The economic uncertainty that accompanied the emergence of the COVID-19 pandemic resulted in a notable increase in merger and acquisition (M&A) litigation, both actual and contemplated. At issue in almost all of these “busted deal” cases are one or both of two key contractual risk allocation mechanisms widely used in acquisition agreements: material adverse effect (MAE) clauses and interim covenants requiring the target business to operate in the “ordinary course.”
In Canada, litigation about MAE provisions has historically been very rare. However, in a precedent-setting decision released in late 2020, Fairstone Financial Holdings Inc. v. Duo Bank of Canada, the Ontario Superior Court of Justice ordered specific performance of the acquisition of Canada’s largest consumer finance business, Fairstone, by Duo Bank of Canada, rejecting Duo Bank’s argument that an MAE had occurred. The transaction closed in January 2021. Almost simultaneously with the release of the Ontario decision, the Delaware Court of Chancery released its first COVID-19 M&A decision, in AB Stable VIII LLC v. Maps Hotels & Resorts One, which reached the opposite conclusion and allowed the buyer to walk away from its transaction.
As discussed below, factual distinctions between the Ontario and Delaware cases played a role, as they always do, in producing different outcomes. That said, the divergent approaches taken by the courts to the interpretation of the ordinary operating covenants and their interplay with other risk allocation mechanisms in the agreements highlight the importance of a party’s conduct in the course of a transaction and the perception the court has about that conduct in its assessment of the parties’ rights and obligations.
The Fairstone Decision
On February 18, 2020, Duo Bank entered into an agreement to purchase the shares of Fairstone, Canada’s largest consumer finance company. The parties anticipated that closing would occur on June 1, 2020, with an outside date of August 14, 2020.
In April, Duo Bank took the position that the COVID-19 pandemic had already resulted or would result in an MAE and breach of Fairstone’s obligation to operate the business in the ordinary course. On May 27th, Duo Bank advised that it would not close the transaction, although it did not terminate the agreement. Fairstone immediately commenced litigation seeking specific performance. The Ontario court concluded that the closing conditions were met and that Fairstone had not experienced an MAE or operated the business outside of the ordinary course. Specific performance was ordered.
- No material adverse effect due to COVID-19. In the first part of the analysis, the Fairstone decision offers the clearest articulation to date by a Canadian court of what constitutes an MAE. Applying principles set out in Delaware case law, the court concluded that although the pandemic had a material adverse effect on Fairstone’s business, three carve-outs in the MAE provision applied. These included a carve-out for “worldwide, national, provincial or local conditions or circumstances” that broadly allocated systemic risks to the buyer. The court further concluded that neither the COVID-19 pandemic nor the related changes in the market or industry had had a materially disproportionate adverse impact on Fairstone relative to others in the industries or markets in which it operates. As a result, there was no MAE entitling the buyer to refuse to close.
- Pandemic responses were ordinary course. The court also rejected the buyer’s argument that Fairstone’s responses to COVID-19 materially breached its covenant to operate the business in the ordinary course. Fairstone had been permitted to and did keep its branches open and its branch employees working on site throughout the pandemic. Fairstone had, however, made adjustments to operations in response to the pandemic, which included the following:
- controlling access to premises to maintain social distancing;
- brief closures of a small number of branches;
- implementing a nationwide program that allowed customers to defer payments;
- giving employees extra leave days and a daily pay premium; and
- decreasing marketing and other expenditures by 10 percent relative to budget.
The court held that the purpose of ordinary course covenants is to ensure that the business the buyer pays for at closing is essentially the same as the one it agreed to buy and to mitigate the moral hazard of management acting in a self-interested, opportunistic manner detrimental to the buyer’s interest between signing and closing.
