Since the outbreak of the COVID-19 pandemic, there has been a wave of cases in Canada and the United States where buyers have sought to walk away from an acquisition. In justifying their decision not to close, buyers have invoked material adverse effect (“MAE”) clauses and covenants to carry on business in the ordinary course. The recent decision of the Ontario Superior Court of Justice in Fairstone Financial Holdings Inc. v. Duo Bank of Canada has established an important Canadian precedent for the interpretation of these commonly-found provisions in M&A transaction agreements. Interestingly, around the same time, the Delaware Court of Chancery released its AB Stable VIII LLC v. MAPS Hotels and Resorts One LLC decision, which also centered on a purchaser’s right to abandon an M&A transaction in the face of COVID-19. Since these types of disputes are typically settled before trial, these decisions offer some important takeaways. This article primarily focuses on the Fairstone decision and then compares it to the Court’s analysis in AB Stable.
The Fairstone Decision: Facts
In early 2020, Duo Bank of Canada (“Duo”) won a highly competitive auction to purchase Fairstone Financial Holdings Inc. (“Fairstone”), Canada’s largest consumer finance company for near prime borrowers. The share purchase agreement (the “SPA”) was signed on February 18, 2020, with the closing date set for June 1, 2020 and an outside date of August 14, 2020.
At the time of signing, the World Health Organization had already declared that COVID-19 was a "public health emergency" and the mounting pandemic only exacerbated Fairstone’s financial situation over the coming months. Duo ultimately communicated to Fairstone on May 27, 2020 that it would not be closing the transaction on the planned date of June 1, taking the position that it could abandon closing because the MAE clause and the ordinary course covenant had been breached. In response, Fairstone brought an application for specific performance.
Did the COVID-19 Pandemic Constitute an MAE?
The SPA included a closing condition that no MAE could occur between signing and closing. The definition of MAE in the SPA was fairly typical. It included any fact, circumstance, condition or occurrence that has (or would reasonably be expected to have) a material adverse effect on Fairstone’s business, operations, or condition (financial or otherwise). The definition then went on to identify a number of carve-outs; that is, circumstances or events that would be deemed not to be an MAE under the SPA. The carve-outs included:
- worldwide, national, provincial, or local conditions or circumstances, including emergencies and crises;
- changes in the markets or industry in which Fairstone operates; and
- the failure of Fairstone to meet any financial projections.
The first two carve-outs were further subject to a disproportionate effects exception whereby the carve-out would not apply (and thus an MAE would occur) if the carve-out event had a materially disproportionate adverse impact on Fairstone compared to other players in its industry or market.
The Court ultimately found that although Duo had met its burden of proof to establish that there was an MAE, all three of the carve-outs applied and none of them had a materially disproportionate adverse impact on Fairstone relative to others in the industry or market. Accordingly, an MAE did not occur and the no MAE condition was satisfied.
The decision sheds light on several important considerations for the interpretation of MAE provisions:
- Issues of timing were clarified. The Court agreed with Fairstone that August 14, 2020, the outside date by which the transaction was to close, was the appropriate date to assess whether an MAE had occurred. Duo had argued that May 27, 2020 – the date that it gave notice that it would not close - was the appropriate date. The “outside date” was chosen by the Court because Duo made the strategic decision not to terminate the SPA before then to avoid a potentially significant damages claim by Fairstone and to reserve its ability to close. Had Duo formally terminated the SPA, the termination date would have been the proper assessment date.
A second timing-related issue addressed by the Court was the question of how far into the future a court should look to determine if a condition is reasonably expected to constitute an MAE. While the answer to this question will depend on the circumstances of the case, the Court underscored that the forward-looking period cannot be indefinite and the nature of the business to be acquired will play a role in this determination.
- Delaware case law can be influential in Canada, eh. Justice Koehnen affirmed the principle that MAE clauses are to be interpreted from the perspective of the party for whose benefit they were granted. He cited with approval case law from Delaware that sets out three requirements for an MAE:
- an event that is unknown when the agreement is signed;
- which is a threat to overall earnings potential; and
- which has “durational significance”.
