Chancellor McCormick’s opinion in Snow Phipps Group, LLC, et al. v. KCake
Acquisition, Inc., et al.
(Del. Ch. April 30, 2021) is 125
pages long, but she helpfully digests the holding in a single
sentence on page 3: “Chalking up a victory for
deal certainty
, this post-trial decision resolves all
issues in favor of seller and orders the buyers to close on the
purchase agreement.” In reaching this order, the court applied
the prevention doctrine, finding that the unavailability of
buyer’s debt financing did not permit buyer to circumvent its
obligation to close because buyer materially contributed to the
debt financing being unavailable. The application of the prevention
doctrine in this context is noteworthy and raises some interesting
(albeit unanswered) questions as it relates to the remedy regime
that has become commonplace in deals with private equity buyers.
Additionally, the court rejected buyer’s argument that it was
permitted to terminate the transaction, finding that the target did
not suffer an MAE and did not breach its conduct of business
covenant, distinguishing this case from the court’s November
2020 opinion in AB Stable, which also involved a
COVID-related M&A dispute.

Transaction Background: Not Selling Like Hotcakes

On March 6, 2020, DecoPac, a portfolio company of private equity
firm Snow Phipps, entered into an agreement to be acquired by an
affiliate of private equity firm Kohlberg & Company for $550
million. DecoPac is a supplier of cake-decorating products and
ingredients to in-store supermarket bakeries. As is typical in a
leveraged buyout, the receipt of debt financing was a condition to
seller’s right to obtain specific performance of buyer’s
closing obligation. In circumstances where the debt financing was
unavailable, receipt of a reverse termination fee would be
seller’s sole and exclusive remedy. At signing, buyer had a
binding debt commitment from a third-party lender and an equity
commitment from its sponsor parent, Kohlberg. Shortly following
signing, “Kohlberg’s senior leadership began to develop
buyer’s remorse”, theorizing that the acquisition of a
company-whose success was dependent on the occurrence of
celebratory events-may not be the best use of capital during a
nationwide lockdown. On May 18, 2020, following a call with its
litigators, Kohlberg started a series of modeling exercises to
reforecast DecoPac’s projections considering the impact of
COVID-19 on DecoPac’s business. On March 26, 2020, Kohlberg
sent one particularly pessimistic set of projections to its lead
lenders for the transaction. Those projections-which were prepared
without input from DecoPac’s management and “based on
uniformed (and largely unexplained) assumptions that were
inconsistent with real-time sales data”-showed that DecoPac
would be in breach of its financial covenants under the debt
documents on day one if the transaction were to close. Given the
doomsday scenario reflected in the projections, Kohlberg requested
several changes to the debt documents, including a revolver
increase, uncapped add-backs for lost revenue due to COVID-19, and
a 12-month holiday from financial covenant testing. All of those
demands were rejected by the lenders. However, the lenders remained
committed to close on the terms of the debt documents that were
executed at signing. Despite the lenders’ willingness to fund,
Kohlberg informed Snow Phipps on April 1, 2020 that the debt
financing was unavailable. After a half-hearted four-day attempt to
obtain alternative financing, Kohlberg purported to terminate the
purchase agreement on April 20, 2020, arguing that its conditions
to closing could not be satisfied due to DecoPac’s breach of
certain reps (No MAE; Top Customers) and its breach of the ordinary
course covenant resulting from actions DecoPac took in response to
COVID-19. This lawsuit followed shortly thereafter.

Court Orders Specific Performance: It’s a Contract, Not a
Cakewalk

To contextualize the court’s decision to order specific
performance of buyer’s obligation to close despite the
unavailability of debt financing, it is important to understand
that COVID-19 did not have a devastating impact on DecoPac’s
business. DecoPac’s sales were down in the month of March 2020
(and substantially so), but sales had already started to rebound by
the following month, which DecoPac’s management had predicted
in its own reforecast (rejected by buyer as “illogically
optimistic”). In the end, DecoPac’s revenue for 2020 was
down only 14% compared to 2019, and DecoPac is currently on track
to achieve 2019 revenue levels in 2021. Seller was able to show
that not only did buyer fail to use reasonable best efforts to
obtain the financing, but it took active steps to derail the
financing by creating uninformed projections and insisting on
unreasonable terms from its lenders (among other things). Per one
of buyer’s lenders: “they changed the ask and risk profile
of the deal and were not willing to adjust the economics, so they
were really looking for a way out.”

The prevention doctrine provides that “where a party’s
breach by nonperformance contributes materially to the
nonoccurrence of a condition of one of his duties, the
nonoccurrence is excused”. Given the ample evidence that buyer
sought to derail the financing to get out of closing, application
of the prevention doctrine to require specific performance seems
appropriate. If the court had held otherwise, it would have been
more accurate to characterize agreements with a similar specific
performance regime as option contracts (i.e., buyer can
unilaterally determine not to close despite the satisfaction of the
closing conditions and its lenders’ willingness to fund, and
seller’s sole remedy would be payment of the reverse
termination fee). Of course, most sellers that decide to transact
with private equity buyers would not characterize their purchase or
merger agreements as option agreements; it’s also not how most
private equity buyers would describe these agreements to the
sellers. In fact, private equity buyers often go to great lengths
to assure sellers that their only risk in getting to closing is in
the event of a true financing failure (as opposed to a financing
failure engineered by the buyer). Perhaps that’s why-despite
questions as to enforceability-Kohlberg decided not to appeal the
decision, and the parties informed the court that they closed the
transaction on May 14.

