"Financial" buyers are amongst the most active participants in M&A. Alleged material adverse effects ("MAE") are amongst the most complex disputes in M&A.
What happens when the two meet? Numerous Delaware decisions have indicated that a different MAE analysis might apply where the M&A transaction features a "financial" buyer (as opposed to a "strategic" buyer). Moreover, the scant Canadian caselaw that has considered the issue arguably points in the same direction.
Given that Canada is consistently the largest foreign destination for U.S. outbound M&A by deal volume,1 we explore this issue for the benefit of M&A lawyers on both sides of the border.
"Financial" Buyers vs "Strategic" Buyers
Private equity ("PE") has become an increasingly important force in M&A, largely due to the classic PE model whereby a PE fund acquires an underperforming business to improve such performance before selling the business for a profit.
This "flipping" of businesses by PE (often called "financial" buyers) is in contrast to the typical goals of a "strategic" buyer. Being an established industry player, a "strategic" buyer usually acquires the business not for short-term improvement but for comprehensive and long-term integration into its operations and growth plans and for potential synergistic and operational savings.
Material Adverse Effect Disputes
A detailed dive into the MAE clause is beyond the scope of this article.2
What is important for the current discussion is that, first, MAE clauses allow the buyer to avoid closing the transaction where the target has experienced a "material adverse effect," and second, in deciding whether a "material adverse effect" has occurred, courts consider the anticipated duration of the adverse impact on the target. Simply put, an adverse development of only momentary consequence is unlikely to be considered "material" as intended by an MAE clause.
When a "Financial" Buyer Meets an MAE
What is the consequence of the convergence of an M&A transaction with a "financial" buyer and an alleged MAE on the target such that the "financial" buyer argues it is entitled to walk away from the deal?
The answer is that several courts have indicated— although none to the knowledge of the authors definitively—that the required duration of the adverse impact experienced by the target may be briefer where the buyer is a "financial" with a shortterm investment horizon. Stated differently, these courts have shown an appreciation of the distinction in acquisition motivations and intentions between "strategics" and "financials" and have implied that such differences may in part drive their MAE analysis.
Delaware Caselaw
Indeed, such indications are relatively longstanding, at least in Delaware.
In IBP the Court of Chancery noted the MAE clause "must be read in the larger context in which the parties were transacting" before distinguishing between "a short-term speculator" and a "strategic buyer." For the former, the failure of the target "to meet analysts' projected earnings for a quarter could be highly material." For the latter it would be "odd" to "view a short-term blip in earnings to be material . . ."
Both Hexion and Bardy stated that, in the absence of evidence otherwise, "a corporate acquirer may be assumed to be purchasing the target as part of a long-term strategy." Level 4 Yoga remarked that "durational significance is particularly important here because [the buyer] was seeking to acquire [the target] as part of a long-term strategy."3
Another recent example is Snow Phipps, which involved the sale of a cake decorations company by a mid-market PE firm to a larger PE group. The Court of Chancery summarized:
[The buyer] argues that, in a debt-financed acquisition, the timeframe for evaluating durational significance should align with the timing of post-closing covenant compliance testing. [The buyer's] argument effectively invites the court to view private equity transactions dissimilarly from strategic acquisitions when interpreting an MAE, an idea that is the subject of a wealth of scholarly commentary that the parties neither cited nor discussed. This decision flags the issue without engaging in it . . . (emphasis added)
This "wealth of scholarly commentary" was also noted in Akorn, where the Court of Chancery recognized that "[c]ommentators have suggested that 'the requirement of durational significance may not apply when the buyer is a financial investor with an eye to short term gain.' ''
Canadian Caselaw
Noteworthy for U.S. "financial" buyers eyeing a Canadian target is that these themes recurrent in Delaware MAE caselaw were recently echoed by the Ontario Superior Court of Justice (the Court) in Fairstone.4
First, the Court endorsed the statement in IBP that, "[f]or a short-term speculator, the durational requirement may be relatively short to constitute a MAE."5 The Court also acknowledged that, in other instances, U.S. courts have required adverse changes that "persist significantly into the future," including adverse changes "consequential to the [target's] long-term earnings power . . ."6
The result for Fairstone was that "[t]he length of the durational requirement depends on the context."7
This led the Court to base its required adverse duration of "approximately two years" in reference to the buyer's expected "synergies," "scale," and "diversification."8 Furthermore, there are other instances of Fairstone emphasizing the importance of context, including when, in considering the MAE's carve-outs, the Court explained that "[o]ne of the factors that Canadian and American courts have identified as relevant to interpreting MAE clauses is the identity of the parties."9
Practical Takeaways for U.S. Private Equity Considering a Canadian Acquisition
Canadian and Delaware law generally align on many key M&A issues, but on certain others they do not.10 One difference pertinent to the intersection of "financial" buyers and MAE clauses is that between the "factual matrix" and the "four corners."