Of particular interest, the Court concluded that while the existence of the pandemic was known at the time the SPA was signed, the effect of the pandemic was not. The effect was, therefore, the unknown condition.
- MAE clauses are not meant to protect purchasers against systemic risks. In finding that each of the three carve-outs applied, Justice Koehnen adopted a broad interpretation that supported the principle that MAE clauses are intended to allocate systemic risks to the purchaser, whereas company-specific risks are borne by the seller. Against this backdrop, the findings further highlighted that the MAE clause could have been drafted in a way that better protected the purchaser from exogenous risks like a pandemic, however the Court made a point not to afford either party protections they could have had but did not bargain for.
Were Fairstone’s responses to COVID-19 ordinary course?
The second issue the Court considered was whether Fairstone breached the ordinary course covenant, which required Fairstone to operate the business in the ordinary course between the signing of the SPA and the closing date. “Ordinary Course” was defined in the SPA as an action consistent with past practices and taken in the ordinary course of the normal day-to-day operations. The only way that Fairstone could forego this obligation was to obtain the consent of Duo, which could not unreasonably withheld.
Duo argued that Fairstone took various steps in response to the pandemic that violated the ordinary course covenant, namely that Fairstone made changes:
- to its branch operations;
- its collection process;
- its employment policies;
- its expenditures; and
- its accounting methods.
The Court disagreed and made the following key holdings in reaching this conclusion:
- The interpretation of the ordinary course covenant warrants a contextual analysis. The Court rejected Duo’s submission that Fairstone’s conduct during the pandemic ought to be compared to its conduct before the pandemic. Instead, a contextual approach was applied whereby the Court found that in the face of an economic contraction, it was more appropriate to look at what Fairstone had done in similar economic circumstances or what other businesses were doing. Although it was deemed in the ordinary course of any business to respond to economic downturns, the magnitude and the duration of the response factored into the Court’s analysis. The Court concluded that, in response to an economic contraction, if a business takes prudent steps that have no long-lasting effects and do not impose any obligations on the purchaser, such steps fall within the realm of ordinary course operations.
- The purpose of the ordinary course covenant is to protect a buyer against company-specific risks and moral hazard. The Court’s interpretation of the ordinary course covenant in light of this purpose sought to evaluate whether Fairstone’s conduct was pursued in good faith for the purpose of continuing the business, as opposed to changing it. The Court found that none of the actions taken by Fairstone in response to the pandemic fundamentally changed its business. Fairstone’s responded to the pandemic with the aim of preserving normal operations, as much as possible. Conversely, if a seller is responding to economic challenges that are unique to the target business or is behaving opportunistically, then a Court will be hard-pressed to find that such conduct falls within the ordinary course.
- Obtaining the purchaser’s consent to operate outside of the ordinary course may not be required if withholding such consent would be unreasonable. The SPA allowed Fairstone to operate outside of the ordinary course if it obtained prior written consent from Duo, which Duo could not withhold unreasonably. The Court found that Fairstone did not need to seek Duo’s consent because it was operating within the ordinary course. However, the Court went further and determined that even if Fairstone’s conduct fell outside of the ordinary course, Duo would have had to provide its consent because it would have been unreasonable to withhold consent in the circumstances. The inclusion of a reasonableness standard left it to the Court to ultimately decide whether or not obtaining the purchaser’s consent was just a legal formality. It remains to be seen how similar clauses will be interpreted in subsequent decisions.
A different approach in AB Stable
The AB Stable litigation stemmed from a September 2019 agreement of Mirae Asset Financial Group (“Mirae”) to acquire Strategic Hotels & Resorts (“Strategic”), a luxury hotel portfolio. The transaction was set to close in April 2020; however, Mirae provided notice to the seller, a subsidiary of Anbang Insurance Group (“Angbang”), that it was not required to close. Mirae asserted that Strategic’s business had suffered an MAE due to COVID-19 and Angbang had breached its covenant to ensure Strategic continued to carry on its business in the ordinary course between signing and closing by reason of the changes that Strategic made to its business to respond to the COVID-19 pandemic. Angbang sued Mirae to compel it to close.
