The Delaware Supreme Court recently affirmed Vice Chancellor Laster’s much talked of AB Stable post-trial decision, holding that the buyer of a $5.8 billion hotel portfolio could terminate the transaction due to, among other things, the seller’s breach of an ordinary course covenant by making operational changes in response to the COVID-19 pandemic. The Supreme Court’s affirmance provides critical guidance for the interpretation and navigation of such provisions, particularly in extraordinary times.
The at-issue merger agreement was signed in September 2019, and slated to close in April 2020. Shortly before the planned closing, and without obtaining the buyer’s consent, the seller made “drastic” changes at its 15 hotels in response to COVID-19. These included: (i) closing two hotels entirely, (ii) gutting operations at 13 others, (iii) terminating or furloughing staff, and (iv) cutting spending on marketing and capital expenditures. After the buyer refused to close, the seller sued, seeking specific performance to force a closing. The buyer responded with counterclaims contending, among other things, that it had no obligation to close due to the seller’s breach of the ordinary course covenant.
Vice Chancellor Laster sided with the buyer, holding that it had validly terminated the merger agreement because the ordinary course covenant had been breached and a condition (related to issuance of title insurance) had failed. The Supreme Court did not reach the title insurance issues (and the trial court’s related harsh criticism of the seller and its advisors), but affirmed the conclusion that the buyer was permitted to walk away on the basis of the ordinary course covenant breach, and provided several pieces of guidance for participants and advisors in M&A transactions. Among them:
- Consistent with Delaware’s highly contractarian regime, ordinary course covenants will be interpreted literally.
- The covenant at issue required operation “in the ordinary course of business consistent with past practice in all material respects.” The Supreme Court looked to dictionary definitions and precedent to interpret “ordinary course” as the “normal and ordinary routine of conducting business” and explained that such provisions prevent a seller “from taking any actions that materially change the nature or quality of the business that is being purchased, whether or not those changes were related to misconduct.” As a consequence, the fact that the seller made changes that were reasonable in the face of the COVID-19 pandemic was irrelevant. What mattered was that those changes constituted a material change in the nature and quality of the business being sold as compared to its prior operations.
- Should parties want “ordinary course” obligations to be measured with reference to a history beyond that of just the target company (g., measured against the actions of an industry), or qualified by a “reasonableness” standard, they should say so expressly in the contract.
- Notice and consent requirements should not be taken lightly; the outcome may have been different had the seller sent a notice seeking the buyer’s consent in advance.
- The Supreme Court’s several page discussion of notice requirements warrants some focus for its practical guidance.
- The seller requested the buyer’s consent to the above-referenced, material changes (g., closing two hotels) two weeks after they were implemented, and argued that this did not constitute a material breach and, alternatively, that the buyer had “unreasonably withheld” its consent (itself a breach of the agreement).
- The Supreme Court disagreed, and reiterated Vice Chancellor Laster’s reminder that “compliance with a notice requirement is not an empty formality.”
- Although the seller was “not required to run its hotels into the ground to comply with the Sale Agreement” in the face of a global pandemic, it had a contractual obligation to seek consent before making changes (consent the buyer could not “unreasonably” withhold).
- This holding will likely serve as a nudge for sell-side companies and practitioners to err on the side of requesting that a buyer consent to operational changes (at least when coupled with a buyer’s obligation to not “unreasonably” withhold such consent). The contours of what would be “unreasonable” in this setting, however, were not addressed, leaving more guidance on that question for another day.
- Material adverse effect (MAE) provisions are inherently distinct from ordinary course covenants.
- The seller had argued that because pandemic risk was allocated to the buyer via the MAE, the ordinary course covenant should be read in tandem with the MAE provision. Otherwise stated, the seller claimed that where an ordinary course covenant overlaps with an MAE allocation of risk to the buyer, the ordinary course covenant should be read to import that heightened standard.
- Here again the Supreme Court affirmed Vice Chancellor Laster’s rejection of this position, which rested on the plain language of each provision (and the distinct purposes of those provisions in practice).
- Unless written to operate in tandem – by, for example, restricting an ordinary course breach to events that rise to the level of an MAE – ordinary course and MAE provisions will be interpreted separately, pursuant to their plain language.
- Further, the Supreme Court confirmed that ordinary course and MAE provisions “serve different purposes,” with the former providing assurance that the buyer “has not materially changed its business or business practices during the pendency of the transaction” while the latter “allocates the risk of changes in the target company’s valuation.”