A recent decision in Ontario found that the COVID-19 pandemic could not be implied as a material adverse effect in Duo Bank’s attempt to withdraw from the purchase deal.
The December 2 Ontario Superior Court of Justice decision in Fairstone Financial Holdings Inc. v. Duo Bank of Canada is the first in Canada in which a court considered whether a purchaser could refuse to close in the context of the pandemic. The court weighed in on “MAE” clauses in an M&A context — and it’s not a surprising result to practitioners.
“Fairstone is a very important decision,” says John Clifford, a business law/M&A partner at McMillan LLP in Toronto — not for the result, which was “unsurprising,” but because “it’s the only decision we have in Canada that deals with MAE clauses” in the M&A context.
Previous cases dealing with MAE clauses have been in the context of bankruptcy, landlord-tenant or bank loan situations, says Bryan Haynes, a partner at Bennett Jones LLP in Calgary. “This is a very welcome development because [the decision] provides a very extensive overview of all of the various issues and analysis of relevant case law and then a pronouncement by the court on the principles that the Canadian courts should follow.”
Those principles are mainly in line with what the Delaware courts have laid down in the past, particularly in the landmark 2018 decision in Akorn Inc. v Fresenius Kabi AG, Haynes adds.
MAE clauses are a tool to protect buyers from developments that will cause a target business to be materially different at closing from what it was when the transaction agreement was signed. Still, they are not intended to protect against any future business risk. “Carveouts” from the MAE definition in a share purchase agreement are matters specifically deemed not to be an MAE.
On Feb. 18, 2020, Duo Bank of Canada had agreed to purchase Fairstone Financial Holdings Inc. and its subsidiaries. Fairstone is Canada’s largest consumer finance company, targeting near-prime borrowers. The closing was scheduled for June 1, although the share purchase agreement provided an extended closing up to Aug. 14.
On May 27, 2020, Duo advised Fairstone that it would not be closing on June 1. It claimed that the MAE clause and other protections were triggered by the COVID-19 pandemic, giving Duo the right not to complete the transaction. It also charged that actions taken by Fairstone in response to the pandemic constituted a breach of the “ordinary course” covenant in the SPA. In response, Fairstone brought an application for specific performance.
The court was asked to consider whether Duo Bank could abandon the transaction without penalty based on its allegations that the pandemic had a material adverse effect on the target business or that Fairstone’s operational responses to the pandemic constituted a breach of a covenant requiring Fairstone to operate in the ordinary course until closing.
Justice Markus Koehnen looked at the MAE carveouts in the SPA, which excluded material adverse effects caused by (i) worldwide, national, provincial or local conditions or circumstances, including emergencies, crises and natural disasters; (ii) changes in the markets or industry in which Fairstone operates; and (iii) the failure of Fairstone to meet any financial projections.
“Three carveouts are relevant here,” said Koehnen in his reasons. “The carveout for MAEs caused by emergencies, those caused by changes to the markets or industry in which Fairstone operates and those caused by Fairstone’s failure to meet financial projections.”
“What the court said here was, ‘sure, [the pandemic] was a material adverse effect, but it was pulled out” of the MAE clause, says Clifford. “An exception was created because the agreement had language about local emergencies and changes in the markets in which Fairstone operates. And that’s exactly what happened” in the COVID-19 pandemic.
The court in Fairstone reached a different conclusion to that in the recent decision in AB Stable VIII LLC v MAPS Hotels and Resorts One LLC, which allowed the buyers to walk away from the deal. The AB Stable facts were very different from those in Fairstone, with “unbecoming behaviour” by the target company, including some history of alleged fraud, says Haynes.
Regardless, the behaviour of both parties will be scrutinized by courts. In Fairstone, although there was nothing illegal or unbecoming in the buyer’s behaviour, “you could sense through reading the judgment that the judge felt that the buyer was behaving through the process to try to justify its termination . . . perhaps pulling the trigger too quickly to terminate the transaction,” Haynes continues.
“That’s something that you can’t really articulate as a principle, other than act in good faith, be honest in your dealings. Those are principles that the courts have laid down, [and] the reality of who the parties are and how they behave does impact on decisions. . . . It’s one of those factors that is important.”
As well, he says, “In all these cases, it’s important to understand these are factually specific and contextual cases. . . . Each case is very different, decided on its own merits.”
Interim operating covenants and the ordinary course of business
Interim operating covenants (or ordinary course covenants) in M&A agreements regulate the business operations of a target company between the signing and closing of a deal, providing protections to sellers and buyers.
In response to the pandemic, Fairstone took a variety of actions: It closed some of its branches, changed its collection processes, its employment policies and its accounting methods. Duo alleged that, among other things, Fairstone changed its accounting practices in violation of the ordinary course covenant. Therefore, it was not continuing to operate in the ordinary course of business.
Since Fairstone had breached the ordinary course and access to information covenants, Duo claimed, Duo was entitled to terminate the transaction.
But Koehnen rejected Duo’s claim that Fairstone breached the covenant by taking “steps to reduce expenditures and tighten lending requirements. . . . All changes Fairstone made were also consistent with past practices in that they allowed Fairstone to continue its normal day-to-day business operations of lending to consumers, managing the consumer loan portfolio and collecting on its consumer loan portfolio.”
Instead, the judge adopted the contextual approach used in Akorn, in which the Delaware Court of Chancery adopted a standard that “would give the purchaser an exit only if the breach were so material that it went to the root or essence of the contract.”
In times of economic disruption, Koehnen wrote, “the concept of ordinary course is more faithfully interpreted by comparing what the business has done in similar economic circumstances to what it is doing now or by comparing what the business is doing now to what other businesses are doing. . . .
“If . . . the business takes prudent steps in response to an economic contraction, that have no long-lasting effects and do not impose any obligations on the purchaser, it should not be seen to be operating outside of the ordinary course. To hold otherwise risks turning the ordinary course covenant into a guarantee of local or national economic performance over which the seller has no control.”
In Fairstone, “the judge clearly thought that the purchaser was trying to use the ordinary course of business as a back door” to exit the agreement, says Vincent Mercier, a partner at Davies Ward Phillips & Vineberg LLP in Toronto. This situation differed from the Delaware Court’s decision in AB Stable, which found a violation of the ordinary course covenant because Strategic Hotels & Resorts LLC made “extraordinary” changes to its business in response to COVID-19. Fairstone’s business changes in response to COVID, on the other hand, were modest and consistent with past practice.
Cineplex’s case against the U.K.’s Cine-world is expected to be litigated in the fall, with Cineplex seeking damages for the U.K. company’s aborted acquisition in June that could exceed the $2.18 billion outstanding on the deal.
The judge in the Cineplex-Cineworld case will have the latitude to follow either Fairstone or AB Stable, depending on the facts, Mercier adds. “People won’t want to take it for granted that a court will apply Fairstone in all cases,” he says, notwithstanding that Fairstone was decided in Ontario, where the Cineplex-Cineworld case will also be heard.
Lessons for drafting contracts
The pandemic has brought to the fore the importance of MAE clauses. One result is that parties to transactions will scrutinize and negotiate these clauses more than ever, says Haynes. “The pandemic has shown that these clauses can no longer be boilerplate.”
If parties don’t like the allocation of risk in a SPA, “they need to change the clauses.” Even carveouts will become highly negotiated, Haynes predicts, with parties even negotiating “exception to exceptions.”
“You’ll see much more explicit language in your acquisition agreements that deal with the interim covenant and what it means to operate in the ordinary course,” says Clifford. Not only do facts matter, he adds, but “words matter; the courts only interpret what they can see and what they read.”