Ever since the lockdowns imposed by COVID-19 started crippling businesses across Canada, there has been a lot of speculation over whether courts will allow parties to get out of deals they have made as a result of the disruptions caused by the pandemic. In what is likely the first of many decisions on this issue, the Ontario Superior Court of Justice has recently provided some insight.
In Fairstone Financial Holdings Inc. v. Duo Bank of Canada, a bank argued that it should be entitled to escape its obligations under a share purchase agreement after the target company became negatively impacted by COVID-19. The court held that the impact caused by the pandemic did not provide sufficient reason to void the deal.
On February 18, 2020, Fairstone Financial Holdings Inc. (“Fairstone”), a large private consumer finance company, entered into a share purchase agreement (“SPA”) with Duo Bank of Canada (“Duo”), whereby Duo agreed to purchase the shares of Fairstone. The SPA contained a material adverse effect covenant (the “MAE Covenant”), which stated that no material adverse effect (“MAE”) was to occur between the time the SPA was signed and the closing of the transaction.
The MAE Covenant defined a MAE as a fact, circumstance, condition, change, event or occurrence that has (or would reasonably be expected to have) a MAE on the target business. The MAE also contained certain “carve-outs”, which excluded MAEs resulting from or caused by (a) worldwide, national, provincial or local conditions or circumstances, including emergencies; (b) changes in the markets or industry in which Fairstone operates; and (c) the failure of Fairstone to meet financial projections. Carve-outs (a) and (b) were subject to a qualification that if a MAE were caused by one of the two conditions, Duo had to complete the purchase unless the emergency or market change had a materially disproportionate adverse impact on Fairstone compared to other entities in its industry or market.
The SPA also contained the following covenants (the “Covenants”):
- an “ordinary course covenant”, which required Fairstone to operate its business in the ordinary course between the signing and closing of the SPA unless Duo’s consent was obtained for a change in its operations, which was not to be unreasonably withheld. “Ordinary course” was defined as actions consistent with past practices and taken in the ordinary course of normal day-to-day operations;
- an “amortization event covenant”, which provided that no development or event shall exist that results or would be reasonably expected to result in an amortization event under any financing document; and
- an “access covenant”, which stipulated that Fairstone was to provide Duo with all financial and operating data reasonably necessary for the consummation of the transaction within a reasonable time.
The pandemic caused Fairstone’s financial condition to weaken, which created tension between the parties. Duo eventually notified Fairstone that it no longer intended to close the transaction on the basis that a MAE occurred as a result of the pandemic and asserted that a pandemic was not caught by the emergency carve-out. Duo also argued that Fairstone breached the Ordinary Course Covenant as a result of actions that it took in response to the pandemic, and that this, among other reasons, allowed it to avoid closing. Fairstone did not accept Duo’s position and initiated a legal proceeding for specific performance.
At issue before the court was whether there was a MAE and whether Fairstone breached the Covenants.
In determining whether there was a MAE, the court held that the carve-out was broad and its purpose was to allocate systemic risks to Duo while leaving company-specific risks to Fairstone. The broad language included a pandemic, since a pandemic is a “worldwide, national, provincial or local condition or circumstance.” The court also stated that in determining whether a condition is “reasonably expected to have” a MAE, Duo had to show more than a possibility or risk that a MAE would occur, based on evidence that would allow the court to reach an informed judgment that is “tethered to the realities”. MAE clauses should not protect the purchaser against all future economic dislocations, and how far into the future courts should look to see if a MAE is expected to arise will depend on the circumstances.
It was also noted that MAE clauses are not designed to protect purchasers against the fluctuations of market timing, and although MAEs can contain features to protect purchasers against bad market timing, the SPA did not contain such features. It was held that, although the pandemic had a MAE on Fairstone’s operations, the MAE carve-outs applied and Fairstone was not, and not reasonably expected to be, disproportionately affected by the pandemic relative to others in its industry or market.
Regarding the “ordinary course covenant”, Duo argued that Fairstone made changes to its operations in response to the pandemic which diverged from its conduct at the time of signing the SPA. Duo therefore took the position that these changes violated the covenant. The court, however, found that Fairstone made these changes in good faith in order to keep its business running normally in light of the pandemic and not in response to challenges which were unique to it.
It was therefore held that Fairstone’s conduct fell within the meaning of ordinary course as defined in the SPA. Moreover, if Fairstone’s conduct fell outside of the ordinary course of business, it was conduct to which Duo would have been required to consent, had it been asked.
Duo also argued that the “amortization event covenant” was breached. The basis for this argument was that if it reasonably expected an amortization event at any point during the lifetime of Fairstone’s facilities, it was entitled not to close. In response, Fairstone argued that the amortization event must exist at the time of closing on a balance of probabilities for Duo to avoid closing.
The court held that the burden of proof for determining whether an amortization event is likely to occur is “likely, not merely possible”. If projections predict an actual or proximate amortization event, it would more reasonably be expected that Fairstone’s management would be capable of navigating the business away from such an event. Duo’s expectation of an amortization event during the pandemic was not deemed to meet this standard of proof.
Moreover, it was also held that Duo was not able to avoid contractual obligations based on its subjective belief that an amortization event was likely to occur. It was noted that contracts are to be interpreted objectively and allowing Duo to avoid the SPA on this basis would destroy this sense of objectivity.
Finally, Duo also argued that the “access covenant” was violated due to the fact that it allegedly made numerous information requests to Fairstone and that some of them were unanswered or insufficiently answered. The court rejected this argument on the basis that many of Duo’s requests were merely fishing expeditions to support its position that it did not need to close the transaction, rather than legitimate requests for information that it needed to close.
For example, many of the information requests were related to Fairstone’s failure to provide information regarding alternatives to steps it took in response to the pandemic. However, since Duo was in a similar business to Fairstone’s, Duo did not require a list of every alternative. Instead, if Duo was under the impression that Fairstone was doing something inadvisable, Duo had enough business knowledge to engage in a discussion to arrive at a more acceptable alternative. The court found that there was no evidence that Duo engaged in such discussions.
In the end, it was held that none of the Covenants were breached by Fairstone. As such, Duo did not have any basis for refusing to close the transaction. The court therefore granted Fairstone’s action for specific performance and Duo was ordered to perform the SPA and close the transaction.
It is still unclear whether the economic disruption caused by COVID-19 will provide a valid basis for parties to escape their contractual obligations and this issue will likely be dealt with extensively in the courts for the foreseeable future. Although the Fairstone decision does not provide a definitive answer, it does show that, as a starting point, parties will not have an easy time getting out of valid deals, despite the hardships that this pandemic has caused.
The author would like to thank Lucas Morini, Student-at-Law, for his assistance with this article.