In a highly anticipated decision, the Ontario Superior Court of Justice – Commercial List held that Cineworld wrongly terminated its arrangement agreement to acquire Cineplex, which was awarded substantial damages.
In Cineplex v. Cineworld, released on December 14, 2021, Justice Conway of the Commercial List concluded that Cineplex's deferrals of payments to landlords, studios, and suppliers in March through May 2020 were not in breach of a covenant requiring Cineplex to operate in the Ordinary Course until closing.
This is the second Canadian court decision considering whether a buyer was entitled to refuse to close a major acquisition due to the impact of COVID-19 on the target business, after Fairstone v. Duo Bank in December 2020. The Court reaffirmed the interpretation of Ordinary Course covenants from Fairstone, which differs from that adopted by a Delaware court in the first pandemic "deal fail" decision in that jurisdiction, AB Stable VIII LLC v MAPS Hotels and Resorts One LLC.
Cineplex is the first Canadian court decision to assess damages against a buyer for refusing to close an acquisition under an arrangement agreement. While Cineplex could not recover the premium payable to its shareholders had the arrangement closed, the Court awarded Cineplex $1.24 billion in damages for loss of anticipated deal synergies. Together, Fairstone and Cineplex indicate that buyers must meet high thresholds to establish a failure of closing conditions – and may face considerable damages exposure if they cannot.
Cineworld has announced that it intends to appeal the decision, which may lead to appellate guidance on the interpretation of Ordinary Course covenants and damages for failure to close.
The Transaction
In December 2019, Cineworld Group plc (Cineworld) entered into an arrangement agreement (the Agreement) to acquire the shares of Cineplex Inc. (Cineplex). Cineworld agreed to pay $34 per share, or a 42% premium to Cineplex's stock price at the time, for a total transaction value of approximately $2.8 billion. The transaction would have made Cineworld the largest cinema chain in the world.
In February 2020, both Cineplex and Cineworld received overwhelming shareholder approval for the transaction and final approval for the arrangement from an Ontario court. The only outstanding closing condition was approval of the transaction under the Investment Canada Act (ICA). The parties expected to obtain ICA approval by the end of March, with June 30 as the outside date for closing.
In March 2020, Cineplex was required to close its theatres across Canada by government emergency orders, and Cineworld closed its theatres globally due to the pandemic. In response to the decreased revenues, in March through May 2020, Cineplex deferred payments to film studios and other suppliers. Cineplex also told its landlords that it would not pay April rent and received multiple default notices while negotiating rent deferrals and abatements.
The ICA approval process extended through early June 2020. On June 5, Cineworld sent notice to Cineplex alleging numerous incurable breaches of the Agreement. On June 12, Cineworld delivered notice to Cineplex purporting to terminate the Agreement. On the same day, Cineworld withdrew its application for ICA approval.
The Parties' Claims
Cineplex sued Cineworld for over $1 billion in damages for repudiating the Agreement. Cineworld counterclaimed for its transaction costs, alleging breach of the interim covenant requiring Cineplex to operate "in the ordinary course of normal day-to-day operations of the business... consistent with past practice" (Ordinary Course) and other specific interim covenants.
While Cineworld's June 5th notice had also alleged that Cineplex had experienced a Material Adverse Effect, the definition of "Material Adverse Effect" in the Agreement excluded effects caused by "outbreaks of illness," except where they had a materially disproportionate effect on Cineplex. Cineworld did not pursue this allegation at trial, which focused on the alleged breaches of the Ordinary Course covenant.
Cineworld's Decision Not to Close
The Court noted that a great deal of evidence at trial was directed to whether Cineworld "wanted out" of the transaction as early as March or April. While stating that this evidence had no bearing on the analysis of whether Cineplex had breached any covenants, the decision nevertheless begins with a detailed review of that evidence.
Based on that review, the Court concluded that Cineworld had decided not to close the transaction at $34 a share by April 24, and that its "exit strategy" was to delay the ICA approval process in the expectation that Cineplex would eventually fail the separate closing condition that its bank debt not exceed $725 million. As it turned out, Cineplex's bank debt never exceeded $725 million – including because of payment deferrals and spending reductions.
No Breach of Ordinary Course Covenant
The Court found no breach of the Ordinary Course covenant as a result of Cineplex's deferrals of payments to landlords, studios, and suppliers. The Ordinary Course covenant required Cineplex to:
- operate in the Ordinary Course and in accordance with the law; and
- use commercially reasonable efforts to preserve the business, including business relationships with customers, suppliers, and partners.
With respect to the first part of the covenant, the Court held that there was no default when Cineplex's theatres were closed due to government mandates, and that the payment deferrals adopted in response to the closures were consistent with the "cash management tools" that Cineplex had used to manage its liquidity in the past – albeit deployed on a larger scale.
With respect to the second part of the covenant, the Court held that the deferrals and spending reductions by Cineplex to conserve liquidity were commercially reasonable efforts to maintain and preserve the business once the theatres were closed. The Court relied, among other things, on evidence from witnesses from a major landlord and a major studio that Cineplex continued to have strong relationships with those counterparties following the deferrals.
