In a 246-page post-trial decision issued this week, the Delaware Court of Chancery ruled that a buyer could terminate a $4.75 billion public company acquisition because of material adverse effects that had occurred at the seller following signing.1 The decision is the first Delaware case to reach such an outcome and provides critical guidance for such situations going forward.
Background
Fresenius Kabi AG (the buyer) agreed to acquire Akorn, a generic pharmaceutical company (the seller), pursuant to a merger agreement. Immediately after signing, several important developments occurred. The seller's financial performance took a dramatic downturn, including decreases in year-over-year revenue, operating income, and earnings per share of 25 percent, 105 percent, and 113 percent, respectively. The buyer also received several whistleblower letters reporting issues with the seller's regulatory compliance with U.S. Food and Drug Administration (FDA) rules. At the same time, the seller scaled back certain regulatory compliance and audit functions and provided inaccurate information to the FDA. In light of these developments, and following an extensive investigation of the relevant facts, the buyer asserted its rights not to close and to terminate the merger agreement. In response, the seller commenced litigation, seeking to compel specific performance of the merger agreement.
The Opinion
In the resulting decision, Akorn, Inc. v. Fresenius Kabi AG,2 Vice Chancellor J. Travis Laster found that the financial downturn and regulatory compliance issues provided bases for the buyer to refuse to close and to terminate. The court rejected the seller's arguments that the buyer, in turn, had failed to materially comply with its obligations to take actions to obtain antitrust approval and expeditiously consummate the deal and should therefore be prevented from terminating the deal. The following is a summary of key issues in this important decision.
Material Adverse Effects. The court found that: (i) there had been a general material adverse effect (MAE) at the seller; and (ii) the seller had breached specific representations about the company's regulatory compliance that resulted in a separate MAE. The finding of the general MAE was grounded in the downturn in the company's business, with the court noting, among other things, the loss of a key contract, competitive market entrants, and changes in analyst expectations. Citing established Delaware case law providing that an MAE generally must be "durationally significant" and impact the long-term condition of the selling company, the court concluded that the changes rose to that level here. Among other things, the court reasoned that the downturn had "already persisted for a full year and shows no sign of abating," that the seller's problems by their nature would be expected to have long-term effects, and that analyst estimates about the company's value and prospects had dramatically changed. In this analysis, the court emphasized that the existence of an MAE should be assessed based on changes in the company's standalone condition and not on whether the acquisition would still be profitable or synergistically valuable for the buyer. The occurrence of a general MAE permitted the buyer not to close. Meanwhile, under the merger agreement, the breach of representations about regulatory compliance resulting in an MAE permitted the buyer to terminate the agreement. The court measured the regulatory MAE as a qualitative and quantitative matter, finding that the seller's FDA data integrity issues were "pervasive" and that remediation costs (estimated by the court to be $900 million and taking years to implement) could reasonably be expected to amount to approximately 21 percent of the seller's standalone value.
Ordinary Course in All Material Respects. The court also addressed the seller's obligation to operate the business in the ordinary course in all material respects. This covenant, if breached, would provide another basis for the buyer to terminate. The court found that a generic pharmaceutical company operating in the ordinary course would conduct regular regulatory audits and take steps to remediate deficiencies. The court further found that the company had failed to comply with this obligation by canceling audits and ongoing compliance assessments, by failing to properly investigate whistleblower letters, by submitting misleading data to the FDA, and by failing to remediate deficiencies and properly maintain data integrity.
Efforts Standards. Of note, the efforts standards applicable to the seller's obligation to operate the business in the ordinary course and the buyer's obligation to close were "commercially reasonable efforts" and "reasonable best efforts," respectively. While acknowledging that practitioners generally view these standards as different, the court viewed them as equivalent, pointing to the fact that market surveys and the Delaware Supreme Court have viewed these standards as simply requiring parties to "take all reasonable steps to solve problems and consummate the transaction." Therefore, the court applied this same unified standard to both the seller's and buyer's obligations.
Regulatory Approval Strategy. The court also noted that there could have been some tension between the buyer's "hell-or-high-water" obligation to take all efforts to obtain approval from the Federal Trade Commission without delaying consummation of the merger and the buyer's right to control the regulatory strategy to obtain such approval. The court, however, stated that the two provisions together recognized that there is no single and obvious strategy for obtaining regulatory approval, and the buyer could control the strategy subject to the hell-or-high-water provision. Additionally, the court found that even though the buyer had inappropriately considered (but quickly abandoned after one week) an antitrust strategy that would have delayed closing, that momentary issue had not resulted in a material breach by the buyer that would prevent it from exercising its termination rights.
Reliance on Representations. The seller sought to undermine the buyer's right to terminate by alleging that the buyer had known of the regulatory and data integrity issues and, thereby, assumed the risk of the seller's post-signing financial performance. The court rejected this argument, noting, among other things, that Delaware has long permitted parties to efficiently allocate risk through contractual representations, and that the buyer could pursue its contractual remedies for breaches of those representations regardless of the buyer's knowledge. This factored into this decision in important ways, and the court's reasoning is also potentially relevant to another important issue under Delaware law that has been recently raised by the Delaware Supreme Court and practitioners: "sandbagging" (permitting buyers to assert contractual breaches despite knowledge of the breaches). The strong language in this decision could be read to allow for such enforcement of contracts as written, irrespective of knowledge.
Process for Termination. The court emphasized that the buyer had acted almost entirely appropriately between signing and closing. Specifically, the court noted that, after the buyer had been given reasonable cause for concern when the seller's financial performance significantly decreased and the buyer received the whistleblower letter, the buyer justifiably pursued in parallel its obligations toward a potential closing and an exploration and enforcement of its rights toward a potential termination. The court distinguished the buyer's behavior in this case from that of buyers in previous cases that had appeared to rush toward asserting an MAE out of buyer's remorse.
What's Next?
The seller has already announced that it will be appealing the decision to the Delaware Supreme Court, and we will continue to monitor developments. In any event, this litigation will provide landmark guidance for participants in the M&A market and should be carefully considered by parties on both sides of the negotiating table.
For more information about the Delaware Court of Chancery decision or any related matter, please contact David Berger, William Chandler, Todd Cleary, Katherine Henderson, Rob Ishii, Amy Simmerman, Brad Sorrels, and Ryan Greecher, or any member of the corporate governance or mergers and acquisitions practices at Wilson Sonsini.
