The Delaware Chancery Court recently issued an opinion that confirms the difficulty of successfully invoking a “Material Adverse Effect” (“MAE”) clause in a merger agreement. In particular, the decision underscores the challenges of proving up an MAE — particularly when the target company is in a highly regulated industry — and provides useful guidance for drafting disproportionality exclusions in an MAE clause.
The case involves a merger between Hill-Rom (“Hillrom”) and Bardy Diagnostics, Inc. (“Bardy”), a startup medical device manufacturer. Hillrom pulled out of the deal after a sharp, unexpected drop in the regulated Medicare reimbursement rates for Bardy’s sole medical device, a portable heart-monitor patch. For years, government-set Medicare rates had stayed steady at $365 per patch. While Hillrom and Bardy were negotiating the merger agreement, there were signs that the government might even raise the rate by another $100. But just weeks after the parties entered into the final merger agreement, the entity with rate-setting authority sent the rate for Bardy’s patches plummeting to just under $50 per patch. This was an 86% drop from the historic rate of $365 per patch, and meant that Bardy could not profitably serve Medicare customers.
The new rate caught both Hillrom and Bardy entirely by surprise. Both joined a full-court press with others in the industry to convince the rate-setting authority that the $50/patch price was mistakenly low. In response, the authority raised the rate to between $100 and $130 per patch. That was an improvement for Bardy, but still nearly 65% under the historic rate. Hillrom invoked the MAE clause in the merger agreement, and Bardy sued Hillrom in Delaware Chancery Court, seeking specific performance to force Hillrom to close the merger, as well as compensatory damages for failing to close as promised. The parties took the case to trial.
In an opinion by Vice Chancellor Slights, the Delaware Chancery Court agreed with Bardy that the rate drop was not an MAE under the contract, and ordered specific performance of Hillrom’s obligation to close the merger deal. The Court denied Bardy’s request for compensatory damages.
First, in holding that the drastic rate drop was not an MAE, the Bardy Court held that the rate drop did not have a “material adverse effect” on Bardy because Hillrom failed to prove that it was “durationally significant,” i.e., that the rate drop threatened Bardy’s long-term earnings over a “commercially reasonable period.” The Court held that Hillrom did not meet its burden of proof to show that the unexpectedly new low rate would remain at that level for more than two years. After all, the rate-setting authority had historically set rates much higher for the heart-monitor patches, and it was and would be under pressure to raise rates given that the new lower rates might price patch manufacturers like Bardy out of serving Medicare patients. The facts seemed to suggest that the aberrantly low rates were exactly that: a temporary dip that would soon snap back to the higher historical baseline.
Second, as an alternative ground, the Court held that even assuming the adverse effect of the rate drop was “durationally significant,” it could not qualify as an MAE under the contract because changes in law were carved out from the MAE definition. Under the merger agreement, a change in any “Health Care Law” cannot be an MAE. The Court held that the regulated rate met the definition under the merger agreement.
Third, assuming the materially adverse rate drop was “durationally significant” but was excluded from being an MAE because it was a change in a “Health Care Law,” it could nevertheless qualify as an MAE if the rate drop had “a materially disproportionate impact on [Bardy] as compared to other similarly situated companies operating in the same industries or locations.” The trouble for Hillrom was that Bardy was a sole-product manufacturer of a niche medical device with few competitors. The Court found that only one company was “similarly situated” to Bardy — another manufacturer of a similar heart-monitor patch product — and the rate drop had substantially the same effect on this competitor as it had on Bardy. So even if the Bardy Court had found that the rate drop met the initial definition of an MAE, it would not be saved from the “Health Care Law” carve-out because the drop in rates did not hurt Bardy any more than a company offering the same type of product, subject to the same rates.
There are a number of lessons from the Bardy opinion. Among them are that when seeking to invoke an MAE as a result of an unexpected and dramatic change in the regulatory environment, a party may face a dilemma: the very evidence necessary to show that the event is dramatic and unexpected may also show that the event will not become the “new normal” and could instead be reversed by a course-correcting regulator after lobbying and public backlash. As the Bardy Court stressed, the only change that Hillrom relied on was the reimbursement rate, but the evidence showed that “the way in which [the regulator] arrived at that rate is unclear; it revised the rate once in dramatic fashion and continues to engage in conversations concerning flaws in its pricing methodology.” As such, Hillrom had not met its burden of proof. As the Bardy Court explained, it was insufficient to show that the impact of the new rates “might be durationally significant, as a mere risk of an MAE cannot be enough.” (emphasis in original; cleaned up).
In addition, Bardy suggests that MAE clause drafters should pay careful attention to defining the target’s peer group of companies for purposes of expanding the MAE definition to include disproportionate effects on the target. In Bardy, the parties used the term “similarly situated” to define the universe of comparable companies. By contrast, other litigated MAE cases involved broader language, such as “comparable entities operating in the same industry.” As the Bardy Court emphasized, the specific language chosen by the parties is critical, and the use of the limiting phrase “similarly situated” here called for a “more granular parsing of a company’s situation than mere participation in the [relevant] market.” That meant, as a practical matter, the impact of the regulatory changes on Bardy would be measured against only one other company that, unsurprisingly, was also significantly impacted by those changes. Narrowly defining the peer group means that many adverse effects, particularly regulatory changes, may never be disproportionate enough to qualify for an MAE disproportionality clause.