[co-author: Andy Gong, Senior Law Clerk]
Delaware Chancery Court awards specific performance after finding that buyer failed to demonstrate a material adverse effect or ordinary course breach by target and that buyer failed to use reasonable best efforts to obtain committed debt financing.
- A precipitous drop in the target’s sales of more than 40% year-over-year for five consecutive weeks due to the effects of COVID-19 followed by an upward trend in weekly sales and a bottom-up reforecast showing further recovery prior to termination of the purchase agreement did not constitute an event that had or was reasonably expected to have a Material Adverse Effect. Establishing an MAE continues to be a formidable challenge requiring durationally significant change to the target’s business.
- A significant drawdown on the target’s revolving credit facility and cost-cutting measures were not inconsistent with the target’s prior drawdowns and past practices of reducing costs in tandem with a decline in sales and did not reflect a material departure from the target’s ordinary course of business.
- Buyer’s use of a financial model that did not seek input from the target or incorporate the target’s reforecast based on actual sales data and buyer’s additional demands for changes to the debt commitment letter were a breach of buyer’s obligation to use reasonable best efforts to obtain the debt financing.
On April 30, 2021, the Delaware Court of Chancery in Snow Phipps Group, LLC v. KCAKE Acquisition, Inc., et al., entered judgment in favor of plaintiffs on a claim for specific performance of a stock purchase agreement and required buyer to close on the purchase agreement.
In Snow Phipps v. KCAKE, Snow Phipps Group, LLC agreed to sell DecoPac Holdings, Inc., a cake decorations company, to affiliates of Kohlberg & Company, LLC for $550 million. The parties executed the purchase agreement on March 6, 2020, after Snow Phipps agreed to a 10% price reduction due to market volatility caused by COVID-19. Shortly after signing, DecoPac’s sales declined significantly as state and local governments began to impose stay-at-home orders. Weekly regular sales beginning March 21 were down year-over-year by 42.4%, 63.9%, 60.3%, 62.2%, and 53.4%, respectively. Following a March 18 call, buyer began a chain of modeling exercises and developed two different “downside cases.” Buyer eventually adopted a model that essentially assumed complete shutdown through Q3 and facility closures followed by an 18-month rebound to baseline sales—which the Court characterized as “draconian.” Without getting DecoPac’s input on the model, buyer sent the model to the lead lenders together with demands for changes in the debt commitment letter (DCL). The demands included an increase to the revolver, an uncapped add-back related to lost revenue from COVID-19, which was later modified to a $35 million add-back, and a holiday from testing the maximum leverage ratio covenant. The lenders concluded that buyer’s financing demands were outside the scope of what was permitted in the DCL, but they were willing to fund the transaction under the terms of the DCL or to renegotiate the terms of the DCL. Around the same time, DecoPac informed buyer that DecoPac had partially drawn down on its revolver in an abundance of caution, but the funds were never spent. On April 1, 2020, buyer informed seller that the debt financing was no longer available. Thereafter, buyer conducted a four-day perfunctory search for alternative financing, which was unsuccessful. Buyer then notified seller that buyer would not proceed to closing, because it did not believe DecoPac would meet its conditions to closing and the debt financing remained unavailable. Following Snow Phipps’ and DecoPac’s commencement of an action seeking specific performance of the purchase agreement, buyer officially sent DecoPac a termination notice on April 20, 2020 citing two grounds for termination: (i) DecoPac breached the no “Material Adverse Effect” (MAE) and top-customers representations, and such breaches would reasonably be expected to have an MAE, and DecoPac failed to perform and comply with the ordinary course covenant in all material respects, and (ii) the full proceeds of the debt financing would not be funded on the terms in the DCL.
The Court held that DecoPac did not breach the no MAE representation. The purchase agreement contained typical MAE provisions which allocate general market or industry risk to buyer and company-specific risks to the seller. DecoPac represented that there had not been a change, development, or the like that, individually or in the aggregate, has had or would reasonably be expected to have a material adverse effect upon the financial condition, business, properties or results of operations of the target group, taken as a whole. The MAE definition also enumerated a series of common exceptions, including that an MAE would not include any change arising from or related to changes in any laws, rules, regulations, orders, enforcement policies or other binding directives issued by any governmental entity. As is also typical, certain exceptions, including the one related to governmental laws and orders, did not apply to the extent that such matter has a materially disproportionate effect on DecoPac, taken as a whole, relative to other comparable entities operating in the industry in which DecoPac operates.
The Court looked to its previous decisions in In re IBP, Inc. S’holders Litig. and Akorn, Inc. v. Fresenius Kabi AG for helpful benchmarks. In IBP, seller experienced a 64% decline in year-over-year first-quarter earnings due to severe winter weather, but by the time of the termination of the transaction the seller had two weeks of strong earnings and signaled a strong quarter ahead. The court in IBP thus concluded a material adverse effect was not reasonably expected. In Akorn, the target’s EBITDA fell by 55% after the merger agreement was signed, and the downturn persisted for a year and showed no sign of abating prior to buyer sending its notice of termination. In Akorn, the court held that the “sudden and sustained drop” in Akorn’s business performance was reasonably expected to constitute a material adverse effect.
