Snow Phipps Group, LLC v. KCake Acquisition, Inc.
Not reported (2021)
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Rule of Law:
A buyer cannot invoke a Material Adverse Effect (MAE) or a breach of an ordinary course covenant to terminate a merger agreement if the alleged adverse effect is temporary and not disproportionate to the industry, and if the buyer's own failure to use 'reasonable best efforts' materially contributed to the non-fulfillment of debt financing conditions. In such cases, the prevention doctrine may deem the financing condition met, entitling the seller to specific performance.
Facts:
- On March 6, 2020, Snow Phipps Group, LLC, agreed to sell DecoPac Holdings Inc. to KCAKE Acquisition, Inc., and its affiliates (Kohlberg) for $550 million.
- The agreement included a Stock Purchase Agreement (SPA) and a Debt Commitment Letter (DCL) which obligated Kohlberg to use 'reasonable best efforts' to secure debt financing under specified terms.
- During negotiations, Kohlberg considered COVID-19 risks and rejected Snow Phipps's attempt to specifically exclude 'pandemics' from the Material Adverse Effect (MAE) definition, indicating existing broad carveouts were adequate.
- Following the signing, government stay-at-home orders caused a sharp, but ultimately temporary, decline in DecoPac's weekly sales.
- Kohlberg, exhibiting buyer's remorse, then prepared an overly pessimistic financial model of DecoPac without consulting DecoPac management.
- Kohlberg subsequently used its pessimistic model to demand more favorable debt financing terms from the original lenders, who rejected the new terms but remained willing to fund on the DCL's original conditions.
- Kohlberg then conducted a brief, unsuccessful search for alternative financing and, on April 8, 2020, informed Snow Phipps it would not close the acquisition, citing unavailable financing and anticipated MAE/ordinary course breaches.
- DecoPac's sales quickly recovered, with its 2020 year-end results showing only a 14% decline from 2019 and projections for full recovery in 2021.
Procedural Posture:
- Snow Phipps Group, LLC, and DecoPac Holdings Inc. (Plaintiffs) filed an action in the Delaware Court of Chancery seeking specific performance of the Stock Purchase Agreement (SPA).
- Plaintiffs initially moved for expedited proceedings for a trial by May 2, 2020, which the Court of Chancery initially denied.
- On April 20, 2020, KCAKE Acquisition, Inc., et al. (Defendants) sent a letter purporting to terminate the SPA under Section 8.1(d), citing unavailable debt financing and alleged breaches of representations, warranties, and covenants.
- On May 5, 2020, Plaintiffs filed an amended complaint, asserting claims including breach of the SPA (for failing to use reasonable best efforts for debt financing) and seeking specific performance.
- On May 11, 2020, Plaintiffs renewed their motion to expedite after the Debt Commitment Letter (DCL) expired by its own terms on May 12, 2020.
- On May 21, 2020, the Court of Chancery ordered expedited proceedings toward a January 2021 trial.
- On June 18, 2020, Defendants filed an answer to the amended complaint and asserted counterclaims, seeking declarations of valid termination and that Plaintiffs were not entitled to specific performance.
- Defendants also filed a partial motion to dismiss the amended complaint, which the Court of Chancery largely denied on October 16, 2020, but granted as to the implied covenant claim and held that specific performance under the prevention doctrine was possible.
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Issue:
Is a buyer permitted to terminate a stock purchase agreement and avoid specific performance based on alleged Material Adverse Effect (MAE) and ordinary course covenant breaches, or the non-funding of debt financing, when the buyer failed to use 'reasonable best efforts' to secure the debt financing as per the original terms, actively sought to renegotiate for more favorable terms, and the alleged MAE was temporary and not disproportionate to its industry peers?
Opinions:
Majority - McCormick, V.C.
No, a buyer is not permitted to terminate the SPA and avoid specific performance under these circumstances because it failed to demonstrate a Material Adverse Effect (MAE) or a material breach of the ordinary course covenant, and its own actions materially contributed to the non-funding of debt financing, thus triggering the prevention doctrine. The court found Kohlberg failed to prove that DecoPac suffered, or was reasonably expected to suffer, a Material Adverse Effect. While DecoPac experienced a precipitous, short-term decline in sales due to the pandemic (a 'blip'), its performance quickly rebounded and was projected to fully recover, consistent with the standard that an MAE must be 'consequential to the company’s long-term earnings power over a commercially reasonable period.' The court further found that even if an MAE were expected, the decline fell within the SPA's exception for effects 'arising from or related to' governmental orders, and Kohlberg failed to show DecoPac was 'materially disproportionate[ly]' affected compared to its industry peers (suppliers to in-store bakeries for decorated cakes). Kohlberg also failed to prove DecoPac breached its Ordinary Course Covenant 'in all material respects.' DecoPac's $15 million revolver draw was consistent with past practice, done out of caution (a portfolio-wide policy), immediately disclosed, never used, and offered for repayment. Any cost-cutting measures were consistent with decreased production and not material deviations from past practice, and Kohlberg waived this argument by not raising it until pre-trial briefing. Importantly, Kohlberg breached its obligation under Section 6.15(a) of the SPA to use 'reasonable best efforts' to obtain debt financing on the DCL's original terms. Instead, Kohlberg developed buyer's remorse, crafted a pessimistic financial model (the 'March 26 Model') without management input and based on unsupported assumptions, and used it to demand more favorable terms from the lenders. The lenders rejected these 'Financing Demands' (Revolver, Addback, Holiday) but remained willing to fund on the original DCL terms, which Kohlberg refused to accept. Kohlberg's actions were designed to derail financing, not to secure it as per its contractual obligations. Because Kohlberg's breach of its 'reasonable best efforts' obligation materially contributed to the non-occurrence of the debt-funding condition, the prevention doctrine applies. This excuses the non-occurrence of the condition, and Kohlberg cannot rely on the lack of funded debt financing to avoid specific performance. The court ordered specific performance, noting that the balance of equities tipped in favor of the Plaintiffs.
Analysis:
This case reinforces the high bar for invoking a Material Adverse Effect (MAE) clause under Delaware law, emphasizing that temporary market downturns or industry-wide shifts, especially when attributable to broad government orders, rarely suffice unless the target is disproportionately affected. It also critically clarifies the 'reasonable best efforts' standard in merger agreements, holding that a buyer cannot use this clause to strategically renegotiate financing terms to its advantage or to escape an unwanted deal. The decision strengthens sellers' ability to enforce specific performance in M&A deals by applying the prevention doctrine, preventing buyers from relying on a condition's non-occurrence if their own breach materially contributed to it, thereby promoting deal certainty.
