[co-author: Karin Kazakevich]
On December 14, 2021 the Ontario Superior Court of Justice (the Court) ruled in Cineplex v. Cineworld that Cineworld Group PLC (Cineworld) had no basis for terminating its arrangement agreement with Cineplex Inc. (Cineplex), Canada’s largest film exhibitor. At the heart of the case was the determination as to whether Cineplex’s response to the COVID-19 pandemic was justifiable grounds for Cineworld to terminate the proposed CA$2.8 billion acquisition.
Background
In December 2019, Cineworld entered into an arrangement agreement (the Agreement) with Cineplex, pursuant to which Cineworld agreed to purchase all of the shares of Cineplex at a 42% premium to Cineplex’s then share price.
In February 2020, each of Cineplex and Cineworld received overwhelming shareholder approval for the transaction and obtained final court approval. The transaction was subject to various closing conditions and covenants including obtaining the requisite foreign investment approval under the Investment Canada Act.
In March 2020, the global COVID-19 crisis struck and in response to government restrictions, Cineplex closed its theatres across Canada (including in certain provinces where it was mandated to do so). Furthermore, Cineplex also delayed payment to certain creditors and renegotiated the terms of certain accounts payable (notably with its landlords).
On June 5, 2020, Cineworld sent a notice to Cineplex alleging that Cineplex was in breach of the Agreement and that such breaches could not be cured, and shortly thereafter, Cineworld delivered a notice to Cineplex terminating the Agreement and withdrew its foreign investment application.
Positions of the parties
The principal question before the Court was whether Cineworld was entitled to terminate the Agreement due to Cineplex’s alleged breach of its covenants, specifically that Cineplex failed to operate in the “ordinary course of business” between the date of the Agreement and closing. Cineplex’s position was that since Cineworld had no basis for terminating the Agreement, its notice of termination was in fact a repudiation of the deal for which damages could be sought.
Cineworld took the position that they were entitled to terminate the Agreement on the basis that Cineplex breached its covenant to operate in the “ordinary course of business.”
The Agreement
Among other matters, the court focused on two specific provisions of the Agreement.
- The first was the definition of “material adverse effect” (MAE)
- The second was the interim covenant of Cineplex to act in the “ordinary course of business”
MAE clause/allocation of risk
MAE clauses allocate systemic risks between a purchaser and seller. Upon the occurrence of an MAE, a purchaser is entitled to not close the transaction and walk away from the deal. Notably, the Court provided some colour to indicate that an MAE (as a result of the COVID-19 pandemic) had not occurred since the MAE provision specifically carved out “outbreaks of illness”. Finding that COVID-19 fell squarely within this exception, the Court held that the risk of a pandemic was allocated to and assumed by Cineworld. Although the focus of the case was not whether an MAE had occurred, the Court held that the definition of MAE (including the numerated exclusions thereto) should inform whether Cineplex had performed its ordinary course interim covenant.
The interim operating covenant
The determinative issue was the Court’s interpretation of the Agreement’s interim covenant relating to Cineplex’s operations prior to closing. Interim covenants allow buyers to not proceed with a transaction in the event the target’s actions “significantly change the nature of the business or have a long-lasting impact that would affect the buyer in operating the business after closing”.
As is typical in M&A transactions, Cineplex agreed to continue to conduct its business in the “ordinary course”. This is defined in the Agreement in a fairly customary manner as actions “taken in the ordinary course of the normal day-to-day operations of the business of [Cineplex]… consistent with past practice”. Cineworld alleged that Cineplex breached this operating covenant when it took certain actions in response to COVID-19, including closing theatres, reducing capital expenditures and deferring payments to suppliers, film studios and landlords.
What is the “ordinary course” during COVID-19?
Relying on earlier authority for the proposition that “ordinary course” is a contextual and fact-specific analysis, the Court considered what it meant for Cineplex to operate in the “ordinary course” during a pandemic. Furthermore, Cineworld alleged that the MAE provision, in which it accepts the risk of the pandemic, should not be considered when interpreting the operating covenant. The Court rejected this submission and held that: (i) the Agreement must be read as a whole, and (ii) the interim covenant cannot be interpreted in a way that negates the other clauses (and in particular, the MAE provision that allocated the risk of a pandemic to Cineworld).
