On July 9, 2021, the Delaware Court of Chancery (the “Court”), in Bardy Diagnostics, Inc. v. Hill-Rom, Inc., C.A. No. 2021-0175-JRS, denied the attempt by Hill-Rom, Inc. (“Hill-Rom”) to walk away from a $375 million merger with Bardy Diagnostics Inc. (“Bardy”) claiming a material adverse effect (“MAE”) had occurred following a surprisingly drastic 86 percent reduction in the Medicare reimbursement rate for Bardy’s sole marketed product during the interim period between signing and closing. In its analysis, the Court applied the prima facie elements for determining whether an event constitutes an MAE. Most notably, the Court (1) expanded on Delaware precedent that a purchaser seeking to terminate a signed acquisition agreement on account of an MAE must prove by a preponderance of the evidence that the event in question was “durationally significant” and (2) narrowly applied the “disproportionate effect” exception to the carve-outs of the MAE definition that would have allowed Hill-Rom to avoid closing if the event had been found to have a disproportionate effect on Bardy relative to similarly situated companies operating in the same industries. Despite acknowledging that the attempted Hill-Rom termination was not the typical case of “buyer’s remorse” and likening the hit that the rate reduction had to Bardy’s prospective earnings as a “Tyson right uppercut,” the Court declined to find that an MAE occurred and granted Bardy’s request for specific performance to force Hill-Rom to close the merger.
In January 2021, Hill-Rom, a public medical technology company, began pursuing an acquisition of the medical device startup Bardy. Bardy’s appeal was its best-in-class ambulatory electrocardiogram device, a patch marketed as the Carnation Ambulatory Monitor (“CAM”).
Bardy’s largest revenue outlet was servicing Medicare patients, representing 29 percent of Bardy’s revenues. Before January 2021, CAM devices were reimbursed at a temporary rate of $365 per patch, and this rate served as the basis for the $375 million negotiated purchase price. Both parties understood that the reimbursement rate was subject to change as the product moved to a more permanent rate, although neither viewed the risk of a drastic rate shift as substantial. In order to address the uncertainty of the pending rate change, the parties agreed to an earn-out mechanism that would adjust the ultimate purchase price based on Bardy’s future revenue. The parties entered into a definitive merger agreement on January 15, 2021.
Following the signing of the merger agreement, on January 29, 2021, the more permanent rate was announced. The reimbursement rate fell from $365 per patch to a shockingly low $46.68 in Texas and $49.70 in New Jersey—the two markets where Bardy operates facilities.1 On February 21, 2021, just three days before the merger was scheduled to close, Hill-Rom gave Bardy notice that certain conditions to closing were not satisfied due to the MAE that it believed resulted from the rate change.
A week later, Bardy filed a complaint seeking specific performance, compensatory damages and prejudgment interest as a result of Hill-Rom’s alleged breach of the merger agreement by failing to close. Hill-Rom counterclaimed for a declaratory judgment that its obligation to close was excused because the rate decline constituted an MAE under the merger agreement.2
The MAE definition and burden of proof
The ruling rests heavily on a strict reading of the MAE definition set forth in the merger agreement. The MAE definition is a typical one for a heavily negotiated transaction with (i) a general statement of what constitutes an MAE, (ii) carve-outs of certain types of events that would otherwise give rise to an MAE and (iii) exceptions to the carve-outs. The following is an excerpt of the portions of the definition that the Court found relevant to its analysis:
“Company Material Adverse Effect” means any fact, event, circumstance, change, effect or condition that, individually or in the aggregate, has had, or would reasonably be expected to have a material adverse effect on . . . the Business of the Acquired Companies, taken as a whole; provided, however, that . . . none of the following, alone or in combination, will constitute, or will be considered in determining whether there has occurred, and no event, circumstance, change, effect or condition resulting from or arising out of any of the following, alone or in combination, will constitute, a Company Material Adverse Effect: . . .
(ii) any condition or change in economic conditions generally affecting the economy or the industries or markets in which the Acquired Companies operate (including increases in the cost of products, supplies, materials or other goods purchased from third party suppliers); . . .
(v) any change in any Law (including any COVID-19 Measures and any Health Care Law) or GAAP or any interpretation thereof; . . .
provided, that, with respect to a matter described in any of the foregoing clauses (ii)-(vii), any such fact, event, circumstance, change, effect or condition may be taken into account in determining whether or not there has been a Company Material Adverse Effect to the extent such matter has a materially disproportionate impact on the Acquired Companies as compared to other similarly situated companies operating in the same industries or locations, as applicable, as the Business.
As a preliminary matter, the opinion explained how the burden of proof shifts between the parties—the purchaser bears the initial burden to prove by a preponderance of the evidence that the seller suffered an effect that was material and adverse; upon the purchaser satisfying that burden of proof, the burden shifts to the seller to prove by a preponderance of the evidence that the source of the effect fell within a carve-out to the definition of MAE set forth in the merger agreement; and, assuming the target is able to do so, the purchaser then has to prove by a preponderance of the evidence that the exclusion to the carve-outs applies.
