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In Canada’s first Covid-19 busted deal case, Fairstone Financial Holdings Inc. v Duo Bank of Canada,  (Ont. Supr. Ct.; 12/20), an Ontario court rejected a buyer’s arguments that it was entitled to terminate an acquisition agreement based upon the occurrence of a seller MAE & the seller’s alleged breach of its ordinary course covenant.

The Court’s approach to the MAE issue borrowed from Delaware precedent in terms of defining what constitutes a “Material Adverse Effect” and, like the Chancery Court in AB Stable, it concluded that the pandemic did not result in a seller MAE under the terms of the agreement.  However, the Court parted company with the Chancery Court when it came to analyzing the seller’s compliance with the ordinary course covenant, and held that the seller’s actions in response to the pandemic did not violate its obligations under that covenant.

One way in which the Ontario Court differed with the Chancery was in its approach to the requirement that the seller seek the buyer’s consent for departures from compliance with the restrictions imposed by the covenant. While the Chancery Court refused to treat the consent requirement as a mere formality if the actions taken by the seller were reasonable, the Ontario Court came very close to doing just that. It essentially said said that even if the seller’s actions required the buyer’s consent under the terms of the covenant, the buyer would have had to provide its consent because it would have been unreasonable to withhold it in the circumstances.

This excerpt from a Davies memo on the decision explains the Court’s approach to the ordinary course covenant:

– Ordinary course covenants function to protect a buyer from company-specific risks and moral hazard, but are not “one-size-fits-all.” The Court found that the interpretation of an ordinary course covenant is context-dependent and requires the balancing of several factors. The Court noted that a change in conduct is more likely to fall within the ordinary course if it is taken in response to systemic factors, rather than challenges unique to the target business. The Court also noted that ordinary course covenants are designed to mitigate morally hazardous behaviour by a seller that may have incentives to operate the target business to its own benefit to the detriment of the business and the buyer.

While stressing that there are limitations on the types of changes a seller may undertake, including with respect to the magnitude and duration of these changes, the Court found that changes in conduct pursued in good faith for the purpose of continuing the normal operation of the business can be consistent with ordinary course obligations. In this case, the Court relied on communications between Fairstone and Duo to conclude that Fairstone’s responses to the pandemic were pursued in good faith, while Duo’s behaviour appeared to be more opportunistic (i.e., an attempt to abandon the deal).

– It is ordinary course for a business to encounter systemic economic events and respond with prudent (but modest) changes. Comparing what the target business did in similar circumstances in the past, or what the target business is doing relative to other businesses, is considered by the Court to be the most faithful interpretation of ordinary course. Nevertheless, the Court indicated that prudent steps taken in response to an economic contraction should generally not be seen as operating outside the ordinary course if those steps do not have long-lasting effects, do not impose obligations on the buyer that cannot be easily undone, and are pursued for purposes of continuing the business, not changing it.

– A requirement to act in a manner “ consistent with past practice” does not impose a rigid standard. The Court noted that the term “consistent with past practice” affords the target reasonable flexibility: it must be “congruous, compatible and adhere to the same principles of thought and action” as past conduct, but need not be identical. The Court determined that Fairstone’s responses to the pandemic were consistent with its responses to past economic contractions and allowed the business to continue its normal day-to-day operations.

– MAE clauses and ordinary course covenants must be read and understood in the context of the contract as a whole. Duo argued that the protections afforded by the MAE Clause and Ordinary Course Covenant needed to be read independently and on their face. The Court disagreed with this position because the practical implication meant that Fairstone could not respond to a pandemic without operating outside the ordinary course, effectively rendering the pandemic a basis for not closing the transaction even though the pandemic was covered by the MAE Carve-outs. The Court determined that in this particular case, it would not be appropriate to use the more general language of the Ordinary Course Covenant to override the more specific MAE Clause.

The memo reviews the key areas of divergence between the Chancery Court’s decision in AB Stable and the Fairstone decision. It points out, among other things, that AB Stable reflects a much more textual approach to the interpretation of the ordinary course covenant than Fairstone, and that while the Ontario Court read the MAE clause & the ordinary course covenant in tandem, the Chancery approached them as embodying separate and distinct obligations.

– John Jenkins