Developments from the Cineplex v Cineworld Decision in Interpretation, Drafting and Negotiation of “Ordinary Course” Covenants Amid Uncertain Market Conditions
On December 14, 2021, the highly anticipated judgement in Cineplex v Cineworld, 2021 ONSC 8016 was delivered by Justice Conway1 as it relates to the interpretation of different types of covenants that are commonly found in definitive agreements of M&A transactions. The Court was called on to interpret various provisions of an arrangement agreement between Cineplex and Cineworld (collectively, the “Parties”), with particular regard to the interplay between the wording of a material adverse effect covenant (“MAE”) and various other interim covenants negotiated by the Parties. This decision further develops the law and the legal interpretation surrounding contractual risk allocation mechanisms that are commonly used to alleviate and address deal risks within M&A transactions.
The case builds on the December 2020 decision in Fairstone, an analysis of which can be found here. MAE clauses are common tools used in mergers and acquisitions when there is a delay between signing the agreement and the closing of the transaction (the “Interim Period”). They typically address “the occurrence of unknown events that substantially threaten the overall earnings potential of the target in a durationally-significant manner” (Fairstone)2. They allow the purchaser and the seller to negotiate an acceptable level of risk allocation in the Interim Period. They set the parameters of events and/or conditions that, should they occur, allow the purchaser to forego closing. Operating covenants, on the other hand, compel the target to operate its business in a certain way during the Interim Period in order to preserve the purchaser’s value in the target’s assets and operations.
As a result of this decision, parties to an M&A transaction should therefore pay particular care when drafting and negotiating MAE and operating covenants in a transaction document, especially contractual language that specifically reference the “ordinary course of business”. Parties should also be mindful that a court would also review the past financial practices of a business in the interpretation of contractual provisions. This decision in Ontario also highlights the departure in the interpretation of MAE covenants and operating covenants from established Delaware jurisprudence.
On December 15, 2019, the Parties entered into an arrangement agreement (the “Agreement”) pursuant to section 182 of the Business Corporations Act (Ontario). Under the Agreement, Cineworld was to acquire the shares of Cineplex, in a transaction valued at $2.8 billion. The Agreement provided for a June 30, 2020 closing date (“the Closing”), and also required approval under the Investments Canada Act (“ICA Approval”).
In March of 2020, during the Interim Period, the COVID-19 pandemic was declared. As a result, movie theaters were ordered to close around Canada beginning March 16, 2020. Prior to the pandemic, Cineplex had already been suffering decreased revenues due to poor box office performance and economic unease around the impending pandemic. In response, Cineplex employed a variety of corporate financial management strategies, including, among other things:
- Withholding or deferring payables, including to major suppliers;
- Withholding rent payments and negotiating abatements with landlords;
- Deferring payments to film studios pursuant to newly negotiated repayment plans; and
- Delaying uncommitted capital expenditures.
On June 12, Cineworld gave notice to Cineplex that it would be terminating the Agreement. Cineworld subsequently withdrew its ICA Approval Application the same day.
THE PARTIES’ POSITIONS
Cineplex claimed that Cineworld had no basis for terminating the Agreement, and its notice of termination amounted to a repudiation of the Agreement. As a remedy, they sought damages, as Cineworld’s withdrawal of the ICA Approval application prevented Cineplex from seeking specific performance of the Agreement.
Cineworld argued that it was entitled to terminate, as Cineplex had breached its covenant to operate in the ordinary course of business in the Interim Period when it employed the various financial management tools. It further claimed that Cineplex’s operations during this time were subject solely to the operating covenant. They also brought a counterclaim against Cineplex for the cost of the transaction.
In reply, Cineplex argued that its pandemic response was governed by the MAE clause, but if it was subject to the operating covenant, Cineplex had not been in breach. Cineplex further submitted that Cineworld’s argument was based on a narrow interpretation of the Agreement, and as a fundamental principle of contract interpretation, the covenants must be read together so as not to negate one another.
The court, in ruling for Cineplex, agreed with Cineworld that the Interim Period was governed by operating provisions, but accepted Cineplex’s argument that they had not breached the clause, nor any other interim covenants. The reasoning is based on a fundamental principle of contract interpretation- namely, that the Agreement should be interpreted in its entirety so as not to read one clause as negating another.
1. The Material Adverse Effect Issue
Central to the court’s reasoning was the drafting of the MAE covenant. The Parties negotiated and explicitly excluded “outbreak of illness” from the definition of an MAE. The Court found that the MAE clause “squarely addressed the risk of a pandemic and allocated that systemic risk to Cineworld.”3 In doing so, Cineworld had bargained away its right to terminate on the basis of the COVID-19 pandemic alone. This decision reiterates the need for parties to turn their attention to the careful drafting of MAE covenants.
