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Crucial clauses: M&A Bar gleans lessons from blowup of pharma deal

When Delaware courts speak, business attorneys listen, and a ruling allowing a German drug company to pull out of $4.75 billion deal to acquire a U.S. competitor still has M&A lawyers buzzing.

On Oct. 1, 2018, the Delaware Chancery Court handed down a 247-page decision recognizing that Fresenius Kabi AG had a contractual right to terminate its acquisition of generic pharmaceutical manufacturer Akorn pursuant to two separate “material adverse effect” clauses in the parties’ merger agreement.

The Chancery Court ruling in Akorn Inc. v. Fresenius Kabi AG is the first time that a Delaware court upheld the termination of a merger agreement pursuant to an MAE clause. Judge J. Travis Laster found two adverse developments occurred between the parties’ execution of the merger agreement on April 24, 2017, and the scheduled closing date of April 24, 2018.

First, Akorn’s business performance “fell off a cliff” beginning in the second quarter of 2017. The judge noted that when Akorn announced its financial results later that year, the company reported a 29 percent decline in revenue and an 89 percent drop in operating income.

Second, the cratering of Akorn’s business fortunes coincided with Fresenius uncovering evidence that Akorn was misrepresenting its compliance with Food & Drug Administration regulatory requirements, a condition of closing.

Those developments justified Fresenius invoking its contractual right to terminate, Laster concluded.

The Delaware Supreme Court affirmed Laster’s landmark decision in a three-page order issued Dec. 7.

Boston mergers and acquisitions attorney Matthew W. Tikonoff said the language used in the parties’ merger agreement was critical to the outcome in Akorn.

“The case really reminds us that the court is going to respect the parties’ contractual allocation of risk in the [representations] and warranties in the definition [of MAE],” Tikonoff said. “So it’s placing a renewed focus on how the parties draft that definition and allocate that risk as between the buyer and the seller.”

Andrew Spacone called Akorn the “perfect storm” for enforcing an MAE clause. But he did not see the case as opening the door to more buyers being allowed to walk away from M&A deals in Delaware courts.

“You had misrepresentation on the part of Akorn, you had breach of the regulatory M&A, and then you had this really precipitous and significantly durational decline in business,” said Spacone, who teaches business law at Roger Williams University School of Law.

But there are still lessons to be drawn from the case, according to Spacone, a longtime in-house counsel for Fortune 200 company Textron before retiring from practice to teach.

“The lesson for practitioners is that now you can’t say Delaware will never enforce an MAE clause,” he said.

‘Buyer’s Remorse’

Boston’s Jeffrey M. Lipshaw said Delaware courts historically have been skeptical about MAE claims, making Akorn noteworthy.

“That’s because it doesn’t really look like it has anything to do with the underlying business; it’s more ‘buyer’s remorse,’” said Lipshaw, a professor at Suffolk University Law School and former business lawyer and general counsel for AlliedSignal Automotive and Great Lakes Chemical Corp.

Lipshaw said there’s a natural give and take in negotiating an MAE clause into a merger agreement, with the buyer striving to make the contract as much of an option as possible, while the seller wants the deal to be as unconditional as possible. Akorn validates that there is “market value” in having an MAE clause, he said.

Generally speaking, MAE clauses (also referred to as “material adverse change” or “MAC” clauses) address the problem of significant developments affecting the value of a deal that occur during the “gap period” of an M&A transaction — the time between the signing of the agreement and closing.

“The MAE is there to protect the bidder for any material changes in the business,” Spacone said. “Often, it will be the basis for renegotiating the price.”

Spacone said the issue ordinarily arises in the context of the acquisition of large, publicly traded companies that require the scheduling of shareholder votes — and oftentimes regulatory approval — before the parties can complete a deal after an agreement has been signed.

As in Akorn, it’s typical for M&A agreements large and small to be governed by Delaware law, Tikonoff said, noting that Delaware is frequently the law of choice because it is both well-developed and “predictable.”

“Delaware law is extremely influential just because the Chancery Court is the leading corporate court in the country,” Lipshaw said. “It’s going to impact corporate litigation in any state, even if it’s not binding.”

The merger agreement between Fresenius and Akorn included both a general MAE clause and a specific MAE clause holding Akorn to its representations and warranties.

