Reflecting on the past year, we believe that the key lesson of pandemic-era deal litigation has come from the Delaware Court of Chancery’s treatment of interim operating covenants. Recent rulings have provided more clarity on successfully showing a breach of interim operating covenants. They also emphasized the opportunity that parties have to build greater predictability into their agreements ex ante, by defining the conditions and relevant benchmarks for the seller’s interim conduct.
At the beginning of the pandemic, we made three predictions. First, that the pandemic disruption would result in a wave of deal litigation seeking to terminate (or close) deals negotiated before the pandemic. Second, that the initial instinct of litigants to argue that a material adverse event (“MAE”) took place would be met with skepticism in the Delaware courts. Finally, we anticipated that the real battles would be fought on the language of interim operating covenants and the conduct of sellers between signing and closing.
A year later, we have seen this all come to pass. At least ten deal litigation cases were filed in the Court of Chancery since the pandemic began. None resulted in an MAE finding. And interim operating covenants emerged as the key battleground in these lawsuits. In this article we focus on two recent rulings that provide complementary lessons with respect to the role of interim operating covenants in deal litigation.
In AB Stable VIII v. MAPS Hotels and Resorts, Vice-Chancellor Laster held that the seller breached an interim operating covenant when it “made extraordinary changes to its business in response to the COVID-19 pandemic.” [1] The seller owned a Delaware LLC controlling 15 luxury hotels and resorts and, following government restrictions instituted at the beginning of the pandemic lockdown, the seller closed two of the hotels entirely and severely limited operations at the other 13. The seller also furloughed or laid off over 5,000 employees. [2]
Examining these changes, the Court acknowledged that “circumstances created by the pandemic warranted those changes, and the changes were reasonable responses to the pandemic.” But the Court noted that the sale agreement included a requirement that “the business of the [seller] shall be conducted only in the ordinary course of business consistent with past practice in all material respects.” Vice-Chancellor Laster reasoned that “if acting in the ordinary course of business meant doing what was ordinary during the pandemic,” then the seller would not have breached this covenant. The Court held, however, that “under extant Delaware law, the Ordinary Course Covenant required Seller to maintain the normal and ordinary routine of the business,” and not that of the seller’s industry or as adapted to the pandemic.
The MAPS ruling raised a significant question. The parties to merger agreements often provide that an event does not constitute an MAE unless it disproportionately affects the seller relative to the relevant industry. Thus, there is an interplay between MAEs and operating covenants: to avoid an MAE relative to the industry, a seller might take certain prophylactic actions. But the same prophylactic actions taken to avoid an MAE could constitute a violation of the interim operating covenant, if, as in MAPS, the formulation of the covenant required the seller’s interim conduct to be evaluated not against industry standard, but against its own historical practice. That potentially places a seller between Scylla and Charybdis: if it does what the industry has done to avoid an MAE, it may violate an interim operating covenant.
Multiple solutions exist for this potential quandary. First, in MAPS, the parties contracted for a formulation of the interim operating covenant that referenced the “ordinary course of business consistent with past practice.” The Court simply enforced it. Nothing prevents parties from changing that language to refer to industry practice instead. [3] Second, even if the parties adopt the “consistent with past practice” language, they can still provide for mechanisms for buyer consent to depart from the contracted standard of conduct. The parties may provide that the seller may seek buyer consent to such departures, that the buyer may not unreasonably withhold such consent, and that consent is deemed granted if not denied within a defined period. If the parties pursue this latter approach, the parties may want to consider defining the factors that constitute unreasonable withholding of consent. For example, seller may wish to specify that it would be unreasonable for the buyer to withhold consent to prophylactic measures embraced by all or a significant portion of the industry and intended in good faith to maximize or preserve the value of the business. Of course, taking this second approach may only shift the litigation emphasis to what constitutes an unreasonable withholding of consent by the buyer.