Key Takeaway: A purchase agreement does not need to
contain language mirroring the prevention doctrine for the
prevention doctrine to be applicable in an action for specific
performance. Parties often include language mirroring the
prevention doctrine in the termination section of a purchase
agreement (e.g., the agreement will typically specify that a party
can terminate if the transaction has not closed by a certain date
unless such party’s breach materially
contributed to the transaction not closing by such date), but
rarely include similar language in the specific performance
section. This decision should provide some comfort to sellers in
leveraged buyout transactions that the specific performance remedy
has real teeth if seller can prove that buyer engineered its
financing failure.

Enforceability of Specific Performance Award: Not a Piece of
Cake

While application of the prevention doctrine arguably leads to
an equitable result in this case, questions remain regarding the
practical ability to enforce court orders for specific enforcement
given the carefully engineered remedy construct that has become
commonplace in leveraged buyouts. In these deals, the buyer is
typically a shell entity with no assets formed by the private
equity sponsor solely for purposes of the transaction. The shell
buyer will obtain debt commitment letters from third-party lenders
and an equity commitment letter from its parent sponsor for a
portion of the purchase price (ignoring, for this purpose, deals
that are 100% equity backstopped). The buyer will only be permitted
to draw on the sponsor’s equity commitment if the conditions to
closing are satisfied and the debt financing is funded. The court
did not analyze how its order of specific performance would be
enforced considering these arrangements, and because the parties
closed their transaction on May 14 (with buyer presumably having
obtained alternative financing), such analysis won’t be
required. Had buyer been unable to obtain alternative financing, it
remains unclear how the grant of specific performance would have
been enforced, given that buyer had no assets and Kohlberg’s
equity commitment was for an amount that was substantially less
than the full purchase price.

Key Takeaway: Buyer’s actions to derail the debt
financing allowed sellers to prevail in this case, but-as we
described in more detail in an earlier post discussing pandemic-related
M&A disputes-sellers still face an uphill battle when seeking
to obtain specific performance against private equity buyers. An
order of specific performance in a disputed M&A transaction
typically requires the conduct of a trial in the Delaware Chancery
Court, increasing the likelihood that the original debt commitment
will have expired before the court is able to make a decision. As
this case illustrates, expiration of the debt financing commitment
may not be fatal, but seller will need to prove at trial that
buyer’s actions caused the debt financing to be unavailable,
and questions remain as to enforceability if alternative financing
is unavailable.

Material Adverse Effect Argument: Falls Flat as a Pancake

The court also quickly determined that DecoPac had not suffered
an MAE given that its dip in revenue was momentary and given the
historically high bar in proving an MAE, which must involve a
serious decline in earnings that is durationally significant
(measured in years, not months). Despite this conclusion, the court
still analyzed the MAE definition and the impact of the carveouts
therein. That analysis provides some useful guidance, particularly
as it relates to the breadth of MAE carveouts. As is customary, the
MAE definition contained several carveouts, meaning that changes
relating to those carveouts would not be considered in determining
whether an MAE had occurred. The MAE definition in question did not
have a pandemic-specific carveout but did have a carveout for
effects arising from or relating to changes in law. Seller’s
expert was able to show that a majority of DecoPac’s decline in
sales arose from, or at the very least, related
to
governmental orders that were put into place to
address COVID-19. Per the court: “[a] particular effect is
excluded if it relates to an excluded clause, even if it also
relates to non-excluded clauses…[t]hus, revenue declines arising
from or related to changes in law fall outside of the definition of
an MAE, regardless of whether COVID-19 prompted those changes in
law.” The court also rejected buyer’s argument that
changes in law had a disproportionate impact on DecoPac relative to
others in its industry. Buyer argued that DecoPac’s industry
was the supermarket industry in general, but the court found that
to be overbroad and contradicted by the record (including
buyer’s internal deal documents and trial testimony from both
parties). DecoPac’s industry was deemed to be narrower: a
supplier of products to in-store bakeries and cake retailers.
Because most comparable companies are private, DecoPac’s
performance was measured against that of in-store bakeries and cake
retailers (for which public data was available), and its decline in
revenue was not disproportionate compared to those companies.

Key Takeaways:

  • If parties expect the effect of certain events to be considered
    in determining whether an MAE has occurred, it may be worthwhile to
    clearly explain how the MAE definition should be interpreted if
    those events also result in changes that are specifically excluded.
    For example, the agreement could have provided that if a
    non-excepted event (i.e., the pandemic) was the root cause of an
    excepted event (i.e., changes in law), the excepted event could be
    considered in determining whether an MAE had occurred. Another way
    to address this would be add an underlying clause exception to more
    carveouts, like the exception that is often included in carveouts
    for the failure to meet projections. Parties may also want to
    reconsider the breadth of the lead-in language to the carveouts,
    heeding Chancellor McCormick’s reminder that “language
    ‘arising from or related’ is broad in scope under Delaware
    law.” If the idea is that an event should be excluded only if
    such event caused the MAE, then “arising from” or
    “caused by” would be more appropriate than “arising
    from or in any way relating to”.