Does the event have a material adverse effect?
First, the Court considered whether Hill-Rom proved that the rate decline had or would reasonably be expected to have an effect sufficiently material and adverse on Bardy as to constitute an MAE. In analyzing whether Hill-Rom had met its burden of proof, the Court recognized that there is no “bright-line test” to apply in such circumstances and reiterated the well-established principle that the Court would evaluate “whether there has been an adverse change in the target’s business that is consequential to the company’s long-term earnings power over a commercially reasonable period,” or, to put it in other words, the event “substantially threatens the overall earnings potential of the target in a durationally‑significant manner, as opposed to causing only a short-term hiccup in earnings” from the perspective of a “reasonable acquirer.” Summarizing this into the prima facie elements, the Court stated that Hill-Rom needs to prove that, at the time Hill-Rom invoked the MAE clause, (1) the effect of the rate decline on Bardy’s earnings potential would reasonably be expected to constitute an MAE and (2) the rate decline would reasonably be expected to endure for a durationally significant period.
In its analysis, the Court assumed that the first element was satisfied and focused on the durational significance element. The Court determined that Hill-Rom failed to prove that the rate decline would irrevocably impact Bardy’s earning potential for a durationally significant period of time given that the process of rate setting is very unpredictable and the rate could increase within a commercially reasonable period. Importantly, the Court made clear that it was insufficient for Hill‑Rom to prove that the effect of the rate decline “might” be durationally significant, as “a mere risk of an MAE cannot be enough.” Because Hill-Rom failed to prove that it reasonably would have expected that there would not be a meaningful increase in the reimbursement rate in the future, it failed to satisfy the durationally significant element.3
Having found that Hill-Rom failed to meet its initial burden to prove by a preponderance of the evidence that Bardy suffered an effect that was material and adverse, the Court could have concluded its analysis; however, for the sake of completeness, the Court continued on to consider whether Bardy had established whether one of the carve-outs to an MAE applied.
Does the event fall under the change in law carve-out?
The Court noted that the MAE definition in the merger agreement explicitly carved out a change in “Health Care Law” from any event that might constitute an MAE, where “Law” is broadly defined as any regulation or rule issued by any governmental body, including any authorized contractor engaged by any governmental, legislative, executive or judicial agency or regulatory body. Finding that Bardy had proved that the rate setting procedure fell under the “Health Care Law” carve-out, the Court considered whether Hill-Rom proved that the exception to the carve-outs should apply.
Does the change have a materially disproportionate impact on the target compared to other similarly situated companies operating in the same industries or locations?
Considering the exception to the above “Health Care Law” impact carve-out for any change that has a materially disproportionate impact on Bardy compared to other similarly situated companies operating in the same industries or locations, the Court noted that the merger agreement does not provide much guidance on determining “similarly situated companies operating in the same industries or locations.” The Court stressed the difference between the wording of the exception at hand and the wording of the exception from prior Delaware case law (e.g., “as compared to other participants in the industry in which the [target and its subsidiaries] operate . . . .”). Based on several factors (namely revenue, developmental maturity and, most importantly, product portfolio), the Court found that there was only one similarly situated company and that the new rate did not disproportionately impact Bardy compared to this sole similarly situated company. Therefore, the Court held that Hill-Rom had not met its burden to prove that the exception to the carve-out should apply.
For the reasons described above, despite the soured appeal of the acquisition, the Court rejected Hill-Rom’s claim that an MAE occurred4 and granted Bardy’s claim for specific performance and prejudgment interest on the deal price.5
The ruling reaffirms the Delaware court’s strong reluctance to find that events constitute an MAE, thereby absolving purchasers of their obligations under signed acquisition agreements. Purchasers are expected to assume a certain level of risk in any M&A transaction and will be held to the negotiated limits of the MAE definition. In light of Bardy v. Hill-Rom, we expect that MAE clauses will continue to be heavily negotiated. In particular, we anticipate that dealmakers will focus on (1) whether to use broadly defined terms in the MAE definition (e.g., the carve-out for changes in “Law”) and (2) the wording of the disproportionate impact exception to any carve-outs (e.g., parties may try to define with specificity what is meant by “similarly situated companies” or “comparable entities” or “other participants in the industry” that should serve as barometers for the applicable analysis). Additionally, purchasers may begin to request specific closing conditions to address known risks associated with a particular transaction (such as a clear walk right if the pending rate change resulted in a “permanent” rate below a certain amount) rather than relying on closing conditions tied to an MAE as a potential escape hatch.
2 Hill-Rom separately sought to assert the common law doctrine of frustration of purpose by arguing that the value of Bardy is so diminished that the acquisition’s essential purpose, “to acquire something of value,” is correspondingly diminished.
3 The Court noted that, in the period between Hill-Rom’s initial notice of termination and the Court’s opinion, the applicable authorities had already increased the rate to $133 per patch in April 2021.