On December 18, 2019, the Delaware Court of Chancery issued a 119-page post-trial memorandum opinion 1) rejecting a buyer's argument that the target company had breached representations and warranties in the parties' merger agreement which had a material adverse effect (MAE) on the target and 2) ordering specific performance of the merger by the buyer. The opinion, Channel Medsystems, Inc. v. Boston Scientific Corporation, by Chancellor Andre G. Bouchard, is an important counterpart to the landmark Akorn, Inc. v. Fresenius Kabi AG decision from 2018, in which the Delaware Court of Chancery—and ultimately the Delaware Supreme Court—determined that an MAE had occurred and that the buyer in that case could terminate the transaction as a result.1 The new decision, consistent with prior case law, reflects that buyers claiming an MAE face a heavy burden and that Akorn was not a turning point in Delaware law.
Factual Background of the Decision
In 2017, public company Boston Scientific entered into a merger agreement to acquire Channel Medsystems, a private medical device company that had one product, for up to $275 million. Boston Scientific had become an investor in Channel in 2013. Under the merger agreement, Boston Scientific was only required to close the transaction if the U.S. Food and Drug Administration (FDA) approved the target company's sole product by September 2019.
The dispute between the parties arose after the target company discovered that its Vice President of Quality had falsified various expense reports and other documents in a scheme by which he stole approximately $2.6 million from the company over the course of five years. Some of the falsified documents were included in the company's submissions seeking FDA approval. According to the Court's decision, which followed a four-day trial, the target company diligently investigated the fraud and communicated transparently and fully with both the buyer and the FDA. Although the FDA rigorously questioned the target company and subjected it to a remediation plan, the FDA accepted the remediation plan in April 2018, which—according to the Court—was a positive sign that the FDA would approve the target company's product. The buyer, however, terminated the agreement the following month, claiming fraudulent inducement and that the target had breached several representations in the merger agreement.
The target company filed a complaint for specific performance of the merger agreement against the buyer in September 2018, and the buyer filed counterclaims for fraud in the inducement, breaches of representations and warranties and rescission of the merger agreement. The FDA ultimately approved the target company's product in March 2019, consistent with the timeline for FDA approval the parties had anticipated when they first entered into the merger agreement and a month before trial in the lawsuit commenced.
The Court's Conclusions
The Court began by finding that the target company had breached multiple representations in the merger agreement relating to whether its business and product were in "material" compliance with applicable laws or complied "in all material respects" with government requirements. Echoing the Akorn decision, the Court noted that the test for materiality in this context is akin to the test for materiality in the disclosure context: whether there is a "substantial likelihood" that the facts at issue would have been viewed by a reasonable buyer as "significantly altering" the "total mix of information." The Court found that the buyer satisfied that standard for several of the representations the target allegedly breached.
The Court next considered whether an MAE had occurred. Unlike in the Akorn decision, the buyer largely abandoned its argument that a standalone MAE had occurred by the time of trial. It instead primarily argued that the target company's breaches of representations in the merger agreement had or would "reasonably be expected" to have an MAE on the target company's business, as the merger agreement required in order for the buyer to have a termination right. The Court found, however, that such standard was not satisfied here. The Court noted the long-established rule in Delaware case law that a buyer seeking to prove an MAE (where a merger agreement does not define what "material" means) must meet a high threshold, demonstrating that the effect—qualitatively and quantitively—should "substantially threaten the overall earnings potential of the target in a durationally-significant manner."
A key premise for the buyer's argument was that, post-closing, it would have to "shelve" the target company's product for two to four years while it conducted remediation efforts or engaged in a new clinical trial. The Court rejected this argument, particularly given that the FDA had already approved the product. The Court noted evidence that the buyer, in its own affairs and product liability litigations, had taken the position that FDA approval reflected an absence of actionable flaws with a product. Additionally, the Court found that the buyer's valuation expert at trial had not established that the fraud had a meaningful impact on the target's business. Throughout the opinion, the Court remarked that the buyer appeared to have had a change of heart about the acquisition more generally and had not communicated with the target company about its concerns, observing that there was not a "single scrap of paper" reflecting that the buyer had actually analyzed the effects of the fraud on the target company when it made the decision to terminate. Not surprisingly, given these findings, the Court also found that the target company had not fraudulently induced the buyer's prior investments.
The Court reached two significant final conclusions. First, the Court determined that, given the buyer's conduct, the target company demonstrated that the buyer had not satisfied its obligation under the merger agreement to use commercially reasonable efforts to consummate the merger. The Court noted that such efforts standards require a party to "take all reasonable steps to solve problems and consummate the transaction." Second, the Court granted the target company's request for the equitable remedy of specific performance, requiring that the buyer close the transaction in light of its wrongful termination of the agreement. Easily finding that there was a valid contract and that the target company was capable of performing the contract, the Court determined that the final requirement for specific performance—a balancing of equities—weighed in favor of the target company. The Court noted that although not binding on a court, the parties had agreed in the merger agreement that specific performance was an available remedy. The Court additionally noted the lack of harm to the target company's business resulting from—and the target company's own surprise at—the fraudulent scheme it had discovered.
As with the Akorn case, this decision by the Delaware Court of Chancery is a critical reference point when a deal threatens to unravel. The two cases involve very different sets of facts that illustrate when an MAE may or may not exist—although consistent with historical case law, this decision reiterates that Delaware courts will not readily find an MAE, particularly in the context of a large deal.
 Our alert on Akorn, Inc. v. Fresenius Kabi AG is available here: https://www.wsgr.com/en/insights/delaware-court-of-chancery-finds-a-material-adverse-effect-and-permits-termination-of-merger-agreement.html.