Written by Kristopher Hanc, Bryan Haynes, James McClary, Andrew Sahai and Meg Williams
In Fairstone Financial Holdings Inc v Duo Bank of Canada, Koehnen J. of the Ontario Superior Court of Justice (Commercial List) had the opportunity to further the limited jurisprudence on material adverse change/material adverse effect (MAE) clauses. Unsurprisingly, this jurisprudence has become more prominent as a result of the suddenness and uncertainty of the COVID-19 pandemic. In this decision, Koehnen J. considered the applicability of an MAE clause and other covenants in a share purchase agreement, and provided guiding principles for the analysis of these commonly-negotiated but rarely-litigated clauses.
On February 18, 2020, Duo Bank of Canada agreed to purchase Fairstone Financial Holdings Inc. and its subsidiaries, Canada's largest consumer finance company that targets near prime borrowers. Closing was scheduled for June 1, 2020, with an outside date of August 14, 2020.
On May 27, 2020, Duo advised Fairstone that it would not be closing on June 1, claiming that the MAE clause and other protections were triggered by the COVID-19 pandemic, giving Duo the right not to complete the transaction. In response, Fairstone brought an application for specific performance.
Under the MAE clause in the share purchase agreement (SPA), it was a condition to closing that, "[b]etween the date of this Agreement and the Effective Time, there shall not have occurred a Material Adverse Effect." The MAE clause contained customary carve-outs for MAEs caused by (i) emergencies, (ii) changes to the markets or industry in which Fairstone operated, and (iii) Fairstone's failure to meet financial projections. In other words, if those carve-outs applied, then the MAE would be ignored and Duo would be required to complete the transaction. However, Duo could still terminate the transaction if the emergency or market change (carve-outs (i) and (ii)) had a materially disproportionate adverse impact on Fairstone compared to others in the same market or industry.
Overarching Principles of MAE Clauses
The following principles guided Koehnen J.'s analysis of whether an MAE arose under the SPA, derived from a handful of notable Canadian, American and English cases, including the leading Delaware case, Akorn Inc. v Fresenius Kabi AG.
Definition of MAE
An MAE is "the occurrence of unknown events that substantially threaten the overall earning potential of the target in a durationally-significant manner." Accordingly, an MAE consists of three elements: (i) an unknown event, (ii) a threat to overall earning potential, and (iii) durational significance. In interpreting an MAE clause, the clause should be interpreted from the perspective of the party intended to benefit.
Burden of Proof
Generally, the party asserting a particular proposition bears the burden of proof. Further, the party seeking relief under the MAE clause must demonstrate, on a balance of probabilities, that the event is reasonably expected to have an MAE. To do so, the moving party must adduce evidence that:
- establishes more than a possibility or risk;
- allows the court to reach an informed judgment;
- is tethered to realities and not to mere possibilities; and
- is quantitative and/or qualitative.
The absence of an MAE is a closing condition and so it is appropriate to use the closing date, actual or conceptual, as the date on which to determine whether an MAE has occurred or is reasonably expected to occur. Moreover, while the question of how far courts will look into the future to determine whether an event would be reasonably expected to have an MAE will depend on the circumstances of the case, a seller should not be expected to protect the purchaser against all future economic dislocations.
Duo established that, by August 14, 2020, an MAE had arisen or was reasonably expected to arise because:
- at the time of entering into the SPA, the effect that the virus posed for Fairstone's business was unknown, although the existence of the virus itself was known;
- the COVID-19 pandemic had a material adverse effect on Fairstone's earning potential as a lender and it was reasonably expected to continue at least until a vaccine or accessible and effective treatment was made widely available; and
- the effect was durationally significant as projections indicated that COVID-19 would have an adverse impact on Fairstone's business into 2022.
However, Koehnen J. ultimately concluded that there was no MAE as defined by the SPA because the emergency, industry change and projection carve-outs all applied, and Fairstone was not reasonably expected to be disproportionately affected relative to others in the market or industry.
In addition to the MAE clause, Koehnen J. considered Duo's arguments that Fairstone breached the ordinary course and access to information covenants, and that an "amortization event" had occurred, each of which (Duo claimed) entitled it to terminate the transaction. While the amortization clause was specific to Fairstone's business, the other two clauses are consistently included in purchase agreements and therefore merit discussion.
The Ordinary Course Covenant
The ordinary course covenant in the SPA required Fairstone to act, between signing and closing, in a manner that was consistent with its past practices and that was in the ordinary course of operations. The SPA defined ordinary course as "such action that is consistent with the past practices of the Person and is taken in the ordinary course of the normal day-to-day operations of the Person".
Koehnen J. rejected Duo's claim that Fairstone breached the covenant by taking certain steps to reduce expenditures and tighten lending requirements in response to the pandemic. In doing so, he adopted a contextual approach to the term "ordinary course." Specifically, that in times of economic disruption, the concept of ordinary course should be more faithfully interpreted and take into account the magnitude and duration of disruption. If a business takes prudent steps in response to an economic disruption, 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. Here, the steps taken by Fairstone were within the ordinary course of business.
The Access to Information Covenant
Koehnen J. also heard arguments from Duo alleging that Fairstone breached the access to information covenant of the SPA, which required Fairstone to provide Duo with all such financial and operating data, within a reasonable time frame following a request, as reasonably necessary to complete the transaction. Duo argued that, out of thousands of information requests, seven information requests were insufficiently answered and nine were unanswered. Again, Koehnen J. ruled in favour of Fairstone, finding that many of Duo's requests were a "fishing expedition" meant to overwhelm Fairstone employees in the midst of a pandemic.
In addition to providing guiding principles for analyzing MAEs, the decision offers a few insights.
First, where an MAE clause is negotiated between sophisticated parties, courts are cautious to avoid expanding the clause to provide either party protection that it may have failed to bargain for. However, given the complexity of the issues and the tendency to use indefinite language in drafting (rather than citing objective financial metrics), it is difficult to interpret exactly what has been bargained for.
Second, the Fairstone case supports the proposition that MAE clauses are not designed to protect purchasers from systemic or "external" risks, such as the COVID-19 pandemic. However, two recent cases outside of Ontario—AB Stable in Delaware and Travelport v Wex in England—have found in favour of a purchaser's right to terminate a transaction due to an MAE resulting from the pandemic. Parties negotiating MAE clauses will need to consider these other cases, notwithstanding the significance of Fairstone in Canada.
Another relevant factor in many of these cases appears to be the respective behavior of the parties to the transaction in connection with the transaction negotiations generally and in the interim period leading up to closing specifically and whether their behavior was consistent with their obligations under the purchase and sale agreement.
For further reading on MAE clauses in the context of COVID-19, see Bennett Jones' previous insights:
- The Impact of COVID-19 on M&A Dealflow and
- COVID-19: Material Adverse Change in a Canadian M&A Context.