December 10, 2020

Worried about Material Adverse Effect Provisions in Your Acquisition? Ordinary Course Covenants May Be a Bigger Issue

By: Steven Howard Roth

Tags: Covid-19, Delaware, Litigation, Material Adverse Effect, Mergers & Acquisitions

Some of the most crucial elements of any M&A deal are the covenants, representations and warranties. When it comes to reps and warranties, Buyers want them to have the widest scope possible, while Sellers want to make them as narrow as possible. Why? The answer is simple. From the buyer's perspective, it wants to ensure that certain facts and circumstances remain as they are as of a certain moment and/or that they haven't or will not change during some period of time. In other words, the buyer wants to make sure it isn't surprised by some event or circumstances that the seller may not have lied about, but that either (i) wasn't disclosed for some reason when it should have been, or (ii) has changed or is likely to change prior to closing or within a certain amount of time thereafter. Covenants, representations and warranties are a form of protection for buyers, and provide certain remedies in the event that one of them is breached.

One of the most common representations and warranties given by sellers in stock purchase and merger agreements is that the target has not suffered any "material adverse change" (a "MAC") or that there has been no event that has had a "material adverse effect" (a "MAE") on the target. MACs and MAEs are typically defined as "any event, occurrence, fact, condition or change that is, or could reasonably be expected to become, individually or in the aggregate, materially adverse to (a) the business, results of operations, financial condition, assets, liabilities, or prospects, except an event or effect arising out of natural disasters, calamities, or other acts of god, or (b) the ability of the Seller to consummate the transactions contemplated in an agreement on a timely basis." If the target experiences a MAE or a MAC after signing the agreement, but before closing, the occurrence of the MAE or MAC will typically give the buyer the right to terminate the agreement (in addition to leverage to adjust the terms of the deal, such as the purchase price).

What does this have to do with COVID-19? Well, as you might have guessed, since the start of the pandemic, many buyers have attempted to get out of deals by claiming that COVID-19 was a MAE or MAC. As a general matter, courts have historically interpreted MAE and MAC provisions narrowly, meaning that a change or event would need to be fairly drastic in order for a MAE or MAC to be found to have occurred. Thus, it wasn't a huge surprise when the Delaware Court of Chancery issued its first opinion involving claims of a MAE in AB Stable v. Maps Hotels on November 30.

In AB Stable, the buyer, a subsidiary of Mirae Asset Financial Group ("Mirae"), agreed to purchase Strategic Hotels & Resorts ("Strategic"), a Delaware company, which owns numerous luxury hotels. The closing of the transaction was scheduled to close in mid April, 2020. As with many hotel chains, when the pandemic hit, Strategic closed some of its hotels, reduced its employee count, cut capital expenditures, and restricted services and amenities at the hotels it kept open. Mirae, in response, refused to close the deal, claiming that the pandemic constituted a MAE under the terms of the agreement and that Strategic's response to the pandemic constituted a breach of its covenant to maintain its business in the ordinary course prior to closing. Although the definition of MAE in the agreement between Mirae and Strategic did not explicitly carve out pandemics from the definition, the court found that the exception for "calamities," which was included in the definition, sufficiently encompassed the COVID-19 pandemic.

Despite the somewhat predictable ruling with respect to the MAE claim, the court did, however, somewhat surprisingly, find that Strategic's response to the pandemic did breach its obligation under the agreement to operate in the ordinary course. In the agreement between Strategic and Mirae, the "ordinary course" covenant specifically required that Strategic "operate in the ordinary course consistent with past practices in all material respects." According to the court, the only issue was whether Strategic "substantially deviated" from its "customary and normal routine of managing [its] business." The court explained further that it was irrelevant whether Strategic's response to the pandemic was reasonable or similar to other companies' responses. The purposes of the "ordinary course" covenant, the court explained, is 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." With that being said, the court did note that its analysis would be different if the "ordinary course" covenant wasn't drafted to require operation in the ordinary course consistent with "past practices."

The lesson here for sellers moving forward is to be very careful to avoid the unintended result that a carve out of a certain event, such as a pandemic, from the definition of a MAE or MAC nevertheless has the same effect as if the carve out wasn't included due to the fact that the response to the event breaches an "ordinary course" covenant. With respect to the pandemic, sellers would be wise to include language that explicitly excludes the seller's response to the pandemic as a MAE or violation of any "ordinary course" covenant. On a more general note, sellers, in consultation with their legal counsel, should pay close attention to the language of "ordinary course" covenants, and consider modifying them so that they don't require operation in the ordinary course consistent with past practices, but instead require operation in the ordinary course, subject to deviations which are consistent with industry wide responses to unforeseeable events.