October 29, 2018

A First: Delaware Court of Chancery Holds That Merger Target Suffered Material Adverse Effect

On October 1, 2018, the Delaware Court of Chancery, in Akorn, Inc. v. Fresenius Kabi AG, et al., held for the first time that a target company had suffered a material adverse effect (MAE) sufficient for an acquiror to validly exercise its contractual right to terminate a merger agreement and walk away from a deal without cost.[1]

The Fresenius case is an important additional data point for M&A practitioners in understanding how courts analyze terminations arising from an MAE. While the Court did not alter the legal standard used in prior case law, the fact that the Court ruled in favor of the acquiror and the heavily fact-intensive analysis illustrate the approach that will be taken by courts and provide some useful lessons for those involved in M&A. Key takeaways are discussed later in this Alert.[Key takeaways]

In this case, Fresenius Kabi AG (“Fresenius”) delivered a termination notice to Akorn, Inc. (“Akorn”) following a significant drop-off in Akorn’s business and the discovery of significant regulatory compliance concerns. In response, Akorn sought a declaratory judgment that Fresenius’ purported termination was invalid and specific performance to compel Fresenius to complete the merger. Fresenius countersued, alleging that Akorn had (a) suffered a general MAE, (b) breached its representations and warranties, particularly those related to regulatory compliance, and (c) breached its covenants, including its obligations to operate in the ordinary course of business. If proven and unable to be cured by the “drop-dead” date, Fresenius’ claims in (b) and (c) above would independently give rise to Fresenius’ contractual right to terminate the merger agreement.

Following a five-day trial and extensive fact finding, Vice Chancellor Laster ruled in favor of Fresenius on all three of its allegations.

Background and the Merger Agreement

Akorn is a NASDAQ-listed, specialty generic pharmaceuticals company headquartered in Lake Forest, Illinois. Fresenius, headquartered in Germany, specializes in clinical nutrition, injectable drugs, IV solutions and medical devices. Fresenius is a wholly owned subsidiary of Fresenius SE & Co. KGaA, a Frankfurt Stock Exchange-listed company also headquartered in Germany, which offers products and services for hospitals, dialysis and outpatient treatment.

Following four months of negotiations, Akorn and Fresenius entered into a merger agreement on April 24, 2017, pursuant to which Fresenius agreed to acquire Akorn at a price of $34 per share in cash ($4.3 billion in total equity value). The deal represented a 43.5% premium over Akorn’s market closing price that day of $23.69 per share.

Decline in Financial Performance

On the date the merger agreement was announced, Akorn also reaffirmed, at Fresenius’ request, its full year guidance. Following signing, however, Akorn’s performance sharply declined from its business plan, which first came to light when it reported its 2nd quarter 2017 results, and the company continued to reflect significant decreases in operating performance over the ensuing three quarters. Akorn cited the loss of a key contract, competition and delays in product launches as drivers for the decline but claimed each of these setbacks was temporary in nature.

Regulatory Compliance Concerns

Unfortunately, Akorn’s problems were not limited to financial performance. Although Fresenius learned of a number of deficiencies in Akorn’s testing and manufacturing processes during diligence, the magnitude of the problems was not clear and Fresenius nonetheless decided to pursue the transaction. However, Fresenius received two separate whistleblower letters after the merger agreement was signed, alleging that Akorn’s product development processes failed to comply with regulatory requirements and alleging defects in Akorn’s quality compliance programs.

Fresenius’ investigation of these allegations uncovered a series of inaccurate test results, falsified data records and submissions to the FDA with false data (including in response to an FDA complete response letter in 2012). Fresenius also learned through employee interviews that management at testing and manufacturing sites paid little attention to quality control issues, data protection policies and remedial measures. Employees reported that protocols were ignored and remediation plans were either not followed or never put into place. For example, any employee could access and alter facility computer records. Other records were kept in hand-written notebooks, assigned to individual researchers, but were never secured for safekeeping (and were apparently altered by other individuals during non-business hours). Employees had reported such deficiencies to management, but Akorn had taken no corrective action.

Following Fresenius’ investigations, Akorn self-reported its data integrity issues to the FDA, but barred Fresenius and its advisors from attending. Tensions between Fresenius and Akorn escalated after the FDA meeting, with Fresenius accusing Akorn of providing the FDA with false, incomplete and misleading information. Shortly thereafter, Fresenius met with its advisors and determined, despite the significant issues, to offer to Akorn an extension of the drop-dead date if Akorn believed that the data integrity issues could be further investigated and remedied. Akorn rejected the offer. Fresenius then terminated the merger agreement on April 22, 2018, just two days prior to the drop-dead date.


