What is a Material Adverse Effect?

Review the default provisions of virtually any acquisition agreement and you will find a reference to the following (as an example):

“Any event shall occur that, in Purchaser’s opinion, has a material adverse effect on the collateral, or Borrower’s financial or business conditions, operations or prospects,”

or that reads as follows:

“The entry of any judgment, decree, levy attachment, garnishment or other process and such judgment or other process that would have a material adverse effect on the ability of either party to perform under this Agreement.”

But just what is a Material Adverse Effect (MAE)?  Even though the phrase repeatedly appears in those agreements, there typically is no definition of the term and, when questioned, the parties, and their respective counsel, are unable to provide one.

That is why the decision in Akorn v. Fresenius is important even though it does not involve a financial institution.  For the first time, a Delaware court, where much financially-related litigation occurs, has put some meat on the bones of the phrase.

Fresenius Kabi AG, a German pharmaceutical company, signed an agreement to merge with Akorn, Inc., a US pharmaceutical company on April 24, 2017.  Closing was to occur in 2018.  The acquisition was conditioned on: (1) the truth of Akorn’s representations at closing, (ii) Akorn continuing to operate its business as it had in the past, and (iii) the non-occurrence of a MAE.

During the preceding five years Akorn had experienced healthy growth.  That continued during the first quarter of 2017.  But then the roof caved in – quite suddenly.  Akorn lost a major contract and regulatory issues were raised by the FDA.

For the entire year 2017, Akorn’s revenue declined by 25%, operating income dropped by 105% and EBITIDA fell by 86%.  Obviously, the three quarters of 2017 that followed the execution of the merger agreement were disastrous.

In addition, the FDA received letters from whistle-borrowers complaining about Akorn’s data security system.  The FDA investigated and found that after signing the merger agreement, Akorn had cancelled its regularly-scheduled audits of its data security systems, failed to cure deficiencies, and had made a misleading presentation to the FDA.

Faced with that, Fresenius elected to terminate the agreement.  When Akorn sued to force Fresenius to adhere to the contract, the Delaware Chancery Court ruled in favor of Fresenius.

Although the court bolstered its conclusion by finding Akorn had breached the representations it made in the merger agreement, and failed to continue to operate its business as it had in the past, the crux of the decision was premised upon its finding that a MAE had occurred.  The court said that a MAE must “substantially threaten the overall earnings potential of the target in a durationally-significant manner” and that the relevant period of the MAE should be “measured in years rather than months”.  Applying those criteria the court had no difficulty in ruling for Fresenius.  The financial data told the tale.

What is notable about this case is that it is the first time a prestigious court has articulated what a MAE is.

Potential purchasers faced with an unanticipated significant long-term earnings slump by a prospective target after executing a commitment letter now have a way to measure whether they can reject the transaction based upon a MAE.  But the Delaware court did state that it was not establishing a bright line quantitative test.  Other surroundings circumstances are not to be entirely disregarded.

If you have any questions regarding Material Adverse Effects, please contact Levin Ginsburg at 312-368-0100.