The court rejected each of the buyer’s arguments that Fairstone’s pandemic response measures were outside the ordinary course, finding that actions taken in extraordinary circumstances could be ordinary course, provided that they were responses to systemic circumstances rather than to difficulties specific to the target. The court held that operating “consistent” with past practices did not require practices to be identical. Thus, operational changes consistent with Fairstone’s actions during past economic contractions, or that allowed Fairstone to continue its normal day-to-day consumer lending business, were found to be consistent with past practices. Finally, the court held that the MAE provisions and the ordinary course covenant ought to be interpreted in the context of the contract as a whole and, in particular, that where a material adverse effect on the business has been caused by systemic events, the seller must have the latitude to operate the business in a way that is responsive to the changed circumstances.
The court concluded that Fairstone’s pandemic response measures were undertaken in response to systemic and not target-specific challenges, were made in good faith for the purpose of continuing the business, and were consistent with what other businesses were doing across Canada.
The court also concluded that if the conduct fell outside the meaning of “ordinary course,” it was conduct that the buyer would have been required to consent to, had consent been requested.
The AB Stable Decision
AB Stable involved the purchase by Mirae Asset Financial Group of Korea of Strategic Hotels & Resorts, which owned 15 U.S. luxury hotels. The parties in AB Stable executed a purchase agreement in September 2019. The closing of the transaction was to occur in mid-April 2020. Between signing and closing, the onset of the pandemic had a significant impact on the hotel industry. In response to the pandemic and prior to the anticipated closing date, the seller implemented several changes to the business, which included the following:
- temporarily closing the Four Seasons Palo Alto;
- closing the Four Seasons Jackson Hole in advance of its normal between-season closing, thereby lengthening its seasonal closure by about two months;
- operating other hotels at reduced levels with reduced staffing and with many restaurants closed;
- pausing nonessential capital spending; and
- laying off or furloughing 5,200 employees.
The buyer refused to close on the bases of various alleged breaches by the seller of its covenants and representations, including the following:
- that the changes to the seller’s business constituted an MAE;
- that the seller had failed to operate the business in the ordinary course consistent with past practices; and
- that the seller had failed to comply with an obligation to provide documentation necessary to enable the buyer to obtain title insurance for properties that had been subject to certain fraudulent deeds.
The seller sought specific performance of the agreement, and the buyer counterclaimed seeking an order that the seller’s breaches relieved the buyer from its obligation to close.
Material adverse effect analysis. The court rejected the buyer’s arguments that the pandemic and its impacts qualified as an MAE that enabled the buyer to avoid its obligation to close the transaction. The court declined to assess whether the effects suffered were sufficiently material to meet the “strictures of Delaware law,” noting that at times it is more straightforward to determine whether the effect was attributable to a cause that fell within one of the exceptions in the MAE provision. Assuming there had been an MAE on the business, the court held that the COVID-19 pandemic and its impacts were excluded as a “calamity” and likely as a “natural disaster” as well.
Ordinary course covenant. Contrary to the court in Fairstone, the court in AB Stable held that the actions taken by the seller in response to the pandemic constituted a breach of the ordinary course operating covenant. The court determined that the ordinary course covenant was not to be interpreted as acting in the ordinary course during a pandemic, but rather required the seller to maintain the normal and ordinary routine of the business notwithstanding the pandemic. In reaching this conclusion, the court rejected the seller’s arguments that management must be afforded flexibility to address changing circumstances and unforeseen events including by engaging in “ordinary responses to extraordinary events.”
Distinction between MAE and ordinary course covenant. The court in AB Stable held that the MAE provision and ordinary course operating covenant were separate and distinct obligations that should be analyzed separately and that, without clear language, one provision did not inform the other. In addition, the court rejected the seller’s argument that its conduct had been required by law, stating that this argument was neither fully briefed nor “seriously contended.” Finally, the court dismissed the seller’s argument that even though the seller had not sought consent from the buyer for any of the extraordinary measures it implemented in response to the pandemic, the buyer could not have reasonably withheld consent and therefore the court should not find that the seller had breached the ordinary course covenant. The court noted that “the seller waived this argument by not presenting it in a meaningful fashion.”
