On April 30, 2021, then-Vice Chancellor (now Chancellor) Kathaleen S. McCormick of the Delaware Court of Chancery issued a post-trial decision addressing an array of important topics in the "busted deal" context following a private equity buyer's attempt to terminate its $550 million acquisition of a private cake decorating company. In this decision—Snow Phipps Group, LLC v. KCAKE Acquisition, Inc.—the court rejected the buyer's attempt to terminate the deal on the basis of an alleged material adverse change (MAC) in the target's business and the target's alleged failure to operate in the ordinary course. The court also found that the buyer had breached its contractual obligations to use reasonable best efforts to work toward a definitive credit agreement for the acquisition. The court ordered specific performance, requiring the buyer to close the transaction.

The case is one of many busted deal litigations filed in the Court of Chancery following the onset of the COVID-19 pandemic—although the conclusions in the case will be relevant for deals in the future. The parties had negotiated the underlying transaction in the first quarter of 2020, signing the deal on March 6 of that year. Although the court decided the dispute based on the language of the transaction documents, the evidence at trial showed that the parties were mindful of the looming pandemic and that the buyer negotiated a 10 percent price cut on the eve of signing given the volatility materializing in the markets. The transaction did not have an express financing contingency, but did limit the seller's remedy of specific performance to force a closing to circumstances where debt financing had been obtained or was available. In addition, the buyer was obligated under the acquisition agreement and debt commitment letter to use reasonable best efforts to obtain debt financing or otherwise seek alternative financing.

The target company's business initially "declined precipitously," with its sales falling between 42.4 percent and 63.9 percent year-over-year for the first five weeks post-signing. As 2020 wore on, however, the business began to recover, with 2020 annual revenue ultimately declining only 14 percent and adjusted EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) declining 25 percent, in each case relative to 2019. Like many companies, the target decided in March 2020 to make a partial draw of $15 million on its revolving credit facility out of an abundance of caution, although it never spent the funds and fully repaid them by August 2020. The target also cut various business costs, including labor costs, in the midst of the pandemic, a step it had taken during prior business downturns.

According to the court, the buyer developed "a case of buyer's remorse" in mid-March 2020 when it believed that celebrations and related cake orders would decline during the pandemic and as it considered the capital needs of its other portfolio companies and opportunities to pursue distressed debt investing opportunities. The buyer created its own pessimistic and "unsupported" forecasts for the target's business—dismissing the target's forecast that the business would recover fairly quickly based on a process the court described as "painstaking." The buyer sent its pessimistic forecasts to the lenders for the deal along with a demand for revised financing terms that were beyond the scope of the debt commitment letter. When the lenders rejected those demands, the buyer declared that financing was no longer available and made an unsuccessful four-day effort to assess the availability of alternative financing. The evidence at trial, including an email in which the buyer appeared to view the merger agreement as an option, showed that the original lenders believed that the buyer was trying to back out of the deal, even though the lenders remained willing to fund the deal on the agreed-upon terms.

Ultimately, in April 2020, the buyer attempted to terminate the deal, citing several bases that would form a familiar pattern during the early stages of the pandemic: the existence of a MAC, a breach of the target's covenant to operate in the ordinary course (in this case, based on drawing on the revolver and cutting costs), and the unavailability of debt financing. The target filed a complaint, seeking specific performance of the acquisition agreement.

Following trial, the court rejected all of the buyer's grounds for termination. As for an alleged MAC, the court, echoing prior Delaware decisions, noted that a "short-term hiccup" will not suffice and that, absent some specific agreement by the parties, a MAC will only exist where there has been a "durationally significant" change to the business that is "consequential to the company's long-term earnings power over a commercially reasonable period." The court noted that scholars and the court have considered sustained decreases in profits in the "40% or higher range" to support the finding of a MAC. Such a sustained drop had not occurred here. In addition, the court found that, because the vast majority of the decline in the target's sales was related to shelter-in-place and closure orders across the country, it fell within the acquisition agreement's carve-out from the definition of a MAC for effects "related to … government orders." The acquisition agreement further provided that such carve-out would be inapplicable if there was a "disproportionate effect" on the target's business compared to "other comparable entities operating in the industry" in which the target company operates, but the court determined no such disproportionate effect had occurred when the target was compared to other businesses in the cake-decorating industry (as opposed to the grocery store industry generally, as the buyer urged). The court rejected a related argument that the target had breached a representation relating to its business with top customers, which also required that any breach rise to the level of a MAC.

