Several months ago we asked whether a COVID-19-related impact on
a business might constitute a “Material Adverse Change”
(referred to as a “MAC,” or a material adverse effect,
“MAE”) under merger agreements, and we noted the near
complete absence of case law on the issue in Canada (see: “COVID-19 and Material Adverse Change Provisions in
M&A Agreements“). Fortunately, we now have some
Canadian case law to provide guidance. A recent decision of the
Ontario Superior Court of Justice relating to the impact of
COVID-19 suggests that MAC/MAE clauses will be interpreted narrowly
in Canada, which follows the trend in the case law from Delaware
courts.
The Decision: Fairstone Financial Holdings Inc. v Duo Bank
of Canada
In February 2020, Duo Bank of Canada (Duo) announced that it
would acquire consumer finance company Fairstone Financial Holdings
Inc. (Fairstone) by way of a share purchase agreement (SPA). The
transaction was expected to be completed on June 1, 2020. In the
intervening time, the COVID-19 pandemic hit North America and
Fairstone’s business was significantly affected. In May 2020,
year-over-year new loan origination had decreased by 56%, and it
was clear that Fairstone would have to reduce lending and tighten
lending requirements, thus reducing its earnings potential.
In late May, Duo informed Fairstone that it did not intend to
complete the transaction on the basis that, among other things,
there had been a material adverse effect on Fairstone’s
business and various steps Fairstone took to manage its business
through the pandemic violated its covenant to operate its business
in the ordinary course. Duo was careful, however, not to terminate
the SPA. As the court noted, Duo was the successful and aggressive
bidder in an auction and it knew that if it terminated the SPA,
Fairstone would not be able to sell the business for the same price
that Duo had offered. If Duo turned out to be wrong about its right
to terminate, it would be responsible for damages potentially in
the hundreds of millions of dollars.
In response to Duo’s notice, Fairstone sought to compel Duo
to complete the transaction by way of a court application for
specific performance. Fairstone sought damages for breach of the
SPA as an alternative to specific performance, although Duo made
clear that it would prefer to complete the transaction rather than
pay damages.
Was there an MAE?
In its decision, the court acknowledged that “at first
blush,” it appeared that an MAE had occurred as a result of
COVID-19. However, the MAE clause in the SPA contained a number of
carveouts which excluded material effects caused by (i) worldwide,
national, provincial or local conditions or circumstances,
including emergencies; (ii) changes to the markets or industry in
which Fairstone operates; and (iii) the failure of Fairstone to
meet any financial projections. The first two carveouts included
the further requirement that only an MAE caused by emergencies or
market changes which had a “materially disproportionate
adverse impact” on Fairstone would relieve Duo of its
obligation to complete the transaction. The court concluded that
COVID-19 fell into the definition of the first carveout, and also
that the changes to Fairstone’s business were changes to the
entire market and industry in which Fairstone operates and
Fairstone had not been disproportionately affected.
There are several important takeaways from the court’s
analysis of the parties’ arguments regarding an MAE:
- Burden of Proof: The party alleging the MAE
(in this case, Duo) bears the burden of proving it. However, the
court also found that the burden shifted back to Fairstone to
establish that one of the carveouts to the definition of MAE is
present. - Standard of Proof: The court considered
whether the parties’ use of the phrase “has (or would
reasonably be expected to have).a material adverse effect on the
business” in the SPA signalled an intention that something
lower than the civil burden of proof (i.e. a balance of
probabilities) was required to establish an MAE. After surveying
the case law on the interpretation of similar language in both
Canada and the United States, the court confirmed that the ordinary
civil burden of proof applied, such that Duo needed to demonstrate
on a balance of probabilities that the conditions of the COVID-19
pandemic would reasonably be expected to have a material adverse
effect on Fairstone’s business. - The Role of Expert Evidence: The determination
of whether there had been a disproportionate effect on Fairstone
turned on expert evidence. Fairstone’s experts addressed
directly the issue by comparing Fairstone to its direct competitor
and others in the industry across a broad range of qualitative and
quantitative factors, including net income, expenses, impairment
charges, operational expenses and history of managing problems. The
court preferred this evidence to that of Duo’s expert, who
compared Fairstone’s results against results derived from
analysts’ projections for public companies for a similar
period. - Definition of MAE: The court adopted the
widely used definition of MAE from Delaware case law: “.the
occurrence of unknown events that substantially threaten the
overall earnings potential of the target in a
durationally-significant manner.”
Had Fairstone Conducted its Business in the Ordinary
Course?
As mentioned above, Duo also alleged that Fairstone, in
responding to the pandemic, had breached its covenant to conduct
its business in the ordinary course. The term “ordinary
course” was defined in the SPA as “consistent with past
practices”. In effect, Duo argued that nothing done by
Fairstone in response to the pandemic could be ordinary course
because the pandemic is an extraordinary event. In rejecting
Duo’s position, the court noted that such a conclusion would
make the pandemic a reason for not closing the transaction even
though emergencies in the nature of the pandemic were excluded from
the definition of MAE. The court found that in reading the SPA as a
whole and not as a series of unrelated, standalone provisions,
precedence ought to be given to the specific emergency exclusion in
the MAE clause over the more general ordinary course provision.
The court noted that the “fundamental purpose” of the
ordinary course covenant is “to protect the purchaser against
company specific risks and the moral hazard of management acting in
a self-interested, opportunistic manner detrimental to the
purchaser’s interests. Without purporting to set out a
universal rule, the court set out a number of principles to assist
in the consideration of what actions can be said to be taken in the
“ordinary course”:
- As a general rule, the purchaser of a business accepts systemic
economic risks associated with the ownership of a business,
including the risk of economic contractions and the detrimental
effect they have on a business. - It is part of the ordinary course of any business to encounter
local or national recessions and to take steps in response to those
sorts of systemic economic changes. Whether these steps are taken
in the ordinary course will involve a comparison of (a) what the
business has done in similar economic circumstances to what it is
doing now, or (b) what the business is doing now to what other
businesses are doing. - If a 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.
Recent Delaware Decision
The Fairstone decision aligns with the American
approach to determining when a MAC/MAE has occurred. As noted
above, the Ontario court adopted the definition of MAE used in
Delaware case law.
It is also noteworthy that in a decision released just two days before
Fairstone, the Delaware Court of Chancery reached a
similar conclusion on the issue of whether COVID-19 constituted an
MAE. The Delaware court found that the consequences of the COVID-19
pandemic fell within an exception to the MAE clause for effects
resulting from “natural disasters and calamities.”
However, the Delaware court found a breach of the ordinary
course covenant. Significantly, the court found that the actions of
the seller “departed radically from the normal and routine
operation of the [business] and were wholly inconsistent with past
practice.” This result was driven by very different facts than
were present in the Fairstone decision, but it is
noteworthy that the Delaware court declined to consider the MAE
clause in its interpretation of the ordinary course covenant. As
discussed above, the Ontario court adopted an approach that
considered the SPA as a whole and not as a series of unrelated,
standalone provisions.
Conclusion
The Fairstone decision provides valuable guidance as to
how Canadian courts will interpret MAE carveouts and ordinary
course covenants, which makes it a must-read for participants in
Canadian M&A.
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guide to the subject matter. Specialist advice should be sought
about your specific circumstances.