United States: Significant 2020 Decisions Affecting Private Company M&A

This newsletter is our seventh annual review of significant state court decisions relevant for private company M&A transactions and related governance matters and disputes.

Hallisey v. Artic Intermediate, LLC , C.A. No. 2019-0980-MTZ (Del. Ch. Oct. 29, 2020)

Summary

Acquiror was not entitled to a post-closing purchase price adjustment in its favor due to having delivered its Closing Statement after the contractually agreed deadline.

Background

This decision involved a motion for judgment on the pleadings filed by Hallisey, as seller representative (Seller Rep) under a Securities Purchase and Exchange Agreement (SPA), on the basis that the acquiror (Buyer) had lost its ability to obtain a purchase price adjustment for the $20 million deal as a result of having delivered a Closing Date Report after the deadline provided for in the SPA.

The SPA provided Buyer with six months after closing in order to deliver a Closing Date Report setting forth Buyer's good faith determination of closing cash and closing net working capital, as part of the purchase price adjustment mechanism. Buyer delivered the Closing Date Report almost three months after the deadline, and sought a $12 million purchase price adjustment. Buyer maintained that the delay was valid and justified, given manipulations and misrepresentations by the target's Chief Financial Officer, which led to him being terminated about a month before the Closing Date Report was due. The Seller Rep sought judgment on the pleadings based on the language of the SPA. Buyer opposed the motion, alleging that the Seller Rep had unclean hands.

The court rejected Buyer's unclean hands argument as inapplicable given that the Seller Rep was appealing based on contract law and not to equity. Similarly, the court held that where the dispute involves a documented contract supported by valid consideration, equitable estoppel is not applicable. The court held that under the plain language of the SPA, failure to timely deliver a Closing Date Report obviated the rest of the purchase price adjustment process. The court held that given there were no material disputed facts, judgment on the pleadings was warranted in favor of the Seller Rep.

Takeaways

The decision is an important reminder that failure to meet bargained-for deadlines can have drastic consequences under Delaware's pro contractarian approach. It is not uncommon for acquirors to struggle to meet the deadline to deliver a Closing Statement in connection with purchase price adjustment mechanics, given unforeseen problems with a target company's financials. Reasoning that the target stockholders would not be prejudiced by a short delay, and therefore it is ok to deliver the Closing Statement late because there would be no damages, is an incorrect analysis. Acquirors should either timely deliver the Closing Statement based on the best information they have at their disposal under the circumstances, or negotiate for an extension. Simply delivering the Closing Statement late, as in Hallisey, could result in a complete loss of a purchase price adjustment in the acquiror's favor.

AB Stable VIII LLC v. MAPS Hotels and Resorts One LLC, Mirae Asset Capital Co., Ltd., Mirae Asset Daewoo Co., Ltd., Mirae Asset Global Investments, Co. Ltd., and Mirae Asset Life Insurance Co., Ltd., No. 2020-0310-JTL (Del. Ch. Nov. 30. 2020)

Summary

The court held that whether or not a seller's business was conducted in the ordinary course consistent with past practice during the executory period of an acquisition agreement depended on whether there had been a change in the routine operations of seller's business under normal circumstances, regardless of whether such changes were in response to outside factors beyond the control of the seller.

Background

AB Stable VIII LLC (Seller) and MAPS Hotels and Resorts One LLC (Buyer) entered into a Purchase and Sale Agreement (Agreement) on September 10, 2019, pursuant to which Buyer agreed to acquire all of the membership interests in Strategic Hotels & Resorts LLC (Strategic). Strategic owned 15 limited liability companies, each of which owned a luxury hotel. Buyer notified Seller on April 17, 2020, the scheduled closing date for the acquisition of Strategic, that a number of Seller's representations and warranties were inaccurate and that Seller had failed to comply with its covenants under the Agreement. As a result, Buyer claimed it was not obligated to close and that Seller's failure to cure the breaches by May 2, 2020 would give Buyer a termination right. Seller initiated litigation on April 27, 2020, seeking, among other things, specific performance of the Agreement. After the suit was filed, Buyer terminated the Agreement and then filed counterclaims seeking various determinations, including that Seller had breached its obligations under the Agreement and failed to satisfy certain conditions to closing. This summary focuses on Buyer's allegation that Seller failed to satisfy the interim operating covenant that required Seller to operate its business only in the ordinary course, consistent with past practice in all material respects.

The Alleged Breach of the Interim Operating Covenant

On March 24, 2020, during the executory period, Strategic temporarily closed two of its hotels, the Four Seasons Palo Alto and the Four Seasons Jackson Hole, in response to low demand and governmental orders due to the COVID-19 pandemic. This accelerated the standard seasonal closure of the Four Seasons Jackson Hole by two weeks. Around this time, Strategic significantly reduced operations at its other hotels as well in response to the pandemic. Buyer argued that these actions deviated from the ordinary course of business in breach of the interim operating covenant, which in turn gave rise to the failure of a closing condition.

