In its recent decision in Cineplex v. Cineworld, the Ontario Superior Court of Justice (Commercial List) (Court) delivered a C$1.24-billion damages award for a busted M&A transaction that was a victim of the COVID-19 pandemic. The decision is notable for its ruling on the appropriate damages for a purchaser’s unjustified termination of the purchase agreement and for providing further judicial interpretation of ordinary course covenants in M&A transactions amid the ongoing pandemic.
The Court previously considered ordinary course covenants in M&A transactions amid the ongoing COVID-19 pandemic in Fairstone Financial Holdings Inc. v. Duo Bank of Canada (Fairstone). A summary of the Court’s prior decision in Fairstone can be found in our January 2021 Blakes Bulletin.
On December 15, 2019, Cineplex Inc. (Cineplex) entered into an arrangement agreement (Arrangement Agreement) with Cineworld Group plc (Cineworld). As part of the Arrangement Agreement, Cineworld agreed to purchase all of the outstanding shares of Cineplex for a transaction value of approximately C$2.8-billion. The transaction was subject to approval under the Investment Canada Act (the ICA) and was to close no later than June 30, 2020.
On June 12, 2020, Cineworld sent a notice to Cineplex terminating the Arrangement Agreement and, after having engaged in extensive discussions with government officials, withdrew its application for ICA approval. Cineworld claimed it was entitled to terminate the Arrangement Agreement on the basis that Cineplex had breached its obligations under the Arrangement Agreement, particularly the “ordinary course” covenant and other operating covenants related to the COVID-19 pandemic. In response, Cineplex sued Cineworld for damages, and Cineworld brought a counterclaim to recover its transaction costs from Cineplex.
The Court found that Cineplex had not breached its covenants under the Arrangement Agreement and awarded Cineplex damages in the amount of C$1.24-billion. This was to primarily compensate Cineplex for lost synergies it had expected from the transaction.
ORDINARY COURSE COVENANT
Cineworld claimed it was justified in terminating the Arrangement Agreement on the basis that Cineplex had breached certain of its operating covenants in the Arrangement Agreement, specifically the covenant that Cineplex would “operate in the ordinary course of business” between the date of the Arrangement Agreement and closing. Cineworld claimed as damages its transaction costs of £32-million.
The operating covenant in the Arrangement Agreement required Cineplex to do two things:
Conduct its business in the ordinary course of business
Use commercially reasonable efforts to maintain and preserve its business, assets, properties, employees, goodwill, and business relationships with customers, suppliers, and partners
The Arrangement Agreement also allowed Cineworld to terminate the transaction in the event of a material adverse effect. However, “outbreaks of illness” were excluded from the list of material adverse effects. All parties agreed the COVID-19 pandemic did not constitute a material adverse effect giving rise to a right to terminate.
Cineworld argued that Cineplex started to deviate from its ordinary course of business immediately after the Arrangement Agreement was signed on December 15, 2019. As a result of very real concerns about the COVID-19 pandemic and the possible effect of the pandemic on the movie theatre business, Cineplex began taking steps to preserve its cash. Those steps included deferring payments to landlords, film studios and non-film suppliers, reducing capital expenditures, and repaying bank debt.
In addition to managing its cash flow and liquidity, these steps ensured the debt balance on Cineplex’s C$800-million revolving credit facility would stay below the C$725-million limit. This was a condition in the Arrangement Agreement that, if not met, would allow Cineworld not to close the transaction.
In April 2020, Cineplex told Cineworld of the steps it was taking to manage its cash flow and credit balance. However, it was not until June 2020 that Cineworld objected to these measures and elected to treat them as non-curable defaults under the Arrangement Agreement.
Cineworld claimed Cineplex was not permitted to deviate from its ordinary course of business, even in the face of the COVID-19 pandemic. It also argued that had Cineplex not taken these actions outside of the ordinary course of business, Cineplex’s debt balance under its credit agreement would have exceeded the C$725-million limit, entitling Cineworld not to complete the transaction.
