The COVID-19 pandemic has caused economic disruption impacting transactions where parties seek to abandon deals on the grounds that the business climate is materially different and thereby avoid existing contractual obligations.

The recent decision Fairstone Financial Holdings Inc. v. Duo Bank of Canada involves the application of material adverse effect (MAE) provisions that are common in corporate finance transactions. Justice Koehnon of the Ontario Superior Court of Justice reviewed the application of an MAE clause in a share purchase agreement in the context of the COVID-19 pandemic.

Parties Enter Share Purchase Agreement Weeks Before Pandemic Hits

On February 18, 2020, Duo Bank of Canada and Fairstone Financial Holdings Inc. signed a share purchase agreement with Duo agreeing to purchase Fairstone’s business. The agreement scheduled a closing date of June 1, 2020. The agreement also included a closing condition that no MAE must occur from the signing date up to closing.

The clause contained carve-outs that were deemed not to constitute an MAE, for i) emergencies, ii) changes to the markets or industry in which Fairstone operated, and iii) the failure by Fairstone to meet financial projections. The first and second carve-outs would only apply as exclusions if Fairstone has not been disproportionately adversely affected relative to others in the industry.

On May 27, 2020, Duo notified Fairstone that it did not intend to close on June 1, and citing COVID-19 and Fairstone’s response to the pandemic. Duo claimed these factors had triggered the MAE clause allowing it to not proceed with the transaction. Fairstone responded that the effects of the pandemic fell within the carve-outs and sought an application for specific performance.

Defining the Use of MAE Provisions

In reviewing some principles surrounding the use of MAE clauses, the Court recognized they allocate risk between a buyer and seller. The Court looked to a leading Delaware case and adopted a general definition of MAE, finding that it consists of three elements:

• an unknown event,
• a threat to overall earnings potential, and
• durational significance.

The burden of proof rests with the party seeking to rely on the MAE provision, establishing on a balance of probabilities that the event would reasonably be expected to have an MAE. Significantly, the party does not need to establish that an event will have an MAE, only that it is a reasonable expectation. To do so, the buyer must demonstrate:

• More than a possibility or risk that an MAE might occur;
• Evidence allowing the Court to reach an informed judgement;
• The evidence must be “tethered to realities” and not mere possibilities; and
• The evidence can be quantitative and/or qualitative.

The Court also considered the date on which to assess whether an MAE has occurred, finding that it is appropriate to use the closing date as the date on which to find whether an MAE has or is reasonably expected to occur. Yet, there is also a question of how far into the future it is appropriate to look in finding whether an event could reasonably be expected to constitute an MAE. On this question, the Court concluded the timeframe cannot be indefinite as a buyer accepts forward-looking risks in acquiring a business. Instead, the timing will depend on the circumstances of each case.

COVID Fell Within a Broadly-Worded Carve-Out for “Emergencies”

The Court found that the pandemic fell within the first (emergencies) carve-out which was broadly worded and encompassed a pandemic even if the word “pandemic” was not included as a contemplated event. A wide interpretation of the carve-out was justified on a commercial basis as MAE clauses allocate systemic risks to the buyer leaving company-specific risk in the hands of the seller. As well, the changes that Duo objected to were changes to the market and industry and not unique to Fairstone. The Court also concluded that Fairstone was not disproportionately adversely affected compared to others in the market.

Responding to Economic Contractions falls Within Ordinary Course Covenants

Duo also argued that it should not be forced to close on the basis that Fairstone had not operated the business in the ordinary course between signing the agreement and the closing date. The Court maintained that ordinary course provisions ensure that the business being bought is essentially the same as the one contracted for when signing the purchase agreement. Duo alleged that steps taken in response to the pandemic violated the covenant, namely changes to i) its branch operations model, ii) payment collection process, iii) employment policies, iv) expenditures, and v) accounting methods.

The Court rejected the argument, accepting that if a business takes prudent steps in response to an economic contraction that leave no long-lasting effects without imposing obligations on the buyer, it will not be viewed as operating outside of the ordinary course. Moreover, there was some reluctance to allow the general ordinary course provision to override the more specific MAE clause.

Application of MAE Provisions in Corporate Transactions

Fairstone shows that an analysis of MAE provisions is highly dependent on the facts of a transaction and the specific drafting. Nevertheless, it is evident that courts will take care not to expand the reach of provisions to include protections that were not clearly bargained for. A carefully drafted agreement may be able to protect purchasers against additional uncertainties. Additionally, the case notes that MAE clauses are not generally intended to protect against systemic risks. Consequently, carve-outs involving systemic external events will usually be given a broad interpretation.

The Toronto lawyers at Milosevic & Associates are skilled litigators who regularly guide clients through complex commercial matters, contract disputes and commercial issues related to the COVID-19 pandemic. Our team has extensive experience and expertise advocating for our clients’ rights. Call us at 416-916-1387 or contact us online to schedule a consultation.