Vice Chancellor Laster found that the COVID-19 pandemic did not result in an MAE on the target business because the consequences of the pandemic fell within the plain meaning of the carve-out to the MAE definition for “natural disasters and calamities.” However, the Vice Chancellor found that Angbang made significant changes to Strategic’s business to respond to the pandemnic and that these changes were not undertaken in the ordinary course of business, in breach of Angbang’s covenant in the merger agreement to operate Strategic’s business in the ordinary course between signing and closing. As result of that breach, Mirae could avoid closing.
Below is a summary of critical findings from the decision and how they compare to the Ontario Court’s approach in Fairstone:
- Baseline assumptions of risk allocation warrant a broad interpretation of the MAE clause. Because the structure of a typical MAE definition (as described above in the Fairstone SPA) shifts systemic risks to a purchaser, it made sense to read the “calamity” exception as shifting the systemic risk of a global pandemic to Mirea. This reasoning supported the Court’s rather expansive interpretation of the plain meaning of “calamities” and it mirrors the broad reading of MAE carve-outs taken by the Court in Fairstone. Both decisions also suggest that deviations from the underlying assumptions of risk allocation should, therefore, be explicit.
- The Delaware Court’s analysis of the ordinary course covenant largely relied on the specific contractual language in the merger agreement. In response to COVID-19, Angbang took various actions that included closing hotels, severely limiting operations of other hotels, and reducing its staff. While acknowledging that these changes were “reasonable responses to the pandemic,” the Court viewed inclusion of the word only in the ordinary course covenant – i.e. Strategic was to conduct its business “only in the ordinary course consistent with past practices” (emphasis added) - as creating a standard that looked exclusively at how the target business was operated before and after entering into the merger agreement. The Court in AB Stable rejected the kind of contextual analysis undertaken by the Ontario Court in Fairstone and concluded that the steps taken by Angbang “departed radically” from Strategic’s routine operations. The AB Stable decision highlights that the flexibility to respond to extraordinary events must be drafted into the ordinary course covenant, whereas the Ontario Court’s analysis in Fairstone imported a degree of flexibility in its analysis.
- “Compliance with the notice requirement is not an empty formality.” Vice Chancellor Laster stated these words in support of his finding that Angbang was obligated to seek Mirae’s consent before operating outside of the ordinary course. The Court explained that notice allows a purchaser to protect its interests, such as proposing reasonable conditions to providing consent. Accordingly, if a purchaser’s consent is not granted, then a seller’s recourse is to sue the purchaser for unreasonably withholding its consent. This approach is in stark contrast to the conclusion reached by the Ontario Court in Fairstone where it held that in the circumstances, actions taken by the target in response to the pandemic, the purchaser could not have reasonably withheld its consent even if the seller had deviated from the ordinary course.
These decisions provide important guidance for Canadian and American M&A practitioners negotiating MAE clauses and ordinary course covenants. They are significant because in each respective jurisdiction, a court had not previously opined on this subject matter in the context of COVID-19. The Fairstone decision is also the first Canadian decision that approvingly cites a string of modern Delaware cases that generally have been viewed as being pro-seller.
The Court in Fairstone ultimately ordered the purchaser to specifically perform the SPA, and the purchaser completed the acquisition on January 5, 2021. Remedies were therefore not a major point of contention and we will have to wait for further Canadian judicial guidance on this point. Conversely, the Court in AB Stable ruled that the purchaser was entitled to a return of the deposit it paid plus interest, in accordance with the terms of the transaction agreement.
 John F. Clifford is a partner (and head of the Business Law/M&A Group) and Mikolaj Niski is as associate in the Toronto office of McMillan LLP.