Following a dramatic pause starting last spring, the hotel purchase and sale market has begun to show signs of a rebound. A significant challenge to these sales, however, is the remaining uncertainty around the COVID-19 pandemic and its effect on hospitality operations globally. Despite progress in vaccine distribution, a vaccine is not yet widely available and there remains significant risk of localized outbreaks even after a vaccine is widely distributed. For hospitality buyers and sellers, this uncertainty makes it essential to craft appropriate and effective purchase agreements with interim operating covenants for the pre-closing period designed to protect their interests and smooth the way for sales to proceed regardless of any pandemic-related impact on operations. In this article, we consider a pair of recent court decisions in the United States that shed some light on who bears the pandemic-related business risk under such provisions.
Seller Required to Operate in the Ordinary Course – Seller Bears the Risk
In AB Stable VIII LLC v. MAPS Hotels and Resorts One LLC, et al., 1 the Delaware Court of Chancery terminated a $5.8 billion pre-pandemic contract to purchase fifteen luxury hotels – commonly known in the industry as the Strategic deal or the Anbang-Mirae deal – because the Seller had made changes to its business in response to the pandemic, and the Court concluded these changes breached the purchase and sale agreement’s interim operating covenants. The Court found that the language agreed upon by the parties compelled the result and functionally prohibited the Seller from deviating in any material respect from how it had operated the business prior to executing the purchase and sale agreement.
The operating covenant at issue in AB Stable VIII provided that “between the date of [the] Agreement and the Closing Date . . . the business of the Company and its Subsidiaries shall be conducted only in the ordinary course of business consistent with past practice in all material respects . . .” Before the closing date, much like the rest of the hospitality industry, the Seller made significant changes to the operations and business at its luxury hotels in response to the pandemic, including layoffs and hotel closures. 2 In response, the Buyer argued that the Seller had breached the operating covenant in the purchase and sale agreement because these changes arose pre-closing and deviated from the ordinary course of business. The Court agreed with the Buyer and held that the Seller’s pandemic-related business changes violated the plain language of the interim operating covenant. The Court reasoned that the agreement required strict adherence to the way the business was run at the time the agreement was executed, and the changes altered those operations. In other words, even though the Seller acted reasonably and according to the needs of the business, 3 any change from pre-closing operations would have breached the operating covenant as it was written by the parties. 4
To reach its conclusion, the Court rejected both of the Seller’s primary contractual interpretation arguments. First, the Seller argued that the operating covenant only restricted its conduct across its entire portfolio of hotels, as “a supervisory manager of managers.” The Court disagreed, noting that the operating covenant facially covered “the business of the Company and its Subsidiaries” (emphasis added) and specifically referenced day-to-day hotel-level activities as part of the “business of the Company and its Subsidiaries,” and concluding it reached all levels of the Seller’s business. Second, the Seller argued that the “ordinary course of business” should be read to permit “ordinary responses to extraordinary events,” and ought to be considered in the overall context of the hospitality industry. The Court again disagreed. Here, Delaware precedent, given the parties’ choice of “ordinary course” language, required the Court to “compare the company’s actions with how the company has routinely operated and hold that a company breaches an ordinary course covenant by departing significantly from that routine.” Even if that were not the case, the parties’ invocation of “past practice” precluded examination of industry competition and practices compared to those of the Company. Moreover, the Court specifically noted that the absence of any efforts-based limitation on the overarching operating covenant (e.g., a “best efforts” or “commercially reasonable efforts” requirement) resulted in a “flat, absolute, and unqualified” obligation to operate the Company’s entire business in the ordinary course, fully consistent with its own past practices. 5
Thus, the Court ultimately held that the parties had agreed to prohibit any significant pre-closing modification of the Company’s business, regardless of what was reasonable or necessary to weather the pandemic, even if that imposed an unreasonable obligation on the Seller. 6 As the Court said:
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.
Seller Required to Use Commercially Reasonable Efforts – Buyer Bears the Risk
By contrast, in In Re Condado Plaza Acquisition LLC,7 the United States Bankruptcy Court for the Southern District of New York interpreted a differently-worded operating covenant of a hotel purchase and sales agreement to permit a Seller to make reasonable changes to its business in response to the pandemic. Unlike AB Stable VIII, the Condado Plaza court refused the Buyer’s demand to escape its obligation to purchase the hotel because of the Seller’s pandemic-related business changes. The Condado Plaza court reached this result because of a key difference in the language of the operating covenant which avoided the extreme result in AB Stable VIII. Here, the language was not unqualified; the parties only required the Seller to “[u]se commercially reasonable efforts to . . . operate and maintain the [hotel] substantially consistent with the operation and maintenance of the [hotel] over the previous three (3) month period.” Importantly, the agreement also provided that “[n]otwithstanding anything to the contrary contained herein, Seller shall not be required . . . to maintain operations at the hotel.”
