A recent bankruptcy court decision out of the United States Bankruptcy Court for the Central District of California, In re Verity Health Sys. of Cal., Inc., Case No. 2:18-bk-20151 (ER) (Bankr. C.D. Cal. Nov. 27, 2019), is a good reminder of how difficult it is for a purchaser under an asset purchase agreement to get out of the deal by invoking a Material Adverse Effect clause (also known as a Material Adverse Change clause) (an “MAE”). Difficult, but not impossible, as we reminded our readers in a prior blog post: There is Such a Thing as a “Material Adverse Effect:” Delaware Court Supports Buyer’s Right to Terminate. It may be even more difficult for a purchaser to terminate an asset purchase agreement in a bankruptcy situation in comparison to other contexts because there is already a court with knowledge of the facts that will be ready to enforce the agreement against the purchaser without a requirement to initiate a new lawsuit or develop the facts in depth.
A stalking horse bidder that executed an asset purchase agreement to buy the remaining assets of certain chapter 11 debtors (comprised of four hospitals) sought to postpone the closing of the sale. The would-be buyer of the hospitals alleged that the debtors had failed to comply with all of their obligations under the asset purchase agreement, resulting in an MAE that relieved it of the obligation to close the sale. The court held that no MAE had occurred, and that the stalking horse bidder was obligated to close the sale.
Strategic Global Management (the “Purchaser”) served as the stalking horse bidder for the chapter 11 debtors in In re Verity Health System of California, Inc. (the “Debtors”) for the purchase of the Debtors’ remaining principal assets—four hospitals (the “Hospitals”). No other party bid to purchase the Hospitals. The Purchaser and the Debtors executed an asset purchase agreement (the “APA”) to consummate the sale of the Hospitals (the “Sale”). The APA required the Sale to close no later than ten business days after the satisfaction of all conditions precedent therein. However, the Purchaser argued that the Debtors had failed to comply with certain conditions and obligations under the APA, resulting in an MAE, such that the Purchaser did not have to close the Sale.
The Bankruptcy Court first addressed certain gating items. First, the Bankruptcy Court rejected the Purchaser’s contention that the Purchaser’s obligations under the APA had to be adjudicated pursuant to an adversary proceeding, finding no such requirement in the APA and disagreeing with the Purchaser’s argument that this determination was “a proceeding to recover money or property” that would have to be decided by an adversary proceeding pursuant to Bankruptcy Rule 7001. Next, the Bankruptcy Court rejected the Purchaser’s contention that the issue of the Purchaser’s obligations under the APA was not yet ripe, holding that the Purchaser had made representations to the Debtors (in the form of two letters that the Purchaser mailed to the Debtors that were presented to the Bankruptcy Court under seal) casting serious doubt upon whether the Purchaser would perform its obligations under the APA and close the Sale.
The Bankruptcy Court next turned to the crux of the Purchaser’s argument, holding that no MAE had occurred. The precise allegations made by the Purchaser for what conditions and obligations of the Debtors had not been satisfied is not available on the record, and the Bankruptcy Court declined to discuss the allegations in its opinion to avoid harming the Debtors and their estates. The Bankruptcy Court noted that the APA’s definition for an MAE was very general, and so found that the parties to the APA intended that the term-of-art meaning for an MAE should apply. Finding that California law (which governed the APA) was not well-developed regarding MAE clauses, the Bankruptcy Court turned to the well-developed case law on MAE clauses in Delaware as persuasive authority. Noting the exceptionally heavy burden under Delaware case law for successfully enforcing an MAE clause, the Bankruptcy Court held that none of the Purchaser’s allegations were close to rising to the level needed for establishing that an MAE had occurred. Interestingly, the Bankruptcy Court did provide examples in dicta of certain occurrences that it would have considered sufficient for establishing an MAE: (i) if the Debtors had failed to maintain the Hospitals’ licenses or (ii) if the Debtors had operated the Hospitals in such a way that regulators were forced to shut down key departments like the emergency rooms or the pharmacies.
The Bankruptcy Court had some harsh words for the Purchaser, stating that the Purchaser was simply attempting to delay the Sale for as long as possible to hold the Debtors and creditors “hostage” to “extort” a lower purchase price from the Debtors (currently agreed at $610 million for the Hospitals). The Bankruptcy Court stated that the Purchaser’s tactics were “especially offensive” in light of what was at stake—given the Debtors’ critical liquidity position, if the Sale did not promptly close, three of the four Hospitals would have to shut down, with those closing Hospitals housing significant numbers of long-term, severely ill patients that would have to be relocated. The Bankruptcy Court reiterated that all conditions precedent to the APA had been satisfied as of November 19, 2019, such that the Purchaser was obligated to close the Sale by no later than December 5, 2019.
Parties negotiating complex purchase agreements should take broadly drafted MAE clauses for what they are, rather than what they wish them to be. In other words, MAE clauses should be relied on only in the event of exceptional events that substantially alter the terms of the deal that was negotiated; MAE clauses are not a tool to be relied on to get out of a deal that has become less economically beneficial since being negotiated, particularly if the reasons that made the deal less optimal were foreseen and/or addressed. If a purchaser wants to be able to get out of an asset purchase agreement if certain circumstances occur, it should draft specific termination events relating to those circumstances rather than relying on a generic MAE clause. Of course, in the bankruptcy context, when asset sales are generally done via a public auction, building overly broad termination events into such an agreement may make the purchaser’s bid less attractive as it increases conditionality. A purchaser should weigh the broad ability to terminate against the risk that its bid could be discounted as a result, keeping in mind that every situation is different.
December 5, 2019 passed without the Purchaser closing the Sale. The Debtors filed a motion seeking to compel the Purchaser to testify as to why the Sale did not close by December 5, 2019, and for findings that the Purchaser was in material breach of the APA, that the Debtors could retain the Purchaser’s $30 million deposit, and that the Debtors could proceed with alternative plans to dispose of the Hospitals. The Bankruptcy Court declined to compel the Purchaser to offer testimony as to why the Sale had not closed, finding that it would not increase the likelihood of the closing actually occurring in light of the monetary penalties already at stake. The Bankruptcy Court noted that the Debtors will have the opportunity to litigate whether the Purchaser breached the APA and whether the Debtors could retain the Purchaser’s deposit. The Bankruptcy Court did hold that in light of the health and safety concerns of the Hospitals’ patients and the precarious liquidity position of the Debtors, the Debtors could proceed with efforts to dispose of the Hospitals without materially breaching the APA. On January 3, 2020, the Debtors filed a notice terminating the APA and initiated an adversary proceeding against the Purchaser, alleging breach of contract, promissory fraud, and breach of the implied covenant of good faith and fair dealing. On January 6, 2020, the Debtors filed a motion seeking to close one of the Hospitals.