Written by Drew C. Broughton and Peter Amrhein
Purchasers of businesses often want an "escape hatch" prior to closing if the target business suffers a "material adverse change" (or a "material adverse effect"). Historically, based on court decisions primarily out of the U.S. (and Delaware in particular), this right has been viewed as extremely difficult to exercise in practice. As reported by Reuters, last week’s decision of a Delaware judge affirms a purchaser's ability to walk if a true "material adverse change" occurs with respect to a target business.
"Material Adverse Change" Condition Validly Exercised
In a significant opinion issued on October 1, 2018 by Vice Chancellor Travis Laster of the Delaware Chancery Court (Akorn, Inc., v. Fresenius Kabi AG Case No. 2018-0300-JTL), it was ruled that a purchaser could walk away from an acquisition due to factors which were found to constitute a "material adverse change" ("MAC"). This decision is of particular importance as it represents the first time a Delaware judge has found that a MAC has occurred, and confirmed the purchaser's right not to close as a result.
The Court found that Akorn, Inc., the target company and a specialty generic pharmaceuticals company, had suffered a long-term decline in performance that resulted from unforeseen "company-specific problems, rather than industry-wide conditions". Additionally, Akorn had systemic quality control problems resulting in a valuation hit of approximately $900 million on an overall transaction price of $4.5 billion. This change in valuation was considered to be material to a reasonable acquirer and accordingly, the judge ruled that the buyer, Fresenius Kabi AG, could terminate the acquisition due to these material adverse effects.
What is the impact of this decision?
This decision is a first—but it has limits. Given the severity of the negative effects in this case, it reinforces the position that a MAC represents an extremely high "seller-friendly" threshold that will only be satisfied in exceptional circumstances. While not a Canadian decision, there are similarities in the law in Canada and the U.S. as it relates to these types of M&A provisions, and courts in Canada have historically looked to the U.S. when interpreting MAC clauses. We expect that the analysis used in Laster's decision would be considered by a Canadian court, and should be taken into consideration when advising clients.
Some key takeaways from this decision are:
- Generally speaking, typical MAC conditions continue to favour the seller, and purchasers have a very high threshold to meet. This decision should not significantly change the advice given to clients when drafting and negotiating MAC clauses.
- Purchasers who wish for a definitive allocation of risk should either draft specific conditions to address known risks, or draft the MAC clause with specific financial milestones in mind (e.g. failure to meet a specified amount of earnings before interest, taxes, depreciation, and amortization).
- "Material adverse effects" should be viewed from a longer-term perspective (measured in years, not months). Short term effects are unlikely to constitute a "material adverse effect".
- Considering the pro-seller position courts use as a starting point, purchasers should consider pushing back on seller-friendly carve-outs from the MAC definition, which further diminish the usefulness of a MAC clause and allocate further risk to the purchaser.
- For sellers who are looking for deal certainty, a standard MAC condition does not significantly increase closing risk. We expect that the overwhelming majority of M&A transactions in Canada and the U.S. (both public and private) will continue to include a MAC condition.
- Process is important. Rather than terminate the agreement immediately upon the occurrence of the MAC, the purchaser pursued a strategy of information seeking and investigation, which formed the basis for the exercise of its rights.