By Gail Weinstein, Philip Richter and Steven Epstein

Law360 (December 4, 2020, 7:11 PM EST )

Gail Weinstein

Philip Richter

Steven Epstein

A number of cases are currently pending in various courts relating to whether — under an acquisition agreement signed prior to the COVID-19 pandemic — the effects of the pandemic and the target company's responses to it constituted a material adverse effect and/or a breach of the covenant requiring the company to operate in the ordinary course of business between signing and closing.

On Nov. 30, the Delaware Court of Chancery reached the first decision, on the merits, on these issues, in AB Stable v. Maps Hotels.

Vice Chancellor J. Travis Laster ruled that the pandemic was not a material adverse effect — because the MAE definition in the agreement excluded "calamities" — but that the target company's responses to the pandemic constituted a breach of the ordinary course covenant. Therefore, the buyer was not obligated to close.

As a result of the decision, the focus on ordinary course covenants as a possible basis for not consummating deals is likely to intensify, both in the context of the COVID-19 pandemic and with respect to the potential for the occurrence of other kinds of extraordinary events — including those that are less extreme and occur more commonly.

We note that ordinary course covenants appear in many types of agreements outside the M&A context — such as financing and operating agreements — and, thus, there is the potential that the decision could have broad impact.

Background 

The buyer, a subsidiary of Mirae Asset Financial Group, a Korea-based financial services conglomerate, agreed in September 2019 to acquire Strategic Hotels & Resorts, a Delaware company that owns 15 luxury hotels.

The seller is a subsidiary of Dajia Insurance Group, a Chinese company that is the successor to Anbang Insurance Group.

The closing of the $5.8 billion deal was scheduled to occur in mid-April 2020. After the pandemic hit, Strategic, similar to other companies in the hotel industry, closed hotels, restricted the services and amenities at hotels that remained open, reduced employees, and cut capital and other expenditures.

The buyer refused to close, on the basis that the pandemic and Strategic's responses to it constituted both an MAE and a breach of the seller's ordinary course covenant.

The Decision

The court held that Strategic's responses to the pandemic breached the ordinary course covenant and, therefore, the buyer was not obligated to close.

The court ruled that, under the specific terms of the sale agreement relating to termination, the buyer is entitled to a return of the deposit it paid, with interest, and reimbursement for $3.7 million in transaction-related expenses plus its attorneys' fees and expenses.

Based on the decision, it appears that the court may, more readily than had been expected, find that a target company's responses to the pandemic breached an ordinary course covenant.

The decision highlights that sellers and target companies should seek to ensure that an ordinary course covenant is specifically drafted to provide sufficient flexibility for the target company to respond to extraordinary events so that such responses do not breach the covenant and trigger a right by the buyer to terminate the deal.

Based on the language of the covenant in this case — which required that the business be operated "only in the ordinary course consistent with past practices in all material respects" — the court held that the only relevant issue was whether Strategic, after entering into the agreement, "substantially deviated" from its "customary and normal routine of managing [its] business."

It was irrelevant, the court stated, whether Strategic's responses to the pandemic were reasonable or were similar to other companies' responses.

The court specifically rejected the seller's arguments that an ordinary course covenant permits a target company to engage in "ordinary responses to extraordinary events" and that Strategic had "operated in the ordinary course of business based on what is ordinary during a pandemic."

The seller argued that an ordinary course covenant leaves room for a company to address changed circumstances and unforeseen events, "including by engaging in an ordinary response to extraordinary events."

The court stated that, although "prior cases have not framed the interpretive question so starkly, the weight of Delaware precedent" supports the contrary view.

The precedential decisions have treated the contractual term "ordinary course" to mean "the customary and normal routine of managing a business in the expected manner," the court wrote.

The court stated that this approach is consistent with the provision's purpose to "reassure a buyer that the target company has not materially changed its business or business practices during the pendency of the transaction" and that the buyer is "paying for the same business at closing that it thought it was buying."

The court indicated that its analysis would be different  — i.e., the responses of other companies to the event at issue would become relevant — if the ordinary course covenant were not drafted to require operation in the ordinary course consistent with past practices.

The decision confirms that the court continues to interpret MAE clauses narrowly as a general matter.

Although the MAE definition did not specify an exception for effects arising from pandemics, or epidemics, the court concluded that the specified exception for calamities encompassed the COVID-19 pandemic.

The decision is thus in line with the court's long tradition of not finding the occurrence of an MAE — with 2018's Akorn Inc. v. Fresenius Kabi AG being the only case we know of in which the court has ever found that an MAE occurred.

The decision appears to confirm the view that developed among many practitioners over the course of the pandemic that the court is more likely to find that the pandemic and a company's responses to it resulted in a breach of an ordinary course covenant than that they resulted in an MAE.

The court held that the term calamities encompasses the COVID-19 pandemic.

MAE was defined in the sale agreement as:


Relying on the dictionary definition of calamity — i.e., "a serious accident or bad event causing damage or suffering" — the court found that the term encompasses the COVID-19 pandemic given the widespread human and economic loss and suffering the pandemic has caused.