  • Analysis of the MAE definition often involves an analysis of
    the target’s industry given that certain excluded events can be
    considered if they have a disproportionate impact on the target
    relative to others in its industry. However, target’s industry
    is rarely defined in the deal documents. This decision indicates
    that the court is not inclined to take a broad view of a
    target’s industry and if the industry is undefined, as is
    common, the court will generally look to internal deal documents
    and witness testimony to determine the appropriate scope of the
    target’s industry.

Ordinary Course Covenant Breach: Not Gonna Take the Cake

DecoPac was required to operate its business consistent with its
past custom and practice in the period between signing and closing.
If buyer could prove that DecoPac had not complied with that
covenant in all material respects (and was unable to cure the
breach), buyer would not be required to close. Buyer argued that
DecoPac materially breached its ordinary course covenant by drawing
down on its revolver and by implementing certain cost-cutting
measures in response to COVID-19. The court disagreed, looking to
AB Stable in its analysis, but ultimately reaching a
different conclusion given the facts. To determine whether a
covenant has been complied with in all material respects, the
question becomes “whether the business deviation significantly
alters the buyer’s belief as to the business attributes of the
company it is purchasing.” The revolver draw did not pass that
test, as DecoPac had drawn on its revolver five other times since
2017 and because DecoPac’s management credibly testified that
it was drawn upon to address counterparty risk with its creditor,
rather than to manage DecoPac’s own liquidity issues. DecoPac
also informed buyer of the draw the day after it happened, never
used any of the funds, and offered to pay the revolver back as soon
as buyer expressed concern. Furthermore, buyer failed to provide
DecoPac with notice of the breach and an opportunity to cure it, as
required by the agreement. DecoPac’s cost-cutting measures were
also insufficient to show a material breach of the conduct of
business covenant, as DecoPac “proved at trial that decreasing
labor costs in line with decreased production was in fact a
historical practice of DecoPac” and “[s]pending varied
only in expected and de minimis ways from prior years with
higher sales.”

Key Takeaway: COVID-related disputes have put the
conduct of business covenant on center stage, as the pandemic forced many
parties to take actions outside the ordinary course of business.
The AB Stable decision, which permitted the buyer to walk
from a deal due to seller’s breach of that covenant, further
highlighted its importance. This Snow Phipps Group
decision should provide some comfort to sellers that not all
changes to the business-particularly those which are consistent
with prior actions taken by the target company in times of
declining revenue-will be sufficiently material to allow buyer to
walk from a transaction. However, parties should continue to pay
close attention to this provision, given that unforeseen events may
require more substantial changes to business operations.
Furthermore, nothing in the opinion indicates that the revolver
draw or the cost-cutting measures violated specific restrictions in
the ordinary course covenant (e.g., a specific prohibition on
incurring additional debt), so it is unclear how the analysis may
have differed had such specific restrictions been
included. 

Prejudgment Interest: The Icing on the Cake

Finally, the court indicated that further briefing was required
to determine whether sellers are entitled to receive interest on
the purchase price, or whether the purchase agreement-which
expressly prohibits the award of both specific performance and
monetary damages-forecloses such a result.

Key Takeaway: It is common for purchase agreements with
private equity buyers to prohibit sellers from receiving both an
award of specific performance and monetary damages. Accordingly, if
seller expects to obtain prejudgment interest on the purchase price
if it obtains an order requiring buyer to close, consider including
that as a specific exception to the prohibition on monetary
damages.

Conclusion

The Delaware Chancery Court is a court of equity, and its
decision to apply the prevention doctrine to require specific
performance highlights its willingness to flex it equitable muscles
when necessary. Whether other spurned sellers will seek specific
performance remedies based on the prevention doctrine remains to be
seen given the cost of obtaining specific performance and the
uncertainty in the practical ability to force shell buyers to fund
the purchase price. This decision, particularly when contrasted
with AB Stable, also underscores the fact-intensive nature
of the court’s analysis. While it remains extremely difficult
for a buyer to prove the occurrence of an MAE (particularly given
the breadth of carveouts), in transactions where unforeseen events
force target companies to take actions that may be outside the
ordinary course, buyers may be able to avoid closing by proving
that target’s actions constituted a material breach of the
conduct of business covenant. The outcome may depend on the
contractual language, the specific actions taken by the target, how
and whether the target informed buyer of those actions and whether
the buyer gave target notice of breach and an opportunity to cure
any conduct that is capable of being cured. We expect continuing
focus in the negotiation of operating covenants as a point of
potential deal uncertainty for targets and for targets and their
counsel to keenly focus on compliance with these covenants prior to
closing.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.



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