COVID-19 Hotel M&A Contract Case Offers Drafting Takeaways – Corporate/Commercial Law

Bizar Male

The COVID-19 pandemic has caused parties to M&A transactions
to reconsider proper allocation of risk—particularly for the
period between the signing and closing of a transaction. This
includes negotiating the definition of “material adverse
effect” (MAE) and what will or will not count as an MAE that
gives buyer the right to walk away from the transaction.

A recent case in the Delaware Court of Chancery, AB
Stable
, looks at the issue of MAE clauses and interim
operating covenants and offers some insights on drafting merger and
acquisition contracts.

The fact pattern and legal issues in AB
Stable
 are complex, but the key facts surrounding the
case were as follows. The target business was in the hotel industry
(which had been devastated by the COVID 19 pandemic), the deal was
signed before the worst impacts of the pandemic on the hotel
industry were known, and these impacts became evident during the
executory period. A key issue in the case was whether these impacts
relieved the buyer of its obligation to close the transaction.

During the executory period, the seller responded to the
pandemic by taking a number of actions involving its hotel
businesses, including closing one hotel, closing another hotel in
advance of its normal between-season closing, operating other
hotels at reduced service levels, and pausing all non-essential
capital spending.

The buyer claimed that there was an MAE that justified it not
closing the transaction. However, the court found that, even
assuming the impact on the business was material and adverse, the
pandemic fell within an exception to the definition of MAE for
“natural disasters and calamities.”

As such, there was no MAE (as defined in the sale agreement) so
there was no failure of the related closing condition.

Interim Operating Covenants

The sale agreement had a fairly standard closing condition that
required the seller to operate the business in the ordinary course
consistent with past practice except for specifically scheduled
exceptions unless the buyer provided its prior written consent to
not operate in the ordinary course of business (such consent not to
be unreasonably withheld, conditioned or delayed).

The court held that the seller’s responses to the COVID-19
pandemic were outside the ordinary course of business because they
were not consistent with its past practices. The court did not
accept the seller’s attempt to frame its actions as ordinary
responses to extraordinary circumstances because whether ordinary
or reasonable in light of the COVID-19 pandemic, they were not
ordinary in light of seller’s past business practices.

No MAE Closing Condition

The court specifically rejected the seller’s argument that
items carved out from qualifying as MAEs should therefore be read
into how the ordinary course covenant should be read.

In other words, the court found that the COVID-19 pandemic not
qualifying as a MAE (as defined) had no impact on whether the
COVID-19 pandemic should be considered in the context of the
ordinary course covenant. The court noted that if that were the
intention, the parties could have said that only a departure from
the ordinary course that constituted an MAE would breach the
covenant.

The court also specifically rejected the seller’s argument
that there was no breach because deviations were permitted if
consented to by the buyer and, although such consent was never
sought, the  buyer could not reasonably have withheld
its consent. Therefore, its consent should be deemed to have been
given, which effectively would mean there was no breach of
covenant.

The court flatly rejected this assertion and concluded that
complying with a notice requirement is more than an empty formality
as it would have, at minimum, allowed the buyer to engage in
discussions with the seller on the topic and to seek additional
information so that it could protect its interests.

Key Drafting Takeaways

In light of this opinion and its underlying rational, we offer
the following three key recommendations for drafters of M&A
contracts.

MAE Definition

If representing a buyer, reconsider some exceptions to the
definition of MAE that have become relatively common (such as
wholesale exclusions of pandemics, epidemics, or social unrest)
given the possibility of unanticipated extraordinary
circumstances.

Allocation of Risk

As with many aspects of M&A contracts, when drafting an
ordinary course operating covenant that serves as a closing
condition, the parties should carefully consider the allocation of
risk, including who bears the risk of extraordinary circumstances
happening during the executory period.

Typically, sellers are expected to operate in the ordinary
course for things that they can control, but who should bear the
risk for things that sellers cannot control (such as consequences
of the COVID-19 pandemic) is a more complex question. This will be
a negotiated point and may ultimately come down to leverage, but
who should (and will) bear this risk should be carefully considered
when drafting these provisions.

Seek Consent

During an executory period when a seller is subject to an
ordinary course operating covenant, if the seller intends to
deviate from its ordinary course operations, it should seek the
buyer’s consent. This is especially true when the seller
intends to respond reasonably to extraordinary circumstances and
the M&A contract requires the buyer to not unreasonably
withhold such consent (as it did in the AB
Stable
 case).

This article was originally published in BloombergLaw.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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