ArticleBefore Selling A Middle Market Business: Five Lessons For Owners
In late November of last year, the Court of Chancery in Delaware handed down a decision in a case called AB Stable VIII LLC v. MAPS Hotels and Resorts One, LLC, et. al..[1] This case, which involved many issues beyond those addressed here, highlighted the import of contractual provisions regarding a seller’s representations, warranties and covenants in the context of sale of a business and the potential that these provisions could be used to relieve a buyer of its obligation to close a transaction. Specifically, the Court considered “Material Adverse Effect” and “Ordinary Course of Business” clauses in the context of the COVID-19 pandemic. The Court’s decision is worth reading for any transactional attorney as it offers a very thorough analysis of the contractual provisions at issue, focusing in great detail on general rules of contractual interpretation, which party carries the burden of proof and judicial precedent.
This case arose out of the failure of MAPS Hotel and Resorts One, LLC (the “Buyer”) to consummate the purchase of various hotel properties from AB Stable VIII LLC (the “Seller”) pursuant to the terms of a Sale and Purchase Agreement entered into by the parties on September 10, 2019 (the “Agreement”). On April 17, 2020, the scheduled closing date of the proposed transaction, the Buyer asserted that it was not obligated to close because certain of the Seller’s representations and warranties were untrue and because Seller had failed to satisfy all of the conditions to closing. Essentially, the Buyer argued that COVID-19 had caused a “Material Adverse Effect” which rendered the Seller’s representations inaccurate, and that COVID had caused the Seller to operate other than “in the ordinary course of its business” in violation of its covenants.
The Court rejected the Buyer’s assertion that COVID-19 had resulted in a “Material Adverse Effect,” which would have permitted the buyer not to proceed with closing, because the Agreement defined “Material Adverse Effect” to include “any event, change, occurrence, fact or effect that would have a material adverse effect on the business, financial condition or results of operations” of the Seller other than any event, change, occurrence or effect arising out of, or attributable to or resulting from a series of excluded circumstances described in the Agreement. One of the enumerated excluded circumstances was “natural disasters or calamities.” The Court, after a thorough analysis of various issues regarding contractual interpretation, the burden of proof and the applicability of the other exceptions to the “Material Adverse Effect” definition, concluded that the COVID-19 pandemic was encompassed by the “natural disaster and calamity” exclusion. Essentially, the Court concluded that even if COVID-19 had a material and adverse effect on the Seller, the Seller established that the adverse effect resulted from a natural disaster or calamity. Because the event giving rise to the material and adverse consequences resulted from an event excluded from the definition of “Material Adverse Effect,” the Buyer could not then rely on this clause to excuse its performance under the Agreement.
The Court reached a very different conclusion, however, when analyzing Buyer’s claim that it was excused from proceeding with the purchase because the Seller had failed to operate “only in the ordinary course of business, consistent with past practice in all material respects.” The Court determined that the Seller had failed to operate in the ordinary course of business, highlighting several examples of Seller’s failure: (1) it closed “two of [its] Hotels entirely and limited operations at the other thirteen severely”; (2) it “slashed employee headcount, with over 5,200 full-time-equivalent employees laid-off or furloughed”; and (3) it “minimized spending on marketing and capital expenditures.”[2] The court also found that Seller failed to prove that these changes were made as a result of government orders, leaving open the question of which party would have borne the risk of changes implemented due to such mandates.[3] Because the Buyer proved that the Seller had made significant changes to its business in response to the COVID-19 pandemic and that, as a result, had not complied with the ordinary course covenant which was a condition to closing, the Court ruled that Buyer was relieved of its obligation to consummate the sale.
This case highlights the importance of careful drafting to address issues surrounding the impact of COVID-19 on any transaction. When representing a Seller, it is certainly imprudent to rely upon traditional formulations of “ordinary course” covenants or standard definitions of “material adverse effect/change.” In the event of a dispute between the parties, these clauses are subject to interpretation which could well create uncertainty for your client. It is, therefore, very important to address the impact of COVID-19 directly and early on, providing as much clarity as possible with respect to the intent of the parties.
Of course, how these issues are ultimately addressed in a purchase agreement will depend upon the relative negotiation power of a seller and a buyer. Buyers will typically proffer purchase agreements with traditional clauses not unlike those that appeared in the Agreement giving rise to the case cited above. Sellers should certainly seek COVID-19 related exclusions to these traditional ordinary course covenants or material adverse change provisions. Buyers, on the other hand, will likely resist general COVID-19 or pandemic exclusions arguing that a general exclusion is too broad to offer the Buyer appropriate protections. In this circumstance, Sellers should minimally seek exclusions to ordinary course covenants to the extent necessary to permit them to comply with governmental orders (for example, orders to cease operations to prevent the spread of a virus) without risking their ability to satisfy a closing condition. If Buyer’s counsel rejects a general COVID-19 exclusion to the definition of “material adverse effect,” Seller’s counsel should consider seeking an exclusion for COVID-19 with a “disproportionate impacts” clause. That is, consider negotiating an exclusion which carves out of the definition of “material adverse effect/change” changes resulting from the impact of COVID-19, unless those changes disproportionately impact the Seller’s business relative to other similarly situated businesses.
In this post-COVID world of contracts, it is very likely that issues involving the definition of material adverse change or of ordinary course of business, whether in purchase and sale agreements or other commercial agreements, will be tested in other courts. Whether they present a similar analysis and come to the same conclusion will likely depend upon the facts and circumstances impacting the seller and upon the exact language in the operative agreement. COVID has reminded us to be prepared for the unexpected and to be mindful of all possible scenarios when negotiating commercial agreements.
[1] AB Stable VIII LLC v. MAPS Hotels and Resorts One LLC, et. al., 20 WL7024929 (Del. Ch. Nov.30,2020).
[2] Id. at *75-76, 79.
[3] Id. At *80.
