Bankruptcy court rejects material adverse effect claim

Verity Health System of California, Inc., and its affiliated entities (VHS) operated an integrated nonprofit health care system, including five hospitals, with approximately 1,680 inpatient beds, six active emergency rooms, a trauma center, and 11 medical office buildings. Suffering severe financial distress, VHS commenced a Chapter 11 bankruptcy reorganization case in August, 2018. In connection with its bankruptcy case, the debtor initiated as sale process. Ultimately, in consultation with its investment banker and other advisors, VHS selected Strategic Global Management (SGM) to be the stalking-horse bidder based on its offer to acquire the debtor's four remaining hospitals for a purchase price that consisted of a cash payment of $610 million, plus assumption of certain liabilities, and payment of cure costs associated with assumed contracts and assumption of other obligations.

In January 2019, SGM executed an asset purchase agreement to purchase the hospitals and related assets from VHS, subject to bankruptcy court approval. In February 2019, the court approved the agreement, SGM as the stalking-horse bidder, and procedures for potential overbids and an auction. It turned out that there were no better bids and in May 2019 the bankruptcy court entered an order approving the sale to SGM pursuant to the agreement. Unfortunately for the bankruptcy estate and its creditors, the sale did not close.

SGM contended that the debtor failed to satisfy certain conditions and obligations under the asset purchase agreement, and that these alleged performance failures resulted in a material adverse effect under the agreement, relieving SGM of its obligation to close. In a decision issued in November, the bankruptcy court rejected these contentions, stating "the Court finds that SGM's contention that it is not obligated to close is a cynical attempt to extract a better purchase price. A key component of SGM's negotiation strategy is its attempt to delay as long as possible the adjudication of its obligations under the agreement. The Court will not facilitate SGM's dubious tactics." In re Verity Health Sys. of Cal., 2019 Bankr. LEXIS 3661, *10.

The asset purchase agreement provided that the bankruptcy court would have exclusive jurisdiction to resolve any dispute regarding whether a material adverse effect had occurred. Further, the court found that in the agreement SGM had waived the right to appeal any such determination in exchange for receiving "substantial benefits under the agreement, including the right to receive a breakup fee in the event that it was outbid and consultation rights in the event that an auction of the hospitals occurred." The agreement's definition of "material adverse effect" was brief and circular, providing a "material adverse effect" is "a material adverse effect upon the Hospitals, taken as a whole."

The bankruptcy court explained that "'material adverse effect' is a term of art routinely used in asset purchase agreements of the type at issue here. The parties' use of a term of art, combined with their decision to define the term with only minimal detail, shows that the parties intended to rely upon the definition of the term contained in applicable caselaw." Turning to California law made applicable by the agreement, the court stated: "California law on the meaning of a material adverse effect clause -- sometimes known as a 'material adverse change clause' -- is not well developed. The few cases which do address material adverse effect clauses view their enforcement with disfavor." The court then moved to Delaware law, stating that "[a]lthough the is governed by California law, Delaware cases interpreting material adverse effect clauses are helpful persuasive authority. A significant amount of the litigation over the enforcement of asset purchase agreements occurs before Delaware courts, and the Delaware caselaw interpreting material adverse effect clauses is well developed."

Surveying several Delaware cases, the bankruptcy court found that a buyer faces a heavy burden and must make a strong showing to invoke a material adverse effect exception to its obligation to close a purchase, citing In re IBP, Inc. Shareholders Litig. (IPB, Inc. v. Tyson Foods, Inc.), 789 A.2d 14, 68 (Del. Ch. 2001), and Hexion Specialty Chemicals, Inc. v. Huntsman Corp., 965 A.2d 715, 738 (Del. Ch. 2008). In the VHS case, the court explained that the "[a]ssessment of the occurrence of a Material Adverse Effect must take into account the $610 million purchase price for the Hospitals. To prevail upon its assertion of a Material Adverse Effect, SGM would be required to show the occurrence of the unexpected events which have substantially reduced the value of the Hospitals."

The court provided examples of what could constitute a material adverse effect in the VHS case, including the debtor's failure to maintain the licenses for its hospitals, or the debtor's operation of the hospitals in a manner that led to regulators closing key departments within the hospitals. The bankruptcy court concluded that none of the allegations of SMS came even close to showing a material adverse effect (the specific allegations were filed under seal and are undisclosed). The court further found that even if the allegations of SGM were true, SGM would not be excused from closing the sale. Clearly disturbed by SGM's tactics, the court stated: "SGM is well aware that it was the only bidder for the Hospitals. By presenting non-meritorious arguments as to why it is not obligated to close, SGM is holding the estates, creditors, and patients of the Hospitals hostage in an attempt to extort a better purchase price. SGM's cynical tactics are especially offensive given the significant harm that closure of the Hospitals would impose upon patients."

SGM failed to fulfill its obligation to close the purchase. In a separate decision issued last month, the bankruptcy court stated that "[b]y failing to close, SGM risks the loss of its $30 million good-faith deposit as well as the possibility of damages for breach of contract in an amount of up to $60 million." The agreement contains a provision limiting damages to $60 million. Last week, VHS, on Jan. 3, filed a notice with the bankruptcy court terminating the agreement with SGM. On that same day, the debtor also filed a complaint initiating an adversary proceeding in the bankruptcy court against SGM and its affiliates for breach of contract, promissory fraud, and tortious breach of contract (breach of implied covenant of good faith and fair dealing). Presumably, the debtor will contend that fraudulent conduct by SGM lifts the cap on damages under the agreement.

In the complaint, VHS asserts SGM engaged in "intentional, misleading conduct ... designed to wrongfully and fraudulently lock" VHS into the asset purchase agreement "for the sale of four hospitals under the auspices of a Bankruptcy Court order, with which defendants had no intention of complying." The debtor further contends that SGM never anticipated that VHS would obtain consent from the California attorney general not to impose conditions on the sale transaction different from those in the agreement. VHS alleges that SGM believed it would never be obligated to pay the full purchase price and "would eventually be positioned to either walk away from the transaction or coerce ... [VHS] into a re-trade at a significantly lower purchase price." Meanwhile, the debtors were obligated to continue operating the hospitals with daily operating losses of $450,000 and were precluded from selling to anyone else. 