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Delaware Supreme Court Upholds Rare Ruling That Material Adverse Event Allowed Purchaser to Negate Merger

December 20, 2018

On December 7, 2018, the Delaware Supreme Court upheld Delaware Chancery Court Vice Chancellor Travis Laster’s rare finding in Akorn, Inc. v. Fresenius Kabi AG, et al., that a merger agreement’s material adverse effect (MAE) clause had been triggered, absolving the acquirer of its obligation to complete the transaction. Fresenius does not represent a change in Delaware MAE jurisprudence, but Vice Chancellor Laster’s 246-page opinion (available here) offers some helpful guideposts to assist companies and their advisors in understanding the circumstances that might constitute an MAE. And, it evokes key reminders about best practices for buyers and sellers in M&A transactions.


On April 24, 2017, German healthcare company Fresenius Kabi AG (Fresenius) agreed to acquire Indiana-based Akorn, Inc. (Akorn) for $34 per share and a total purchase price of $4.75 billion. Op. at 47. The merger agreement was signed, and the transaction announced, shortly after Akorn released its financial results for the first quarter of 2017. Id. at 2. Fresenius’s obligation to close was conditioned on three key factors: (i) Akorn’s representations being true and correct as of closing, except where the representation’s inaccuracy would not reasonably be expected to constitute an MAE; (ii) Akorn’s having complied in all material respects with the merger agreement’s covenants, including that Akorn operate in the “ordinary course” of business until closing; and (iii) Akorn’s not having experienced an MAE. Id. at 115. The “Outside Date” for closing was April 24, 2018. Id. at 47.

Following the merger announcement, Akorn’s “business performance [fell] off a cliff,” and its second-quarter 2017 results were “dismal.” Id. at 2. Although Akorn’s CEO reassured a “shocked Fresenius” that the downturn was only temporary, Akorn’s performance continued to slide. Id. at 2–4. On July 31, 2017, ten days after Akorn’s stakeholders approved the merger, Akorn reported second-quarter revenue, operating income, and earnings per share that represented year-over-year declines of 29%, 84%, and 96%, respectively. Id. at 53–54. Akorn’s results continued to slide in the third quarter, with year-over-year declines in revenue (29%), operating income (89%), and earnings per share (105%). Id. at 61.

Serious regulatory compliance issues exacerbated the concerns posed by Akorn’s dramatic decline in performance. In October 2017, a whistleblower sent an anonymous letter to Fresenius detailing alleged regulatory failures in Akorn’s product-development process. Op. at 3. The following month, Fresenius received a longer version of the letter that further detailed flaws in Akorn’s compliance program and questioned the accuracy of Akorn’s regulatory compliance representations in the merger agreement. Id. Invoking its continuing information rights under the merger agreement, Fresenius conducted its own investigation that “uncovered serious and pervasive data integrity problems.” Id. It was not until March 2018—after Fresenius’s investigation “forced [Akorn’s] hand”—that Akorn began addressing its data integrity issues. Id. at 28–29. Akorn then discovered that its Executive Vice President of Global Quality Affairs (EVP) had submitted to the United States Food and Drug Administration (FDA), after the merger agreement was signed, false data in support of a new drug application. Id. at 19. During a March 16, 2018, meeting with the FDA, Akorn was “not fully transparent” about the scope of its issues. Id. at 92. Akorn (i) falsely presented Fresenius’s various investigations as joint efforts with Akron; (ii) “endorsed as valid [the EVP’s] claimed justification for signing the [submission] with fabricated test results”; and (iii) provided a “one-sided, overly sunny depiction” of its data-integrity improvements. Id. at 92–95. Fresenius accused Akorn on March 22 of providing the FDA with “false, incomplete and misleading information.” Id. at 95.