On this background, the recent ruling from Vice-Chancellor McCormick in Snow Phipps v. KCake provides a useful complement to MAPS. The Court held that the seller’s actions did not breach the interim operating covenant to operate “in a manner consistent with the past custom and practice of the [seller] (including with respect to quantity and frequency)” in all material respects. In response to the pandemic, the seller, a purveyor of cake decorating solutions, had cut costs with respect to labor, consultants, and shipments and had drawn $15 million on a $25 million revolver.
KCake agreed with MAPS that, “[w]here an ordinary course provision includes the phrase "‘consistent with past practice’ or a similar phrase,” the court evaluates only “how the specific seller company has operated.” (Absent such language, the court would look at how similar companies have performed.) Under either benchmark, the court evaluates the seller conduct “both generally and under similar circumstances.”
But even while applying the same analysis as MAPS, the KCake Court found that the draw was consistent with the last five draws on the revolver since 2017, was the result of a policy applied by the seller’s private equity parent to all portfolio companies, and was ultimately never spent. The Court also noted that the buyer had a similar policy for its portfolio companies. In addition, the Court commented that the supposed breach could be cured easily: seller had disclosed the draw to buyer within one day of making it and offered to repay it within two days of buyer raising concerns about it. To the extent that any had questioned whether MAPS opened the door to a buyer-friendly standard, KCake provides a useful reminder that, particularly as the world enters the recovery era, Delaware courts are as likely as ever to enforce deals that remain within the parties’ original intent.
We venture to draw some conclusions from these recent decisions for the recovery period to come.
- Parties should carefully review interim operating covenant language. They should select the appropriate benchmark given their goals: for example, the seller’s own historical conduct, the conduct of the relevant industry as a whole, or even more generally what is advisable in response to extraordinary macro developments. If industry conduct is the relevant yardstick specified, the parties may also want to define the industry or identify a list of peers. The parties may also wish to specify whether the court should examine the relevant benchmark by looking at historical practices or by examining conduct only under similar circumstances.
- Buyers seeking to place limitations on interim seller conduct should consider specifying measurable metrics or parameters, rather than relying solely on past seller or industry practice which runs the risk of a factually intense inquiry in court.
- Sellers faced with limitations on interim conduct should make every effort to seek buyer consent to arguably material variations from the covenanted conduct. Delaware case law on the reasonableness of consent is limited and comes primarily from outside the merger context. Some clients are now adding specific provisions to their agreements defining the reasonableness of withholding consent. Such provisions could, for example, address value-maximizing/value-preserving measures required by exceptional circumstances, or by adopting contractual language specifying the relevant benchmark. By contrast, other agreements are relying on the language of the covenant itself for this purpose.
In light of MAPS and KCake, we expect the reasonableness of buyer consent to deviations from interim operating covenants to feature prominently in upcoming litigation.
[1] The Court found that seller had not suffered an MAE, as defined in the sales agreement, which excluded “natural disasters and calamities.”
[2] In MAPS, seller’s overall case was not helped by the Court’s perception that seller’s counsel had withheld certain facts from the Court, in what the Court deemed “fraud about fraud.” While those facts do not factor in the Court’s analysis of the operating covenant, they are featured prominently elsewhere in the order.
[3] As a side note, MAPS suggest that parties should not place undue reliance on “efforts” qualifiers to the interim operating covenant. Delaware courts are unlikely to give variations in such language the same significance as the ABA has or as transactional lawyers may sometimes ascribe to it. If such language is used, it should be tied to a concrete level of effort, such as, for example, by reference to the definition provided by the ABA Mergers and Acquisitions Committee. See AB Stable VIII LLC v. Maps Hotels & Resorts One LLC, No. 2020-0310-JTL, 2020 Del. Ch. LEXIS 353, at *237 (Nov. 30, 2020) (enumerating definitions) (citing ABA Mergers & Acqs. Comm., Model Stock Purchase Agreement with Commentary 212 (2d ed. 2010)).
