In an April 30, 2021 opinion penned by Vice Chancellor Kathaleen S. McCormick, the Delaware Chancery Court handed a decisive victory to private equity firm Snow Phipps Group, LLC, awarding them specific performance regarding the previously failed sale of one of their portfolio companies. The case is unique in that it’s one of the first litigations involving the effect the 2020 Q1 pandemic shutdown had on the valuation of businesses and M&A transactions. The outcome is best summed up in the Court’s own words: “Chalking up a victory for deal certainty, this post-trial decision resolves all issues in favor of the seller and orders the buyers to close on the purchase agreement.” There is no doubt that Delaware upholds M&A agreements.
On March 6, 2020, just a few weeks before the U.S. went into national lockdown due to the rising threat of COVID-19, Snow Phipps entered into a definitive agreement to sell its portfolio company DecoPac Holdings Inc. to private equity firm Kohlberg & Company. Kohlberg had agreed to purchase DecoPac for $550 million, most of which was to be funded through debt financing. DecoPac is a leading seller of cake decorations and technology to supermarkets for use in their in-store bakeries.
When prior to closing quarantine and social distancing executive orders were issued a few weeks later, DecoPac’s sales dropped sharply. This prompted severe buyer’s remorse in Kohlberg’s partners who feared that the new social restrictions would severely limit cake-having celebrations, specifically birthday parties. Kohlberg then sought a way to pull out of the deal.
Kohlberg created new financial models for DecoPac’s future 2020 performance (without any actual input from DecoPac) that were based on unsubstantiated assumptions and resulted in overly pessimistic projected sales. DecoPac created its own comprehensive reforecast which predicted that the decline in their sales would be a mere blip (and indeed it was—DecoPac began to recover by mid-April), but Kohlberg effectively ignored these numbers. Kohlberg also failed to correct and update its own models when DecoPac’s actual results proved Kohlberg’s draconian predictions quite wrong.
Instead, Kohlberg sent the grim financial projections to its lenders, using it as an opportunity to demand more favorable (and arguably unreasonable) debt financing terms. The lenders refused the new terms. Kohlberg told Snow Phipps that the debt financing had become unavailable to fund the transaction, and Kohlberg terminated the definitive agreement on April 20th.
Snow Phipps filed a suit against Kohlberg seeking specific performance to compel Kohlberg to complete the purchase of DecoPac. Kohlberg claimed that the termination of the transaction was valid under the Material Adverse Effect (MAE) clause of the agreement, which allows a buyer to terminate a transaction if an unforeseen event can “reasonably be expected to have a material adverse effect” on a target company’s business operations. However, after a detailed contractual and financial analysis, the Court deemed Kohlberg’s financial models to be unreliable and found that the actual data regarding DecoPac’s sales was trending upward, making it unreasonable to expect DecoPac’s sales decline to evolve into a full-fledged material adverse effect.
Moreover, the Court found that Kohlberg had breached its obligation to use reasonable best efforts to secure debt financing when it inaccurately represented DecoPac’s risk profile and subsequently demanded more favorable financing terms from its lenders. The Court suggests that Kohlberg likely knew that the new financing terms were unreasonable and would necessarily result in the lenders’ rejection, providing a convenient “out” from the deal.
Because Kohlberg’s own actions were the cause of the debt financing being unavailable, the remedy of specific performance became available to Snow Phipps. The Court determined that “under the prevention doctrine, Kohlberg is barred from asserting the absence of Debt Financing as a basis to avoid specific performance.”
This case sets the precedent for the application of potential Material Adverse Effect defenses based on the pandemic and related shutdowns for the other similar cases that are likely to follow. The outcome of this particular case is also somewhat unusual in that it’s rare to see instances where a seller can get a court order that forces a buyer to purchase an entire business. The decision also stands out as a penetrating analysis of the private equity buy/sell process and is important for that reason alone.
If you have further questions related to M&A transactions or private equity, please contact William A. Newman.