Failure to disclose/misleading actions of seller—the equities. Finally, and perhaps most importantly, the court also held that the buyer was not required to close because of the failure of the seller to meet the closing condition regarding title insurance. Although this issue was unrelated to the MAE provision and ordinary course operating covenant, the court made a number of findings about the seller’s troubling conduct relating to certain fraudulent activity engaged in by an unrelated third party. In particular, the court found that (1) the seller had knowledge of the fraudulent deeds on the hotel properties but elected to withhold these facts from the buyer until late in the day; (2) the seller misled the buyer regarding the identity and level of sophistication of the fraudster and the nature of the fraud; and (3) the seller downplayed the nature of the litigation between the seller and the fraudster regarding these issues.
Observations: The Court’s Perception of the Good-Faith Behavior of a Party May Influence the Analysis of the Contractual Obligations
It would be easy to chalk up the divergent results in Fairstone and AB Stable to the specific facts, the nuances in the language of the ordinary course of business covenants in the agreements, or jurisdictional differences. However, to do so would ignore the fundamental importance of the presentation of the case in a manner that highlights the reasons why the equities should fall in one party’s favor. The different contractual interpretation approaches appear to have been influenced, at least in part, by each court’s respective view of the parties and their conduct in the transaction.
In AB Stable, the court saw the seller as a party of questionable credibility—a party that opportunistically withheld information from the buyer and misled the buyer (and the court itself) about its knowledge of an alleged perpetrator of the fraud and ultimately “committed fraud about fraud.” This perception undoubtedly colored the court’s view of all of the seller’s evidence and arguments, including its approach to contractual interpretation. The Delaware court proceeded to apply a very strict interpretation to the ordinary course covenant and, in particular, to the meaning of operating “consistent with past practices” in the context of a pandemic. The court’s interpretation of the ordinary course operating provision arguably gutted the intended risk allocation negotiated between the parties and reflected in the MAE provision. The court dismissed as unpersuasive the fact that at least some of the conduct taken by the seller in response to the pandemic was similar (at least in nature, if not magnitude) to past practices, including steps taken in response to the 2008 financial crisis and temporary closures during periods of low demand. Arguments that some of the conduct was required by law were given similarly short shrift and found to be tendered late in the day and generally unsupported by the record.
In Fairstone, the Ontario court reviewed the conduct and communications between the parties prior to the allegation of breach of the ordinary course operating covenant. The court found that the buyer’s response to the measures taken by the seller was “disproportionate” and that, far from making a good-faith effort to examine whether Fairstone could manage its way through the pandemic without taking steps that were outside the ordinary course, the buyer had instead set up “a transparent trap” into which it hoped Fairstone might fall. The court went on to state that its view of the evidence was that “this was never about Duo’s disappointment at being deprived of the opportunity to co-manage any business refinements in response to the pandemic, it was about Duo trying to find a way to avoid the SPA [share purchase agreement] or renegotiate it.”
The court in Fairstone applied a contextual interpretation to the ordinary course obligation that depended on the particular factual circumstances. This reflected its view that the courts should be mindful of an “ever present underlying tension” between guarding “vigilantly against moral hazard and opportunistic behavior by sellers” and being “mindful of similar opportunism on the part of purchasers.” This contextual approach was applied with a view to the contract as a whole and led the court to consider a wide range of factors, including the following:
- If the conduct was unusual, was it ordinary in light of the circumstances the business was facing?
- What was the intent behind or reason for the conduct?
- Was the conduct pursued in good faith for the purpose of continuing the business?
- Would the conduct surprise a reasonable business person?
- Are there equities that should weigh in favor of the purchaser?
The divergence between the Ontario and Delaware courts’ interpretive approaches to the ordinary course operating provisions in Fairstone and AB Stable may to some extent reflect the courts’ perceptions of who the “good-faith actors” were in each case. For that reason, it underscores the critical importance in litigation of building a persuasive narrative and evidentiary record that enables your client to lay claim to the equitable high ground.
Danielle Royal is a partner at Stikeman Elliott LLP in Toronto, Ontario.
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