Strong medicine and a bitter pill: Ontario court upholds shotgun clause despite COVID-19 pandemic

Amid the deluge of high-profile 2020 decisions relating to the impact of COVID-19, there have been some less publicized but nevertheless instructive judgments on more conventional commercial issues. One such example is FSC (Annex) Limited Partnership, 2020 ONSC 5055, which dealt with a dispute over the effect of a shotgun buy/sell clause concerning a real estate development project.

FSC (Annex) is a timely reminder of how commercial judges apply the well-established doctrines of frustration and specific performance. It also warns litigants that although the COVID-19 pandemic is unprecedented, economic downturns are not, and sophisticated commercial parties must bear the risks of their business and strategic decisions.

Background

FSX (Annex) involved a dispute between FSC (Annex) Limited Partnership, the affiliate of a private equity firm (the applicant), and Adi 64 Prince Arthur L.P., a single-purpose entity affiliated with a real estate development group (the respondent).

The applicant and the respondent were partners in a joint venture to rezone and redevelop a property into a luxury condominium. The parties had difficulty working together. As a result, on December 20, 2019, the applicant exercised a shotgun buy/sell clause in the parties’ limited partnership agreement.

A shotgun clause allows a party to trigger the dissolution of a joint business venture by requiring one party to buy out the other. Shotgun clauses are relatively common in partnership and shareholder agreements in Ontario. They typically work as follows: one party triggers the clause by offering to buy out the other party (the target) at a set price. In response, the target can either accept the offer and sell its interest to the offering party at the stipulated price, or buy out the offering party at the same price.

In theory, a shotgun clause ensures a fair price to the exiting party because the offeror must select a fair price – namely, one at which it would be content to sell its own interest in the venture. In practical terms, capital inequality between the parties can undercut the supposed fairness of a shotgun clause.

On January 9, 2020, in response to the applicant’s shotgun offer, the respondent elected to purchase the applicant’s interest rather than selling its own interest to the applicant. The respondent also agreed to complete the purchase on April 8, 2020. But on March 25, the respondent advised it would not complete the purchase due to the “unforeseeable delay caused by” COVID-19.

The applicant commenced an application in the Ontario Superior Court of Justice for specific performance of the purchase pursuant to the shotgun clause. The respondent opposed the application, arguing, among other things, that (i) the agreement to purchase under the shotgun clause had been frustrated and (ii) equitable principles militated against specific performance.

The decision

The court ordered the respondent to purchase the applicant’s interest in the project pursuant to the terms of the shotgun clause.

Frustration Argument

The court rejected the respondent’s argument that it was not in breach of the purchase agreement because its ability to complete the purchase had been frustrated by COVID-19.

The doctrine of frustration is well established. The Supreme Court of Canada has described this doctrine as follows: “When a situation has arisen for which the parties made no provision in the contract and performance of the contract becomes a thing radically different from that which was undertaken by the contract.”¹

Since March 2020, there has been a significant rise in the number of cases where a party has attempted to rely on the doctrine of frustration to justify the non-performance of contractual obligations. In this case, the respondent argued that when it entered into the purchase agreement with the applicant pursuant to the shotgun clause, market conditions were favourable and the economic downturn due to COVID-19 was unforeseeable, thwarting its ability to secure financing.

The court found two main problems with the respondent’s frustration argument.

First, there was insufficient evidence of actual frustration. The purchase obligation under the shotgun clause had been triggered on January 9, 2020, well before Ontario declared a state of emergency due to COVID-19 on March 17, 2020. The respondent’s efforts to secure financing, however, were described by the court as “somewhat relaxed.” The respondent chose to approach only a few potential lenders rather than canvassing the broader commercial lending market, and it sought significantly more funding from lenders than it required to buy out the applicant’s interest in the project.

Second, while this pandemic is unprecedented, restrictions on credit are not uncommon. They occur regularly as part of the ebb and flow of economic cycles. Likewise, there is nothing unusual about sharp declines in real estate values. As a result, the court held that economic shifts are “one of the risks entrepreneurs face,” and “[t]he potential for an economic downturn is an inherent risk in any purchase decision and is not one from which a purchaser should be protected by the doctrine of frustration.” In any event, as the court observed, the loss of liquidity in the marketplace is a risk that potential purchasers can protect themselves against by making a purchase conditional upon financing. The respondent chose not to do so in this case.

The respondent argued that conditional financing was not possible in this case because a conditional purchase would have been invalid under the terms of the shotgun buy/sell clause. The court did not accept this argument, finding that it misses the point. If the respondent lacked the financial wherewithal to exercise the purchase option, it should not have done so.

This strict interpretation of the parties’ agreement is grounded in the principle that a shotgun clause is “strong medicine” that must be taken “strictly and in accordance with the prescription or not at all.”² The respondent chose to purchase the applicant’s interest rather than allow the applicant to buy out the respondent’s interest, and it was therefore held to its decision.

Equitable Considerations Argument

The court rejected the respondent’s arguments that the equitable remedy of specific performance was inappropriate in this case.

Specifically, the respondent had argued that equity should not assist the applicant because there was nothing unique or special about the purchase agreement, and the applicant’s interest was solely for the purpose of realizing a financial return. 

The court disagreed, noting that the parties’ agreement expressly provided for specific performance. The court found that the equities favoured specific performance over contractual damages because the latter would have required the applicant to sell its interest to a third-party purchaser and then sue the respondent for the difference between the price of the shotgun sale and the price of the third-party sale. 

This would have embroiled the parties in further litigation, the court observed, and created other practical complications, including the fact that the respondent would have had the right to approve any third-party sale. If the respondent refused to approve a potential purchaser, there would presumably be a further dispute about whether the refusal was based on bona fide reasons. Given that the relevant provisions of the agreement in issue would have created a series of practical complications, the court held that specific performance was appropriate in the circumstances.

Key takeaways 

The court’s practical approach in FSC (Annex) to assessing the impact of COVID-19 on the parties’ contractual obligations, and its common-sense balancing of the equities, make FSC (Annex) a valuable decision for commercial litigants in Ontario. FSC (Annex) reminds business owners that shotgun clauses are “strong medicine” and“[t]he risk of committing to purchase under a buy/sell provision is well known.” The specific terms of any shotgun clause should be carefully negotiated and the decision to exercise one’s right to buy out an opposing party’s interest pursuant to a shotgun clause should not be made lightly.