Separate from the MAC analysis, the court determined that the target had not breached its covenant in the acquisition agreement to operate the business "in a manner consistent with the past custom and practice" of the company, noting that such language required a comparison to the target's prior business practices. Although the target's 2020 draw on its credit facility was larger than prior draws, the company had drawn on the facility five times since 2017. Moreover, the target promptly notified the buyer of the draw request, and the buyer had not given the target the opportunity to cure any alleged breach of the covenant, as the agreement required. Because the target never spent the funds, the court reasoned that the target could clearly cure any breach. As for the target's cost-cutting measures, the court found that the target had a historic practice of cutting costs when the company's sales decreased.

Finally, the court rejected the buyer's position that it did not have to close the deal because debt financing was no longer available. Under the terms of the acquisition agreement, the remedy of specific performance—which would require the buyer to close the deal—was only available if "the full proceeds of the Debt Financing have been funded" to the buyer. The court concluded, however, that the debt financing became unavailable because of the buyer's wrongful demands of the lenders and refusal to move forward under the agreed-upon terms. The court applied the "prevention doctrine," which excuses non-occurrence of a condition if a party's breach materially contributed to the non-occurrence. Because the court found that the buyer breached its obligation to use reasonable best efforts to arrange and obtain debt financing, it was therefore precluded from refusing to perform its obligations under the acquisition agreement due to the non-occurrence of financing. The court rejected the buyer's argument that the doctrine required bad faith conduct, finding that the doctrine only required a showing of wrongful conduct that materially contributed to the failed condition.

The court found that the target demonstrated it was entitled to an order of specific performance requiring the buyer to close the acquisition and use reasonable best efforts to obtain alternative financing. The court also requested further briefing on whether the acquisition agreement was written to allow the target to seek prejudgment interest on the deal price from the outside closing date of May 4, 2020, in addition to a specific performance remedy requiring the buyer to close.

As with many other recent deal litigations leading up to and during the pandemic,¹ the case offers important lessons to companies and advisors in the deal context. First, Delaware courts will not easily find a MAC, and the bar remains high for buyers to back out of a deal on the basis of one. Second, carve-outs to MAC clauses (including "carve-outs to carve-outs" related to disproportionate effects on a target) should be carefully considered and appropriately tailored. Third, deal litigation during the pandemic, in which businesses have had to adapt to changed circumstances, has highlighted that parties should pay careful attention not only to MAC clauses, but also to covenants that require a target to operate in a particular way in the period between signing and closing. For example, many acquisition agreements now provide that a target need only use reasonable best efforts (or some other efforts standard) to operate in the ordinary course or provide an explicit carve-out to the ordinary course requirement for actions taken in response to COVID-19 measures (such as shelter-in-place or shut-down orders). This new decision is an interesting counterpart to the Court of Chancery's AB Stable decision, which determined that another pandemic-caused busted deal did not involve a MAC but did involve a breach by the target of the ordinary course covenant. Finally, this decision provides important insights into remedies provisions in acquisition agreements, and whether and when private equity buyers, which often rely on financing, may be permitted to back out of a deal based on the availability and terms of financing.

[1] For our firm’s prior discussions of such decisions, see:  https://www.wsgr.com/en/insights/delaware-court-of-chancery-finds-a-material-adverse-effect-and-permits-termination-of-merger-agreement.html; https://www.wsgr.com/en/insights/delaware-court-of-chancery-declines-to-find-a-material-adverse-effect-and-orders-specific-performance-of-a-merger.html;  https://www.wsgr.com/en/insights/delaware-court-of-chancery-addresses-effects-of-pandemic-on-material-adverse-effect-provision-and-ordinary-course-covenants-in-busted-deal-case.html.