As in AB Stable VIII, the Seller in this case made significant pandemic-related changes to its hotel business, conducting layoffs and closing the hotel completely, and the Buyer argued that these business changes violated the operating covenant. This time, however, the covenant’s different language produced a different result. The Condado Plaza court disagreed with the Buyer, finding its interpretation both “tortured” and “utterly preposterous.” In doing so, the Bankruptcy Court held that the plain language of the operating covenant required only “commercially reasonable efforts,” and that “[i]t plainly would not have been ‘commercially reasonable’ for [the Seller] to conduct operations in defiance of governmental shutdown orders.” Thus, the outcome was the opposite of the result in AB Stable VIII:
If [Buyer] were right, the provision would have contractually bound [Seller] to maintain operations no matter what obstacles came in its way, including governmental shutdown orders. Interpreting the provision in that manner would be contrary to the plain statement that “notwithstanding” any other provision in the [purchase and sales agreement], [Seller] would “not be required” to maintain operations.
Risk Must Be Allocated Intentionally, Shared and Incurred Thoughtfully and Sellers Should Seek Broad Operational Flexibility to Respond to the Pandemic.
These cases demonstrate the importance for Sellers to avoid language prohibiting deviation from past practices if it does not take into account pandemic necessities or other operational changes in response to market conditions or government orders. Sellers must at least retain the right to operate their businesses in a commercially reasonable way to protect against a reluctant Buyer at closing. Ideally, Sellers would seek an express right to make whatever operational changes are needed to comply with government orders and health guidelines, including closing a hotel. Sellers should also consider whether to include an express acknowledgment that such operational changes may be needed in response to economic circumstances or government orders.
Buyers Should Seek Notice and Consent Rights for Such Operational Changes and Sellers Should Request Consent Prior to Making Changes.
It is equally important for Buyers to retain some influence on a Seller’s response to the pandemic. While the Seller failed to invoke the provision, in AB Stable VIII, the operating covenant did excuse operational deviations if “the Buyer shall otherwise provide its prior written consent (which consent shall not be unreasonably withheld, conditioned or delayed).” Had the Seller sought the Buyer’s consent, the outcome of the case might have been different.
Restrictions Imposed by Government Order May Provide Added Protection for Operational Changes.
It remains an open question whether a government shutdown or similar order would suffice to excuse a Seller’s breach of an operating covenant. In AB Stable VIII, the Court noted that a contractual obligation is discharged if compliance “is made impracticable by having to comply with a domestic or foreign governmental regulation or order.” But the Court ultimately declined to reach that issue, noting that “Seller does not seriously contend that the drastic changes that [Seller] made in response to the outbreak of COVID-19 were required by law, nor does it cite any examples of legally-required deviations from the ordinary course.” The Court further noted that the Seller “implemented sweeping changes before the [government] orders went into effect.” In Condado Plaza, the Court in part excused the Seller’s conduct, noting that “[i]t plainly would not have been ‘commercially reasonable’ for [Seller] to conduct operations in defiance of governmental shutdown orders.” In short, the decision in each of these cases recognizes that compliance with a government order – regardless of the form of the applicable operating covenant – may help to excuse operational changes made by a Seller.
1 C.A. No. 2020-0310-JTL, 2020 WL 7024929 (Del. Ct. Ch. Nov. 30, 2020) (applying Delaware law).
2 Specifically, “in response to very low demand and government orders,” the Seller advanced a planned seasonal closing at one hotel by roughly two weeks and fully closed a second for the first time in its history. The Seller also “limited operations at the other thirteen [hotels],” operating them in a state described as “closed but open”: reducing on-sight operations to a skeleton staff (which included laying off or furloughing over 5,200 full-time-equivalent employees), ceasing food and beverage operations except for room service (which itself was limited to breakfast, lunch, and dinner with no overnight offering), shutting down or limiting all other amenities, “including gyms, pools, spa and health club operations, recreational activities, club lounge operations, valet parking, retail shops, and concierge and bellhop services,” and minimizing marketing and capital expenditures (which included a total “hold on all FF&E spending until further notice”). Id. at *76.
3 The Court specifically found the Company’s “extraordinary changes to its business in response to the COVID-19 pandemic” were both “warranted” and “reasonable.” Id. at *75.
4 The Court noted that the standard of “in all material respects” is not the same standard applied to find a “material adverse effect.” Rather, its purpose is to “eliminate the possibility that an immaterial issue could enable a party to claim breach or the failure of a condition. The language seeks to exclude small, de minimis, and nitpicky issues that should not derail an acquisition.”
5 Although the operating covenant provided that the “ordinary course of business” would include “using commercially reasonable efforts to maintain commercially reasonable levels of Supplies, F&B, Retail Inventory, Liquor Assets and FF&E consistent with past practice,” the Court noted that the phrase only modified the Seller’s inventory-maintenance obligation. It did not modify the Seller’s overarching ordinary-course obligation.
6 Relatedly, the Court dismissed any argument that the Buyer would have consented to these deviations from the ordinary course because the Agreement specifically required any such consent in writing and “[c]ompliance with a notice requirement is not an empty formality.”
7 620 B.R. 820 (Br. S.D. N.Y.) (applying New York law).