In Snow Phipps, the Court concluded that, even though DecoPac experienced a precipitous decline in sales, sales then rebounded prior to termination and were projected to recover the following year. Accordingly, DecoPac’s sales decrease was not an adverse change in its business that was consequential to the company’s “long-term earnings power over a commercially reasonably period”-generally “measured in years, rather than months” and, therefore, it was not reasonably expected that DecoPac’s sales decline would ripen into a material adverse effect. In addition, the Court found that, even absent a specific exclusion to the MAE definition for pandemics and epidemics (which was specifically rejected by buyer), DecoPac’s sales reductions that resulted from the impact of school closures, shelter-in-place orders, nonessential business closures, and restaurant closure orders in connection with COVID-19 fell within the exclusion to the MAE definition for effects arising from or related to changes in any laws or orders of a governmental authority.
For similar reasons, the Court found that DecoPac did not breach a representation that none of its top-ten customers had “stopped or materially decreased the rate of business” done with DecoPac. While, as of the end of April 2020, year-to-date sales to the top customers were down between 8.1% and 30.8% compared to the same period of 2019, forward-looking projections indicated that sales to top customers would see a near-full rebound by 2021. There was no evidence that would suggest that the decrease in sales to top customers was reasonably expected to be durationally significant and material to a reasonable acquirer.
The Court also found that DecoPac did not materially breach the ordinary course covenant by drawing on its revolver or cutting costs. The Court found that the revolver draw was not inconsistent with past practices, even though it was the largest draw made by DecoPac, and buyer never provided notice that the revolver draw was a breach of the ordinary course covenant. Likewise, the Court found that DecoPac proved that decreasing labor costs in line with decreased production was in fact a historical practice of DecoPac. Of note, unlike AB Stable VIII LLC v. Maps Hotels and Resorts One LLC et al., DecoPac did not close locations, furlough employees, and scale back operations in response to COVID-19 that were inconsistent with historical practice.
The Court further held that buyer breached its obligation to use reasonable best efforts in connection with the debt financing. The purchase agreement required buyer to use its reasonable best efforts to execute debt financing on the terms of the DCL or on better terms and prohibited buyer from modifying the terms of the DCL if doing so would jeopardize debt financing or the closing. The Court found that, rather than use reasonable best efforts to work toward a definitive credit agreement on the terms set forth in the DCL, without input from DecoPac management, buyer prepared a “draconian reforecast of DecoPac’s projected sales based on uninformed (and largely unexplained) assumptions that were inconsistent with real-time sales data.”
The Court determined that buyer did not use reasonable best efforts in making the financing demands and the use of buyer’s model was predestined to reflect a covenant breach as a platform to make such demands. The Court found that the provisions in the DCL that acted as a floor to protect the parties did not give buyer the ability to renegotiate terms of the debt financing and walk away from the DCL if it did not secure terms and conditions acceptable to it. Rather, buyer had to use commercially reasonable efforts to satisfy the specific enumerated items. The Court found that buyer did not work with its counterparties in such a way that was likely to solve the problems it faced. The Court further commented that reasonable best efforts to obtain alternative financing likely required more than just four days of inquiry.
Under the purchase agreement, the parties stipulated to the remedy of specific performance, but only if the full proceeds of the debt financing were funded to buyer on the terms set forth in the DCL. Nonetheless, the Court applied the prevention doctrine and deemed the debt financing condition met because buyer contributed materially to the lack of debt financing. The Court found that the lenders were willing to execute the debt financing on the terms of the DCL and buyer, in making the financing demands, changed the risk profile without allowing for adjustments to the economic terms. The fact that the DCL expired by its terms did not negate the fact that buyer refused to move forward on its terms and in doing so effectively ran out the clock while the lenders were standing by willing to close. The Court determined that the prevention doctrine does not require a finding of bad faith, but rather some form of deliberate action.
In Snow Phipps, the Court confirmed that it will hold parties to the terms of the negotiated acquisition agreement, even in the face of a widespread risk event, such as COVID-19. In her decision, Vice Chancellor McCormick called this a “victory for deal certainty.” The Court made clear that it will continue to enforce the contractual obligations of sophisticated parties, regardless of the economic climate.
Some lessons can be gleaned from Snow Phipps:
First, parties should carefully review the MAE definition and, where appropriate, consider defining “material adverse effect” with greater specificity for more deal certainty. Buyers should also consider whether exceptions to the MAE definition need to be more carefully tailored, so that they do not include unintended matters. Parties should consider specifying the target’s comparable entities for determining whether effects on a target are disproportionate.
Second, sellers should consider whether to add specific exceptions to the target’s ability to operate in the ordinary course in response to extraordinary events or modify the ordinary course covenant to reasonable best efforts for extraordinary events.
Third, buyers should consider using a lower bring-down condition than an MAE standard on select representations and warranties of the target. If buyer’s closing condition related to the accuracy of DecoPac’s representations and warranties was a “true and correct in all material respects” standard as it related to the top customers, the Court might have reached a different conclusion.