Course Correction: Why “Ordinary Course” Covenants in Acquisition Agreements Should be Drafted Carefully
January 07, 2022
Should a buyer be allowed to walk away from an acquisition if an extraordinary event occurs between signing and closing that forces the target company to take emergency remedial measures outside its ordinary course, even if consistent with industry practice under the circumstances? This became a pressing issue during the early months of the COVID-19 pandemic as buyers were attempting to back out of deals. In the first COVID-19 era Delaware court case on this topic, the Delaware Supreme Court on December 8, 2021 upheld the Chancery Court’s decision that the buyer was justified in terminating the purchase agreement because the target’s remedial responses to the pandemic departed from past practice and violated the agreement’s covenant to operate in the ordinary course, even though the measures were a reasonable response to plummeting demand and were widely implemented in the industry.
The dispute in AB Stable VIII LLC v. Maps Hotels and Resorts One LLC grew out of an agreement by MAPS Hotel and Resorts One LLC (the “Buyer”) to purchase fifteen hotel properties from AB Stable VIII LLC (the “Seller”) for $5.8 billion. A closing delay pushed the transaction up against the COVID-19 outbreak and the damage it inflicted on the hospitality industry. In response to the pandemic, the Seller made drastic changes to its hotel operations after signing the purchase agreement, including closing hotels and laying off or furloughing thousands of employees. Although the Seller asked for the Buyer’s consent, it then failed to respond to the Buyer’s reasonable request for relevant information. The Buyer then terminated the purchase agreement and walked away, citing a breach of the Seller’s ordinary course covenant. The Seller then commenced a lawsuit seeking specific performance.
The purchase agreement in AB Stable contained a typical “covenant compliance” condition, under which the Buyer could walk if the Seller breached any of its pre-closing covenants. The issue before the court was whether the Seller failed to satisfy the covenant to operate the business in the ordinary course between signing and closing. The case turned on the specific language of the ordinary course covenant, which read as follows:
“…[B]etween the date of this Agreement and the Closing Date, unless the Buyer shall otherwise provide its prior written consent (which consent shall not be unreasonably withheld, conditioned or delayed), the business of the Company and its Subsidiaries shall be conducted only in the ordinary course of business consistent with past practice in all material respects, including using commercially reasonable efforts to maintain commercially reasonable levels of Supplies, F&B, Retail Inventory, Liquor Assets and FF&E consistent with past practice…”
The Seller argued that “ordinary course of business” during the pandemic should mean the prevailing industry standard under current circumstances, not its own past practice. The court, however, interpreted the adverb “only” in conjunction with the phrase “consistent with past practice” to mean that the parties created a standard that looks exclusively to how the business operated in the past, and that industry responses to the pandemic were not relevant to the standard. The court also rejected the Seller’s alternative argument that there was no breach of the ordinary course covenant because the “business” in question was the parent company’s asset management business, which does not involve the day-to-day operation of the hotels, and in which there were no changes to the parent’s role of deploying capital and overseeing the hotels’ managers. The court rejected this argument inasmuch as the plain language of the covenant requires that the “business of the Company and its subsidiaries be operated in the ordinary course”, meaning that the covenant extended to the operation of the hotels themselves. The court’s reading was also informed by other parts of the same covenant which required the Seller to maintain commercially reasonable levels of assets such as food, furniture, toiletries and other items required in hotel operations. Finally, the court noted the absence of a reasonableness qualifier with respect to the relevant part of the covenant, which supported the proposition that the parties intended the seller’s obligation to be absolute.
The court’s decision at this point would seem to impose on sellers an awful dilemma. Take reasonable measures that preserve the business but which violate the ordinary course covenant, and the buyer gets to walk. Or refrain from taking remedial measures and risk running the business into the ground, which would likely be a material adverse event resulting in the buyer terminating here as well and the seller ending up with a failed business. But by imposing a consent requirement, the purchase agreement anticipated this dilemma by involving the Buyer in the Seller’s response to disruptive events. The Buyer might have wanted to respond to the pandemic in different ways to ensure the long-term profitability of the business or to prioritize certain operations. As the court pointed out, the Seller was not hamstrung by the ordinary course covenant. It was simply required to seek consent before taking action, and if consent was “unreasonably” denied, the Seller could have challenged the Buyer’s unreasonable denial. Here, the Seller did ask for the Buyer’s consent, but then failed to respond to the Buyer’s reasonable request for relevant information in response. Having departed from past practice without securing the Buyer’s consent, the Seller breached the ordinary course covenant, which excused the Buyer’s obligation to close.
The clear lesson of AB Stable is that parties to an acquisition agreement should draft ordinary course covenants very carefully so as not to leave the interpretation of “ordinary course” to chance.
- First, sellers should seek to include, and buyers should seek to exclude, “commercially reasonable efforts” from the covenant. In AB Stable, the covenant to operate in the ordinary course was not qualified by the term “commercially reasonable efforts”, and the court ruled that the Seller had an absolute “flat” obligation to operate in the ordinary course.
- Second, sellers should avoid use of the adverb “only” in conjunction with the phrase “consistent with past practice”. The court interpreted that combination to mean that the parties created a standard that looks exclusively to how the business operated in the past, and that industry responses to the pandemic were not relevant to this standard.
- Third, sellers that operate through subsidiaries should resist, while buyers should negotiate for, the insertion of “and its subsidiaries” in reference to the business that is required to be operated in the ordinary course. The Seller in AB Stable had argued creatively that it had not violated the ordinary course covenant because it had not made any changes to its asset management business, which was the business of deploying capital and overseeing the hotels’ managers, but lost on that argument because the covenant had an explicit reference to the business of the Seller’s subsidiaries.