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On July 9, 2021, the Delaware Court of Chancery issued its latest decision determining whether a buyer’s attempted invocation of a Material Adverse Effect (MAE) clause was effective to excuse the buyer’s failure to close an acquisition of the target company pursuant to a signed merger agreement. While the court relied upon well-trodden paths in reaching its determination that no MAE had in fact occurred, there are a few takeaways worthy of note—i.e., (a) the seemingly “unknown event” element of IBP, Inc.’s theoretical underpinnings to the purpose of an MAE clause generally, is not a built-in requirement to invoking an otherwise carefully defined MAE clause, (b) durational significance remains a key ingredient in determining whether an material adverse effect has occurred, (c) carve-outs can eliminate otherwise truly material adverse effects from constituting an MAE, and (d) the effectiveness of “disproportional effect” exclusions to MAE carve-outs are dependent upon the industry participants that are used to make the disproportionality comparisons.
In Bardy Diagnostics, Inc. v. Hill-Rom, Inc., 2021 WL 2886188 (Del. Ch. July 9, 2021), the buyer of a target company, a medical device startup that was heavily dependent upon the rates Medicare would pay for its primary product, attempted to terminate its proposed merger with the target company based upon its claim that the target company had suffered an MAE. The event that allegedly triggered the MAE was the reduction in the Medicare reimbursement rates applicable to the target’s primary product by approximately 86%. Although the rates were thereafter raised higher than the initial reduced rates, following efforts by both the buyer and target to lobby for change, the resulting increased rate was “still less than half of the historic rate.” In rejecting the buyer’s claim that an MAE had occurred as a result of the reduced Medicare reimbursement rates, the court suggested a number of takeaways that are worthy of note.
First, in responding to the target company’s argument that the decrease in Medicare reimbursement rates could not be an MAE because “the risk of a change in reimbursement rates was not ‘unknown’ at the time the parties signed the Agreement,” the court acknowledged that, in IBP, Inc., the case from which all Delaware MAE law derives, then-Vice Chancellor Strine had referred to an MAE clause as being “best read as a backstop protecting the acquiror from the occurrence of unknown events.” Nonetheless, echoing Professor Robert T. Miller’s argument, the court suggested that, in context, what then-Vice Chancellor Strine was referring to by “unknown events” was “unspecified risks or events.” And because, in Bardy Diagnostics, “the parties structured the MAE definition to incorporate carve-outs and exclusions to allocate risk” (unlike the MAE clause in IBP, Inc.), “[t]he Agreement allows no room for [the target company’s] argument than an ‘event’ under the Agreement’s MAE can only be an unanticipated event.” In other words, by identifying specific risks and exclusions in the MAE definition, there was no basis for invoking “the theoretical underpinnings of the typical MAE regime.” Instead, the MAE definition actually bargained-for would be enforced “as written.” If the parties wanted to limit the events that could give rise to material adverse effect to only those events that were unknown at the time the merger agreement was signed, the parties should have written the MAE clause “to only include ‘unknown facts, events, changes, effects or conditions[;] [i]nstead] they chose to adopt a broadly-worded general MAE and qualify that language with a list of carve-outs.”
Second, while the court was prepared to assume that the Medicare reimbursement rate decrease “would reasonably be expected to have a material adverse effect on [the target company] at the time [the buyer] refused to close the Merger,” the buyer failed in its efforts to prove “durational significance” respecting that material adverse effect because the court found, based on expert testimony, that there was a reasonable basis to assume that the reimbursement rate would be meaningfully revised upwards within a commercially reasonable period of time (i.e., within the next two years). And, “it is insufficient to show the effect of the [decreased Medicare reimbursement rates] might be durationally significant, as ‘a mere risk of an MAE cannot be enough.’”
Third, although the court could have ended its analysis there and ordered the buyer to close the transaction, the court further noted that the general carve out for changes in Law (including “any Health Care Law”) specifically included Medicare reimbursement rates because they were a regulation or rule promulgated by a governmental body or a “contractor engaged by a governmental body.” Consequently, even had the material adverse effect occasioned by the reduced reimbursement rates had durational significance, the carve-out for changes in law would have eliminated that material adverse effect from constituting an MAE.
