White & Case LLPIn the second half of 2018, the Delaware courts once again produced decisions that will guide M&A transactions in the future.

Three cases affecting US M&A stood out in 2018.

1. First-of-its-kind Material Adverse Effect ruling

The Delaware Supreme Court recently affirmed a first-of-its-kind decision by the Delaware Chancery Court, ruling that German pharmaceuticals company Fresenius Kabi AG was not required to close its US$4.3 billion merger agreement with pharmaceutical company Akorn Inc. because, after signing, Akorn suffered a Material Adverse Effect.

In April 2017, Fresenius entered into a merger agreement to acquire Akorn. Under the agreement, Fresenius agreed to acquire Akorn for US$34 per share, subject to certain customary closing conditions, including Akorn not suffering an MAE and Akorn’s representations being true and correct at closing except as would not reasonably be expected to have an MAE.

Immediately after signing the agreement, despite showing persistent growth over the previous five years, Akorn’s financial performance “dropped off a cliff” (for the full year 2017, Akorn’s revenue, operating income and earnings fell by 25 percent, 105 percent and 113 percent respectively).

Moreover, in October of 2017, Fresenius received anonymous whistleblower letters alleging pervasive flaws in Akorn’s data integrity systems, and, after engaging an investigative team that found significant issues, Fresenius notified Akorn that it was terminating the agreement. In response, Akorn filed a claim against Fresenius in the Chancery Court requesting specific performance of the merger, while Fresenius counterclaimed that it had terminated the agreement in accordance with its terms.

The Chancery Court ruled that Fresenius had properly terminated the merger agreement. In determining that Akorn had suffered an MAE, the Chancery Court noted that an MAE must “substantially threaten the overall earnings potential of the target in a durationally significant manner”, and that the relevant period is “measured in years rather than months”—Akorn’s downturn had subsisted for a year and showed no signs of abating.

In also determining that Akorn had breached its representation to be in full compliance with its regulatory obligations, and such breach would reasonably be expected to result in an MAE, the Chancery Court noted that Akorn’s regulatory issues were both qualitatively and quantitatively material (US$900 million in this case, which was a 21 percent decline in Akorn’s implied equity value)—however, the Chancery Court stressed that it was not establishing a “bright-line test”.

The Supreme Court affirmed the Chancery Court’s findings concerning the occurrence of an MAE, though specifically declined to “address every nuance of the complex record”.

Importantly, the Akorn decision is regarded as the first Delaware decision to find that a buyer may use an MAE clause to terminate an acquisition. On the one hand, the case demonstrates the extreme circumstances that are required before a buyer may use an MAE clause to terminate an acquisition. However, on the other hand, it also demonstrates the importance of carefully drafting and negotiating a provision in an acquisition agreement that many parties have traditionally regarded as being merely formalistic.

2. Deal price less synergies drives fair value determination

In an important appraisal decision, the Chancery Court rejected the argument of certain shareholders of digital technology business Solera Holdings, that the value of their shares when exercising appraisal rights should be calculated solely using a discounted cash flow analysis. The court instead concluded that the deal price, which was achieved in an arm’s-length and open sales process, after adjusting for synergies, was the most reliable evidence of the fair value of the shareholders’ shares.

After Vista Equity Partners acquired Solera at a price of US$55.85 per share, certain of Solera’s shareholders exercised appraisal rights requesting that the Chancery Court determine the fair value of their shares. Such shareholders argued that the fair value of their shares was US$84.65 based on a discounted cash flow analysis. Meanwhile, Solera argued that the fair value was the deal price less synergies, which was US$53.95 per share.

The Chancery Court decided in favor of Solera. In reaching a conclusion that the deal price less synergies was the appropriate method of determining fair value, the determinative factors included the following:

  • Solera’s sale process involved robust public information concerning the company (including the view of analysts, buyer and debt providers)
  • A deep base of public shareholders
  • Easy access to non-public information for potential buyers
  • Cooperation from management
  • A special committee composed of independent and experienced directors that had the power to say “no”, advised by competent legal and financial advisors
  • The sale was achieved in an arm’s-length transaction with a third party

With respect to synergies, the Chancery Court agreed with Solera’s argument that a financial buyer, like a strategic buyer, could realize synergies in connection with a transaction, and subtracted the estimated synergies of US$1.90 from the deal price of US$55.85 in reaching its conclusion that the fair value of Solera’s stock was US$53.95 per share.

The decision should give increased comfort to buyers that the deal price in an arm’s-length transaction from a fair and open sales process will be given significant deference by Delaware courts in appraisal proceedings.

In addition, the decision shows that in certain circumstances, financial buyers can argue that the fair value of a shareholder’s shares in appraisal is, in fact, less than the deal price based on the synergies that the financial buyer expected to realize from the transaction.

3. Clarification of “Ab Initio” requirement

The Delaware Supreme Court clarified the circumstances under which a party can obtain the benefit of business judgment rule treatment (and avoid the more stringent “entire fairness” standard) in connection with controlling stockholder transactions.

In Kahn v. M&F Worldwide Corp (“MFW”), the Supreme Court had previously ruled that the business judgment rule applies to a controlling shareholder transaction if such transaction is conditioned “ab initio” upon the approval of the informed vote of a majority of the minority shareholders and upon the approval of an independent special committee of directors.

In the October 2018 case of Flood v. Synutra International, Inc, the Supreme Court clarified that the controlling shareholder satisfied MFW’s “ab initio” requirements by conditioning the transaction on such requirements before substantive economic negotiations had begun.

In Flood, Liang Zhang and his affiliates controlled 63.5 percent of Synutra’s stock. In January 2016, Zhang wrote a letter to the Synutra board proposing to take the company private, but did not provide that such transaction would be conditioned on the safeguards established in MFW (i.e., the informed vote of a majority of the minority shareholders and the approval of an independent special committee of directors). One week after receipt of the letter, the board formed a special committee to consider the offer, and one week after that, Zhang sent a second proposal with the same economic terms, but this time conditioning his offer on the MFW procedural safeguards. After another eight months, the special committee and Zhang agreed on a price of US$6.05 per share.

The plaintiff minority shareholders argued that because the MFW procedural safeguards were not included in Zhang’s initial letter, the “ab initio” requirement of MFW was not satisfied and as such, the business judgment standard of reviewing the transaction had been forfeited.

The Supreme Court affirmed an earlier Chancery Court decision that the business judgment rule applied. The Supreme Court ruled that “ab initio” should not be understood as meaning any fixed point in time, but should be understood as meaning the early stages of a transaction up until substantive economic negotiations commence. In this case, the committee only began substantive negotiations with Zhang regarding price after seven months of due diligence, so economic negotiations had clearly not begun until after Zhang sent his second proposal, which conditioned his offer on the MFW procedural safeguards.

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