In Canada, per the Supreme Court of Canada's decision in Sattva, the "factual matrix" surrounding a contract's execution is considered in every case and can impact the court's interpretation of the contract's terms. By contrast, in Delaware, courts adhere to the "four corners" principle whereby they generally strive to resolve contractual interpretation disputes, where possible, without looking beyond the document.11
Among other things, this difference in basic principles of contract interpretation could facilitate an argument by a "financial" buyer that its nature as such reduces the required duration of an adverse impact on the target in an MAE dispute governed by Canadian law.12 Also notable towards this end is Fairstone's repeated statement that MAE clauses should be "interpreted from the perspective" of the buyer.13
Overall, the practical takeaways for PE buyers are clear. First, should an MAE arguably occur, a PE buyer's nature as such may function to reduce the duration of adverse impact on the target a Delaware court would require as part of an MAE analysis. Second, given that, at a high level, Canadian law gives more consideration to the "factual context" in deciding contractual interpretation disputes than does Delaware law (i.e., given Delaware's "four corners" principle), this argument may be more open to a PE buyer where the M&A agreement is governed by Canadian law (i.e., where the target is a Canadian company).
Footnotes
1. See Paul Weiss' "M&A at a Glance Year-End Roundups" for each of 2022, 2021, 2020, 2019, and 2018.
2. For further discussion, see P. Blyschak, "Material Adverse Effect (MAE) Clauses in Canada: What U.S. Counsel Needs to Know" (2022) 16(2) Virginia Law & Business Review 327.
3. See also Frontier Oil v. Holly, which cautioned that the "notion of [an MAE] is imprecise and varies both with the context of the transaction and its parties . . ." (emphasis added).
4. Fairstone Financial Holdings Inc. v. Duo Bank of Canada, 2020 ONSC 7397 (CanLII) ["Fairstone"].
5. Fairstone at para. 78.
6. Fairstone at paras. 78 and 79, citing IBP, Hexion, Frontier Oil, and Akorn.
7. Fairstone at para. 78 (emphasis added).
8. Fairstone at paras. 81, 84, and 85.
9. Fairstone at para. 93 (emphasis added).
10. See, for example, P. Blyschak, "Material Adverse Effect (MAE) Clauses in Canada: What U.S. Counsel Needs to Know" (2022) 16(2) Virginia Law & Business Review 327.
11. See E. Norman Veasey & Jane M. Simon, "The Conundrum of When Delaware Contract Law Will Allow Evidence Outside the Contract's 'Four Corners' in Construing an Unambiguous Contractual Provision" (2017) 72 The Business Lawyer 893.
12. Note, however, that as a decision of the Ontario Superior Court of Justice, Fairstone would not be binding in Canada's other provinces and territories. That said, it could be considered persuasive in such other jurisdictions. The authors are unaware of any Canadian caselaw other than Fairstone discussing this issue in any meaningful detail.
13. See Fairstone at paras. 25-26, 72, and 86. See also paras. 162 and 166.
Originally published by The M&A Lawyer.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