Since Akorn’s representations and warranties in question were subject to an MAE standard, and Fresenius’ obligation to close was conditioned upon (a) the absence of an Akorn MAE, (b) Akorn’s ability to confirm, or “bring down” the accuracy of these representations at closing, and (c) Akorn’s compliance with its covenants, the Court’s analysis turned on whether an MAE occurred, either generally or as a result of a representation breach, and whether Akorn had materially complied with its ordinary course covenant. MAE definitions in merger agreements are customarily broadly defined, and in a somewhat circular manner, as any material, adverse effect that does not fall into a specified exception or carve-out; Delaware courts are left to rely on case law to fill in the substance of the definition.

The Legal Standard

The Court relied on the widely cited standards under Hexion Specialty Chems., Inc. v. Huntsman Corp. and In re IBP, Inc. S’holders Litig., the two seminal Delaware cases on this topic, which held that Delaware law places a heavy burden on an acquiror to demonstrate that an MAE has occurred. Under these cases, a short term hiccup in earnings does not suffice and, instead, an MAE must be considered from a “longer-term perspective of a strategic acquiror,” such that there is an adverse change that will have a longer term impact on performance, in years rather than months. Hexion further held that the effect should “substantially threaten the overall earnings potential of the target in a durationally-significant manner.” The Court focused on periods of comparability (such as against the same period from the prior year) rather than quarterly fluctuations in performance.

General MAE in Akorn’s Business

In applying these tests, the Court held that the underlying causes for the material decline in Akorn’s financial performance after the signing date were durationally significant and specific to Akorn, not simply industry headwinds. The below table, excerpted from the Court’s opinion, illustrates the magnitude of Akorn’s financial decline.

 Year-Over-Year Change in Akorn's Performance
  Q2 2017 Q3 2017 Q4 2017 FY 2017 Q1 2018
Revenue (29%) (29%) (34%) (25%) (27%)
Operating Income (84%) (89%) (292%) (105%) (134%)
EPS (96%) (105%) (300%) (113%) (170%)

The Court also noted that Akorn’s performance on a relative basis was significantly worse than its industry peers, which led to the conclusion that the decline resulted from factors specific to Akorn – a risk that was allocated to Akorn under the merger agreement.

Breach of Representation; Regulatory MAE

In addition to the foregoing, the Court found that Akorn also suffered a “regulatory MAE” by breaching its representations and warranties because Akorn suffered extensive regulatory violations and compliance failures, some of which existed at signing but worsened considerably between then and the merger agreement termination date. The Court held that Akorn’s systemic failures were so extensive that it could no longer prove to the FDA that its data was accurate. The Court also held that this, together with Akorn’s failure to comply with facility regulations, constituted an MAE. In the Court’s view, both qualitative and quantitative aspects should be considered in the analysis, and it determined that the record supported the conclusion that the economic impact of Akorn’s regulatory noncompliance led to a decline in approximately 21%, or $900 million, of Akorn’s value, which it deemed material from the “longer-term perspective of a reasonable acquiror.”

Failure to Operate the Business in the Ordinary Course

Further, the Court found that Akorn failed to comply in all material respects with the covenant to continue to operate its business in the ordinary course between signing and closing by failing to (a) conduct regular audits and take steps to remediate deficiencies, (b) maintain a data integrity system that would demonstrate to the FDA that the data underlying its submissions is accurate and complete, (c) undertake any data integrity projects, (d) submit filings to the FDA based on true and correct data as opposed to “fabricated” data, and (e) investigate whistleblower claims. Interestingly, the Court compared Akorn’s actions to a hypothetical generic pharmaceutical company and not to Akorn’s specific history of business practices. The Court found that curing the breaches above would take up to three years, which would prevent Akorn from being in material compliance with its covenants on the drop-dead date.

Fresenius’ Breach Was Temporary

Finally, the Court rejected Akorn’s argument that Fresenius could not terminate the merger agreement because Fresenius was in breach of its covenant to use reasonable best efforts to close. The Court found that while Fresenius was technically in breach of such covenant for considering and, for one week, pursuing an antitrust approval course of action that would have delayed the closing of the merger, Fresenius promptly reversed course and reverted to the approval path that was most expeditious. Thus, while Fresenius technically breached its covenant obligation, its breach was not a continuing material breach sufficient to deprive it of its right to terminate the merger agreement.