Section 7.3(a) of the Agreement provided that, as a condition to Buyer's obligation to close, "Seller shall have performed in [all] material respects all obligations and agreements and complied in all material respects with all covenants and conditions required by this Agreement. The interim operating covenant provided that:

Court's Finding that Seller Breached the Interim Operating Covenant

Seller argued that for purposes of the interim operating covenant, the "business" was the business of Seller as an asset management firm and a manager of managers who in turn operated the hotels. It contended that in that capacity, it continued to operate its business as it always had, letting the managers of the hotels make the decisions. The court rejected Seller's interpretation of "business" based on the plain language of the interim operating covenant which referenced the business of the Company and its Subsidiaries and detailed that operating the "business" in the ordinary course included using commercially reasonable efforts to maintain reasonable levels of certain supplies and inventory consistent with past practice.

Seller argued that the "ordinary course of business" meant it should have flexibility to address changing circumstances in unforeseen events and that this covenant would be satisfied so long as it engaged in "ordinary responses to extraordinary events." Seller argued that its hotel closures and reduced operations were ordinary course responses to the COVID-19 pandemic. The court rejected this interpretation and agreed with Buyer that "ordinary course of business" involved comparing how the business routinely operated under normal circumstances, without regard to any extraordinary event, such as the COVID-19 pandemic.

The court also considered the meaning of the words "only in the ordinary course of business consistent with past practice." The court noted that there are two potential reference points for determining whether the company has operated in the ordinary course: (i) how the company has operated in the past, and (ii) how comparable companies operate. Here, the wording "only" and "consistent with past practice" meant that the court should just consider the former.

The court rejected Seller's argument that the interim operating covenant imposed only an obligation to use commercially reasonable efforts, as opposed to an absolute and unqualified contractual obligation. The court held that breach of contract under common law is based on strict liability, but this can be modified by efforts-based language in the contract. The court held that there was no such language applicable here, even though efforts-based language appeared elsewhere in the contract.

Seller argued that the interim operating covenant incorporated a material adverse effect (MAE) overlay. Elsewhere in its opinion, the court held that pandemics were the kind of systematic risk that fit within the MAE carve-out for "calamities." Therefore, an MAE overlay to the interim operating covenant would mean that the covenant had not been breached. Seller argued that a contrary interpretation would negate the risk allocation under the Agreement. Rejecting this argument, the court held that the interim operating covenant could have included language providing for an MAE overlay, but did not.

The court held that Seller breached the interim operating covenant because "[o]verwhelming evidence demonstrates that Strategic departed form the normal and customary routine of its business as established by past practice. In response to the COVID-19 pandemic, Strategic closed two of the hotels entirely and limited operations at the other thirteen severely."

Seller argued that there was no breach because Seller was contractually obligated to depart from ordinary course operations, given its representations that operations were in compliance with law. The court noted the public policy considerations and associated Delaware law that does not permit a court to enforce a contract prohibited by law. Rejecting Seller's argument, the court noted that a contractual condition operates differently from a covenant. It allocates the risk associated with operating outside the ordinary course to Seller, but does not force anyone to violate law. The court noted that had Seller argued that Strategic deviated from operating in the ordinary course because it was required to do so by government order, and that discharged its obligation to operate in the ordinary course in all material respects, and thus satisfied the condition, that would have been a credible argument. However, Seller did not describe any such government orders or otherwise prove any such illegality. The court noted that many of the changes in Strategic's business were implemented before states imposed stay-at-home orders, and there was also no evidence that stay-at-home orders required hotels to close.

The court also rejected Seller's argument that no breach occurred because Seller could deviate from the interim operating covenant with Buyer's consent, which "shall not be unreasonably withheld," and so had Seller requested consent, Buyer would have had to have given it. While the court's rejection was based on Seller having merely raised the argument in a footnote and not have properly briefed it, the court made clear its skepticism that such an argument was legally supportable.

Takeaways

Before this decision, most deal practitioners assumed that the pandemic was the type of systematic risk that would be picked up in the typical carve-outs form the MAE definition, so the court's confirmation of that is unsurprising. But many practitioners did not also focus on the need to carve out the pandemic-related business changes from the interim operating covenants. This decision makes clear that sellers who want to shift the pandemic risk (or other systematic risk) to buyers need to include language to that effect in the purchase agreement.

The decision also contains an important reminder of the pro-contractarian nature of Delaware law, and that if an agreement provides for notice in order to trigger certain consequences under the agreement, the notice provisions are not immaterial formalities and need to be complied with.

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