Publication
Avoiding legal and regulatory pitfalls in digital transformation projects
This article first appeared in the September 2024 issue of Financier Worldwide.
Author:
Canada | Publication | February 2022
In December, Justice Conway awarded Cineplex $1.24 billion for “loss of synergies” after Cineworld terminated a contract to acquire Cineplex (see our summary here). Both parties are appealing the decision.
This update looks at the decision to award expectation damages for lost synergies.
Cineplex’s expert presented the following damages calculations:
Justice Conway rejected the first damages theory: as third-party beneficiaries, Cineplex shareholders did not have any rights to enforce the agreement or sue Cineworld, and the contract did not entitle Cineplex to recover loss on their behalf.
Justice Conway found that lost synergies was the appropriate damages measure because these were Cineplex’s own losses, which Cineplex would have realized had the deal closed.1
Both parties have filed appeals.
Cineworld’s grounds are twofold. Firstly, it says Justice Conway erred in finding the ordinary course covenant permitted deviation from past practice in response to the pandemic, and Cineworld bore the risk of a pandemic. Secondly, Justice Conway erred in awarding damages for “lost synergies,” as if these were benefits Cineplex was contractually entitled to.
Cineplex is cross-appealing the damages amount. Cineplex seeks an award based on the shareholders’ lost consideration.2 Alternatively, it seeks amounts for: (1) the diminished value of the business as a result of Cineworld’s termination ($808 million); or (2) liabilities that Cineworld would have discharged post-completion ($714 million);3 or (3) disgorgement of Cineworld’s benefits from the breach ($1.1 billion).
Cineworld’s strategy
Cineworld planned to enter the Canadian market through acquiring Cineplex, which would make it the largest cinema exhibitor in the world.
Cineplex’s operations would be combined with those of Regal, a US entertainment company Cineworld acquired in 2018. The combination would achieve substantial synergies4 – Cineworld’s CEO testified that estimated synergies were one of the bases for the $2.8 billion purchase price.
Ernst & Young report estimated value of synergies
Before agreeing to buy Cineplex, Cineworld engaged Ernst & Young to report on the anticipated synergies.5 EY estimated $163.5 million in annualized benefits to Cineplex specifically.
At trial, Cineplex’s expert used the EY report to calculate present value of Cineplex’s lost synergies, which included: operational consolidation, cost savings from economies of scale, and increased revenue from new initiatives. Various discounts were applied (e.g., for COVID-19 delayed rationalization), to reach a final number of $1.24 billion.
While Cineworld did not present an alternative, its expert noted these synergies would only result from the business combination, and would accrue to Cineworld as buyer, not Cineplex.
Justice Conway did not discuss this point. She accepted Cineplex’s calculations and rejected Cineworld’s arguments that synergies should be discounted to reflect purchase price debt that would be placed at the Cineplex level.
Justice Conway found that, while Cineworld as shareholder would have had the ultimate synergistic benefits, the synergies would have been realized by Cineplex. Awarding damages on this basis would therefore put Cineplex in the position it would have been in had Cineworld not terminated the contract.
It will be interesting to see how the parties’ arguments are considered on appeal, and what practical effect this reasoning will have. For example:
When can lost synergies for a failed M&A deal be awarded to a seller where the parties had planned to combine that seller with another entity post-closing?
While $1.24 billion damages were intended to put Cineplex in the position it would have been in had the contract been performed, the decision does not go into detail on the intended fate of Cineplex post-closing. In its appeal notice, Cineworld states it would have operated Cineplex as it saw fit.
Justice Conway noted Cineworld’s rationale for the transaction was to “combine the operations” of Cineplex and Regal, but the decision does not discuss the legal form the “combination” may have taken (such as an amalgamation) and the implications for Cineplex. For example, the Ontario Business Corporations Act provides that amalgamating corporations cease to exist as separate entities from the amalgamated corporation,6 but the jurisprudence is not clear on whether an amalgamation actually extinguishes a predecessor corporation’s existence.7
What factors are required for lost synergies to be an appropriate expectation damages measure?
Expectation damages must be proven with reasonable certainty, but synergistic benefits are often speculative and aspirational. Justice Conway found Cineplex’s expert had chosen the “most probable” outcome because Cineworld had been successful in achieving expected synergies in its previous acquisition of Regal. However, Justice Conway did not discuss how likely anticipated synergies should be for consideration in substantial damages valuations.
Cineworld is arguing that any synergies would belong exclusively to the purchaser; Cineplex was not contractually entitled to synergies, and so they are an improper measure of expectation damages. Also, failure to discount the purchase price debt that Cineworld would have imposed on Cineplex after closing puts Cineplex in a better position than if the contract had been performed.
The uncertainty for companies in M&A transactions is always what, if any, damages are recoverable if a party refuses to complete. We will see whether an appeal clarifies this uncertainty, and considers the general utility of lost synergies in damages valuations. Buyers in particular should be alive to the risk of synergistic damages claims, and consider including break fees in the contract.
The decision does not define synergies, but generally speaking synergies result from economies of scale: they are the realization of reduced costs and increased earnings that result from the combination and consolidation of businesses.
There is no suggestion in Justice Conway’s reasons that the parties had jointly commissioned the report to facilitate the deal negotiations (e.g., to help determine a price).
Business Corporations Act, R.S.O. 1990, c. B.1, s. 179(a.1).
740170 Ontario Inc. v. Bromac Construction & Engineering Ltd., 2013 ONSC 7774 at para 19.
Publication
This article first appeared in the September 2024 issue of Financier Worldwide.
Publication
The Digital Markets, Competition and Consumers Act (DMCC Act) received Royal Assent on 24 May 2024 and is generally expected to come into force in autumn this year.
Publication
On 26 July 2024, the People’s Bank of China (PBOC) and the State Administration of Foreign Exchange (SAFE) jointly released revised rules in respect of the investments into China’s financial market through the Qualified Foreign Institutional Investor and Renminbi Qualified Foreign Institutional Investor (collectively, QFII) regime (the New Rules).
Subscribe and stay up to date with the latest legal news, information and events . . .
© Norton Rose Fulbright LLP 2023