On November 30, 2020, Vice Chancellor J. Travis Laster of the Delaware Court of Chancery issued a post-trial decision addressing contractual issues related to the effects of the COVID-19 pandemic on the sale of a collection of luxury hotels. The case, AB Stable VIII LLC v. MAPS Hotels and Resorts One LLC, was one of many busted deal lawsuits filed in the Court of Chancery implicating COVID-19's impact on M&A, with the opinion being the first to formally address these issues. The 242-page opinion found that the pandemic did not cause a material adverse effect (MAE) on the seller's business under the contract. But the court found that the buyer was entitled to walk away from the deal because the seller had changed its business in response to the pandemic, breaching its ordinary course covenants in the sale agreement. Both holdings are noteworthy given that busted deal disputes in the pandemic have largely focused on these two issues—and there had been open questions about which types of typical exclusions from MAE definitions might cover the pandemic and about how the Court of Chancery would handle ordinary course covenants, given the limited treatment of that issue in prior M&A case law.

The lawsuit arose from a September 10, 2019, agreement by AB Stable VIII LLC (the seller) to sell Strategic Hotels & Resorts LLC (the company), a subsidiary of the seller and the owner of 15 luxury hotels in the United States, to MAPS Hotels and Resorts One LLC (the buyer), for $5.8 billion. In the months between signing and closing, the COVID-19 pandemic significantly hampered the hotel industry, causing the seller to close two of the company's hotels, reduce operations at the others, and lay off thousands of employees. On the transaction's closing date, the buyer claimed that it was not obligated to close the deal because the seller had breached certain covenants and representations in the sale agreement. The seller filed a complaint for specific performance to compel the buyer to close the deal. The buyer then attempted to terminate the agreement and filed counterclaims asserting, among other things, that the company's business had suffered an MAE, that the seller had failed to comply with ordinary course covenants in the agreement, and that the seller had breached the agreement by withholding information about fraudulent judgments and deeds.

The court rejected the buyer's MAE claim. The contractual definition of an MAE was typical and—unlike some of the other provisions in recent COVID-19 busted deal lawsuits¹—did not include a carveout for pandemics, but contained an exception for "natural disasters and calamities." The court found that, even if the company had experienced an effect that was material and adverse (though the court did not decide that issue), the effects of the pandemic were a "calamity" and, arguably, also fell under the definition of a "natural disaster." The buyer also argued that the exception for "general changes" in the company's industry could not apply because the "root cause" of the changes was COVID-19 and there was no "pandemic" exception. The court disagreed, explaining that the plain language of the MAE definition excluded the specified effects and did "not require a determination of the root cause of the effect."

The court found, however, that actions taken by the seller in responding to the pandemic, including closures and suspending certain services, violated ordinary course covenants in the sale agreement. The court observed that the agreement required the company to operate in the ordinary course "consistent with past practice." Rather than assessing whether it operated in the ordinary course "based on what is ordinary during a pandemic"—as the seller requested—the court assessed how the business had been conducted before the pandemic versus after. The court held that the seller's actions breached the covenant because they "depart[ed] significantly" from "how the company ha[d] routinely operated." Because the covenant did not contain a more seller-friendly "efforts" qualifier but was a "flat contractual obligation" to operate in the ordinary course, the court also rejected the seller's argument that it was only required to use "commercially reasonable efforts" to maintain the company's course of business.

The court further considered whether a separate covenant in the agreement by the seller to comply with "applicable law" (such as shelter-in-place orders) should counsel in favor of a finding that the company operated in the ordinary course. The seller argued that, to the extent it operated outside the ordinary course, it did so to comply with state and local mandates where the company's hotels were located. The court called this the "most difficult issue" raised in the context of the seller's operating covenants, and acknowledged the arguments on both sides, but concluded that it need not squarely reach the issue because certain significant changes to the business went into effect before stay-at-home orders were issued and also exceeded what applicable law required.

Because the seller had failed to operate the company's business in the ordinary course and also separately failed to satisfy a title insurance condition related to prior fraudulent judgments and deeds that the seller did not fully disclose (or misrepresented) to the buyer, the buyer was relieved of its obligation to close. The court permitted the buyer to terminate the sale agreement and ordered the seller to return the buyer's deposit with interest and pay the buyer's reasonable attorneys' fees and deal expenses.

Although many of the court's findings are tailored to the facts and contract at issue, the decision is critical reading for companies in the midst of M&A transactions that are affected by the COVID-19 pandemic. The opinion provides valuable guidance on how Delaware courts will interpret standard MAE provisions and ordinary course covenants when the target faces extraordinary circumstances. The court reaffirmed the high threshold for demonstrating an MAE and the importance of carefully drafting the definition of an MAE in a transaction agreement. The ruling also underscores that the specific language of ordinary course covenants, such as whether the obligations have an "efforts" qualifier, can be critical. Here, the buyer-friendly language in the sale agreement meant that the seller's business was assessed based on its own past practices. Finally, the court's observation that the seller's failure to disclose (or misrepresentation of) previous fraud might have been enough to void the buyer's obligation to close illustrates how a transaction party's handling of material information can lead to negative deal consequences.

[1] For example, the merger agreement at issue in the recently settled case Forescout Technologies, Inc. v. Ferrari Group Holdings, L.P., C.A. No. 2020-0385-SG (Del. Ch.) included an MAE provision with a specific carveout for pandemics. In suing for specific performance, the seller relied on that carveout in arguing that it had not suffered a contractually defined MAE. Our firm represented the seller in that litigation and the related renegotiation of the transaction.