COURT OF CHANCERY ORDERS SPECIFIC PERFORMANCE OF MERGER AGREEMENT, FINDING THAT FRAUD CONTAINED IN FDA FILINGS FOR APPROVAL OF TARGET PRODUCT DID NOT RISE TO A “MATERIAL ADVERSE EFFECT”

By: Annette Becker and Teresa Teng

In Channel Medsystems, Inc. v. Boston Scientific Corporation, C.A. No. 2018-0673-AGB (Del. Ch. December 18, 2019), the Delaware Court of Chancery ordered specific performance of a merger agreement, finding that breaches of the representations and warranties arising from the fraud of a key employee of the seller did not rise to the level of a “Material Adverse Effect.” As a result, the buyer was not entitled to terminate the merger agreement and breached the further assurances provision of the merger agreement by failing to meaningfully engage with seller upon seller’s discovery of the fraud.

On November 1, 2017, Boston Scientific Corporation, a Delaware corporation (“Boston Scientific”) entered into a merger agreement (“Merger Agreement”) for the acquisition of Channel Medsystems, Inc., a Delaware corporation (“Channel”), who had produced a medical device named Cerene used to treat heavy menstrual bleeding by ablating the uterine lining. A condition to closing required that Channel obtain approval for Cerene from the U.S. Food and Drug Administration (“FDA”). Cerene was a “Class III” product subject to the most stringent regulatory control by the FDA. The bring-down condition in the Merger Agreement contained a “bring down” of the representations at closing to a “Material Adverse Effect” standard, and Boston Scientific was entitled to terminate the Merger Agreement in the event of the failure of such condition.

After signing of the Merger Agreement, Channel discovered that its Vice President of Quality Assurance, Dinesh Shankar (“Shankar”) had engaged in a fraudulent scheme through use of falsified invoices and expense reports to steal approximately $2.6 million from Channel. Channel engaged a law firm to conduct an investigative process, a forensic accounting firm to conduct an audit and a healthcare regulatory and quality consulting firm (“Greenleaf”) to conduct an independent review. It was discovered during investigations that six reports provided to the FDA included information falsified by Shankar. By April 2018, the FDA confirmed that Channel had addressed all of the FDA’s concerns in relation to Shankar’s fraud and accepted Channel’s remediation plan. Boston Scientific did not express concerns regarding the effect of Shankar’s fraud on FDA approval when Channel initially disclosed the fraud in January 2018, and Boston Scientific continued its integration work in the several months following. Only after the FDA had accepted Channel’s remediation plan did Boston Scientific raise concerns regarding the report produced by Greenleaf, and in May 2018, Boston Scientific sent Channel a notice of termination on the basis of breach of representations in the Merger Agreement. Channel subsequently received FDA approval for Cerene in March 2019, several months ahead of the September 2019 deadline in the Merger Agreement.

In September 2018, Channel filed a complaint asserting that Boston Scientific breached the Merger Agreement by terminating without a valid basis and seeking specific performance of the Merger Agreement. The complaint also sought a declaratory judgment that Boston Scientific breached its obligations under the Merger Agreement and was not entitled to terminate the agreement, that no “Material Adverse Effect” (“MAE”) had occurred, and that Channel had not breached the Merger Agreement.

In its memorandum opinion post-trial, the court analyzed (i) whether Boston Scientific was entitled to terminate the Merger Agreement, (ii) whether Boston Scientific breached the further assurances provision in the Merger Agreement, (iii) whether Channel was entitled to specific performance and (iv) whether Boston Scientific was entitled to damages for its counterclaim of fraudulent inducement.

To determine whether Boston Scientific was entitled to terminate, the court examined the alleged breaches of the representations and whether such breaches rose to the level of a MAE. The court found that the representation that Channel was in material compliance with healthcare laws applicable to Channel and several related representations were inaccurate as of the signing date due to the six reports to the FDA containing falsified information.

The court subsequently analyzed whether such breaches rose to the level of a MAE. The operative language in the Merger Agreement permitting termination was premised on a failure of the representations and warranties to be true and correct that would reasonably be expected to result in a MAE. As an initial matter, the court found that the appropriate time at which to examine whether a MAE was reasonably expected to occur was from the vantage point of the date of actual termination and that as of such date, the MAE was reasonably expected to occur around the date of expected closing.

On the MAE standard, while Boston Scientific advocated for the disclosure-based standard of materiality which examines whether the fact in question would have been important to the acquirer’s decision to enter into the acquisition agreement, the court stated that such position was “devoid of merit” and that a higher standard as applied in Akorn, Inc. v. Fresenius Kabi AG was the appropriate standard.  Quoting from Akorn, the court stated a MAE required an effect that would substantially threaten the overall earnings potential of the target in a durationally-significant manner. The court further stated that while future occurrences where the effects have not yet been felt can qualify as a MAE, the mere risk of such occurrences is insufficient. The court then examined both the quantitative and qualitative evidence provided.

Regarding the qualitative evidence, given the FDA’s acceptance of Channel’s remediation plan, Boston Scientific could not argue that failure to receive FDA approval would be the relevant MAE at the time of termination. Instead, Boston Scientific argued that notwithstanding FDA approval, Cerene would need to be remediated and retested before going to market and that Shankar’s fraud would expose Boston Scientific to future products liability litigation, regulatory actions and competitive harm. The court found that such effects were either not objectively reasonable or unsubstantiated speculation.

On the quantitative significance and how Shankar’s fraud had impacted Channel’s value, the court noted that no bright-line test existed but again quoted Akorn in stating that any such decline must be “material when viewed from the longer-term perspective of a reasonable acquirer.” Boston Scientific provided expert testimony showing several models under which Channel’s value decreased between 24% to 54% due to delays in realizing cash flows for two to four years as a  result of the required remediation. While Channel agreed that shelving Cerene for two to four years would have a massive impact on Channel’s valuation, Boston Scientific showed no reliable basis that such a delay would occur. The court criticized Boston Scientific’s expert for failing to substantiate the inputs (including the two to four year delay) provided by Boston Scientific or to otherwise question whether such inputs were valid. As a result, the court found that Boston Scientific failed to provide quantitative evidence of a MAE and concluded that the breach of representations in the Merger Agreement failed to constitute a MAE.

The court found that Boston Scientific had breached the further assurances provision of the Merger Agreement and  completely failed to make meaningful attempts to confer with Channel once the fraud was discovered.  The court pointed to evidence that Boston Scientific was separately looking for a way out of the deal for unrelated commercial reasons.

Although the court noted that the specific performance provision in the Merger Agreement did not “tie the court’s hands” in determining equitable relief, the presence of such a provision showed the parties’ understanding that specific performance would be available. The court found that the equities weighed in Channel’s favor given Channel itself was a victim of the fraud, and acted in good faith to resolve the issue. In addition, Boston Scientific would receive the benefit of its bargain in performing the contract – an FDA-approved Cerene device. As a result, the court granted Channel’s request for specific performance.

On Boston Scientific’s claims that Channel fraudulently induced Boston Scientific into making certain investments into Channel prior to entry into the Merger Agreement, the court found that the allegedly false statements regarding Shankar’s qualifications were in fact true. Further, even if any of the statements were false, under the theory of corporate liability for the acts and knowledge of a company’s agents, the court pointed to the exception where an employee abandons the employer’s interests and acts solely to advance his own personal interest. The court concluded that Shankar’s fraud and theft constituted a total abandonment of Channel’s interests as Shankar’s actions did not benefit Channel. As a result, the court found there was no legal basis to impute Shankar’s knowledge to Channel.