On April 22, 2018, Fresenius gave notice that it was terminating the merger agreement on three grounds. First, Akorn’s regulatory-compliance representations were so false that the difference between what had been represented and what Fresenius later discovered would reasonably be expected to result in an MAE. Second, Akorn violated its contractual obligations to conduct its operations in the ordinary course by, among other things, misleading the FDA. Third, Fresenius was no longer obligated to close because an MAE had occurred. Akorn filed suit the next day in Delaware.

Court of Chancery Ruling

Following a five-day trial in July 2018 involving almost 1,900 exhibits, 54 deposition transcripts, nine live fact witnesses, and seven expert witnesses, Vice Chancellor Laster agreed with Fresenius that it had no obligation to close. He began by noting that a purchaser asserting an MAE faces a “heavy burden” under Delaware law, and that the Court of Chancery has “correctly criticized” buyers who seek to use litigation to invalidate their deals after “cyclical trends or industrywide effects” negatively affect a target’s financials. Op. at 5, 129 (citing Hexion Specialty Chems., Inc. v. Huntsman Corp., 965 A.2d 715, 738 (Del. Ch. 2008)). In this “markedly different” case, however: (i) the sudden and sustained deterioration in Akorn’s business performance constituted an MAE under § 6.02(c) of the merger agreement;1 (ii) Fresenius properly terminated the merger under § 7.01(c)(i)2 because Akorn’s false regulatory-compliance representations were reasonably expected to result in an MAE; and (iii) Akorn materially breached its covenant to act in the ordinary course. Id. at 116. The Supreme Court affirmed on the first two grounds, but did not reach the third. Akorn, Inc. v. Fresenius Kabi AG, et al., No. 535 at 2 & n.5 (Del. Sup. Ct. Dec. 7, 2018).

MAE Based on Decline in Financial Performance

Relying on Hexion and In re IBP, Inc. Shareholders Litigation, 789 A.2d 14 (Del. Ch. 2001), the Chancery Court explained that the test for the materiality of an adverse event is whether “when viewed from the longer-term perspective of a reasonable [acquirer], . . . [it] substantially threaten[s] the overall earnings potential of the target in a durationally-significant manner.” Op. at 129–30 (citing IBP, 789 A.2d at 68). Here, Akorn’s dramatic decline in revenue, operating income, and earnings per share was caused principally by (i) increased competition for Akorn’s top three products from new market entrants, and (ii) the loss of a key contract to sell the hormone progesterone, resulting in a loss of revenue where Akorn had forecasted growth. Id. at 54. These facts presented a record “of a sustained decline in business performance that is durationally significant and which would be material to a reasonable buyer.” Id. at 135–37, 142. In so ruling, the Court rejected the following Akorn arguments:

