COVID-19 and Merger Litigation: Takeaways After Two Years

In Short 

Background: The COVID-19 pandemic prompted significant litigation concerning Material Adverse Effect ("MAE") clauses and interim operating covenants, with the latter seeing particular prominence. After two years of litigation, courts in the United States, Canada, and England have all now weighed in on the proper interpretation of these contractual terms in the merger context.  

The Results: Several significant judicial decisions in the last two years illustrate different ways in which courts interpret MAE clauses and operating covenants, both separately and together. 

Looking Ahead: It remains difficult to establish an MAE. Companies and their counsel should be focused on how nuances in these clauses have been interpreted and adjust language in M&A agreements as necessary to accurately capture the parties' intent.

Before the pandemic, it was generally accepted that establishing an MAE was very difficult—indeed, only one case in Delaware, 2018's Akorn v. Fresenius Kabi, had ever found that an MAE occurred. Following the pandemic, this remains unchanged. Courts have, however, allowed buyers to walk away from deals due to noncompliance with operating covenants. Even so, courts remain focused on the precise language used in the contracts and whether the seller's actions fully complied with its obligations. 

Travelport: MAE Likely Based on Court's Interpretation of "Industries" 

In late January 2020, WEX, a U.S. payments company, agreed to buy eNett and Optal, two UK-based payments businesses, from Travelport and other shareholders. The sale agreement was governed by English law. The MAE definition in the agreement provided that any changes resulting from pandemics were not to be taken into account in determining whether eNett and Optal had suffered an MAE, except to the extent that such changes had a "disproportionate effect" on them "as compared to other participants in the industries" in which they operated. The contract did not specify what "industries" these were, however. 

At the end of April 2020, the buyer informed the sellers that it believed that an MAE had occurred and so it was not required to close. The sellers filed suit in the English High Court in May 2020, seeking a declaration that there had been no MAE. The court ordered certain issues to be tried on a "preliminary basis," the most significant of which was the determination of the "industries" in which the sellers operated. The sellers argued that they operated in the "travel payments industry" and claimed that they had not been affected significantly worse than the rest of this segment. The buyer claimed that the sellers were in the "business to business payments industry"—relative to which, as a whole, the sellers had performed poorly given their focus on travel, which largely dried up early in the pandemic. 

In September 2020, the court sided with the buyer. The court concluded that there was no "travel payments industry" and the relevant "industries" were the "business to business payments industries." The ruling put the buyer in a strong position. In December 2020, rather than walking away, the buyer agreed to purchase eNett and Optal with a significant price reduction. 

AB Stable: No MAE, but Operating Covenant Breach

A similar result—albeit one based on entirely different reasoning—was reached in the Delaware case of AB Stable VIII LLC v. MAPS Hotels and Resorts One LLC

AB Stable arose out of a deal by Mirae, a Korean company, to acquire 15 luxury U.S. hotels from the Chinese conglomerate Anbang. The parties entered into the transaction in September 2019, and it was scheduled to close in April 2020. The sale agreement contained an MAE clause that excluded from the definition of an MAE any change that resulted from "calamities," regardless of whether the change had a disproportionate effect on the sold businesses. The sale agreement, however, also provided that the seller was required to operate the business "only in the ordinary course of business consistent with past practice in all material respects."  

After the pandemic hit, the seller shut two hotels and severely curtailed operations at the others. Mirae refused to close, asserting an MAE and a violation of the ordinary course covenant, and Anbang filed suit. 

In November 2020, the Delaware Court of Chancery ruled that the seller's business had not suffered an MAE, because impacts from "calamities" were excluded from the contractual definition. But the court also held that the seller's "reasonable responses to the pandemic" were not "consistent with past practice in all material respects" as required by the operating covenant. Therefore, despite the lack of an MAE, the buyer did not have to close. In December 2021, the Delaware Supreme Court affirmed the Court of Chancery's decision. 

DecoPac: Buyer Is Forced to Close 

In both Travelport and AB Stable, it was clear that the target company had been significantly harmed as a result of the pandemic. By contrast, in the Delaware Chancery case of Snow Phipps v. KCAKE, the court believed that the buyer was simply suffering from buyer's remorse. 

Snow Phipps concerned the sale of DecoPac, a cake decoration company. The buyer and seller, both private equity firms, had entered into the transaction agreement on March 6, 2020—only a few days before the World Health Organization declared COVID-19 a global pandemic. Under the agreement, the buyer was required to use its reasonable best efforts to obtain debt financing, and the seller was permitted to seek specific performance only if such financing had been provided.  

After the pandemic was declared, the buyer quickly pivoted to trying to escape the deal. On April 20, 2020, the buyer purported to terminate the purchase agreement on the ground that there had been an MAE. The seller sought an order from the Delaware Court of Chancery to force the buyer to close. The court declined to hear the case on an expedited basis and, in April 2021, issued an order requiring the buyer to close (almost a year after the outside date).  

The court rejected the buyer's contention that DecoPac had suffered an MAE. At the time that the buyer terminated, the downturn in DecoPac's forecast sales was relatively minor, and the court found it could not reasonably be expected that DecoPac would suffer an MAE in the future. While the buyer had drawn up its own extremely pessimistic forecasts at the time it purported to terminate, the court found them unreliable. Indeed, by the end of 2020 when the case was tried, it was clear that the impact of the pandemic on DecoPac had been a "momentary blip." 

The court also rejected the buyer's argument that DecoPac had failed to operate its business "in a manner consistent with [its] past custom and practice." While DecoPac had cut some costs to attempt to deal with the temporary downturn, the court found that its actions were consistent with those it had taken in lean times in the past. 

