An Ounce of Prevention: Delaware Court of Chancery Orders Specific Performance in Private Equity Deal Nearly a Year After Deal Collapse

After a year of expedited litigation, including five days of trial, on April 30, 2021, Chancellor (then Vice Chancellor) Kathaleen McCormick of the Delaware Court of Chancery in Snow Phipps Group, LLC v. KCake Acquisition, Inc., 2021 WL 1714202 (Del. Ch. Apr. 30, 2021), directed the buyer — an entity sponsored by Kohlberg & Co. — to specifically perform its contractual obligation to close the purchase of DecoPac, a cake decorating business — a first in pandemic deal litigation. The court found that Kohlberg had breached its agreement to use reasonable best efforts to obtain debt financing. The court also concluded that (i) there was no material adverse effect (MAE) on DecoPac caused or reasonably expected to be caused by the pandemic, (ii) any MAE alleged by the buyer would have fallen within the carve-out to the MAE clause relating to effects stemming from government rules and regulations, and (iii) DecoPac did not act outside the ordinary course by drawing on its revolver. And in what the court proclaimed was “a victory for deal certainty,” the court ordered defendants — buyer and several Kohlberg funds — “to close on the purchase agreement.”

Background

On March 6, 2020, KCake Acquisition, Inc., an entity sponsored by Kohlberg & Co., agreed to purchase DecoPac Holding, Inc., the owner of a business selling cake decorations and technology to in-store supermarket bakeries, for $550 million. By the date of the purchase agreement signing, the parties were well aware of the COVID-19 pandemic; buyer had rejected seller’s request for a carve-out in the agreement’s MAE clause for pandemics, and the parties had agreed to lower the purchase offer by $50 million. The agreement’s MAE clause did include a carve-out for effects “arising from or related to . . . changes in any Laws, rules, regulations, orders, enforcement policies or other binding directives issued by any Governmental Entity.” The agreement also included a disproportionality exclusion that shifted the risk of the MAE back to the seller—to the extent an MAE that would otherwise be subject to the enumerated carve-out has “a materially disproportionate effect [on DecoPac]… relative to other comparable entities operating in the industry.” The agreement also required seller to operate the business “in the Ordinary Course of Business”—defined as “in a manner consistent with the past custom and practice of [DecoPac] (including with respect to quantity and frequency).”

Additionally, the agreement included provisions related to financing for the transaction. Buyer agreed to use reasonable best efforts to work toward a definitive credit agreement based on the terms of a debt commitment letter buyer had entered into with lenders, or to seek alternative financing if the debt commitment expired or became unavailable. The purchase agreement provided for specific performance “of Buyer’s obligations to consummate the transaction contemplated hereby if and only if … the full proceeds of the Debt Financing have been funded to Buyer on the terms set forth in the Debt Financing Commitment Letter … or would be funded at the Closing if the Equity Financing is substantially contemporaneously funded at the Closing.” Buyer also entered into an equity commitment letter with various Kohlberg funds to finance the remainder of the purchase price.

Shortly after the parties’ entry into the purchase agreement, DecoPac’s sales declined. Buyer conducted an initial “shock case” analysis which, according to the court, indicated that DecoPac could experience a steep decline in sales while nonetheless remaining in compliance with its post-closing debt covenants. However, the court found, starting in mid-March (i) buyer “began to develop buyer’s remorse,” (ii) the senior leadership of its private equity sponsor wanted to allocate capital to other opportunities, and (iii) buyer began to have near daily calls with litigation counsel. Subsequently, Kohlberg developed more pessimistic models than its original “shock case,” even though Kohlberg had received minimal data from DecoPac warranting such a shift. Using these new models, buyer sought modifications to the debt commitment letter, including addbacks to EBITDA for COVID-19 and an increase in its revolver. The lenders rejected those demands — characterizing them as “looking for a way out” — but indicated that they stood behind the original debt commitment letter. After a perfunctory search found that alternative financing was not as attractive as the still-available debt commitment, on April 8 buyer told seller it did not intend to close because seller would not meet the conditions of closing and debt financing on terms acceptable to buyer was unavailable.

