August 9, 2021

Acquirer Beware: “Material Adverse Effects” in Merger Contracts and How Shifting Reimbursement Rates Impact the Healthcare Sector

On July 9, 2021, the Delaware Court of Chancery (Slights, V.C.) issued an opinion in Bardy Diagnostics, Inc. v. Hill-Rom, Inc., No. 2021-0175-JRS, concluding that the requirements of a “material adverse effect” (“MAE”) clause in a corporate merger contract had not been met, and ordering specific performance by the corporate buyer to close the transaction. The decision has important implications for merger agreements more broadly, and for any acquisition where the target company faces a severe shock during the interim period between signing of the agreement and closing. Ultimately, the Court found that a 60% reduction in the temporary Medicare rates for the target’s only product was not proven to be long-lasting enough to qualify as an MAE, and even if it did, the parties’ negotiated exclusion for changes in “Health Care Law” excepted this price reduction as a ground for an MAE.


The contract at issue was an agreement by Hill-Rom, Inc. and a subsidiary (“Hillrom”) to acquire Bardy Diagnostics, Inc. (“Bardy”), a medical device startup (the “Merger Agreement”). Bardy is essentially a single-product company that sells a type of ambulatory electrocardiogram (“AECG”). Bardy’s AECG is a single-use, bandage-sized patch that can detect heart arrhythmias for up to 14 days. Bardy’s primary revenue stream for its product is Medicare. At the time of the negotiation of the deal to acquire Bardy, the Centers for Medicare & Medicaid Services (“CMS”) had not yet established a permanent price for devices in the AECG market, but a CMS contractor had consistently set a temporary price at approximately $365 per patch.

Both Hillrom and Bardy originally anticipated that CMS would set a permanent price before the transaction was finalized. But, unexpectedly, in December 2020, CMS elected to defer the pricing again to a contractor for at least another fiscal year. After CMS’s decision, but prior to the CMS contractor updating its temporary pricing for the upcoming year, Hillrom decided to forge ahead with the acquisition, and it renegotiated the Merger Agreement to include variable earnouts depending on Bardy’s post-closing revenue. The parties signed the deal on January 15, 2021.

Two weeks later, the CMS contractor set temporary rates for AECGs to a maximum of $49.70 – an 86% decrease. Industry participants, shocked by the news, petitioned the contractor to increase the rates. The contractor did so in April, raising them to a maximum of $133.47, but still representing an over 60% decrease from previous levels (the “April Rates”).

The MAE Clause

In response to rate deductions in January and April, Hillrom refused to close the transaction, arguing that the over 60% price reduction in Bardy’s only product constituted an MAE under the Merger Agreement. The MAE clause in the Merger Agreement followed a typical framework. First, it defined an MAE as “any fact, event, circumstance, change, effect or condition that, individually or in the aggregate, has had, or would reasonably be expected to have a material adverse effect on . . . the Business of [Bardy], taken as a whole.” Second, the MAE clause contained carveouts, including, importantly here, “any change in any Law (including any COVID-19 Measures and any Health Care Law) or GAAP or any interpretation thereof.” Third, and finally, there were exceptions to the carveouts, where even a Health Care Law change would qualify as an MAE “to the extent such matter has a materially disproportionate impact on [Bardy] as compared to other similarly situated companies operating in the same industries or locations.” As is typical, the non-occurrence of an MAE was a standalone closing condition, and Hillrom refused to close on that basis.

The Court’s Conclusion

Following a trial where each side presented experts and witnesses, the Court determined that the reduction in reimbursement rates as a result of the April Rates did not constitute a “material adverse effect” on Bardy’s business, failing the first step in the chain to qualify as an MAE. While the reduction in price was dramatic, the Court noted that Delaware law requires an adverse effect to “substantially threaten[] the overall earnings potential of the target in a durationally-significant manner.” Even assuming that the drastic price reduction had a significant effect on the earnings potential, Hillrom failed to show that that effect was “durationally significant” — on the time scale of five or more years rather than a few months. The Court noted that, because Bardy was a start-up focused on market growth, Hillrom had already been intending to own Bardy for several years at a loss, so some loss of profitability in the short term was not inherently inconsistent with the economics of the deal. Moreover, because the April Rates were by their nature temporary, and CMS was anticipated to set permanent rates in the future, Hillrom could not show that the low rates would have a long-term, lasting effect on Bardy. As the Court stated, “when future outcomes rest in the hands of unpredictable actors, the burden to prove durational significance becomes nearly insurmountable.”