Since Cineplex’s theatres were closed due to government mandates, the Court found that Cineplex could not be held in default of the “ordinary course” covenant when it was prevented from conducting its normal day-to-day operations due to a legal mandate.
In considering Cineplex’s actions, such as deferring payments and implementing cash management measures, the Court found that Cineplex’s response to the closures was consistent with measures it had used to manage its liquidity in the past. The Court noted that “consistent” with past practice does not mean identical; it means congruous, compatible and adhering to the same principles of thought and action.
The Court also discussed and distinguished the matters before the Court from other cases where a seller did not take actions to preserve their business and instead “gutted” the business radically changing the character of its operations. The Court found that Cineplex’s spending reductions and cash management strategies to preserve its cash flow during the interim period (specifically while its theatres were closed) were commercially reasonable measures consistent (although not identical) with past practice. The Court found that Cineplex’s actions, while technically due to the pandemic, were taken to maintain the business and avoid its deterioration.
However unattractive it may have been to Cineworld to purchase Cineplex at a premium to the December 2020 Cineplex share price (approximately double the Cineplex share price in June 2021), the Court held that the termination was not lawful and that Cineworld cannot attempt to use the operating covenant as a means of circumventing the very risk that it specifically assumed under the definition of MAE.
Damages
Cineworld argued that Cineplex was not entitled to expectation damages because Cineplex could have sought specific performance of the Agreement but chose not to. The Court rejected Cineworld’s submission and found that when Cineworld issued the notice of termination and withdrew its foreign investment application, it precluded Cineplex from seeking specific performance.
Unsurprisingly, the Court also rejected Cineplex’s submission that they should be entitled to recover the value of the consideration that would have been payable to its shareholders had the transaction been completed. Given the legal distinction between shareholders and corporate entities, the only damages recoverable by Cineplex were the losses sustained by Cineplex, not its shareholders ,with the Court noting that shareholders were only third-party beneficiaries in the event the transaction closed.
Loss of synergies
In a seemingly novel approach to contractual damages, the Court found that “loss of synergies” was a proper measure of damages suffered by Cineplex. Based on the evidence of an expert report, the ‘synergies’ considered were those that would have been realized by Cineplex had the deal been completed. The Court found that an award of damages on this basis would therefore put Cineplex in the position that it would have been in if Cineworld had not terminated the deal. Damages of approximately CA$1.24 billion were awarded to Cineplex (plus CA$5.5 million in transaction costs).
Dentons’ insight
Cineworld immediately announced it would be appealing the decision, so we can expect further judicial guidance on these principles in the future –although it is unclear whether the appeal will focus on the interpretation of “ordinary course of business” or the quantum of damages awarded. In the meantime, the Court’s findings remain relevant to the Canadian M&A landscape and participants should consider the following takeaways from the decision:
- The “ordinary course of business” does not exist in a silo. A seller/target is permitted to manage its business in response to a risk that the purchaser willingly assumed, so long as the actions do not radically alter the nature of the business and are consistent in principle with past practice of the seller/target.
- Ordinary course of business covenants will be interpreted on the basis of the agreement as a whole. Accordingly, purchasers should carefully consider the risks they are willing to assume and how such allocation of risk interacts with other provisions in an agreement.
- Particular attention should be paid to MAE clauses. In particular, MAE carve-outs (such as the pandemic carve-out) will be clear indications of the allocation of risk agreed to by the parties.
- Where specific performance is not available, an aggrieved party may be able to rely on “lost synergies” as a proxy for expectation damages.
- This decision provides little guidance on how courts will interpret an “ordinary course” covenant for targets that, unlike Cineplex, have minimal operating history. With no true barometer against which decisions may be evaluated for consistency with the target’s past practice, more specificity in drafting may be required to avoid potential exploitable ambiguities.
We wish to thank Karin Kazakevich, articling student in Toronto, for her assistance with this insight.
