The Ontario Superior Court recently awarded $1.2 billion damages to Cineplex after Cineworld repudiated a deal to buy the movie theatre operator. The court rejected Cineworld’s arguments that Cineplex’s pandemic response breached an interim covenant to operate in the ordinary course and held that Cineworld had assumed the risk of completing the deal if a pandemic occurred.
Importantly, Cineworld was not entitled to invoke the material adverse effect (MAE) termination right as the definition of MAE specifically excluded “outbreaks of illness” (which the court held included the COVID-19 pandemic that was declared by world and national health authorities a few months after the agreement), and the agreement did not contain a reverse break fee entitling Cineworld to walk away from the transaction in certain circumstances upon paying a negotiated termination payment. The decision sheds light on what constitutes “ordinary course” in a pandemic and how risk is allocated in the period between signing and closing and is a timely reminder of the importance of MAC and MAE definitions and clauses in an M&A context.
Cineworld contracted to buy all of Cineplex’s shares under an Arrangement Agreement signed on December 15, 2019, before COVID-19 had become recognized as a global pandemic (total transaction value $2.8 billion). Closing was to happen no later than June 30, 2020. The agreement did not contain a reverse break fee that might enable Cineworld to walk away from the transaction in certain circumstances for a negotiated termination payment (although when reverse break fees are included in a public M&A agreement, they do not simply allow buyers to walk away from the transaction for any reason or “for convenience” upon payment of a negotiated fee), and the MAE definition excluded “outbreaks of illness.”
The pandemic was declared in March 2020, Cineworld terminated the agreement on June 12, and Cineplex filed a claim for breach of contract on July 3.
Cineworld argued Cineplex had breached various interim covenants applicable between signature and closing, including failing to operate its business in the ordinary course (the Operating Covenant). Cineplex argued the MAE exclusion allocated the risk of a pandemic to Cineworld and, in any event, Cineplex’s response to the pandemic did not breach the Operating Covenant.
The Arrangement Agreement contained a customary condition to closing that no material adverse effect had occurred since signing, but the MAE definition excluded “outbreaks of illness” (i.e., the COVID-19 pandemic).
Cineworld argued the actions Cineplex took from March 2020 were unrelated to the pandemic and were Cineplex’s attempt to comply with a debt condition. Justice Conway rejected this: Cineplex’s actions must be seen in context. Its attempt to manage cash flow was a response to increasing economic uncertainty resulting from COVID-19.
MAE clauses are intended to address two categories of interim period risk: business risks assumed by the seller, and systemic risks beyond both parties’ control that the buyer assumes. By excluding “outbreaks of illness” from the MAE definition, the agreement allocated the systemic risk of the pandemic to Cineworld.
The Operating Covenant required Cineplex to conduct its business in the “ordinary course” during the interim period and use commercially reasonable efforts to preserve relationships and goodwill. The covenant prohibited Cineplex from selling assets, creating new indebtedness, making changes to contracts and making changes to the annual budget (among other things).
Cineworld alleged Cineplex breached its covenants by taking various actions from March 2020 onwards, including closing theatres, deferring payments to suppliers, studios, landlords and reducing capital expenditures.
Justice Conway made the following points:
- The purpose of interim covenants (including the Operating Covenant) is to: (1) ensure the business the buyer bargained for is the same at closing as it was at signature; and (2) reduce the interim risk of a seller acting to the buyer’s detriment.
- What constitutes “ordinary course of business” is a mixed question of fact and law. The term is flexible and should be interpreted in the context of the pandemic. Temporary operational changes, consistent with measures taken in past economic contractions, will not relieve a buyer from its obligation to close.
- In the context of the COVID-19 pandemic, examples from case law of conduct that is compliant with ordinary course covenants include 10% decreases in capital expenditures, minor workforce reductions, and tightening customer credit requirements. By contrast, excessive measures that significantly alter the nature of a business may breach such covenants – e.g., premature closing of premises and significant layoffs that would create staffing shortages upon re-opening.
Cineplex had taken commercially reasonable steps in the context of the pandemic: rather than selling assets or restructuring, it made payment deferrals and spending reductions to preserve cash flow. It also negotiated payment plans with landlords, studios and suppliers. These were temporary cash management measures that enabled Cineplex to preserve the business and its relationships.
Justice Conway rejected Cineworld’s interpretation that the Operating Covenant required Cineplex to operate exactly as it had during pre-pandemic times: had Cineplex done so, it would have no liquidity.
Further, the court found that Cineworld’s narrow interpretation of the Operating Covenant would ignore the context of the agreement as a whole, reallocate the systemic risk of a pandemic back to Cineplex, and render the MAE clause meaningless.
Duty of honest performance
Justice Conway rejected another argument by Cineworld that Cineplex breached its duty of honest performance by failing to provide sufficient information during the interim period. Cineplex had informed Cineworld about its deferred payment plans, and while the agreement permitted Cineworld to request further operating data, this did not include burdensome information requests (such as an invoice by invoice analysis of all Cineplex’s accounts payable).
The court awarded Cineplex expectation damages of over $1.2 billion plus $5.5 million in transaction costs.
Damages were based on the lost synergies Cineplex would have realized had the transaction completed. The court rejected Cineplex’s request to recover the value of the consideration that would have been payable to shareholders; the shareholders were third-party beneficiaries and had no clear right to sue Cineworld under the agreement.
The decision is welcome confirmation of the flexibility permitted in interpreting covenants to operate in the ordinary course in a pandemic context. It provides useful guidance for parties to M&A transactions disrupted by COVID-19.
It also highlights the importance of the parties paying close attention to the specific wording of MAC and MAE definitions and exclusions. The decision further shows the importance of communicating regularly with the seller during the interim period, raising concerns as early as possible, and working with the seller to negotiate reasonable solutions. In addition, sellers should be cautious about taking excessive or unprecedented actions in the interim period, and consider how operational decisions are consistent with previous measures used to manage the business through difficult times, although in this instance, the court found that Cineplex’s actions during the interim period were reasonable and thus not outside the ordinary course of business in light of the pandemic.