Takeaways and Practice Tips

  • MAE Remains a High Bar. In Fresenius, the Court depicts Akorn’s actions as fairly egregious. In future situations, buyers will still need to meet the heavy burden of showing a substantial threat to “the overall earning potential of the target in a durationally-significant manner” and most cases will not have the level of “bad facts” presented here.

  • Analysis Remains Highly Fact Specific. Determining whether an MAE exists is a highly fact-intensive analysis, as shown by the Court’s extensive recitation of the facts in this case. Courts will dig deep into the surrounding circumstances to determine whether an action or event rises to the level of an MAE. Bright line rules will be hard to come by, and the specific context will determine what an MAE means in each situation.

  • It’s All About Risk Allocation. Every deal has risks. The Fresenius Court emphasized the definition of “material adverse effect” as a critical mechanism for allocating those risks between buyers and sellers in M&A transactions, even those risks that buyer becomes aware of through the diligence process. Those page-long definitions with multiple exceptions and “exceptions to exceptions” can play a dispositive role in a disputed termination scenario. Practitioners should spend the time necessary to ensure that this dense thicket of words allocates risks as desired – often with general market risk allocated to the buyer and company-specific risks to the seller.

  • Right to Terminate Generally Comes Down to MAE Analysis. In public company M&A deals, most representations and warranties are subject to MAE qualifiers, and related closing conditions generally limit the accuracy and performance of representations, warranties and covenants to an MAE standard. Therefore, in litigation over whether an MAE has occurred the outcome will be binary: either an MAE has occurred and an acquiror can terminate the agreement prior to closing, or an MAE has not occurred and the acquiror must close the transaction.

  • Synergies Don’t Count; Not Enough to Just Turn a Profit. Determining whether a target has experienced an MAE requires an analysis of the target as a standalone entity – and is not mitigated by taking into account the synergies anticipated by a particular buyer, as Akorn unsuccessfully argued. Akorn also unsuccessfully argued that no MAE could have occurred so long as it would make a profit.

  • Working to Close Doesn’t Mean Buyer Cannot Protect Itself. While a reasonable best efforts clause requires parties to take all actions to satisfy closing conditions as promptly as reasonably practicable and consummate a merger, a party is not required to sacrifice its contractual rights to benefit the counterparty.

  • Seller Still Has to Operate Its Business. M&A parties often focus extensively on the negative interim operating covenants – the ones that specify what “thou shall not do” as seller between signing and closing. The Fresenius Court found substantive meaning in the customary affirmative interim operating covenant requiring the seller to continue to operate its business in the ordinary course. Shutting down remediation efforts and Akorn’s problematic interactions with regulators were found to be a breach of that covenant based on a comparison to a hypothetical generic pharmaceutical company as opposed to Akorn’s own historic practices.

  • Remember the Access Covenant. The covenant in a merger agreement allowing a buyer to access the target’s facilities, records and personnel post-signing (known as the access covenant) is so customary that it frequently becomes an afterthought to practitioners. For Fresenius, however, the access covenant was the critical mechanism through which it could conduct extensive post-signing due diligence and determine whether the merger agreement had been breached.

  • Do the Right Thing. Fresenius’ conduct (e.g., notifying Akorn of its concerns, giving it an opportunity to respond, and even offering to extend the drop-dead date) seemed to help sway the Court away from finding that Fresenius was motivated merely by “buyer’s remorse” (as courts found in precedent cases). On the other hand, the Court did not look favorably on Akorn failing to diligently conduct its own investigation into regulatory and data integrity matters as opposed to relying primarily on Fresenius’ efforts, shutting down remediation efforts pre-closing, “fabricating data” and being less than fully forthcoming with the FDA when self-reporting.

Note: Goodwin did not represent Fresenius Kabi AG in its merger negotiations with Akorn, nor in the resulting litigation. Goodwin does represent Fresenius Kabi USA LLC on other matters.

[1]“Material adverse effect” or “MAE” is a standard customarily used in merger agreement representations and closing conditions to minimize the risk of a deal failing to close by setting a high threshold before a party can refuse to close or can terminate. A party will be obligated to close the deal unless the other party cannot reaffirm many of its representations subject to the high MAE standard or suffers an MAE.