Important and complex Fairstone ruling on material adverse effect still leaves questions: M&A lawyer

The recent decision of Fairstone v. Duo Bank appears to settle some important questions related to “material adverse effect” claims when a buyer wants to back out of a deal and adheres to or adopts many aspects of Delaware law. However, it departs from its Canadian and Delaware counterparts on some key points, says Calgary-based mergers and acquisitions lawyer Paul Blyschak.

“It also makes these departures without either signaling it is doing so or explaining why it is doing so,” says Blyschak in a paper he wrote for the University of Virginia’s Virginia Law & Business Review. “The result is several interrelated, unresolved and problematic issues of which U.S. and Canadian counsel should be aware of and take caution.”

Blyschak summarizes in his paper: “Fairstone’s unclear and inconsistent approach is unfortunate. As the first significant Canadian MAE decision in almost twenty years, Fairstone is likely to assume an outsized role in Canadian MAE law going forward. A clear-eyed understanding of how Fairstone breaks from its Canadian and Delaware counterparts, and the confused course that results, is therefore imperative.”

He adds: “This is of course the case for Canadian M&A counsel. However, given that the U.S. is by far the largest source of foreign investment into Canada, it is equally the case for U.S. counsel with a cross-border practice.”

In an interview, Blyschak says it is a “very complicated decision.” He adds, “the tricky thing is that it’s more complicated than what it seems when you first read it – it’s when you dig into it do you only realize there are some areas that are still ambiguous.”

Blyschak was until recently a partner with Blake, Cassels & Graydon LLP, where he specialized in complex M&A and cross-border transactions. He now practices in these areas on a consulting basis and has also spent time writing academic articles related to M&A law. He plans to publish a 12-chapter book on various aspects of merger and acquisition law aimed at others in the legal profession.

Fairstone v. Duo Bank involved the purchase of Fairstone, Canada’s largest consumer finance company, at a price estimated to be over $1 billion. The deal was executed in the early stages of the COVID-19 pandemic on February 18, 2020, with the closing date set for June 1, 2020.

Duo Bank argued that the pandemic’s impact was so severe that it fundamentally changed the transaction, and Fairstone argued that the deal should close. However, on May 27, 2020, Duo advised Fairstone that it would not be proceeding, taking the position that the pandemic had resulted in an MAE and the closing condition requiring that no MAE had occurred could not be satisfied. The case ended up at the Ontario Superior Court of Justice (Commercial List).

Justice Markus Koehnen disagreed with Duo, concluding there had not been a material adverse effect. He ordered the parties to close the deal as planned.

Typically, Blyschak says, the parties first define what constitutes an MAE. This definition is then incorporated into select clauses of the acquisition agreement as negotiated by the parties, including certain representations and warranties given by the seller to the buyer and in certain conditions to the buyer’s obligations to close the transaction.

“For example, a typical approach provides that a buyer is excused from closing where, during the interim period between signing and closing, one or more events have occurred which have had or could reasonably be expected to have a material adverse impact on the target’s business.”

The “seminal 2001 decision” of the Delaware Court of Chancery in IBP v. Tyson Foods provides one example of an MAE definition. The merger agreement stated that a “material adverse change” means: any event, occurrence or development of a state of circumstances or facts which has had or reasonably could be expected to have a [material adverse effect] . . . on the condition (financial or otherwise), business, assets, liabilities or results of operations of [IBP] and [its] subsidiaries taken as a whole.

By today’s standards, this is a relatively short MAE definition, Byschak says, as they have grown longer thanks to features such as “carve-outs” to the MAE definition and exceptions to those carve-outs.

The Fairstone agreement defined an MAE as an “act, circumstance, condition, change, event or occurrence that has (or would reasonably be expected to have), individually or in the aggregate, a material adverse effect on the business, operations, assets, liabilities or condition (financial or otherwise) of the [target], taken as a whole.”

Blyschak writes in his paper that the result of the Fairstone decision creates an “unusual and uncertain” path between Canadian and Delaware case law “for all M&A transactions governed by Canadian law.”

Blyschak’s analysis of the Fairstone decision makes several key points:

• Fairstone moves away from the “purchase decision” focus of its Canadian case law predecessors (Consumer’s Glass v. D’Aragon, Cariboo Redi-Mix v. Barcelo, Mull v. Dynacare, Inmet Mining v. Homestake and Extreme Venture Partners v. Varma) in favour of a three-element MAE analysis. It looks at factors such as “an unknown event,” a “threat to overall earnings potential,” and “durational significance.” It does not entirely abandon a “purchase decision” analysis, but it is no longer the driver. 
•  The decision instead emphasizes that MAE clauses are “to be interpreted from the buyer’s perspective, though the decision does not explain what this means. Blyschak says it only indicates that this can result in “the benefit of the doubt” being given to the buyer and that MAE clauses “must be construed” to give buyers “the protections they bargain for,” whatever this might mean.
• The decision partially employs a “purchase decision” to the third element of its three-prong analysis. However, it does not indicate whether a “purchase decision” analysis should always apply to that element whether it could ever apply to either of the other two elements.
•  To the extent Fairstone imposes a “purchase decision” analysis, whether to the first, second, or third elements of making a case for an MAE, it does so in direct conflict with Delaware law. Specifically, Delaware makes clear that MAE clauses and “materiality qualifiers” are “analytically distinct” and that a “purchase decision” analysis applies to the latter but not the former. 
•  Fairstone’s requirement of an “unknown event” as the third element of its MAE analysis also directly conflicts with Delaware precedent. The case of Akorn Inc. v. Fresenius Kabi AG recalibrated Delaware law on this point, Blyschak says, including to honour the risk allocation generally intended by MAE clauses, to support freedom of contract, and to avoid unintended structural consequences. 
• Finally, to the extent any of the above—including the principle that MAE clauses are to be “interpreted from the perspective of the buyer” or the application of a “purchase decision” analysis—results in any advantage for the buyer, this also puts Fairstone in direct conflict with Delaware law. Delaware imposes a “heavy burden” on a buyer alleging an MAE, including for the public policy goal of protecting “deal certainty.”

None of the Canadian MAE precedents relied on in Fairstone conducts as detailed an analysis of what constitutes a “material adverse effect” on a target as makes the Fairstone decision, Blyschak says. However, all focus on the impact the circumstances giving rise to the alleged MAE had, or would be expected to have, on the buyer’s decision to acquire the target.

“Fairstone is certainly a quantum leap forward in many ways, and it does a great job of bringing Canadian case law up to where Delaware is,” Blyschak says. “The Fairstone court was put in a difficult position to catch up to Delaware in one single case, so you have to commend the judge.”

Blyschak’s paper also discusses the Ontario Superior Court of Justice judgement in Cineplex v. Cineworld, awarding Cineplex $1.2421 billion in damages for Cineworld’s termination of their merger agreement based on the COVID-19 pandemic. This decision was grounded primarily in applying the amalgamation agreement’s “ordinary course” of business clause, as the deal’s MAE clause did not prove critical to the court’s analysis. For example, Cineworld conceded that the MAE clause carve-out for illness outbreaks captured the pandemic.

Still, the Cineplex judgment and its referral to Fairstone underscore the importance of Fairstone in future cases involving MAE claims, Blyschak says. Cineplex is the first to consider Fairstone in any “meaningful” fashion, and the judgement acknowledges that Fairstone defined an MAE as “the occurrence of unknown events that substantially threaten the overall earnings potential of the target in a durationally-significant manner.”

However, what the Cineplex decision does not do “is expressly acknowledge, comment on, or otherwise illuminate the tension between Canadian and Delaware law regarding MAE clauses."