On April 14, seller commenced litigation against buyer seeking specific performance of buyer’s obligation to close under the purchase agreement. Seller also brought a claim, as a third-party beneficiary to the equity commitment letter, against the funds, seeking specific performance of the funds’ obligation to finance the purchase. Seller sought an expedited trial by May 2, prior to the expiration of the purchase agreement and debt commitment letter. As we reported in Sue First, Talk Later: Lessons From Recent Delaware Court of Chancery Decisions on Expediting Proceedings During the COVID-19 Pandemic, on April 17 Chancellor McCormick denied seller’s motion to expedite because “the pace of the case would force persons involved in the lawsuit to engage in behavior that might risk their health, making the cost of expedition much greater than usual,” and the “threatened irreparable harm to [seller] does not outweigh the extraordinary cost of moving forward on the requested schedule.” Buyer then terminated the purchase agreement because the debt commitment had not been funded by the time the debt commitments expired, and claimed that there was an MAE and that seller breached the ordinary course covenant in the purchase agreement, which caused a failure of the related closing condition from being satisfied. The court thereafter denied buyer’s motion to dismiss, holding among other things that seller stated a claim that buyer breached the purchase agreement by seeking to negotiate more favorable terms with its lenders, and that seller stated a potential claim for specific performance notwithstanding the lack of funded debt financing based on application of the prevention doctrine.

As the litigation progressed, DecoPac’s business recovered. At the end of the year, sales were down only 14% from 2019 — within the margin of error for DecoPac to have complied with its post-closing debt covenants under buyer’s original “shock case.” By December 2020, sales had grown year-over-year from 2019.

The Opinion

After a five-day trial and pre- and post-trial briefing, on April 30, 2021, the court “resolve[d] all issues in favor of the seller.” First, the court held that buyer did not reasonably anticipate an MAE at the time it terminated the agreement. The contemporaneous projections by DecoPac’s management that 2020 revenue would fall by only 11% and EBITDA by 22% compared to 2019, and an initial projection by buyer that revenue would fall 15% and EBITDA would by 27%, before recovering in 2021, would not rise to a level of an MAE. The court compared these projections for a steep but temporary decline to those in In re IBP S’holders Litig., 789 A.2d 14 (Del. Ch. Jun. 18, 2001) — where a 64% decrease in seller’s year-over-year first quarter earnings caused by severe weather did not justify an MAE. And the court distinguished the expected temporary decline from that addressed in Akorn, Inc. v. Fresenius Kabi AG, 2018 WL 4719347 (Del. Ch. Oct. 1, 2018) — where the court concluded that there had been an MAE based on a more than 60% decline in expected EBITDA for each of the next three years, which had “already persisted for a year and show[ed] no sign of abating.”

Second, the court held that even had there been an MAE, the carve-out for effects “arising from or related to” government rules or regulations applied, and the disproportionality exclusion did not. The court took a broad view of the phrase “arising from or related to” and concluded, based on expert witness testimony, that DecoPac’s revenue declines arose from or were related to the shutdown and shelter-in-place orders issued by various government entities in response to the outbreak of COVID-19. The court went on to hold that seller’s narrow definition of DecoPac’s industry — “suppliers of products used by in-store bakeries and other cake retailers to decorate cakes and cupcakes for celebratory events and other occasions” — was more “realistic” than buyer’s — “the supermarket industry” — and found that DecoPac did not experience a disproportionate effect on its business compared to other companies in the industry, thus precluding the MAE risk from being shifted back to seller.