2. The “Ordinary Course” Operating Covenant
As noted above, the Court found that Cineplex’s conduct during the Interim Period was governed by the Agreement’s operating covenant, which was drafted as follows:
“The Company shall, and shall cause each of its subsidiaries to, conduct its business in the Ordinary Course and in accordance with the Laws, and the Company shall, in good faith, use commercially reasonable efforts to maintain and preserve its and its subsidiaries business organizations, assets, properties, employees, goodwill and business relationships with customers, suppliers, partners, and other Persons with which the Company or any of its Subsidiaries has material business relations” (the “Operating Covenant”).
Ordinary Course was defined as actions “taken in the ordinary course of the normal day-to-day operations of the business of the Company…consistent with past practice.” Cineworld’s case hinged on the argument that the steps taken by Cineplex to reduce the financial impact of the pandemic were in breach of this covenant, as they did not meet the definition of Ordinary Course. In rejecting this argument, the Court considered the Operating Covenant in two parts: (i) the requirement that Cineplex conduct its business in accordance with the law and (ii) the requirement that Cineplex use commercially reasonable efforts to maintain its assets, goodwill, etc.
In considering the first point, the Court held that it would be unreasonable to claim breach of this covenant when Cineplex had, in fact, closed its doors due to a government mandate and order, which was required in compliance with applicable law. In considering the second point, the court reviewed evidence about the past financial practices of Cineplex. The court had determined that the actions taken by Cineplex were financial management tools which were consistent with previous practices employed by Cineplex. In particular, he noted that such practices did not alter the economics of the deal and had simply deferred or shifted payments. In doing so, Cineplex had been adhering to the very terms of the definition of Ordinary Course – they used commercially reasonable best efforts to preserve its business, employees, assets, and goodwill with its suppliers.
3. The Interplay between the MAE Covenant versus the Ordinary Course Covenant
The Court went on to further discuss the interplay between the MAE covenant and the Ordinary Course Covenant. In employing a fundamental principle of contract interpretation, the court made it clear that Cineworld could not read the Operating Covenant in isolation in order to shift the risk it assumed in excluding an outbreak of illness in the MAE covenant back onto Cineplex. When read as a whole, it was clear that Cineworld could not waive its right to terminate because of a pandemic, and then rely on the very strategies used by Cineplex to manage the pandemic for that very purpose. Such an interpretation would render the MAE covenant meaningless.
The Ontario court’s interpretation of the MAE covenant and Ordinary Course covenant in tandem appears to be a departure of pandemic deal termination jurisprudence in Delaware, and affirmed on appeal – over which MAE covenants and Ordinary Course covenants were read independently of each other as they are to be considered involving separate and distinct obligations4. Although the court in Ontario would not read the MAE covenant in isolation of an operating covenant, it would nonetheless be prudent for parties to turn their attention to the drafting and construction of these provisions.
Cineworld had also claimed that Cineplex breached other interim covenants, including an impermissible transfer of an asset; amending of contracts; as well as the indebtedness and budget covenants. It also submitted that Cineplex had breached its duty of honest performance. The Court rejected these positions.
In considering the allocation of damages, the Court rejected Cineplex’s claim for an award for loss of shareholder consideration. The Agreement only gave shareholders the right to consideration if the transaction closed, but did not provide them third party enforcement rights, nor was Cineplex appointed as their agent for enforcement. The Court did, however, make an award for loss of synergies, with total damages amounting to $1.24 billion.
While notable for the quantum of damages awarded, parties to future M&A deals can takeaway the following:
- Parties need to be aware of the risks that they are assuming when agreeing to MAE covenants early on in the negotiation stage. MAEs can be significant bargaining chips in allocating risk and reducing uncertainties of outcomes in the event that uncertain effects materialize, but they can also carry significant risks if parties are not cognizant of its consequences. Further, given that MAE covenants and operating covenants would be read together, considering each covenant, on an individual basis, would also be a prudent practice.
- In assessing risk allocation during the interim period between signing and closing of a transaction, the purchaser in a transaction should consider interim covenants in relation to the entire agreement. The purchaser should also consider past financial practices of the target’s business in response to adverse conditions in light of catch all “Ordinary Course” operating covenants in order to consider appropriate carve outs to these broadly drafted definitions. It is clear that they will be interpreted so as to reflect the ultimate positions bargained for by the parties.
- In a potentially contentious transaction, the seller in a transaction should be mindful of the drafting of interim covenants in the agreement and seek legal counsel so as to ensure they remain within the permissible range of actions, especially when adverse market conditions arise such that certain financial management and corporate strategies, although prudent in response, may be subject to binding provisions of ordinary course covenants.
1 Cineplex v. Cineworld, 2021 ONSC 8016 [“Cineplex v Cineworld].
2 Fairstone Financial Holdings Inc. v. Duo Bank of Canada, 2020 ONSC 7397, at 64.
3 Cineplex v. Cineworld, at 107.
4 AB Stable VIII LLC v. MAPS Hotels and Resorts One, LLC, et al., 2021 WL 5832875, (Del. Dec. 8, 2021).