Finally, in determining whether the disproportionality exclusion was effective to eliminate the impact of the changes in law carve out, the court noted that the companies that were designated for comparison for the purpose of the disproportionality exclusion were, according to the specific definition of MAE set forth in the merger agreement, only “other similarly situated companies operating in the same industries … as [the target].” Although there were many companies operating in the same industries as the target company, only one company operated in the same industries and was similarly situated to the target company—i.e., there was only one company that had similar relevant characteristics as the target company, which most importantly included a similar “product portfolio (i.e., relative product mix and sophistication).” And, as compared to that one company, there was no disproportionate impact from the reimburse rate decrease; the impact was essentially the same.
Here, according to the court, the target company, “a one-product company that operates in a high-growth, heavily regulated market, … bargained for a narrower, more target-friendly exclusion to the MAE carve-outs.” Importantly, as noted by the court:
The Agreement’s MAE clause … did not delimit the reach of the ‘disproportionate impact’ exception to companies operating in the same “market.” Rather, it required an assessment of whether the impact cause by ‘such matter’ was ‘materially disproportionate’ relative to ‘similarly situated companies operating in the same industries.’ In my view, that language calls for a more granular parsing of a company’s situation than a mere participation in the [long-term ambulatory electrocardiogram device] market.
The English MAE case, Travelport Limited v. WEX Inc.,  EWHC 2670 (Comm) (12 Oct., 2020), previously alerted M&A practitioners to the importance of carefully defining the universe of comparative companies for the purpose of a disproportionality exclusion. And the importance of the exact words used in an MAE clause cannot be overemphasized. As noted by the court in Bardy Diagnostics, “the words the parties agreed to in their contact [is] the best evidence of their intent.”
Bottom line, proving an MAE has occurred under Delaware law remains a heavy burden.
- Robert T. Miller, Material Adverse Effect Clauses and the COVID-19 Pandemic (May 18, 2020), U Iowa Legal Studies Research Paper No. 2020-21, 7, at n.30, available at SSRN here; Bardy Diagnostics, 2021 WL at *23, n. 225. Given the extent to which Professor’s Miller’s work has been cited by the courts, including in Bardy Diagnostics, practitioners would do well to note his overall theories concerning how MAE clauses should be analyzed. See Robert T. Miller, A New Theory of Material Adverse Effects (September 1, 2020), available at SSRN here.↵
- This approach to the concept of “unknown events” is also consistent with Vice Chancellor Laster’s approach in Akorn, Inc. v. Fresenius Kabi, AG, 2018 WL 4719347, at *60-62, *76-81 (Del. Ch. 2018), aff’d, 198 A.3d 724 (Del. 2018).↵
- In Travelport, the comparative companies for determining the applicability of the disproportionality exception to the MAE Carve-outs was not limited to the specialized travel-related payments market in which the target companies operated. By referring to “other participants in the industries in which [the target companies] operate” as the control group for making the comparison, a much broader group of companies is included than would have been had the control group been described as participants in the same “competitive markets,” “market sectors,” or “businesses” as the target companies. And Justice Cockerill specifically suggested that future drafters should specify what they mean by “industry” to avoid the result in this case. In this case, the court interpreted the clause as meaning the B2B payments industry, not just the travel-related B2B payments industry.↵
- This is not the first time we have had occasion to parse the language of an MAE clause. See Glenn West, The MAE Clause, Mrs. Palsgraf and Events “Arising From or Related To” MAE Exceptions, Weil’s Global Private Equity Watch, May 11, 2021, available here.↵
- See Glenn West, Richard Slack & Joshua Glasser, Just Because a Really Bad Thing Happens Does Not Mean a Material Adverse Effect has Occurred: Assessing the Latest Delaware MAE Decision, Weil’s Global Private Equity Watch, December 26, 2019, available here.↵