  • That its financial decline should be assessed “against its value to Fresenius as a synergistic buyer” and not as a standalone entity. The Chancery Court found that this standard would be contrary to the agreement’s plain language that broadly defined an MAE as any “material adverse effect on the business, results of operations or financial conditions of the Company and its Subsidiaries, taken as a whole.” Id. at 139 (emphasis in original).
  • That there can be no MAE as long as Fresenius could profit from the acquisition. The Chancery Court held that the MAE definition focuses on “value of the seller” and not “profitability of the deal to the buyer.” Id. at 140.
  • That there can be no MAE because Akorn’s decline resulted from a downturn in the generic pharmaceutical industry, and “everyone, including Fresenius, knew about the[] ‘industry headwinds.’” Id. at 143. The Chancery Court found that (i) it was company specific factors—like increased competition for Akorn’s top products and a key lost contract—that had caused the decline, id. at 144–45, 148; (ii) any industry effects had “disproportionately affected Akorn,” id. at 145; and (iii) that disproportionate effect was a risk contractually allocated to Akorn, id.
  • That there was no MAE because the merger agreement had prevented Akorn from growing through additional acquisitions between the signing and closing. Id. at 149. The Chancery Court found that the sharp downturn in Akorn’s existing business had occurred so quickly as to defeat any suggestion that it was caused by the merger agreement’s restriction on acquisitions. Moreover, there was no evidence of available acquisitions that Akorn had actually surrendered due to the pending merger. Id.
  • That MAE provisions are “best read as a backstop protecting the [acquirer] from the occurrence of unknown events,” not to protect the buyer from existing business risks it learned about, or failed to investigate, during due diligence. Id. at 150 (citing IBP, 789 A.2d at 68). The Chancery Court found, however, that (i) the events causing the MAE were unexpected, and (ii) those events would have qualified as an MAE even if they had been foreseeable, because the parties had negotiated an MAE clause that was “forward looking and focuse[d] on events,” did not exclude matters disclosed during due diligence or unforeseeable effects, and allocated to Akorn “the risk of the problems that resulted in a [] MAE.” Id. at 156. Notably, the Chancery Court also acknowledged that buyers can obtain representations and warranties in response to particular concerns identified during the due diligence process. Id. at 193–94.
  • That Fresenius was barred from exercising its termination right because of its own material breaches of both the “Reasonable Best Efforts Covenant” and the “Hell-or-High-Water Covenant.” Id. at 223. The Chancery Court found that while parties bound by a Reasonable Best Efforts Covenant must take reasonable steps to consummate the transaction, they do not “commit[] themselves to merge at all costs and on any terms.” Id. at 224. Vice Chancellor Laster found that Fresenius—which “had a motive to get out of the deal,” id. at 228—did not breach because it (i) had reasonable grounds to evaluate its rights and obligations given Akorn’s dismal post-signing performance, and (ii) sought to address Akorn’s performance and regulatory-compliance problems before filing suit. Id. at 223–33. And under the Hell-or-High Water Covenant, Fresenius agreed to take “all actions necessary” to secure antitrust approval. Id. at 234. The Chancery Court found that Fresenius’s decision to delay antitrust clearance by two months was a “technical[] breach[],” but because Fresenius changed its decision about a week later and ultimately avoided the two-month delay, the breach was not material. Id. at 242. Fresenius was therefore free to exercise its termination right. Id. at 245.

MAE Based on Breach of the Regulatory Representations

In assessing whether Akorn’s breach of its regulatory compliance representations would reasonably be expected to result in an MAE, the Chancery Court considered both the qualitative and quantitative aspects of the alleged MAE. Op. at 162–63.

On the qualitative side, the Court found that 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.” Op. at 178. Akorn’s compliance with FDA regulations was “an essential part of Akorn’s business” as a generic pharmaceutical company and a key to the successful product pipeline that Fresenius sought to acquire through the merger. Id. at 163–64. But Akorn’s regulatory violations were widespread, compliance problems were pervasive, and the problems only worsened after Akorn signed the merger agreement. Id. at 163. As Akorn’s own outside consultant testified, the company’s data-integrity failures were so fundamental that he would not even expect to see them “at a company that made Styrofoam cups,” let alone a pharmaceutical company manufacturing sterile injectable drugs. Id. at 27. He further testified that the “FDA would [be] extremely upset” about Akorn’s lack of data integrity “because this literally call[ed] into question every released product [Akorn has] done for however many years it’s been this way.” Id. at 27, 163–68. And Akorn had exacerbated the situation by providing the FDA with misleading and non-transparent descriptions of the issues and Akorn’s efforts to address them. Id. at 169.

Vice Chancellor Laster acknowledged the difficulties in quantifying the financial impact of Akorn’s data-integrity issues, but determined that the “valuation hit” would be approximately $900 million, a 21% decline from the $4.3 billion equity value implied by the merger agreement. Op. at 184. He considered “external sources” to cross-check his “intuitive belief” that 21% would be material to a reasonable strategic acquirer, including that (i) a bear market occurs when stock prices fall at least 20% from their peak, suggesting a “broad cultural sense” that a 20% loss is material; (ii) on average, parties renegotiating an acquisition following an MAE agree to a 15% reduction in price; (iii) lower bounds for merger “collars,” which significantly change a deal’s pricing when they are met, are typically only 10%; and (iv) reverse termination fees, which the buyer agrees to pay the seller if the buyer does not complete an acquisition, are typically around 6.36% of transaction value, “far lower than the remediation expense in this case.” Id. at 187–190. The 21% decline would therefore be material when viewed from the longer-term perspective of a reasonable acquirer. Id. at 191.