While Cineplex conceded that it could not have deferred payables solely for the purpose of staying under the $725 million debt condition outside a pandemic, the Court agreed with Cineplex that it was commercially reasonable for Cineplex to consider all debt limits (including the closing condition) in managing its cash flow in response to the pandemic.
The Court reaffirmed several conclusions from Fairstone regarding the interpretation of Ordinary Course covenants, notably:
- Buyers will be excused from closing a transaction where the seller's actions significantly change the nature of the business or have a long-lasting impact that would affect the buyer in operating the business after closing. The focus is on the nature and degree of any operational changes.
- The Ordinary Course covenant did not require Cineplex to operate exactly as in non-pandemic times. Reasonable actions taken by a target business in response to extraordinary systemic circumstances are not outside the Ordinary Course.
- As in Fairstone, this conclusion was supported by the exclusion of outbreaks of illness from the Material Adverse Effect clause, which indicated that the parties intended the transaction to close even in the event of a pandemic.
Notably, the Delaware court in AB Stable reached different conclusions on each of these points in interpreting a similarly-worded Ordinary Course covenant, holding that:
- The covenant required the target to keep operating in a routine manner;
- Ordinary responses to extraordinary events are not Ordinary Course conduct; and
- Exclusions from the definition of a Material Adverse Effect could not be used to interpret the Ordinary Course covenant, as these were distinct risk allocation mechanisms.
The Cineplex decision distinguished AB Stable on its facts, noting that the steps taken by the seller in that case (unprecedented closures of a hotel chain, which were not legally required, and layoffs of thousands of employees) had "gutted" the business, whereas Cineplex's responses were temporary steps to preserve the business that did not engage the concerns underlying Ordinary Course covenants.
Damages for Repudiation of the Arrangement
Having found no breaches of covenants by Cineplex, the Court assessed damages for Cineworld's wrongful termination of the Agreement.
The Court rejected Cineworld's argument that Cineplex was not entitled to damages as it could have sought specific performance of the Agreement, including a term requiring Cineworld to use best efforts to seek ICA approval. This was held not to be an appropriate remedy given that Cineworld had withdrawn its application for ICA approval following an extended negotiation process.
The Court also rejected the first measure of damages proposed by Cineplex, namely the loss of the premium that would have been payable to its shareholders had the transaction closed. The Court held that there was nothing in the Agreement that entitled Cineplex to recover losses suffered by its shareholders.
The Court accepted, as an alternative measure of damages, the anticipated deal synergies that were lost to Cineplex. The damages calculation was based on a synergies report prepared for Cineworld prior to entering into the Agreement, which estimated $176 million in synergies for Cineworld, of which $163 million would have been realized by Cineplex. The present value of the lost synergies to Cineplex was $1.24 billion.
The Court rejected the argument that the ultimate benefit of those synergies would have accrued to Cineworld as the sole shareholder of Cineplex. It also declined to apply a discount for the probability of Cineplex achieving those synergies.
Conclusions
- The Cineplex decision highlights the high bar for buyers to establish a failure of closing conditions entitling them to refuse to close an acquisition, as well as the potential for substantial damages if a court concludes that they have wrongly repudiated the deal.
- The Ontario courts in Fairstone and Cineplex have held that Ordinary Course covenants do not require target companies to operate identically to their past practices. Particularly where the risk of an event has been allocated to the buyer (e.g. through carve-outs in a Material Adverse Effect clause), commercially reasonable actions taken in response to preserve the business may not be in breach of Ordinary Course covenants.
- The Ontario courts' interpretation of Ordinary Course covenants can be contrasted to that of the Delaware court in AB Stable, which held that a similar covenant required the target company to operate in a routine manner prior to closing.
- On the assessment of damages, the Court in Cineplex held that, absent provisions to the contrary in the transaction agreement, target companies cannot recover the loss of consideration payable to their shareholders in the event that an arrangement does not close. They may, however, be entitled to substantial damages on alternative measures, including for loss of deal synergies.
- Pending appellate guidance on these issues, practice points
from the decision include that:
- Carve-outs from Material Adverse Effect clauses, and other contractual provisions that allocate systemic risk between parties, may attract greater focus in negotiations, given their potential implications for the interpretation of interim operating covenants.
- When considering synergies from a proposed transaction, buyers should be aware that damages in respect of synergies that would have been realized in the target business may be recoverable by the target if the buyer refuses to close.
Target companies should not, in the absence of specific provisions to the contrary, expect to recover losses equal to any premium payable to their shareholders if a buyer refuses to close and specific performance is not available. Accordingly, targets with a strategic buyer may heighten their focus on the ability to obtain specific performance of the transaction, including increased scrutiny of the buyer's financing arrangements, or consider negotiating a reverse termination fee. These measures are commonplace in transactions with financial/private equity buyers but have to date been seen less frequently in transactions with strategic buyers.
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