Bardy Diagnostics v. Hill-Rom: New Lessons on Material Adverse Effect Clauses

Back in July, in Bardy Diagnostics, Inc. v. Hill-Rom, Inc., 2021 WL 2886188 (Del. Ch. July 9, 2021), the Delaware Court of Chancery (Vice Chancellor Slights) once again had to apply a “Material Adverse Effect” (“MAE”) clause to determine whether an acquirer was required to close an acquisition. As has almost always happened in the past, the court concluded that there had been no Material Adverse Effect within the meaning of the agreement between the parties. As a result, the court granted the request of the target, Bardy Diagnostics, Inc. (“Bardy”), to specifically enforce the agreement and ordered the acquirer, Hill-Rom, Inc. (“Hillrom”), to close the transaction. After initially saying it might appeal to the Delaware Supreme Court, Hillrom subsequently completed the merger.

In a paper recently posed on SSRN, I identify and discuss some important ways that the opinion in Bardy develops the law of MAEs. Most important, in my view, is that Bardy significantly affects how exceptions in MAE definitions will be applied. The reason relates to the basic structure of MAE definitions. That is, such definitions typically define the capitalized term “Material Adverse Effect” to refer to an event, fact, circumstance, etc. (for short, an “event”) that has, or would reasonably be expected to have, an (uncapitalized) material adverse effect on the target. Such definitions thus refer to two separate realities that are related as cause to effect. Now, by their plain terms, exceptions in MAE definitions apply to events, not effects, but, as I have argued in a recent article in the Journal of Corporation Law that, in applying exceptions in MAE definitions, the Court of Chancery has in dicta sometimes confused the events having material adverse effects on the company and the material adverse effects themselves, making the exceptions apply to an effect rather than the event causing it. Citing another article in which I had made the same point, the Bardy court expressly acknowledges the distinction between events and effects in the context of exceptions in MAE defintions and then consistently applies the distinction throughout the opinion. This suggests that the Court of Chancery will observe the distinction in future cases. As I argued in the Journal of Corporation Law article, this will significantly affect how exceptions in MAE definitions are interpreted and applied.

Second, Bardy contains important lessons about MAE Objects, the aspects of the company that the definition of “Material Adverse Effect” requires to be materially adversely affected. These objects are typically limited to the company’s business, financial condition and results of operations, but the agreement between Hillrom and Bardy substituted for these customary MAE Objects a bespoke defined term “Business.” The court’s treatment of this individually-negotiated language in place of the standard, boilerplate language is highly instructive: having considered the language in the definition of the term, the court construed it in a way that made it functionally equivalent to the boilerplate language. This confirms a long-unacknowledged trend in Delaware law of essentially ignoring the detailed list of MAE Objects and merely inquiring about the adverse effect of the alleged MAE on the value of the company as reasonably understood in accordance with accepted principles of corporate finance. This suggests that if parties intend anything other than this usual meaning, they need to express that meaning not with bespoke MAE Objects but with some wholly different concepts and language.

Third, the court in Bardy faced a situation in which, although the target’s cashflows had declined sharply after the agreement was signed, there was reason to believe that they might return to historical levels, at least in the medium term—a fact pattern in some ways similar to that in the seminal MAE case, In re IBP Shareholders Litigation. In that case, of course, then-Vice Chancellor Strine articulated Delaware’s doctrine that an (uncapitalized) material adverse effect must “substantially threaten the overall earnings potential of the target in a durationally–significant manner.” Applying this doctrine, some later cases have considered how long a period is required for a reduction in earnings to be “durationally significant,” with the court in Hexion stating that, in general, a material adverse effect must be “consequential to the company’s long-term earnings power over a commercially reasonable period, which one would expect to be measured in years rather than months.” By contrast, Bardy concerned not so much the period during which the target’s cashflows would be depressed but the probability that they would rebound to levels more consistent with historical ones, it being assumed that, if they rebounded at all, they would rebound relatively quickly and once they had done so, they would stay at historical levels indefinitely. Although the court thus focused on whether the reduction in cashflows would be “durationally significant,” I argue that the question would better be framed in terms of how the actual events of the case affected a reasonable understanding of the probability distribution of the company’s future cashflows and their present value. In the end, what matters is not, properly speaking, how sharply a company’s expected cashflows have been reduced nor how long they are expected to be reduced, but rather changes in the present value of all expected cashflows, which changes are based on changes in the probability distribution of such cashflows.

Finally, the court in Bardy interpreted a disproportionality exclusion qualifying exceptions in the MAE definition, thus providing guidance on two important issues related to such exclusions: first, which companies will form the control group against which the proportionality of the adverse effect on the target is measured, and, second, what it means to say that an otherwise excepted event will not be excepted “to the extent” that it has a disproportionate effect on the target. While agreeing that the court’s interpretation of the contract reflects the intentions of the parties, I show that the typical contract language, read literally, involves the same confusion of events and effects so common in discussions of exceptions in MAE definitions, and so I argue that drafters should replace the typical language with language that more accurately reflects the intentions of the parties.

The full paper can be found here.