Failure to Comply with Covenant to Operate in the Ordinary Course

Finally, Vice Chancellor Laster found that Akorn had breached in four ways its obligation to operate in the ordinary course of business until closing. First, Akorn canceled audits and related inspections after signing the merger agreement. Op. at 216. Second, it failed to maintain a data-integrity system that could prove to the FDA that the data underlying its regulatory filings and product sales was accurate and complete. Third, Akorn had submitted fabricated data to the FDA. Fourth, Akorn did not conduct its own investigation when presented with the whistleblower allegations. Id. at 216–18. Vice Chancellor Laster found that these material breaches “departed from what Fresnius could reasonably expect and changed the calculus of the acquisition for the purposes of closing.” Id. at 220.

Supreme Court Affirmance

The Delaware Supreme Court found in a three-page summary affirmance that the factual record adequately supported the Chancery Court’s determinations that (i) an MAE had occurred under § 6.02(c) of the merger agreement, and (ii) Fresenius properly terminated the merger under § 7.01(c)(i) because Akorn’s breach of its regulatory representations and warranties gave rise to an MAE, and Fresenius had not materially breached the Reasonable Best Efforts and Hell-or-High-Water covenants. Akorn, Inc. v. Fresenius Kabi AG, et al., No. 535 at 2 & n.4 (Del. Sup. Ct. Dec. 7, 2018). The Court noted that Vice Chancellor Laster had “issued extensive reasoning on all of the issues presented,” but it stopped short of endorsing that reasoning, “[b]ecause there is no need [to do so] to decide this expedited appeal.” Id. at 3 n.5. For the same reason, the Court did not address whether Fresenius had an additional basis to terminate because of Akorn’s breach of the ordinary course covenant. Id.

Practice Takeaways

Fresenius stands as an important reminder that Delaware courts will defer to the risk allocations that sophisticated parties negotiate in a merger agreement or similar contracts. And while conventional wisdom was that Delaware MAE jurisprudence created a near-insurmountable standard for successfully invoking an MAE, this decision clarifies that Delaware courts will enforce an MAE clause in appropriate circumstances, even where the buyer had assumed various post signing systemic or industry wide risks. The decision also provides several key practice takeaways:

