Delaware Court of Chancery Provides First Guidance on COVID-19 Broken Deal Issues
The Situation: In AB Stable VIII LLC v. MAPS Hotels and Resorts One LLC, the Delaware Court of Chancery provided long-awaited guidance on two issues raised repeatedly—but never before decided—in COVID-19-related broken deal litigation.
The Result: The court first ruled that a Material Adverse Effect ("MAE") definition that did not expressly carve out the impacts of "pandemics" or "epidemics" still excluded COVID-19's impact because it carved out the impact of "calamities." The court suggested that broader exclusions of industry-wide impacts would also cover COVID-19. Second, the court ruled that even "reasonable" operational changes in response to COVID-19 can breach a covenant to operate in the ordinary course.
Looking Ahead: While not the final word given that the terms of the relevant provisions vary from deal to deal, AB Stable suggests that: (i) MAE carve-outs intended to shift industry-wide risk to buyers will be read broadly to cover unexpected developments with industry-wide impacts like COVID-19; and (ii) the Court of Chancery is unlikely to provide much latitude when interpreting contractual ordinary course covenants, even in unexpected and trying circumstances like COVID-19.
This action arose out of a $5.8 billion deal by Mirae Asset Financial Group, a Korean financial services company, to acquire Strategic Hotels & Resorts LLC, the owner of 15 luxury U.S. hotels, from AB Stable, a subsidiary of Anbang Insurance Group, a Chinese company. The sale agreement was signed in September 2019, and the sale was scheduled to close in April 2020. On the closing date, Mirae refused to close, asserting that (i) Strategic Hotels had suffered a MAE in light of COVID-19; (ii) Strategic Hotels had materially breached its covenant to operate in the "ordinary course of business consistent with past practice" by shutting two hotels entirely and limiting operations at the other 13 severely in light of COVID-19; and (iii) Strategic Hotels was unable to obtain clean title insurance on the hotels in light of ongoing litigation that Strategic Hotels had not disclosed to Mirae. AB Stable filed an action on April 27, 2020, seeking specific performance. Mirae counterclaimed seeking a declaration that it was entitled to terminate the deal.
After a week-long trial in late August, Vice Chancellor Laster issued a 242-page opinion on November 30, 2020, ruling for Mirae on second and third issues. The court held that Mirae was entitled to terminate the deal and awarded Mirae its deposit, attorneys' fees, and costs.
A number of broken deal litigations have raised similar questions regarding the interaction among MAE provisions, ordinary course covenants, and termination rights in light of COVID-19, but to date all have settled prior to substantive rulings. The court's decision in AB Stable, albeit in the unique factual background of this particular transaction, provides the first judicial guidance on these two key issues:
COVID-19 and MAE Provisions Silent on "Pandemics"
The MAE definition in the sale agreement did not expressly exclude the impact of "pandemics," "epidemics," or "health emergencies." Mirae argued that this meant the impact of COVID-19 should be included in determining whether Strategic Hotels had suffered a material adverse effect.
The court rejected this argument, ruling that COVID-19 fell within the definition of a "calamity," and that the MAE definition excluded the impact of "calamities." The court suggested that the impact of pandemics would also have been excluded in light of carve-outs of the impact of "general changes or developments in the industries in which the Company…operates," and "changes in…general economics, business, regulatory, political or market conditions or in national or international financial markets." The court emphasized that its ruling was supported by the complete text of the MAE definition, which "broadly shifts systematic risk" to the buyer, and that "the risk from a global pandemic is a systematic risk."
While the court's ruling turns on its interpretation of the term "calamity," its reasoning indicates that MAE exclusions written to shift industry-wide risk from seller to buyer will be held to exclude the impacts of COVID-19—regardless of whether "pandemics" are expressly listed.
COVID-19 and Ordinary Course Covenants
The ordinary course covenant here provided that "unless [Mirae] shall otherwise provide its prior written consent (which consent shall not be unreasonably withheld, conditioned or delayed), the business of [Strategic Hotels] shall be conducted only in the ordinary course of business consistent with past practice in all material respects" between signing and closing. Mirae argued that by closing two hotels and dramatically reducing operations at all other hotels in light of COVID-19, Strategic Hotels breached this covenant. AB Stable responded that Strategic Hotels' actions were reasonable in light of COVID-19, consistent with actions its competitors had taken, and represented the ordinary response to an extraordinary situation. As the court described the dispute at an expedition hearing early in the action: "The real question is whether an ordinary course covenant means ordinary course on a clear day or ordinary course on the hand you're dealt."
Parsing the language of the covenant closely, the court held that in this case it was the former. The court noted the lack of any "commercially reasonable efforts" qualifier in the covenant, and ruled that the inclusion of "consistent with past practice" precluded the court from looking to evidence AB Stable presented that Strategic Hotels' competitors had all taken similar actions. As the court put it:
Seller breached the Ordinary Course Covenant when Strategic made extraordinary changes to its business in response to the COVID-19 pandemic. The circumstances created by the pandemic warranted those changes, and the changes were reasonable responses to the pandemic. Consequently, if acting in the ordinary course of business meant doing what was ordinary during the pandemic, then Seller would not have breached the Ordinary Course Covenant. But under extant Delaware law, the Ordinary Course Covenant required Seller to maintain the normal and ordinary routine of the business.
The court also ruled that, while the sale agreement permitted AB Stable to request Mirae's written consent to operational changes, and provided that Mirae was not permitted to unreasonably withhold consent, AB Stable had not sought Mirae's consent to any of the operational changes and so was unable to rely on this protection.
Three Key Takeaways
- Even in extraordinary circumstances like COVID-19, a court will still focus on the precise contractual language and seek to enforce the parties' intent as reflected in the contract.
- Sellers should carefully review covenants in a sale agreement before making material operational changes even in extraordinary circumstances, and consider seeking buyers' consent, particularly if buyers are prohibited from unreasonably withholding consent.
- Deal parties should focus on ordinary course covenants to ensure they reflect the parties' intent as to the scope of a seller's flexibility to address extraordinary developments between signing and closing, as well as a buyer's right to be involved in those determinations.
Jones Day publications should not be construed as legal advice on any specific facts or circumstances. The contents are intended for general information purposes only and may not be quoted or referred to in any other publication or proceeding without the prior written consent of the Firm, to be given or withheld at our discretion. To request reprint permission for any of our publications, please use our “Contact Us” form, which can be found on our website at www.jonesday.com. The mailing of this publication is not intended to create, and receipt of it does not constitute, an attorney-client relationship. The views set forth herein are the personal views of the authors and do not necessarily reflect those of the Firm.