Finally, the court rejected the buyer's claim that it was excused from closing because it had not obtained financing. The court found that the buyer had not made the necessary efforts to obtain financing; to the contrary, the buyer had made unreasonable new demands on its lenders, and then tried to blame the lenders for not acquiescing.  

In May 2021, shortly after the court's ruling, the buyer closed the transaction on the original terms. 

Cineplex: Court Orders $1 Billion in Damages for Failure to Close 

In evaluating whether the operating covenant had been breached, the DecoPac court adhered to the standard and reasoning set out in AB Stable but distinguished the case on the facts. In a dispute involving Cineworld and Cineplex, two chains of movie theater companies, the Ontario Superior Court was less willing to follow the AB Stable approach.  

In December 2019, Cineworld had agreed to buy Cineplex. On March 16, 2020, in response to the pandemic, Cineplex closed its theaters. Cineworld then purported to terminate the merger agreement. Cineworld did not claim that Cineplex had suffered an MAE: The merger agreement provided that any negative impact on Cineplex resulting from an "outbreak of illness" could constitute an MAE only if it had a disproportionate effect on Cineplex's business. Here, the pandemic had affected Cineplex and the other members of the cinema industry equally. But Cineworld did claim that Cineplex, by closing its theaters and taking actions to conserve its liquidity, had violated the operating covenant in the agreement, which required Cineplex to conduct its business "in the ordinary course consistent with past practice." 

The court rejected this argument and held that closing theaters did not violate the operating covenant, because Cineplex was required to shut its theaters pursuant to government orders. Moreover, and in contrast to AB Stable, the court reasoned that the parties had negotiated an MAE clause that had placed the risk of a pandemic on Cineworld and further reasoned that this provision would be "meaningless" if Cineworld could refuse to close because of the operating covenant instead.  

The court also rejected the argument that Cineplex had violated the operating covenant by deferring payables and reducing spending in order to preserve cash flow. "'Consistent' does not mean identical," the court held, and because the measures that Cineplex had taken followed the "same principles of thought" as those Cineplex had adhered to in the past, they were acceptable. 

The court awarded approximately $1 billion in damages to Cineplex. Cineworld has appealed. 

Level 4 Yoga: Court Adopts Seller's Reading of Ordinary Course Covenant 

The idea of compulsion excusing an alleged breach of an operating covenant also played an important role in the recent Delaware case of Level 4 Yoga v. CorePower Yoga. CorePower, an owner and franchisor of yoga studios, wished to buy the studios operated by Level 4, one of its franchisees. Under the terms of the parties' franchise agreement, CorePower had the right to buy Level 4's studios. Level 4, however, was an unwilling seller, and was accordingly able to bargain for a "one-way" purchase agreement that did not give CorePower the right to terminate. In the agreement, Level 4 represented that at the time of signing (November 2019), it was operating its business in the ordinary course and had not suffered an MAE, and also agreed that these representations would remain true between signing and closing. Level 4 further agreed to indemnify CorePower if these reps were false. But CorePower did not have the express right to refuse to close if Level 4 was in breach of its reps.  

On March 15, 2020, in response to the pandemic, CorePower ordered Level 4 and all its franchisees to close their studios. Five days later, CorePower's board met and decided to delay the Level 4 acquisition, the first phase of which was scheduled to close on April 1, 2020. CorePower thereafter told Level 4 that it was not operating in the ordinary course of business, because it had shut its studios—despite doing so at CorePower's request—and announced that its contractual performance had been "discharged." Level 4 sued to force CorePower to close. 

Level 4 prevailed. The court rejected CorePower's arguments and concluded that the unusually drafted purchase agreement did not permit CorePower to refuse to close. Nor could CorePower invoke a common law right to refuse to close. Level 4 had not failed to operate its business in the ordinary course by closing the studios, because CorePower had told it to close, and as a franchisee, Level 4 was required in the ordinary course to do whatever CorePower ordered it to do. Nor had Level 4 suffered an MAE at the time that CorePower refused to close, which was the relevant time for determining whether there had been an MAE. In fact, on the day CorePower decided not to close, CorePower was expecting that Level 4 would close its studios for only six weeks. 

CorePower has requested a stay of the court's judgment pending an appeal.

Four Key Takeaways 

  1. Contractual language is key. In both Travelport and AB Stable, the courts reached a pro-buyer result but suggested that they might have reached opposite conclusions if the parties had drafted the contracts differently: in Travelport, by defining the relevant "industries," and in AB Stable, by incorporating the MAE standard in the operating covenant.
  2. Courts find decisions from other jurisdictions persuasive—but need not follow them. Both the Travelport and Cineplex decisions invoked Delaware precedent but used this precedent in different ways. Even within a jurisdiction, broken deal cases are highly fact-specific. 
  3. The conduct of the parties matters. In the DecoPac case, the court appeared to be influenced by the fact that the buyer was seeking to avoid its obligations, and was communicating more regularly with its litigation counsel than with DecoPac management. Similarly, in Level 4 Yoga, the court was troubled that the buyer came up with many of its arguments why it was permitted to avoid the deal for the first time only in litigation. 
  4. At least in Delaware, there is a trend toward construing operating covenants literally and independently of MAE clauses. Drafters should be aware of how courts will construe the separate provisions of their agreement and ensure that they work harmoniously in an integrated whole. Nevertheless, if the seller is required to take unusual actions with regard to its business—whether by the government, as in Cineplex, or by a franchisor, as in Level 4 Yoga—a court may be less likely to find that even a buyer-friendly operating covenant has been violated.
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