Authors: Gesta Abols, Co-Leader U.S. Practice and Brad Moore, Partner, Fasken.
The COVID-19 pandemic threw a wrench into a large number of mergers entered into in late 2019 and early 2020. Not surprisingly, some buyers wanted to walk away or renegotiated their deals. Out of those challenges, two important court decisions emerged in Canada that, for the first time, addressed the meaning of a “Material Adverse Change” and what the typical covenant by the target to act in the “ordinary course of business” really means. The courts also addressed whether a target can recover the lost premium the shareholders would have received if a transaction closed.
Material adverse change and material adverse effect clauses (collectively referred to as a “MAC”) and ordinary course of business covenants are found in a wide variety of agreements, most often in the M&A context.
Where the target has suffered a MAC before closing, the buyer can typically walk away from the transaction without penalty or legal exposure. Ordinary course of business covenants are similarly intended to protect a buyer from a major transformation in the seller’sbusiness between signing and closing. These covenants require a seller to continue to conduct its business “in the ordinary course”.
Before the decisions in Fairstone Financial Holdings Inc. v Duo Bank of Canada and Cineplex Inc. v Cineworld Group plc, there was virtually no case law in Canada on what constituted a MAC. Practitioners turned to the United States for guidance, and the Delaware Courts in particular, but it wasn’t clear if those cases would be adopted by courts in Canada.
Fairstone Financial Holdings Inc. v Duo Bank of Canada is Canada’s first MAC decision. Regarding what constitutes a MAC, the court adopted the Delaware definition of a MAC and its three key elements: (1) the occurrence of an unknown event (2) a material threat to overall earnings potential of the target and (3) durational significance.
At “first blush”, the court found there was a MAC as a result of the pandemic. However, the MAC clause in the Agreement contained typical carveouts excluding material effects caused by emergencies (geographical or circumstantial), changes in the market or industry, and missed financial projections, forecasts or estimates. The court concluded that each of these carve-outs were present, the related risks were assumed by the purchaser, and Fairstone was not reasonably expected to be disproportionately affected by the pandemic relative to others in its industry. Therefore, there was no MAC as defined in the Agreement.
The Agreement also contained a covenant that required Fairstone to act in a manner consistent with its past practices between signing and closing. The court rejected Duo’s claim that Fairstone breached this covenant, finding the steps Fairstone put in place after the pandemic was declared were consistent with steps it had put in place during past recessions or that would be expected of similarly situated businesses. This interpretation was seemingly motivated by a reluctance to provide Duo the right to walk away given that it found that Duo assumed the risks associated with COVID-19 in its analysis of the MAC definition.
The decision in Cineplex v Cineworld followed shortly thereafter. In December 2019, Cineworld Group plc (“Cineworld”) entered into an agreement with Cineplex to acquire all its issued and outstanding shares for $2.8 billion.
The Court relied on the definition of a MAC as set out in Fairstone and the Delaware decision in Akorn v Fresenius Kabi, and excluded effects caused by “outbreaks of illness” from the definition. The Court also noted that the ordinary course covenant must be read in the context of systemic risks assumed by the buyer. Interim covenants – such as the ordinary course covenant – address the manner in which the seller is to operate its business during the period between signing and closing. What is in the ordinary course of business is a flexible and contextual concept.
Cineplex sought to recover the value of the consideration that would have been payable to its shareholders had the transaction been completed, less the residual value of the shares on the termination date. The court rejected this measure of damages because Cineplex, as the contracting party, could not recover the losses of the shareholders that are only third-party beneficiaries to the contract in similar fashion to the New York Second Circuit’s decision in Consolidated Edison Inc. v Northeast Utilities.1Instead, the court elected to award damages in the amount of $1.2366 billion based on “loss of synergies”. The court concluded that the lost synergies were Cineplex’s own losses as a result of Cineworld’s termination, and that those synergies would have been realized had the transaction been completed. The award was intended to put Cineplex in the position it would have been in had Cineworld closed the transaction.
Cineworld has since appealed the “loss of synergies” aspect of the decision, which will be watched closely moving forward. In the meantime, practitioners may want to consider negotiating for the lost premium, or the “benefit of the bargain” in public M&A agreements.
Key Takeaways
Canada now has two MAC cases that provide valuable guidance as to how Canadian courts will interpret MAC carveouts and ordinary course covenants. The determination of whether there has been a MAC will always be highly fact-specific, but it would appear that Canadian courts will be fairly reluctant to let buyers walk away from merger agreements. While Canadian courts have adopted the Delaware definition of a MAC, the courts in Fairstone and Cineplex depart from the US law in their interpretation of the ordinary course covenant. In Canada, the ordinary course is interpreted by comparing what the business has done in similar economic circumstances and as compared to similar businesses. In the US, the courts interpret the covenants more narrowly with the focus being on past practices of the company itself.2 Moving forward, practitioners may look to revisit how “ordinary course” is defined in merger agreements.
For more information, please visit Fasken online at www.fasken.com.
The authors would also like to thank and acknowledge the contributions of Montana Licari in preparing this note.
1 426 F.3d 524 (2d Cir 2005).
2 AB Stable VIII LCC v MAPS Hotels and Resorts One LLC held that the seller breached the ordinary course covenant and the buyer could not be forced to close. The breach was based on the seller significantly altering its business in response to COVID-19 and acting in an unprecedented manner by closing two of its hotels, limiting the operations of others, and laying off or furloughing 5200 full time employees. The resulting business would have been inoperable and not what the buyer initially bargained for.