In AB Stable VIII LLC v. MAPS Hotels and Resorts One LLC et al., the Delaware Court of Chancery, held for the first time that reasonable measures aimed at combatting COVID-19 can violate the ordinary course of business covenant in a sale agreement if those measures “materially change [the] business or business practices” of the target company. In connection with the attempted sale by AB Stable VIII LLC ( “Seller”) of a subsidiary holding 15 hotels to MAPS Hotel and Resorts One LLC ( “Buyer”), the Court held that by temporarily closing two hotels, limiting the capacity and amenities in others, and by furloughing and laying off workers in light of the COVID-19 pandemic, the Seller materially breached its covenant to operate in the ordinary course of business between the signing and closing of the transaction. Accordingly, the Buyer was not required to complete the transaction.
In September 2019, the Buyer entered into a sale and purchase agreement providing for the purchase of a subsidiary of the Seller that owned 15 luxury hotels. The $5.8 billion transaction was scheduled to close in early 2020 and was conditioned on, among other things, the Seller continuing to operate in the ordinary course of business consistent with past practice and the absence of a Material Adverse Effect (“MAE”).
As the closing date approached, Seller notified Buyer that due to the worsening COVID-19 pandemic, the Seller made operational changes including temporarily closing certain hotels, reducing capacity at other hotels and pausing all non-essential capital spending. Note that Seller did not seek Buyer’s consent before taking these actions, and that, pursuant to the purchase and sale agreement, Buyer was prohibited from unreasonably withholding consent. On the day scheduled for closing, Buyer notified Seller that, because of COVID-19 and the resulting operational changes, the Seller was in breach of both its covenant to continue operating in the ordinary course of business, its representation that no MAE had occurred. Because of these breaches, the Buyer expressed its intent to terminate the agreement if the breaches were not cured by May 2, 2020.
Court of Chancery Decision
On April 27, 2020, the Seller sued the Buyer in the Delaware Court of Chancery, seeking to compel the Buyer to close the deal. Despite this lawsuit, on May 4, 2020, the Buyer purported to terminate the merger agreement due to the Seller’s alleged breaches of the agreement. To support the termination, the Buyer advanced two main arguments related to the pandemic.
The first argument was that the pandemic caused the target business to suffer an MAE, which excused its obligation to close. In this agreement, MAE was defined as “any event, change, . . . that would have a material adverse effect on the business, financial condition, or results of operations of the [c]ompany . . .” The definition also included an extensive list of exceptions, which is typical in merger agreements. Notably, there was no “pandemic” exception.
The second argument was that the Seller failed to operate its business “only in the ordinary course of business consistent with past practice in all material respects. . .”, which also excused its obligation to close, irrespective of the MAE provision. Specifically, the Buyer argued that the standard for “ordinary course of business” should be the ordinary course of business under normal circumstances, and not a standard of normal given the circumstances (i.e. normal during a pandemic).
The Court noted that, despite the lack of pandemic, health, or disease-related exception, the pandemic could still fall under the “natural disaster and calamities” exception present in this deal, thereby eliminating the need to decide whether the pandemic was a MAE to begin with. Accordingly, on this ground, there was no basis for Buyer to terminate the agreement. The Court reaffirmed in dicta its view of the purpose of the exceptions to the MAE definition – namely to ascribe to the target company business-related risks, and the acquiror all other risk.
Although the Court found that the pandemic did not constitute a MAE, the Court held that the Seller breached its ordinary course of business covenant through the operational changes it made in light of the COVID-19 pandemic. The Court noted that pursuant to the agreement’s ordinary course of business covenant, the standard for the ordinary course of business was the “customary and normal routine of managing a business in the expected manner.” It reasoned that the purpose of the provision is to “reassure a buyer that the target company has not materially changed its business or business practices during the pendency of the transaction.” It further noted that, practically speaking, the provision “help[s] ensure that the business [the buyer] is paying for at closing is essentially the same as the one it decided to buy at signing.” Accordingly, it was irrelevant whether the Seller acted reasonably given the circumstances. To the Court, it mattered only that the operational changes were a significant deviation from the ordinary course of the Seller’s business.
Importantly, this finding rejected the argument that a company could satisfy the ordinary course of business covenant by simply acting reasonably, or even responsibly, toward an extraordinary event. As the first case decided on this issue in the post-COVID era, this outcome could have far-reaching consequences in the negotiating and drafting of the ordinary course of business covenant.
- The Court is willing to find that reasonable, preventative public health measures can breach the ordinary course of business covenant. Given the prevalence of suggested and mandated public health measures in the light of the COVID-19 pandemic, this decision can have far-reaching consequences. Importantly, the Court acknowledged, but failed to analyze, whether a company could violate its ordinary course of business covenant if it is required by law to take preventative health measures. Accordingly, sellers seeking to maintain flexibility in the face of unexpected circumstances should include explicit language in the ordinary course of business covenant provision to allow themselves the ability to take preventative measures.
- It remains exceedingly difficult to establish a Material Adverse Effect. With the exception of Akorn, the Court has consistently refused to establish an MAE as to allow buyers to walk away from closing. This case was no different—the Court found that the MAE exceptions applied even though there were no explicit pandemic or disease exceptions. The Court reasoned that the pandemic could satisfy the “natural disaster or calamity” exception, an exception that is already present in a “supermajority” of M&A agreements.
- Accordingly, when negotiating or drafting COVID–specific language, parties should focus their attention on the ordinary course of business operating covenant, in addition to the MAE definition, as a potential pressure point on deal certainty. The use of COVID-19 or pandemic-specific provisions in the MAE definition has increased substantially over the last several months. However, it is likely that there will be continued focus on ordinary course of business operating covenants in the future, and parties should carefully negotiate the standard that will be applied, paying particular consideration to whether the covenant allows Sellers to react to extraordinary circumstances (or at least requires to Buyer not to unreasonably withhold consent to Seller taking appropriate actions to deal with extraordinary circumstances). In this case, the Court noted that the use of “only” and “consistent with past practice” in the ordinary course of business covenant created a standard that looked exclusively to how the business itself operated in the past. Without these phrases, the Court might have looked to how other companies behaved in similar circumstances, which may have produced a different result.