  • Buyers who contemplate invoking an MAE provision should be mindful of their post-signing conduct. Akorn predictably sought to cast Fresenius in the mold of the IBP and Hexion buyers as having “buyer’s remorse.” But the Chancery Court found that Fresenius responded properly after its “legitimate investigation uncovered pervasive compliance failures.” Op. at 230. Fresenius (i) communicated directly with Akorn about its deteriorating performance before filing suit, (ii) continued working towards a closing despite its reservations, and (iii) uncovered “real problems” rather than manufactured disputes. Id. at 226–29. Because the Chancery Court viewed Fresenius as acting in a manner consistent with the contractually required effort necessary to close the transaction, the Chancery Court was more willing to view Fresenius’s invocation of the MAE closing condition as valid rather than pretextual.
  • Target companies should be proactive in responding to potential MAEs between signing and closing, including investigating and, if necessary, remediating and disclosing significant developments. A target’s failure to act—including, where appropriate, investigating allegations, terminating wrongdoers, or disclosing information—could be deemed a breach of the merger agreement obligation to conduct business in the ordinary course. Vice Chancellor criticized Akorn’s passive response to the serious issues that arose post-signing. Akorn, for example, declined to investigate the whistle-blower allegations, Op. at 69–70, was “not fully transparent” with the FDA, id. at 92, and failed to terminate the EVP who had misled the FDA, retaining him as a “Quality Advisor,” id. 18–19. Each of these actions was deemed inconsistent with Akorn’s contractual obligation to conduct its business in the ordinary course in all material respects. The Supreme Court declined to consider that issue, however, and thus did not affirm on that basis.
  • Target counsel should negotiate MAE clause language that allocates to the buyer specific categories of adverse change risks. Vice Chancellor Laster made clear that it had no interest in allocating, after the fact, an agreement’s risk to suit his sense of equity or fairness. Op. at 150. He therefore rejected Akorn’s argument that Fresenius cannot claim an MAE based on risks it learned about during due diligence because that position ran counter to the MAE clause’s plain language. Id. at 156. With that in mind, sellers’ attorneys should be mindful to carve out exclusions to the MAE provision that allocate certain risks to the buyer, such as whether a seller is in material breach of any material contracts or other circumstances identified during due diligence. Moreover, if specific “synergies” are key motivating factors for the buyer in agreeing to the deal, it should consider negotiating changes to the standard MAE language that reflect this intent, as opposed to using the standard MAE language that simply focuses on the “value of the seller” generally.
  • Buyers who contemplate terminating a merger contract should be cautious in relying on an ordinary-course covenant. The Supreme Court did not address the Chancery Court’s holding that Fresenius was permitted to terminate the agreement based on Akorn’s breach of the ordinary-course covenant. It’s not unprecedented for a Delaware Court to rely on that provision in freeing a buyer of its obligation to close.3 But buyers should be cautious in relying on such provisions, as evidenced by the Court’s failure to affirm on that basis, even with the unique factual record demonstrating, among other things, that Akorn misled the FDA.

1 Section 6.02(c) states: “Since the date of this Agreement there shall not have occurred and be continuing any effect, change, event or occurrence that, individually or in the aggregate, has had or would reasonably be expected to have a Material Adverse Effect.”

2 Section 7.01(c)(i) states in relevant part: “This Agreement may be terminated and the [merger] abandoned at any time prior to the Effective Time (except as otherwise expressly noted), whether before or after receipt of the Company Shareholder Approval: . . .

(c) by [Fresenius]: (i) if the Company shall have breached any of its representations or warranties . . ., which breach . . .

(A) would give rise to the failure of a condition set forth in Section 6.02(a) . . . and

(B) is incapable of being cured . . . by the Outside Date . . .

provided that [Fresenius] shall not have the right to terminate this Agreement pursuant to this Section 7.01(c)(i) if [Fresenius] is then in material breach of any of its representations, warranties, covenants or agreements hereunder . . .”

3 See, e.g., Cooper Tire & Rubber Co. v. Apollo (Mauritius) Hldgs. Pvt. Ltd. 2014 WL 5654305 (Del. Ch. Oct. 31, 2014) (holding that potential buyer no longer had contractual obligation to close after potential seller failed to act in ordinary course after merger announcement caused labor strike at seller’s Chinese subsidiary; “due to the [subsidiary’s] strike and physical takeover of the [subsidiary’s] facility, apparently orchestrated by Chairman Che, and due to [the seller’s] reaction to that takeover, which involved an effort to cut off supply from third-party contractors to [the subsidiary], [the seller] failed to comply with [the ordinary-course covenant].”).

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Jonathan Rosenberg, an O’Melveny partner licensed to practice law in New York, Edward Moss, an O’Melveny partner licensed to practice law in New York, Patrick McKegney, an O’Melveny counsel licensed to practice law in New York, Sherri Snelson, an O’Melveny partner licensed to practice law in New York and the Supreme Court of England and Wales, David Schultz, an O’Melveny partner licensed to practice law in New York, and Valerie Cohen, an O’Melveny counsel licensed to practice law in Connecticut and New York, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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