Section §6.02(c) of the parties’ agreement subjected Fresenius’ obligation to “effect” the merger by the closing date to the condition that, since the date of the 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.”

Section 7.01(c)(i) of the merger agreement provided Fresenius with the right to terminate if Akorn breached any of its representations or warranties or failed to perform any of its covenants or agreements. That right arose if the breach gave rise to certain conditions, “incapable of being cured,” including the failure of a condition set forth in §6.02(a).

Section 6.02(a) established that, as a condition to closing, Akorn’s representations and warranties “shall be true and correct … except … where the failure to be true and correct would not, individually or in the aggregate, reasonably be expected to have a Material Adverse Effect.”

Citing those provisions and others, Fresenius gave notice to Akorn that it was terminating the merger agreement on April 22, 2018.

Problems at Akorn

Fresenius received a letter from an anonymous whistleblower in October 2017 alleging that Akorn’s product development process failed to comply with regulatory requirements.

According to Judge Laster, Fresenius’ investigation into the matter “uncovered serious and pervasive data integrity problems that rendered Akorn’s representations about its regulatory compliance sufficiently inaccurate that the deviation between Akorn’s actual condition and its as-represented condition would reasonably be expected to result in a Material Adverse Effect.”

Akorn responded to Fresenius’ termination attempt by filing an action in Delaware Chancery Court, seeking a declaration that Fresenius’ attempt to terminate the merger was invalid.

Laster first found that Fresenius validly terminated the merger agreement because “Akorn’s representations regarding its compliance with regulatory requirements were not true and correct, and the magnitude of the inaccuracies would reasonably be expected to result in a Material Adverse Effect.”

Secondly, the judge found that Fresenius properly refused to close in reliance on the fact that Akorn had indeed suffered an MAE.

Thirdly, Laster concluded Fresenius could terminate the agreement because “Akorn materially breached its obligation to continue operating in the ordinary course of business between signing and closing.”

The Delaware Supreme Court affirmed the Chancery Court on the first two grounds, seeing no need to address the third ground.

Reading tea leaves

Tikonoff noted that the courts found the occurrence of an MAE with respect to two separate fact patterns: (1) the financial deterioration of the target after signing; and (2) Akorn’s regulatory noncompliance.

“The first thing you wonder is whether the court would have reached the same decision taking each of those things in isolation, or was it just the compounding effect of the two,” he said.

Tikonoff and fellow Mintz Levin lawyer Breton Leone-Quick recently led a discussion on Akorn at a bar seminar.

Leone-Quick agreed that, after Akorn, companies will continue to have a very heavy burden when seeking relief under an MAE clause.

However, he said the fact that practitioners now have a Delaware case on the books giving effect to an MAE does provide a “roadmap” for successfully invoking such clauses in the future.

“If you have something approaching these facts, this does provide a concrete example for how you may be able to exercise that provision in the agreement and refuse to close because a general MAE has occurred,” Leone-Quick said. “The more interesting question going forward is how much less egregious than this case can you get to clear what historically has been a very high standard.”

One of the key lessons from Akorn is the measured approach that Fresenius took in exercising its contract rights, Leone-Quick said. As demonstrated by the unique result in Akorn, Delaware judges have historically been loath to provide relief to companies perceived as simply being “remorseful buyers.”

Leone-Quick credited Fresenius for demonstrating through the course of its conduct that it was making good-faith efforts to close the merger and that it accordingly deserved relief with the occurrence of the adverse effects. He recommended a deliberate approach by a lawyer representing a buyer faced with a seller’s deteriorating financial or regulatory situation.

“It’s very clear that what you don’t do is break off communications, run into court prematurely and say, ‘Hey look, judge! An MAE has occurred and we’re walking,’” Leone-Quick said.

Tikonoff said attorneys should take note that the Chancery Court also recognized that Akorn during the gap period failed to fulfill its contractual commitment to conduct its operations in the ordinary course of business. Though the Delaware Supreme Court did not affirm on that ground, the Chancery Court’s finding shouldn’t be overlooked, he said.

“That’s interesting because it demonstrates the buyer can get out of a transaction — even if it can’t prove an MAE — by simply proving that the target deviated materially from its operating competence,” Tikonoff said. “It potentially provides buyers with an angle to get out of a transaction.”