Cineplex’s biggest blockbuster of 2021 is not on the screens: Ontario Court Awards $1.2 billion in damages to Cineplex because Cineworld walked from its merger deal
Can a purchaser in a merger transaction walk away from the deal because of COVID-19? For the second time in a year, the Ontario Superior Court of Justice has clearly said “no”. In the case of Cineplex Inc. v. Cineworld Group plc, the Court granted Cineplex more than $1 billion in damages when its counterparty walked from the deal because of COVID-19.
The decision is Cineplex is consistent with the first substantive decision on “material adverse effects” (MAE) clauses in Fairstone Financial Holdings, which we reviewed here. The two key points from Cineplex from the decision are as follows:
- A clause requiring a company to operate in the “ordinary course of business” has to be read in the context of risks transferred to the buyer. In this case, Cineworld assumed risks associated with “outbreaks of illness”. It could not effectively transfer that risk back to Cineplex by forcing it to operate in the “ordinary course of business”, as though COVID-19 did not exist.
- The target company cannot sue for damages sustained by its shareholders. In this case, Cineplex “only” recovered $1.266 billion, being the “synergies” that it expected to receive from the Cineworld deal. It could not recover the full purchase price. This is a result we anticipated in our prior article.
To a certain extent, the Cineplex decision adds little to the analysis as to how Canadian courts will interpret “material adverse effect” clauses, and there are still key questions that will have to be addressed in other cases. What constitutes a material adverse effect, the onus of proof with the shifting burdens in a MAE clause, and how disproportionality will be proven, are still questions for another day.
However, the decision is valuable for understanding the interaction between MAE clauses and other covenants, and is mandatory reading for Canadian M&A practitioners and participants alike.
The dispute in Cineplex v. Cineworld
On December 15, 2019, Cineplex and Cineworld entered into an Arrangement Agreement, whereby Cineworld would acquire all of the shares of Cineplex for $34 per share. This was a premium of about 42% to Cineplex’s shares trading price. The transaction was subject to a number of conditions and covenants, including approvals under the Investment Canada Act (the “ICA”).
Cineplex obtained an interim order on January 9, 2020, in connection with the arrangement. On February 11, 2020, shareholders for both Cineplex and Cineworld voted overwhelmingly in support of the transaction. The parties obtained a final order approving the transaction, with only pre-closing conditions left to be fulfilled (the only one of significance being the ICA approval).
COVID became well-known in March. Cineplex closed its theatres across Canada on March 16, and on the following day, the government of Ontario declared a provincial state of emergency.
On June 5, Cineworld sent a notice to Cineplex, which alleged a number of breaches of the Arrangement Agreement, with such breaches not being capable of being cured. Cineplex denied any breach.
A week later, Cineworld terminated the Arrangement Agreement. Cineplex sued shortly thereafter.
The Arrangement Agreement has a standard MAE clause in it, which allowed Cineworld to walk from the deal where certain events or circumstances occurred that would have a MAE on Cineplex’s business or affairs. Like all MAE clauses, there were exclusions. Here, one such exclusion was “any earthquake, flood or other natural disaster or outbreaks of illness or other acts of God”. Cineworld could not terminate the agreement in such a circumstance. The only time it could, would be if such an outbreak had a materially disproportionate effect on Cineworld, relative to comparable companies operating in the industries in which Cineplex operated. Cineworld did not take the position that there was a disproportionate effect on Cineplex.
As a result of the positions taken by the parties, the Cineplex decision is not really a MAE decision at all. The question of whether COVID-19 was, or was not, a “material adverse effect”, was not determined, because the exclusion of “outbreaks of illness” would clearly apply. And the question of how “disproportionality” is to be determined also was not considered, because Cineworld never argued disproportionality. As a MAE case, Cineplex v. Cineworld tells us very little.
What it does explain is the interrelationship between MAE clauses and other operating covenants, and how damages are to be calculated.
Cineworld argued that Cineplex breached its operating covenants, notably, the obligation to operate the business in the intervening pre-closing period in the “ordinary course of business”. First, Cineworld pointed to certain actions taken before COVID was known, such as clamping down on expenses and pushing out payables on March 2. But the Court found that even though the full impact of COVID-19 was not known, it was already well on Cineplex’s radar by that point, having had experienced supply chain challenges in early to mid-February, and cinemas had already been closing in China. Justice Conway found that “the decision to defer payables and restrict spending in early March was made in the context of the very real concerns about COVID-19 and the reality of its impact on the Cineplex business.”
Second, Cineworld pointed to a number of Cineplex’s actions after the world went on high alert over COVID-19. Cineplex closed its theatres: it never did that before. Cineplex deferred payment to landlords. It deferred payments to film studios. It deferred payments to other suppliers. It put a hold on capital expenditures. None of this was “ordinary course of business”, argued Cineworld.