The court expressly rejected the seller's argument that the parties' omission of the word pandemic from the list of exceptions must have been intentional and evidenced that the risk of a pandemic was intentionally allocated to the seller.

The court found it could not reach "strong conclusions" from data that were presented to the court relating to the prevalence and usage of the word "pandemic" in a sample of purchase agreements entered into before the pandemic began. However, based on that data, the court stated:
The court held that the term natural disasters also arguably encompasses the COVID-19 pandemic.

Relying again on the dictionary, the court described the plain meaning of "natural disaster" as a "sudden and terrible event in nature  — such as a hurricane, tornado, or flood — that usually results in serious damage and many deaths."

The court found that the COVID-19 pandemic arguably fits this definition, given that "it is a terrible event that emerged naturally in December 2019, grew exponentially, and resulted in serious economic damage and many deaths."

The court rejected the seller's more limited view of natural disasters as being only "sudden, single events" that are "attributable to the classic elements of nature" — earth water, fire and air — and that "threaten direct damage to property."

The court reasoned that some but not all natural disasters are sudden. For example, a drought generally arises over a lengthy period. Some, but not all, arise from the "four earthly elements" — for example, a meteor strike would not arise from these elements, and "[t]here is also no reason to prioritize property damage over the suffering of living beings."

The decision illustrates the anomalous result that can occur through the interplay of an MAE condition and an ordinary course covenant.

Traditionally, it is the MAE clause that parties utilize to allocate the risk relating to the potential for an extraordinary event to occur between signing and closing.

By contrast, an ordinary course covenant imposes restrictions on the target's flexibility in making decisions about how to operate pending closing, so that the seller does not decide to make major changes, at least without the buyer's consent.

The materiality standards applicable to these provisions typically are different. Case law has established that MAE sets a very high standard, requiring severe effects to the long-term value of the company; while an ordinary course covenant generally is drafted such that compliance is required "in all material respects"  — which, the court confirmed, is a much lower standard than MAE.

Thus, we would note, an anomalous result can obtain, as it did in this case, that a buyer has agreed in the MAE clause that certain specified extraordinary events will not provide a basis for an MAE, but the buyer nonetheless may be excused from closing on the basis that the target company's responses to that same event constituted a breach of the ordinary course covenant  — notwithstanding that the responses may have been dictated by the circumstances and largely non-volitional.

As we read the opinion, the court was essentially indicating that it interprets agreements based on the plain language presented — and, if parties intend a result different from the one just described, they must accomplish this through changes to the typical drafting of these provisions, as we show in our practice point, below.

We note the following open issues:

First, the court expressly left open the issue whether changes a company is "legally required" to make could constitute a breach of an ordinary course covenant.

The court found that it was unclear whether any governmental orders required hotels to shut down or limit amenities–but, even if they had, the court stated, that still would not have legally obligated Strategic to make other changes — such as layoffs, cuts to sales efforts, and decreased expenditures.

Second, the court did not specifically address to what extent a company's responses to past extraordinary events might support a view that its responses to the pandemic were consistent with past practice.

This may well be because no other event has been sufficiently similar to this pandemic to provide a reasonable basis for the analysis.

We anticipate that any such analysis would necessarily depend on the extent to which the past event was similar to the event at issue; how often such an event had occurred; and how similar the company's responses had been in each instance.

The court reasoned that the structure and content of the MAE definition in support the court interpretation of calamities to encompass the pandemic.

First, the court reasoned that the structure of the definition "broadly shifts systemic risk to buyer" — through its express exceptions for general industry changes or developments, changes in political or economic conditions or financial markets, and changes in law.

Given that "[t]he risk from a global pandemic is a systematic risk... it makes sense to read the term 'calamity' as shifting the risk to the buyer."

Second, the court wrote, the content of the MAE definition reflects a seller-friendly intent — as, for example, there was no exclusion from the exceptions for events having a disproportionate effect on Strategic as compared to other firms in its industry.

Practice Point

A seller should seek to avoid the anomalous result that a buyer that has agreed (in the MAE clause) that certain specified extraordinary events will not provide a basis for an MAE, nonetheless may be permitted not to close on the basis that the target's responses to that extraordinary event constitute a breach of the ordinary course covenant.

To avoid this potential result, the typical drafting of the ordinary course covenant could be changed to impose an MAE standard, rather than "in all material respects" standard, and/or to except from the general restriction to act in the ordinary course certain specified, or all, actions taken in response to certain specified, or all, extraordinary events — possibly, unless such actions would have an MAE.

Over the course of the pandemic, drafting practice has generally evolved such that, in newer agreements, the parties typically do except from the ordinary course covenant specified responses to this ongoing pandemic.

Going forward, parties may wish to consider whether broader exceptions should be made to cover other extraordinary events, or unexpected events even if they are not extraordinary, that may occur.

Correction: A previous version of this article incorrectly identified the owner of the Waldorf Astoria. It is owned by Dajia Insurance Group and was not part of the deal discussed. A previous version of this article also misspelled Anbang's name. The errors have been corrected.

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Gail Weinstein is senior counsel, and Philip Richter and Steven Epstein are partners, at Fried Frank Harris Shriver & Jacobson LLP.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

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