Delaware Chancery Rejects a Buyer’s MAE Claim (Again)

Last month, the Delaware Court of Chancery rejected a buyer’s claim that a target suffered a “material adverse effect” and ordered specific performance requiring the buyer to complete the acquisition.  This is the second transaction in recent months in which Delaware courts have rejected material adverse effect claims, affirming the high threshold set by prior Delaware decisions.  Several takeaways are offered below. 

Background

In Bardy Diagnostics, Inc. v. Hill-Rom, Inc.,¹ the target corporation was characterized as a “start-up” medical device manufacturer.  After the purchase agreement was signed, there was a significant reduction in the Medicare reimbursement rate applicable to the target’s product.  Although the parties knew the reimbursement rate could change, neither party expected a material reduction.  After it unsuccessfully attempted to seek a reversal of the rate reduction, the buyer claimed that the target suffered a material adverse effect (“MAE”) and refused to close.  The target brought an action for specific performance.

Court of Chancery’s Opinion

The court assumed that the Medicare reduction rate had an immediate material adverse effect on the target’s business, but the buyer failed to prove at trial that the MAE would continue for a “durationally-significant” period.  In weighing competing evidence and expert witness testimony, the court found it more likely than not that the Medicare rate reduction would be reversed in the future and thus would not have a long-term effect.  Noting prior case law,² the court affirmed that an MAE must affect the target for a “commercially reasonable period” when viewed from the perspective of a “reasonable acquiror” that “one would expect … to be measured in years rather than months.”  Applying this standard, the court found the buyer had “failed to prove that it reasonably would have expected that [Medicare] would not meaningfully increase the current Medicare reimbursement rates.”  “[I]t is insufficient,” the court wrote, “to show the effect of the [decreased Medicare reimbursement rates] might be durationally-significant, as ‘a mere risk of an MAE cannot be enough.’”

The court also found the change in Medicare reimbursement rates was a “change in [] Law” that the parties expressly excluded from the definition of MAE.  Under the purchase agreement, changes in law could be considered “to the extent” the target was disproportionately impacted relative to “similarly situated companies operating in the same industries or locations.”  After examining various factors including operational scale, developmental maturity, and product portfolio, the court found there was only one peer company that was “similarly situated,” and that such company was comparably affected by the new Medicare reimbursement rate.  As a result, the change in the reimbursement rate was contractually excluded from being considered an MAE.

The court ordered the buyer to complete the transaction.  It also awarded prejudgment interest.

Take-Aways

• MAE Threshold in Delaware: This is the second decision in 2021 to reject a buyer’s MAE claim to avoid closing.³  The last case involved a COVID-19-related disruption to the target’s business, whereas Bardy Diagnostics did not.  To date, only one Delaware decision has found an MAE to have occurred in an MAE transaction.⁴ This does not mean MAEs have not occurred in other transactions that were either renegotiated or aborted, but it reaffirms the high burden that Delaware has set for invoking an MAE clause. 
• Allocating Risk: The target argued that a change to the Medicare reimbursement rate could not be an MAE because it was a known risk.  Rejecting this argument, the court said that a customary, broad-based MAE definition is not limited to allocating unknown events.  In providing context from the court’s 2001 ruling in IPB,⁵ the Bardy Diagnostics court said a “broadly-worded general MAE” also allocates “unspecified” risks or events.  Therefore, the fact that the parties knew of this risk did not mean it was unconditionally assumed by the buyer.  This is consistent with the court’s opinion in Akorn, where it similarly rejected an argument that an event discoverable during due diligence could not qualify as an MAE.
• Durational Significance: In many MAE disputes, a critical issue will be whether the event will have a durationally-significant effect on the target.  Bardy Diagnostics’ analysis provides guidance to further litigants.  The court also indicated in dicta that buyers will face an additional burden in proving an MAE when the adverse effect is within the control of a third party (in this case, Medicare and its contractors).  This dicta may prove controversial among practitioners given the highly contextual nature of MAE disputes and the conflicting expert witness testimony in this case.
• Strategy: The court noted favorably the buyer’s good faith efforts to seek a reversal in the Medicare reimbursement rate reduction before the buyer declared an MAE.  Although the court still ruled for the target, the buyer’s actions were probably helpful in building credibility with the court and avoiding a picture of mere “buyer’s remorse.”
• Drafting Points: Although Delaware doctrine provides general guidance on MAEs, drafting still matters.  For example, the definition of MAE was based on, among other things, an “event” that affected the “Business.”  Because the defined term “Business” focused on the target’s operations and not its financial condition, the target argued (unsuccessfully) that the Medicare rate reduction was not an MAE since it was a financial rather than operational change to the “Business.”  More importantly, the court’s focus on peer groups in its disproportionate impact analysis is instructive.  The court suggested that “similarly situated companies operating in the same industries” was a seller-friendly standard and led to there being only one “peer” company.  The court said the contract language of “similarly situated companies” required a “more granular parsing of a company’s situation than mere participation in the [relevant] market,” and the court thus looked at size, developmental maturity, and product mix in identifying peers.  In contrast, the parties in the Snow Phipps case argued over various industry subsets as the peer group where the purchase agreement language used the phrase “other comparable entities operating in the industry in which the Group Companies operate.”⁶
• Contractual Alternatives: In Bardy Diagnostics, neither party reasonably expected a significant reduction to the Medicare reimbursement rates.  In other situations, however, buyers and sellers may bargain for more specific allocations of fundamental risks, particularly where the target has a single or primary product.  For example, specifically tailored closing conditions or targeted representations with buyer-friendly “bring-down” standards can be used.

¹ See Bardy Diagnostics, Inc. v. Hill-Rom, Inc., C.A. No. 2021-0175-JRS, mem. op. (Del. Ch. July 9, 2021).

2 See, e.g., Frontier Oil v. Holly Corp., 2005 WL 1039027, *34 (Del. Ch. Apr. 29, 2005); Hexion Specialty Chems., Inc. v. Huntsman Corp., 965 A.2d 715, 738 (Del. Ch. 2008).

³ See Snow Phipps Group, LLC v. KCAKE Acquisition, Inc., C.A. No. 2020-0282-KSJM, mem. op. (Del. Ch. Apr. 30, 2021).

⁴ See Akorn, Inc. v. Fresenius Kabi AG, C.A. No. 2018-0300-JTL, mem. op. (Oct. 1, 2018).

⁵ See In re IBP, Inc. S’holders Litig., 789 A.2d 14, 68 (Del. Ch. June 15, 2001) as corrected (Del. Ch. June 18, 2001).

⁶ See Snow Phipps Group, LLC v. KCAKE Acquisition, Inc., C.A. No. 2020-0282-KSJM, mem. op. (Del. Ch. Apr. 30, 2021).