The Court of Chancery recently allowed a buyer to walk away from an acquisition due to, among other things, the seller’s failure to satisfy the ordinary course covenant because of changes made to the operating business in response to the COVID-19 pandemic. The opinion, penned by Vice Chancellor Laster, is the first decision offering post-trial guidance as to the application of material adverse effect (MAE) and ordinary course provisions during the pandemic. Its guidance on the application of these provisions should be of interest for all negotiating M&A deals and other commercial agreements generally, and during the COVID-19 pandemic in particular.
In AB Stable VIII LLC v. Maps Hotels and Resorts One LLC, plaintiff sought to sell a subsidiary that owned an approximately US$5.8 billion portfolio of luxury hotels. The deal was signed in September 2019, and was slated to close in April 2020. Due to COVID-19, shortly before the planned closing, the seller made material changes to its business. These included closing two hotels entirely, gutting operations at 13 others, terminating or furloughing staff, and cutting spending on marketing and capital expenditures. The seller filed a complaint seeking specific performance to force a closing; the buyer responded with counterclaims contending, among other things, that it had no obligation to close because an MAE occurred, and the seller breached the ordinary course provision. The Court’s rulings on both of these points are highly instructive.
MAE provisions allocate among contracting parties the risk between signing and closing in the event of a significant downward shift in the target company’s valuation. Usually, market or industry risk is allocated to the buyer, while company-specific risk is allocated to the seller. But such provisions typically list exclusions that might qualify as being material and adverse, though are agreed by the parties ex ante to be without recourse.
Here, the contract included an exception for “natural disasters and calamities,” which the Court held covered the COVID-19 pandemic. This is the first such ruling and provides interpretive guidance for similar MAE provisions going forward. This may be of limited utility, however, because many contracts executed over the prior year also have incorporated a belt and suspenders exclusion accounting specifically for a “pandemic.”
The buyer also claimed that a closing condition was not satisfied because the seller made COVID-19-related changes to the operating business that violated the ordinary course covenant. In response, the seller attempted to frame its actions as an “ordinary response to an extraordinary event,” thereby satisfying the ordinary course provision. The Court sided with the buyer, pointing to precedent defining “ordinary” course to mean the “ordinary routine of conducting business,” with reference to prior practices. The Court further explained that such provisions are intended to “to reassure a buyer that the target company has not materially changed its business or business practices during the pendency of the transaction.” Reference to past practice thus excluded actions taken solely in response to the “extraordinary.” This finding was reinforced by the particular language of the parties’ contract, which required the business be operated “only in the ordinary course of business consistent with past practice,” which narrowed the inquiry to just the business at hand, even excluding reference to how comparable businesses might have operated.
One open question following this decision is whether legally mandated conduct — perhaps, shuttering a business due to a government order — could constitute a breach of the ordinary course covenant. In dicta, the Court noted such an argument might carry weight, but even assuming as much, the seller had not proven the claim at trial.
Putting it all together: MAE and ordinary course provisions
The Court also rejected the seller’s argument that the MAE clause and ordinary course covenant should be read in tandem. Although the parties chose to allocate pandemic risk to the buyer through the “calamities” exception in the MAE clause, that did not obviate the seller’s ordinary course obligations during the pandemic. In making this finding, the Court focused on the plain language of the parties’ agreement, highlighting: (i) that these were separate provisions that implicated separate closing conditions; (ii) that these provisions could have cross-referenced each other but didn’t; and (iii) that each traditionally seeks to address different forms of risk (MAEs, a decreased valuation; ordinary course provisions, changes to the way in which the target business is operated).
While it is unclear as of this writing whether there will be an appeal from this ruling, for now it stands as a comprehensive guide to analyzing claims relating to MAE and ordinary course provisions during the COVID-19 pandemic. Buyers and sellers alike should heed its guidance carefully and focus on the plain language of MAE and ordinary course provisions to ensure a mutual understanding of how much latitude a seller will have to operate the company during these extraordinary times, mindful that Delaware courts likely will construe and enforce their contract literally.