For as long as many of us can remember, buyers and sellers in transactions of all types, including 363 asset sales and new money investments, have utilized “Material Adverse Effect” clauses (also known as “Material Adverse Change” clauses) to allocate the risk of changes in a target’s business between the execution of definitive documents and the closing of the transactions contemplated thereby and to define the circumstances in which a buyer need not fulfill its obligation to close a transaction.
More than 17 years ago, in In re IBP, Inc. Shareholders Litigation,1 then Vice Chancellor Leo Strine — now Chief Justice of the Delaware Supreme Court — required Tyson Foods to complete its agreed-upon merger with IBP. He ordered specific performance of the merger agreement notwithstanding Tyson Foods’ claim that IBP had suffered a “Material Adverse Effect,” the absence of which was an express condition to Tyson Foods’ obligation to consummate the merger. In reaching that decision, then Vice Chancellor Strine characterized a standard Material Adverse Effect condition (a “MAE”) as follows:
[E]ven where a Material Adverse Effect condition is as broadly written as the one in the Merger Agreement, that provision is best read as a backstop protecting the acquiror from the occurrence of unknown events that substantially threaten the overall earnings potential of the target in a durationally-significant manner. A short-term hiccup in earnings should not suffice; rather the Material Adverse Effect should be material when viewed from the longer-term perspective of the acquiror.2
The claimed MAE affecting IBP involved a 64% decrease in IPB’s first-quarter earnings, but such decrease was “unaccompanied by expert evidence that identifie[d] the diminution in IBP’s value or earnings potential as a result of its first quarter performance.”3 Following IBP, amid the height of the latest economic downturn, in 2008, another Delaware decision, Hexion Specialty Chems., Inc. v. Huntsman Corp.,4 reinforced that “[a] buyer faces a heavy burden when it attempts to invoke a material adverse effect clause in order to avoid its obligation to close.”5 In Huntsman, the court emphasized that an MAE involves “an adverse change in the target’s business that is consequential to the company’s long term earnings power over a commercially reasonable period, which one would expect to be measured in years rather than months.”6
The result of IBP and its progeny is that no Delaware decision has ever found an MAE to have occurred. And lawyers have generally cautioned clients to assume that invoking an MAE would require a virtually catastrophic event.7
Well, lawyers can no longer say that no Delaware decision has ever found an MAE to have occurred.
On October 1, 2018, in Akorn, Inc. v. Fresenius Kabi, AG,8 Vice Chancellor Laster held that the acquiror was relieved of its obligation to consummate its merger with the target based upon the occurrence of an MAE. In doing so, Vice Chancellor Laster distinguished the facts in Akorn from prior Delaware cases where the court had rejected a buyer’s efforts to invoke an MAE clause:
In prior cases, this court has correctly criticized buyers who agreed to acquisitions, only to have second thoughts after cyclical trends or industrywide effects negatively impacted their own business, and who then filed litigation in an effort to escape their agreements without consulting with the sellers. In these cases, the buyers claimed that the sellers had suffered contractually defined material adverse effects under circumstances where the buyers themselves did not seem to believe their assertions. This case is markedly different.9
This case was, indeed, “markedly different”; but the court seemed to cast the difference as being primarily on the facts, not necessarily with respect to the applicable legal analysis. However, aspects of the court’s decision suggest that there may be some differences from prior cases in how that legal analysis may now be deployed when short-term drops in performance are projected to have longer-term impacts.
In Akorn, Vice Chancellor Laster described the target’s performance following the signing of the merger agreement with the acquiror, as having “fell off a cliff, delivering results that fell materially below [the target’s] prior year performance on a year over year basis.”10 Vice Chancellor Laster then used certain metrics to reach his conclusion that the “sudden and sustained drop in Akorn’s business performance constituted a General MAE.”
The chart below shows each of the metrics Vice Chancellor Laster used in his MAE determination. The Vice Chancellor examined revenue, operating income, and earnings per share after the merger agreement was signed, and compared those results from the same periods of the prior year. Though none of these metrics alone was decisive, taken together they were found to have constituted an MAE:
Year-Over-Year Change In Akorn’s Performance
|Q3 2017||Q4 2017||FY 2017||Q1 2018|
|Earnings per Share||-96%||-105%||-300%||-113%||-170%|
* Chart reproduced from Vice Chancellor Laster’s opinion11
Importantly, Vice Chancellor Laster also found that the target had breached a representation regarding regulatory compliance, and that such breach independently resulted in an MAE. In reaching his conclusion that the breach of the regulatory representation resulted in an MAE, Vice Chancellor Laster concluded (based on expert testimony) that the required remediation of the regulatory noncompliance would result in a hit to the target’s valuation of more than 20%.12
The Akorn decision is also notable for Vice Chancellor Laster’s conclusions that (a) the “unknown” requirement for triggering an MAE required more than just general knowledge by the acquiror of risks facing the business (the target’s poor performance post-signing of the merger agreement appears to have related to increased competition and delayed product launches), (b) even if the events constituting an MAE were events affecting the industry generally, the target had been disproportionately affected, (c) the target materially breached its covenant to use its “commercially reasonable efforts” to conduct its business in the ordinary course, (d) the acquiror was not, itself, in breach of its obligation to use its “reasonable best efforts” to close the transaction, and, (e) while the acquiror was found to have breached the “hell or high water” covenant regarding its obligation to obtain anti-trust approval (which had no “efforts” qualifier at all),13 the breach was short-lived and not material.
The Akron decision comprises 246 pages of text (in its original format) and 867 footnotes. There is much for the deal community to digest concerning efforts covenants, MAE exceptions and their impact, the meaning of “ordinary course,” the nature of the “unknown events” element of the IBP requirements for an MAE, and more. For now, the quick message of Akorn is that, for the first time, a Delaware court found that an MAE had occurred. Yet, the requirements for such an occurrence seemingly remain what they have always been under IBP and its progeny. For now, buyers should still assume that they will face a heavy burden when attempting to invoke an MAE.