Canada looks for clarity on buyers’ ability to terminate deals – Analysis

13 May 2020

Canadian dealmakers are closely watching a court case over a disputed tie-up between two auto financing companies that could provide a precedent in the country on how to interpret material adverse effect clauses in merger agreements.


  • Judge to weigh more evidence in Rifco/CanCap dispute
  • Court expected to consider Delaware precedent
  • Bought deal ‘disaster out’ clause also unresolved

Canadian dealmakers are closely watching a court case over a disputed tie-up between two auto financing companies that could provide a precedent in the country on how to interpret material adverse effect clauses in merger agreements.


The case before the Court of Queen’s Bench of Alberta concerns a deal signed in early February by CanCap Group, the parent of Toronto-based automotive lender AutoCapital Canada, to acquire Red Deer, Alberta-based alternative auto financing company Rifco for CAD 25.5m (USD 19.2m).


AutoCapital walked away from the bid in late March, citing a material adverse effect (MAE) from the coronavirus pandemic and oil price crash, among other reasons.


The court, which was set to rule after the final hearing under the plan of arrangement, decided it needed more time and evidence to assess the bidder’s claims and what would be the best process to adjudicate the case, according to Rifco.


While only a small deal in terms of value, how the court ultimately rules may have far-reaching consequences for Canadian M&A, the attorneys said. The case will notably demonstrate “for the first time” how the country’s courts review an MAE dispute, according to Gesta Abols, an M&A partner at Fasken.


Merger agreements typically define a material adverse effect or material adverse change (MAC) clause as any change or development that has a material adverse effect on the operations of the target or the ability of a party to complete the deal. The clause includes extensively negotiated carve-outs for events and circumstances that do not count as an MAE in an effort to allocate risk between the parties, but typically never define what is meant by material.


Unlike in the US, Canada has few relevant court decisions on what constitutes an MAE, not the least in the context of a pandemic, leaving Canadian dealmakers in uncharted waters when it comes to navigating whether the impact of COVID-19 impact could constitute valid grounds for terminating a merger agreement, the attorneys said. Notably, the Rifco/CanCap deal agreement does not have a pandemic carveout in its MAE clauses. 


Amid the uncertainty caused by the pandemic, unhappy buyers across the world have been considering how to escape from already-signed deals, but often are finding they are restricted by narrowly framed language in merger contracts. One potential escape hatch, however, lies in MAE provisions, which enable some parties to construct an exit argument, this news service previously reported.


Delaware offers material precedent


In Alberta, the judge and practitioners will likely look to jurisprudence from Delaware for assistance, Abols said, noting there are several well- articulated Delaware decisions in IBP v. Tyson Food and Akorn v. Fresenius Kabi on how to evaluate MAE claims. 


As reported, Delaware court precedent makes it challenging for a buyer to walk away from a merger by citing an MAE. The court’s understanding of the MAE concept was developed from the classic 2001 IBP case, where Vice Chancellor Leo Strine said the purpose of the MAE provision is not to facilitate an exit by a remorseful buyer. The ruling in the 2018 Akorn case further noted that “the typical MAE clause allocates general market or industry risk to the buyer, and company-specific risks to the seller.” 


The fact that both US and Canada have similar common law traditions suggests that the Delaware cases “should be very informative,” Abols said. A key outcome from Alberta will be whether the court adopts Delaware’s thinking or decides to adopt a distinct approach from its US counterpart.


Andrew Gray, a litigation practice partner at Torys, noted an issue to watch is the court’s approach to the threshold question of defining “materiality.”


Delaware’s precedent has focused on the duration of the disruption when evaluating materiality, Gray said. In the IBP decision, MAEs are defined as “unknown events that substantially threaten the overall earnings potential of the target in a durationally-significant manner,” and the test cannot be met by a “short-term hiccup in earnings.” 


The duration emphasis was further demonstrated in the 2018 Akorn case, where the court determined an MAE has occurred, on the finding that the target’s decline was substantial in five straight quarters and showed “no sign of abating.” 


Thomas O’Leary, a partner at Dentons, agreed that Canadian courts have not set standards on what constitutes materiality. The Rifco case, if it proceeds to a decision, will potentially provide significant new guidance on Canada law, he said. 


Given its significance, the case might take a number of months in litigation before reaching a final decision under the court, O’Leary estimated. The spurned suitor Rifco, on the other hand, is likely to pressure an expedited process, he said.


The Alberta court’s procedural ruling last week that the dispute needed to be examined further came days after a hearing about an application for the final order to the proposed plan of arrangement.


The interim update did not come as a surprise. “The judge appears sensitive to the commercial realities of the decision,” Abols said, noting the court specifically requested more actual evidence for its further review.


Other than relying on MAE claims, some unhappy buyers could take the position to test other closing conditions, such as interim operating covenants, two of the attorneys said. There are few precedents in Canada for operating covenants.


Some suitors in the US have cited covenant breaches as a rationale for termination during the pandemic given the challenges of mounting a standalone MAE case, as reported. Others have looked to combine an MAE and covenant claims.


In Canada, Air Canada is reportedly considering invoking an MAE clause to walk or renegotiate its pending acquisition of Montreal-based leisure airline Transat, according to Reuters. The MAE clause on the deal excludes events like “natural disasters … outbreaks of disease” from counting as a material adverse effect.


Air Canada is suspending most international flights until June, while Air Transat has cancelled all trips until the end of May due to the pandemic.


Another pending Canadian deal with an MAE question is UK-based Cineworld’s bid for Toronto-based movie theater operator Cineplex. The Cineplex merger agreement specifically precludes the outbreak of illness as a rationale for walking, though lenders to Cineworld have explored options for avoiding financing the deal due to the coronavirus outbreak, as reported.


Cineplex this week announced it is delaying the filing of its 1Q20 earnings as it deals with the pandemic and the closure of all of its theaters. The company says Cineworld remains a committed buyer, but that it is unclear if the conditions to close will be met by the 30 June termination date.


Bought deal disruption


While awaiting the outcome in Alberta, practitioners are watching another case that could have ramifications for Canada’s equity capital markets.


In mid-March, National Bank Financial terminated its bought deal agreement to acquire CAD 75m worth of shares in SilverCrest Metals, citing the “disaster out” clause. The deal was terminated seven days after the announcement, after Silvercrest’s stock value had plunged close to 50% in a week.


SilverCrest countered that the coronavirus pandemic was known when National Bank agreed to back the equity offering and that the assumption was the precious metals market would gain on the risk, according to SilverCrest.


The case could point to COVID-19-related disruptions in Canada’s bought deal market and a rise in disputes, the attorneys said. A bought deal is a common form of equity issuance in Canada, whereby the underwriting investment banks commit to buying the full amount of shares being offered by a company with plans then to resell the stock to investors.


Fasken’s Abols noted that all underwriting agreements have market-out clauses, which allows the underwriter to cancel the agreement without penalty. A market out clause can be activated for specific reasons such as souring market conditions. In the face of COVID-19 outbreak, he predicted that some underwriters might rely on such “disaster out” provisions to avoid commitment in bought deals, while issuers could pursue legal remedies for breach of contract.


One related precedent under Ontario Superior Court is a 2013 decision to award damages against Thomas Weisel Partners Canada, now part of brokerage Stifel Financial, in Stetson Oil & Gas v. Stifel Nicolaus Canada for failing to close on a bought deal private placement, confirming the binding nature of the bought deal letter. 


Still, each dispute needs to be reviewed on a case by case basis, and the wording of MAE or force majeure clauses will be a key part of the analysis, O’ Leary said. 

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