On April 30, 2021, the Delaware Chancery Court (the “Court”) issued a decision in Snow Phipps Group, LLC v. KCake Acquisition, Inc., ordering an affiliate of private equity buyer Kohlberg & Co. (“Kohlberg”) to acquire cake decoration supplier, DecoPac Holdings Inc. (“DecoPac”), for $550 million. In the opinion, newly sworn-in Chancellor Kathaleen McCormick affirmed prior case law on several common contractual provisions that bear on deal certainty in the time of COVID-19 (including material adverse effect, or “MAE,” conditions; interim operating covenants; and the reasonable best efforts standard). Most notably, however, the Court said it had “chalked up a victory for deal certainty” by granting DecoPac's request to force Kohlberg to specifically perform its agreement to acquire DecoPac despite an unfulfilled condition precedent to such remedy.
Minnesota-based DecoPac is the world's largest supplier of cake decorations to professional cake decorators and bakeries. On March 6, 2020, at the beginning of the global pandemic, Kohlberg entered into a stock purchase agreement (“SPA”) with DecoPac and Snow Phipps, the private equity representative of sellers, agreeing to acquire DecoPac. In addition to the SPA, the buyer also entered into, among other agreements, a debt commitment letter with several lenders (“DCL”). Under the terms of the SPA, Kohlberg agreed to use reasonable best efforts to finance the acquisition on the terms of the DCL and to seek alternative financing if funding under the DCL became unavailable.
Shortly after signing, however, DecoPac's revenues declined significantly as a result of COVID-19 and related stay-at-home orders. Internal emails showed that Kohlberg had developed buyer's remorse and began to evaluate ways to exit the transaction in order to preserve funds in its fully-committed Fund VIII to meet the needs of existing portfolio companies and exploit distressed debt and other more attractive investment opportunities. Kohlberg furnished to its potential lenders a “shock case” forecast based on largely unexplained assumptions and despite contradictory forecasts from DecoPac's management. Kohlberg also requested more favorable financing terms from its lenders, including an increased revolving loan commitment, relief from financial covenant testing and an uncapped COVID-19 revenue addback to earnings before interest, taxes, depreciation and amortization (“EBITDA”). The lenders rejected the request, but each lender affirmed their commitment to fund the acquisition pursuant to the agreed terms of the DCL.
On April 5, 2020, Kohlberg advised DecoPac that no debt financing (or alternative financing) was available, that a MAE was reasonably expected to occur as a result of the escalating pandemic and that Kohlberg's counsel was investigating whether DecoPac had breached its obligation to operate its business in the ordinary course after signing. DecoPac later communicated to Kohlberg that it was in a position to proceed with closing, but Kohlberg refused.
Subsequently, on April 14, 2020, DecoPac filed suit against Kohlberg seeking to force Kohlberg to specifically perform its obligation to close the transaction under the terms of the SPA. In the same week, DecoPac's revenues began to rebound. After DecoPac made repeated attempts to clarify and counter Kohlberg's claims with no success, DecoPac filed an amended complaint on May 5, 2020, which asserted that Kohlberg (1) breached its obligations under the SPA to use “reasonable best efforts” to secure debt financing and failed to secure alternative financing, (2) breached the implied covenants of good faith and fair dealing relating to the DCL, and (3) breached its obligations under the equity commitment letter that it delivered concurrently with signing. The amended complaint sought specific performance of the SPA and, alternatively, a termination fee and other damages in the event specific performance was not available.
Award of Specific Performance and Application of Prevention Doctrine
While the Court's analyses of MAE conditions, interim operating covenants, the “reasonable best efforts” standard and other common M&A contract provisions in light of the COVID-19 pandemic are instructive, its assessment of the availability of a specific performance remedy to DecoPac is particularly noteworthy.
In evaluating DecoPac's request for specific performance, the Court articulated that the party seeking specific performance (DecoPac) must establish that (1) a valid contractual obligation exists; (2) such party is ready, willing and able to perform; and (3) the balance of equities tips in favor of such party.1 Under the terms of the SPA, DecoPac's ability to pursue specific performance was available “if and only if . . . the full proceeds of the Debt Financing have been funded to Buyer on the terms set forth in the [DCL] to fund the payment of the Estimated Closing Payment at Closing (or would be funded at the Closing if the equity financing is substantially contemporaneously funded at the Closing).”2 Kohlberg argued that a specific performance remedy should not be available to DecoPac because “it is undisputed that the full proceeds of the Debt Financing were not funded,”3 and thus, the condition precedent to granting of specific performance had not been satisfied.
The Court held that Kohlberg could not rely on the absence of debt financing to avoid specific performance due to the application of the prevention doctrine. The prevention doctrine provides that “where a party's breach by non-performance contributes materially to the non-occurrence of a condition of one of its duties, the non-occurrence is excused.”4 The Court explained that in determining whether non-performance “contributed materially” to the non-occurrence of a condition, the relevant question is not whether the conduct was the sole and exclusive reason for the failure of the condition, but rather whether the applicable conduct made the satisfaction of the condition less likely. The Court found that Kohlberg's refusal to move forward with debt financing pursuant to agreed terms in the DCL despite the lenders' willingness to proceed, combined with Kohlberg's breach of its obligations to use reasonable best efforts to obtain debt financing under the DCL and to obtain alternative financing, contributed materially to Kohlberg's failure to obtain debt funding at closing. As a result, the Court held that the debt financing condition could not be a condition to the enforcement of the specific performance provision and granted specific performance in favor of DecoPac.
Implications of the Delaware Chancery Court's Holding
The Delaware Chancery Court ruling is “a victory for deal certainty” in that it specifically enforced the obligation of Kohlberg's acquisition vehicle to close, notwithstanding the sponsor's attempts to blame its financing sources for an inability to close and raise defenses to its obligation to close. Private equity sponsors and their advisors should take note and recognize that the very typical condition of debt financing funding in a specific performance clause is not absolute and will not permit a sponsor to turn a purchase agreement into an option, i.e., to buy or pay a reverse termination fee. The sponsor's conduct post-signing matters. However, the ruling also creates many uncertainties. How will the acquisition vehicle, presumably an empty shell, specifically perform its obligations to purchase DecoPac, which we know was earmarked to be the last investment of Kohlberg's Fund VIII? Absent the debt financing funding condition, will Fund VIII be required to fund the entire purchase price or only the equity it committed? Does Fund VIII still have the money? If not, does the decision mean that the private equity sponsor itself must fund the acquisition? Or must investors in Kohlberg's Fund IX assume the equity commitment? In this sense, the ruling casts doubt on the overall funding construct commonly found in leveraged buyout deal documents. All private equity sponsors and their advisors should pay attention to the progress of this case.
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