Third, the court held that seller did not breach the ordinary course covenant, either by drawing on its revolver or implementing cost-cutting measures during the COVID-19 pandemic. With regard to the revolver drawdown, the court noted that seller had drawn down on its revolver five times previously since 2017, and that sellers “disclosed the draw request to Kohlberg within one day of making it, offered to repay it within two days of Kohlberg raising issue with it, and never used any of the funds.” Therefore, the drawdown “was not inconsistent with past practices and did not reflect a material departure from the ordinary course of business.” Regarding seller’s cost-cutting measures, the court found that decreasing labor costs in line with decreased production was in line with seller’s historical practice. This result differed from the application of a similar ordinary course covenant in AB Stable VIII LLC v. MAPS Hotels and Records One LLC, 2020 WL 7024929 (Del. Ch. Nov. 30, 2020); there, Vice Chancellor Laster found that seller breached the ordinary course covenant by reducing staffing and services at hotels it agreed to sell to buyer. (See What’s Past Practice Is Prologue: A Recap of Recent Developments in COVID-19-Related Delaware M&A Litigation).

Fourth, the court found that buyer did not use its reasonable best efforts to obtain debt financing based on the debt commitment letter or alternative financing, and ordered specific performance of the obligations of all the Kohlberg defendants. The court recognized that the purchase agreement conditioned specific performance of the buyer’s obligations “if and only if … the full proceeds of the Debt Financing have been funded to Buyer,” but applied the prevention doctrine nonetheless to order specific performance on the basis that buyer’s own actions prevented that condition from occurring. The prevention doctrine provides that “where a party’s breach by nonperformance contributes materially to the non-occurrence of a condition of one of his duties, the non-occurrence is excused.” The court emphasized that the prevention doctrine requires only “some form of deliberate action” by the breaching party, and that “it is not necessary that there be a specific malevolent intent.” The court held that the prevention doctrine does not require a showing that buyer “actively scuttle[d] the debt financing,” let alone acted in bad faith, though the court indicated that buyer’s claims of good faith were “suspect.” The court ultimately held that Kohlberg — defined as buyer and the defendant Kohlberg funds — was obligated to close on the purchase agreement.

Following the court’s decision, on May 17, 2021, the parties announced that they had reached a settlement and that buyer had closed on the acquisition of DecoPac on May 14. No financial terms of the final transaction were announced.

Takeaways

The Snow Phipps decision has important implications, both for the application of MAE clauses and for future deal litigation, particularly those involving private equity transactions. Specifically:

• A court is unlikely to find an MAE absent a reasonably expected sustained effect on the seller. A steep but transitory decline in sales and/or profitability alone will generally not be enough to establish an MAE. If it is unclear whether a decline in sales and/or profits prior to closing will be prolonged or temporary, buyers should consider that it may be difficult as a practical matter to prove an MAE if, by the time of trial, seller’s financial performance has begun to recover.
  
  
• Courts will examine not only the litigation record, but also the process that created that record. In Snow Phipps, the court had visibility into when buyer brought in litigation counsel, and drew the inference that buyer’s subsequent aggressive demands of lenders and pessimistic projections regarding seller’s business were driven by a desire to get out of the deal. Deal participants should be mindful that at trial any pre-closing shift to a litigation posture may become apparent and taken into account by a court in considering whether a party genuinely tried to satisfy its obligations under the purchase agreement.
  
  
• The Court of Chancery may apply the prevention doctrine to conditions for the remedy of specific performance and order buyer to perform absent the satisfaction of those conditions if the buyer prevented them from occurring by breaching other obligations under the purchase agreement — even if buyer did not act in bad faith. The purchase agreement in Snow Phipps expressly made specific performance available “if and only if … the full proceeds of the Debt Financing have been funded to Buyer,” and the court determined that buyer prevented that condition from occurring by failing to undertake reasonable best efforts to obtain debt financing, as buyer was obligated to do under the purchase agreement.
  
  
• The court may have applied the prevention doctrine in part to prevent an unsatisfactory result when specific performance is unavailable because it is simply impossible to litigate fast enough to save a deal. As we previously reported, Chancellor McCormick denied seller’s motion to expedite in April 2020 because a trial within a month would be unusual under the best of circumstances and a potential public health concern in light of the COVID-19 pandemic. By using the prevention doctrine to save a specific performance remedy, the court provided seller with a meaningful remedy and prevented a breaching buyer from capitalizing on the limits of expedited litigation.