Clash Of The Cine-Titans: Court Finds That COVID-19 Is Not An Excuse To Walk Away From An M&A Transaction
A recent decision of the Ontario Superior Court of Justice in Cineplex v Cineworld, 2021 ONSC 8016 (" Cineplex") awarded the plaintiff Cineplex damages of $1.24 billion for breach of contract arising from Cineworld's purported termination of an agreement to buy Cineplex, an operator of movie theatres in Canada. The case is an illustrative example of judicial skepticism of attempts to use the COVID-19 pandemic to avoid contractual obligations, and of how the duty of honest performance can be applied in the context of M&A transactions. The case is also noteworthy for basing a very significant damages award on 'lost synergies' that would have been realized had the deal closed.
Cineplex and Cineworld entered into an agreement for Cineworld to purchase all outstanding shares of Cineplex in December 2019 for a total price of $2.8 billion. The deal was subject to several regulatory approvals, including under the Investment Canada Act ("ICA"). It also included a closing condition requiring Cineplex to keep its debts under $725 million.
In response to the emergence of COVID-19 in early 2020, Cineplex took a number of steps to conserve liquidity, including deferring payments to and agreeing to payment plans with suppliers, studios and landlords, reducing capital expenditures, and paying down its bank debt. The Court ultimately found that Cineplex's decisions were made to preserve and manage its liquidity in view of the impact of COVID-19 while ensuring that it did not violate the debt condition.
By mid-April 2020, the Court found that Cineworld had no intention of proceeding with the deal at the price it had agreed to in December. On June 5, 2020, Cineworld provided notice to Cineplex alleging that Cineplex had breached the contract. On June 12, 2020, Cineworld terminated the agreement and advised the agencies responsible for granting ICA approval that it was withdrawing its application. Cineplex sued for breach of contract in response.
The dispute centred around the interplay between the "material adverse effect" ("MAE") clause and general operating covenant in the parties' contract.
The MAE clause provided that Cineworld could terminate the transaction if Cineplex suffered a "material and adverse effect" on its business but included exceptions for systemic factors including "outbreaks of illness". That is, the agreement stated that an outbreak of illness (such as COVID-19) was not an MAE that would entitle Cineworld to terminate the contract.
The general operating covenant required Cineplex to (1) operate its business in the "Ordinary Course and in accordance with Laws", and (2) "use commercially reasonable efforts" to maintain and preserve its business, assets, properties, goodwill and business relationships with customers, suppliers and any other persons it has material business relations with prior to closing.
Operating In The Ordinary Course In A Pandemic
Cineworld argued that actions Cineplex took in early 2020 were impermissible and violated the deal's "Ordinary Course" operating covenant. Cineplex took the position that the pandemic and any responses to it were controlled by the MAE clause, not the operating covenant, and that it committed no such breach. Cineplex argued in the alternative that the operating covenant must be read in a way that does not negate the allocation of pandemic risk to Cineworld.
The Court concluded that Cineplex's use of payment deferrals and spending reductions did not result in the "Ordinary Course" covenant being violated. Instead, the Court found Cineplex's steps were "commercially reasonable" and "consistent with past practice", even if Cineplex used them "on a larger scale" than in the past and Cineplex was "focused on staying under the $725M debt condition" when taking them. In coming to this conclusion, the Court noted that Cineworld's position that the debt condition required Cineplex to operate as it had prior to the pandemic ignored the other provisions of the contract and failed to appropriately consider the contract as a whole.
The Court elaborated that the exclusion of a pandemic from the definition of a MAE in the contract allocated the risk of a pandemic to Cineworld, and that interpreting the operating covenant as requiring Cineplex to operate as it had prior to the pandemic would reallocate that risk back to Cineplex. Cineplex reflects the view that clauses designed to address specific fact scenarios ought to inform the interpretation of other parts of the contract when those fact scenarios arise.
Cineplex also shows the importance of context for contractual interpretation. The Court interpreted "Ordinary Course" in the operating covenant to be informed by the (unusual) context of a pandemic, which permitted Cineplex to take more aggressive steps to deal with liquidity issues than it had in the past.
The Role Of The Duty Of Honest Performance
The duty of honest performance was set out in Bhasin v Hrynew, 2014 SCC 71 in 2014 and reaffirmed last December in C.M. Callow v Zollinger, 2020 SCC 45. It requires parties to "not lie or otherwise knowingly mislead each other about matters directly linked to the performance of the contract". Cineplex provides one of the first examples of how courts will apply the duty in in the context of failed M&A deals. In its analysis, the Court reinforced how the duty of honest performance is not a general duty of disclosure or one that requires full transparency. The Court stated that Cineplex had no implied duty to provide information to Cineworld outside of information rights in the contract. The Court ultimately concluded the duty of honest performance was not breached because Cineplex kept Cineworld updated about material matters and answered Cineworld's information requests. Cineplex reinforces the low burden the duty of honest performance imposes for compliance.
Expectation Damages In M&A Deals With Strategic Buyers And No Reverse Break Fees
Cineplex is an example of a novel and potentially lucrative method of using 'lost synergies' (synergies that would be realized had the transaction completed) to calculate damages.
Because the agreement at issue did not contain a break fee, Cineplex put forward several theories of damages. The two most notable were (1) the value of the premium that would have been payable to Cineplex shareholders if the transaction had completed, and (2) the value of the synergies that were expected to be achieved by Cineplex, both as determined at the time of the agreement. The synergies were to flow from combining the operations of Cineworld and Cineplex, and included cost savings from the removal of the Cineplex board, the elimination of redundancies and spending reductions, as well as additional revenues that Cineplex would have realized after the transaction.
The Court rejected Cineplex's first theory of damages, reinforcing that a loss to a corporate entity is distinct from a loss to shareholders. However, the Court accepted the value of the 'synergies' approach and awarded damages of $1.24 billion on this basis (being the value of the synergies expected to be realized by Cineplex of $163.5 million on an annualized basis, discounted to reflect their present value and also for "delayed realization" to take into account the impact of COVID-19), in addition to $5.5 million in transaction costs. The amount of the damages award is very significant, and nearly the combined value of Cineplex and Cineworld's market capitalization at around the time of the award.
This approach to damages arguably provides Cineplex with a substantial windfall. Cineworld was the strategic buyer in the transaction. The synergies would arguably have accrued to Cineworld (as purchaser) if the transaction were completed. Instead of realizing these benefits, Cineworld was forced to pay them to the company it wanted to acquire. While the approach to computing damages is somewhat novel, the level of damages awarded appears to reflect a concern that a lesser award would allow parties in Cineworld's position to retain the deal premium that, if not for their breach, would have flowed to the other party's shareholders.
Cineworld has indicated it intends to appeal the decision. The means of calculating damages in particular are likely to be the subject of comment by the Court of Appeal.
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