conditions, rather than qualifiers to the target company’s representations and warranties. We don’t truly know whether the analysis would be the same in the context of an indemnification claim based on the use of a MAE qualifier in a representation and warranty vs. the use of a MAE-related closing condition.
So, while the Akorn case doesn’t really change the fundamental understanding that the MAE is a really high bar, we now have one example to help us quantify when a MAE may have occurred. In the Akorn case, that bar appears to be a decline in the target’s value of 21% or more. The court even looked at different indicators to question whether the percentage decline that constitutes a MAE may actually be even lower (10% to 15%), but we don’t know if the court was actually willing to go that far.
There’s a common saying among lawyers: Bad facts make bad law. The facts in the Akorn case are indeed bad facts, but it doesn’t appear that this case actually sets bad legal precedent. In some ways, this case could be a bit of a blessing, as it finally gives the buyer some understanding of what it may be agreeing to when it concedes a MAE. By the same token, sellers always knew that there was some unknown point at which a MAE comes into existence. Now, sellers have some idea where that breakpoint may lie.
Nonetheless, it’s too early to suggest that Akorn will set a new bar for assessing future MAEs. There remain many unknown questions, including the following:
- Is the 21% number significant? The court in Akorn cautioned against fixating on any particular number. Even if there is a magic number, we don’t yet know if the threshold is 21% or something lower, as the court seemed to imply may be possible.
- Is this case an outlier as a result of the compliance issues? It’s fair to wonder whether the court’s decision would have been different if the decline in Akorn’s value was solely due to sluggish sales vs. Akorn’s atrocious FDA compliance problems.
- How will a MAE qualifier used in representations and warranties be judged? As noted above, we don’t know whether Delaware courts will use the same standards in considering a representation and warranty that is qualified by a MAE, as opposed to a MAE closing condition, as the court in Akorn was focusing on the closing conditions only. Most purchase agreements don’t distinguish one type of MAE from another.
- Will buyers and sellers act differently in the wake of this decision? The most important practical question is whether parties to a transaction will approach the MAE any differently than they did prior to the Akorn decision. For this reason, we wanted to wait for the dust to settle before giving our thoughts on the case. I suspect that most buyers and sellers won’t materially (pun intended) change their approach to the MAE, and that’s been our experience in the several deals we’ve done in the months following the first announcement of the Akorn decision. We always knew that a MAE existed at some point. Now we just have a little more clarity about where that point lies.
In short, the Akorn decision is important and notable from a theoretical perspective, and it offers some significant observations and analysis that should be taken to heart. The next Delaware case dealing with a MAE will truly help us to understand the full impact of this decision. For now, the practical impact of this case is to provide a powerful reminder of what to do – and what not to do – in the context of a transaction that may be going sideways.
Next Month: Transaction Structures – Part 2: Mergers
Read last month’s piece: Potential Deal-Killers