Justice Conway was not convinced. First, she noted that the operating covenants had two aspects: (a) operating in the ordinary course of business; and (b) take reasonable steps to maintain and preserve its business. She said Cineworld was only looking at the first part of the definition, not the second. Operating in the ordinary course, as though nothing was changing, would have been disastrous for Cineplex: it would have been left with zero liquidity in circumstances where it had no revenue at all.
And more than that, given that Cineworld had assumed the risks associated with “outbreaks of illness”, how could it be expected that the ordinary course covenant would prevent Cineplex from reacting to that very outbreak of illness? Justice Conway put it this way:
Cineworld submits that under the Operating Covenant, Cineplex was required to operate during the pandemic exactly as it did during non-pandemic times, failing which Cineplex would be in breach of the Operating Covenant. I cannot accept this interpretation. It ignores the other provisions of the Arrangement Agreement and fails to read the agreement as a whole. […] Cineworld’s narrow interpretation of the Operating Covenant would reallocate this risk [of a pandemic] back to Cineplex. […] It would render the other provisions of the agreement meaningless.
Justice Conway found that Cineplex did not breach the Operating Covenants, and Cineworld had no justifiable basis to terminate the Arrangement Agreement.
Justice Conway's ruling on damages is not particularly controversial. She found that the proper measure of damages is based on “expectations”: damages are to put the innocent party in the position it would have been in, but for the breach of contract. This is a well understood measure of damages.
The interesting part of the case is how Cineplex went for all the marbles: not just damages Cineplex sustained, but also, damages that its shareholders effectively sustained. And Cineplex was not just seeking some premium on the share price, it wanted the whole value of the deal, less the intrinsic value of the shares retained. It also sought damages based on “synergies” that it had anticipated to receive, and transaction costs.
Justice Conway dismissed the claim for the whole of the purchase price. She found that “the losses that Cineplex seeks to recover are those of the shareholders, not Cineplex.” And Cineplex was not in a position to advance a claim for those losses, because under the Arrangement Agreement, Cineplex was appointed as shareholders’ agent only to collect the consideration if the transaction closed. She also said that shareholders “did not have any rights, as third party beneficiaries, to enforce the agreement or to sue Cineworld for any breach.”
This issue has come up infrequently in Canadian law and there may be appellate interest in the issue. There is a curious result here that a party can breach an arrangement agreement, enjoy the “benefit” of their breach (the non-payment of a premium after the value of the asset had declined), causing “harm” of sorts to shareholders, and there is no remedy. If a shareholder were to sue for breach of the agreement, its claim would be dismissed for lack of privity with Cineworld. Other causes of action, such as unjust enrichment, would likely have problems. But awarding damages to Cineplex today, who would have a different set of shareholders from shareholders back in 2020, is also problematic: Cineplex (and its current shareholders) would be effectively obtaining damages that belong, in part, to somebody else entirely. In securities class actions, some care is taken to ensure that damages payable are to the proper parties; the blunt instrument proposed by Cineplex in this case does not account for that.
As for the damages the Court did award, it was significant in terms of dollar amounts, but not particularly significant from a legal perspective. Justice Conway relied on a financial advisor opinion produced to Cineplex before the Arrangement Agreement was even signed, which showed expected combination benefits of $165 million annually to Cineplex. Cineplex led expert evidence that applied those future annualized benefits, applied various discounts, and applied a present value that led to $1.266 billion. Cineworld’s expert challenged that opinion on the basis that those synergies would only have flowed to Cineworld, as buyer, and that there should have been a probability discount. Justice Conway accepted Cineplex’s expert evidence and not Cineworld’s.
The result was that the Court granted Cineplex $1.266 billion on account of expected synergies, and $5.5 million on account of transaction costs, plus costs.
To a certain degree, this is a case with a significant sum of damages, but very little of significance in terms of the law. The Court applied basic principles of contract law that are almost trite law: one is to read the contract as a whole, and not read one provision in a manner that results in another being rendered nugatory or superfluous. The Court ruled that, to recover damages, the damages have to actually be suffered by the plaintiff (Cineplex) and not someone else (shareholders).
Big questions on MAE clauses in Canada still remain and will need to be worked out. Insofar as the Court in Cineplex touched on MAE jurisprudence, Justice Conway tended to do as other Canadian courts have done (as reviewed in our article), applying Delaware jurisprudence almost without any modification. Akorn, and Professor Miller’s seminal U.S. text on the subject, was given appropriate respect. We can expect that to continue in Canada.
This is likely the last chapter on the intersection between COVID and MAE clauses in Canada (absent appeals), because any transaction currently underway in Canada has fully contemplated COVID and allocated risk very clearly. But even for later transactions, the Court’s decision in Cineplex discussing the interaction between going concern covenants, and MAE exclusions, will be useful for the parties and practitioners alike.
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