Next, the Court found in favor of Bardy and against Hillrom on the carveout for changes in any “Health Care Law” during the interim period. While the April Rates were not a law set by a government body, but rather a temporary rule established by a contractor, the parties broadly defined what constituted a “Health Care Law.” That definition included “any” regulation or rule issued by “any” government body, which in turn was defined to include “any authorized contractor” of the government. The Court thus concluded that the April Rates fit squarely within this carveout.

Finally, although the MAE clause excepts from its carveouts, including the “Health Care Law” carveout, adverse effects that have a “disproportionate” effect on the target, the Court found none here. The specific provision was drafted differently than other past Delaware examples. While prior cases had exceptions for disproportionate impact on “comparable entities operating in the [same] industry,” the Merger Agreement here required comparison to “similarly situated companies operating in the same industries or locations.” That distinction made a difference. Rather than review companies that sold multiple products, only some of which were AECGs, the Court concluded that only one other competitor was “similarly situated,” another one-product company selling AECGs. Unsurprisingly, the mandated decrease in price for the single product affected the two single-product companies similarly, and thus the exception to the carveout did not apply.

Having found that no MAE had occurred, the Court ordered specific performance that Hillrom close the transaction to acquire Bardy at the agreed-to price in the Merger Agreement, despite the change in reimbursement rate for Bardy’s core product. Following the Court’s ruling, on August 6, 2021, Hillrom proceeded with the transaction and closed the acquisition of Bardy pursuant to the Merger Agreement.

Key Takeaways

MAE clauses are only infrequently litigated to a full trial in Delaware, and therefore Judge Slights’ decision provides important guidance for any company engaging in M&A activity, public or private, involving Delaware corporations:

  • This decision reaffirms the near-universal inability to enforce an MAE clause to back out of a deal. Yet again, a Delaware Court concluded that there was no MAE, in spite of an extraordinary shock to the target business by a 60% immediate drop in revenue.
  • An acquirer seeking to use an MAE clause bears the heavy burden of proving a near-permanent, long-term, multi-year effect on the target in order to show a significant durational impact. Essentially, an acquirer must convince the Court of its vision of the future, namely, significant and long-term negative effects on the target.
  • The burden on an acquirer becomes “nearly insurmountable” if the target company depends heavily on a single third party or a small number of third parties for its financial health. This is particularly critical in the healthcare industry, where targets often depend on a small number of very large payors. In those situations, the buyers largely bear the risk of loss due to the arbitrary action of the third party.
  • The Court’s finding that a change to CMS’s rate-setting fell within a typically-drafted exclusion for changes in laws has wide implications for any company in the healthcare industry, where the government often serves as the rate-setter. Buyers may need to draft explicit coverage to avoid this exclusion.
  • The Court’s decision acknowledges the importance of drafting, both in the MAE clause itself and in the other economic terms to the merger agreement. Hillrom only partially insulated itself from the revenue loss of Bardy through the earn-out provision. In the MAE clause, the restricted definition of “similarly situated” companies drastically narrowed the value to Hillrom of the “disproportionate impact” exception, since it substantially reduced the number of comparators.
  • Hillrom’s good faith helped—but not enough. The Court lauded Hillrom for its efforts to assist in increasing the reimbursement rates and willingness to close the deal if they came back up. But though bad faith acts to scuttle a deal out of “buyer’s remorse” might make the Court less sympathetic to an MAE claim, it is insufficient in and of itself to justify backing out of the deal.