The Court noted that operating covenants, particularly covenants to operate in the ordinary course of business, serve two fundamental purposes:
Ensure the business the buyer is purchasing is substantially the same from the date of the signing of the agreement to the date of closing
Eliminate the “moral hazard” of sellers acting in their own interest to the detriment of the purchaser during the interim period
It also held that the operating covenant had to be interpreted in the context of the entire Arrangement Agreement, which had allocated the risk of the COVID-19 pandemic to Cineworld.
Determining what conduct is, or is not, in the ordinary course of business is highly fact specific. The analysis is both flexible and contextual. Generally speaking, however, the Court noted that a departure from the ordinary course of business is characterized by a significant change in the nature of the business or a departure that is likely to have a “long-lasting impact” that affects the business after closing.
After reviewing the jurisprudence, the Court accepted Cineplex’s argument that the ordinary course covenant must be read in the context of the whole Arrangement Agreement in which systemic risks, including adverse impacts on the business arising from “outbreaks of illness,” were allocated to the purchaser. The Court, thus, interpreted the ordinary course covenant in a way that would not negate the parties’ allocation of the risk of a pandemic to Cineworld.
In interpreting the Arrangement Agreement, the Court held that the operating covenant required Cineplex to both operate in the ordinary course of business and take reasonable steps to maintain and preserve its business. The Court said that Cineworld considered only the first part of the operating covenant and not the second.
The Court concluded that Cineplex’s responses were “temporary” in nature and were consistent with Cineplex’s use of “cash management tools to manage its liquidity in the past.” These reactions by Cineplex, including the deferral and spending reductions to preserve cash, helped preserve the business that Cineworld had purchased.
Accordingly, the Court held that Cineworld was not justified in terminating the Arrangement Agreement and had breached its obligation to acquire Cineplex.
The Court awarded total damages of C$1.24-billion in respect of lost synergies, plus a further award of C$5.5-million for Cineplex’s transaction costs. The Court relied heavily on a pre-transaction report prepared by Cineworld to estimate the synergies that would be achieved by Cineplex from the transaction. This was supplemented by a report prepared for trial by Cineplex. While Cineworld challenged the methodology of these reports, its expert did not present an alternative method of calculating damages.
Cineworld argued that Cineplex should have mitigated its damages by seeking specific performance of the transaction and, therefore, was not entitled to its expectation damages. However, the Court rejected this argument. It noted that Cineworld’s withdrawal of its ICA application for approval precluded Cineplex from seeking specific performance and ordering Cineworld to use its best efforts to seek ICA approval would not have been an appropriate remedy.
In considering the appropriate measure of damages, Cineplex submitted that it should be entitled to recover the difference between the value of Cineplex shares on the termination date and the C$34 deal price, a measure of damages that would have resulted in a C$1.32-billion award.
The Court rejected this submission on the basis that such losses were those of the shareholders, who were not parties to the Arrangement Agreement. It noted that the shareholders constituted only third-party beneficiaries for purposes of collecting the agreed consideration for a completed transaction, not for purposes of any claims for breach of the Arrangement Agreement if Cineworld failed to close.
However, the Court accepted Cineplex’s alternative submission that damages should be awarded equal to the discounted present value of the expected synergies that Cineplex would realize as a result of the combination with Cineworld.
The Court rejected Cineworld’s argument that those synergies would have ultimately been for the benefit of Cineworld as buyer of Cineplex. It noted that the synergies were among the benefits Cineplex would have itself realized.
The evidence submitted by both parties indicated the purchase price that was to be paid to shareholders in the transaction (although not the correct measure of damages) was reflective of the expected synergies that had been anticipated.
The Court accepted Cineplex’s calculation of synergies. However, it declined to make any deduction for the cost of anticipated debt financing that Cineworld had expected to put in place at the Cineplex level in connection with the transaction. It stated that Cineworld had not submitted sufficient evidence regarding its post-closing plans and what the timing and financial impact would have been of such debt financing.
The Court also did not apply any discount based on the uncertainty of closing due to unfulfilled regulatory approvals, as the evidence had indicated there was a very high likelihood the ICA approval would have been obtained.
The large damages award of C$1.24-billion relative to the total transaction value of C$2.8‑billion, raises the question of whether Cineworld would, in hindsight, have been better off simply performing the agreement rather than terminating.
Cineworld has announced it intends to appeal the decision.
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