Chancery Court Rules Target’s Pandemic Responses Did Not Breach Ordinary Course Covenant

Gail Weinstein is senior counsel, and Steven Epstein and Philip Richter are partners at Fried, Frank, Harris, Shriver & Jacobson LLP. This post is based on a Fried Frank memorandum by Ms. Weinstein, Mr. Epstein, Mr. Richter, Warren S. de Wied, Erica Jaffe, and Randi Lally, and is part of the Delaware law series; links to other posts in the series are available here.

Related research from the Program on Corporate Governance includes Stakeholder Capitalism in the Time of COVID, by Lucian Bebchuk, Kobi Kastiel, and Roberto Tallarita (discussed on the Forum here); Are M&A Contract Clauses Value Relevant to Target and Bidder Shareholders? by John C. Coates, Darius Palia, and Ge Wu (discussed on the Forum here); The New Look of Deal Protection by Fernan Restrepo and Guhan Subramanian (discussed on the Forum here); and Deals in the Time of Pandemic, by Guhan Subramanian and Caley Petrucci (discussed on the Forum here).

In Level 4 Yoga, LLC v. CorePower Yoga, LLC (Mar. 1, 2022), the Delaware Court of Chancery ordered CorePower Yoga, LLC to close the agreement it had entered into, pre-pandemic, to acquire the yoga studios owned by its franchisee, Level 4 Yoga, LLC. CorePower had contended, in March 2020, just before the first of three scheduled closings of the asset purchases, that it was no longer obligated to close the almost $30 million transaction due to the pandemic having emerged in the U.S. and businesses across the country, including Level 4’s studios, having shut down. In this post-trial decision, the court ruled that the pandemic did not constitute a “Material Adverse Effect” and that the closure of the studios did not violate Level 4’s covenant to operate, pending closing, in the ordinary course of business. The court ordered CorePower to close and to pay compensatory damages for the delay in closing.

Key Points

  • The decision was based on atypical features of the transaction and the parties’ relationship. Due to the unusual background of the transaction, the parties had structured their asset purchase agreement without conditions or termination rights—suggesting that they had intended that the closing would occur even if a party breached the agreement. In addition, due to the parties’ relationship as franchisor and franchisee, CorePower (as the franchisor) had directed Level 4’s operational responses to the pandemic. Given the unique factual context, in our view the decision offers little predictive value as to future rulings on a buyer’s failure to close based on an extraordinary event occurring between signing and closing.
  • The court followed the same analytical framework for determining whether the target breached the ordinary course covenant as it applied in the prior two cases—AB Stable and Snow Phipps—in which it has addressed whether the pandemic excused a buyer from closing. In all three cases, the court has interpreted “ordinary course of business” to mean the ordinary course during “normal times” (rather than ordinary course in light of an extraordinary event having occurred); and has interpreted “consistent with past practice” to mean that the only relevant issue is whether the target’s own post-signing operations changed materially from its pre-signing (pre-pandemic) operations. In AB Stable, the court found that the target’s responses to the pandemic constituted a breach of the covenant and that the buyer therefore was not obligated to close; in both Snow Phipps and Level 4 Yoga, the court found that the target’s pandemic responses did not constitute a breach of the covenant and the court ordered the buyer to close.  These cases underscore the facts-intensive nature of the court’s determination as to breach of an ordinary course covenant.
  • The decision continues the Delaware courts’ almost invariable trend in finding that an extraordinary event occurring between signing and closing was not an MAE that excused a buyer from closing. There has only been one Delaware decision ever—Akorn (issued in 2018)—finding that a “Material Adverse Effect” (or “Material Adverse Change”) occurred that excused a buyer from closing. In all three pandemic-related cases, the court has found that the pandemic was not an MAE—based on the parties’ “MAE” definition, the extent of the pandemic’s impact, and/or the lack of “durational significance” of the impact. In Level 4 Yoga, the court found that, at the time CorePower asserted that it had a right not to close, it had no basis to believe that the effects of the pandemic would have durational significance as the closure of the studios was at that time expected to last only a few weeks.
  • The court emphasized that it “will not hesitate” to order specific performance by a buyer who improperly refuses to close.

Background. Level 4 operated 34 yoga studios, as a franchisee of CorePower. Under the franchise agreement, CorePower had a call right to acquire all of Level 4’s studios (which were highly profitable) in a single transaction. Soon after CorePower was acquired by a private equity firm, it decided to exercise the call right. CorePower’s new owner was concerned, however, about acquiring all of Level 4’s studios in one transaction, given the ongoing integration issues relating to its own recent acquisition of CorePower. CorePower negotiated with Level 4 to modify the call right to permit acquisition of the studios in three tranches. In May 2019 (eight months prior to the outbreak of the pandemic in the U.S.), CorePower and Level 4 entered into a definitive Asset Purchase Agreement (the “APA”), which provided for the first of the three closings to occur on April 1, 2020. In March 2020, three months into the pandemic and as businesses across the country were shutting down voluntarily or pursuant to government mandates, CorePower temporarily closed its own yoga studios and directed all of its franchisees, including Level 4, to close their studios. Soon thereafter, CorePower decided that it wanted to delay or terminate the acquisition of Level 4’s studios, and it refused to effect the first closing. A two-year litigation battle followed. After trial, Vice Chancellor Slights ruled that CorePower was obligated to close.

Discussion

The court was influenced by the unusual structure of the parties’ agreement that suggested that they had intended that the transaction close even if a party had breached the APA. As discussed below, the court determined that Level 4 did not breach the APA. Moreover, however, the court noted that the unusual structure of the APA suggested that the parties had intended that the transaction would close even if a party had breached the agreement. The APA did not contain any express closing conditions or termination rights, nor any other common provisions that might have suggested implicit conditions or termination rights (such as a force majeure provision or a termination or reverse termination fee). The court found that this unusual structure supported Level 4’s contention that the parties intended that APA to be “a ‘one-way gate’ through which the parties would pass on their way to inevitable closings.” Level 4 maintained that this structure was agreed in exchange for its agreeing to CorePower’s request for staggered closings.

The court found that Level 4 did not breach the ordinary course covenantbecause it was CorePower, as the franchisor, that had directed Level 4 to close all of its studios; and Level 4, as the franchisee, was required to follow and always had followed CorePower’s directives. The court concluded that, while the closure of Level 4’s studios (and related cost-cutting actions) may have been “extraordinary,” Level 4’s “following the direction of the franchisor was entirely ordinary and consistent with its past practice.” The parties’ franchise agreement obligated Level 4 to follow CorePower’s directives, and this was “precisely why Level 4 took the actions that CorePower now asserts violated the Ordinary Course Covenant,” the court wrote. The court found that “Level 4’s operation of its CorePower-branded studios was almost entirely dictated by CorePower’s System Standards,” and that Level 4 had “historically and faithfully adhered to those standards.” We note that, importantly, the decision does not address whether a target’s following the buyer’s directives as to its interim operations, without a corresponding legal obligation and/or history of having followed such directives, would have led to the same result.

The decision underscores the highly facts-specific nature of the court’s determination whether responses to an extraordinary event constitute operating outside the “ordinary course of business consistent with past practice.” In Level 4 Yoga, Vice Chancellor Slights found that Level 4’s closure of its studios did not breach the ordinary course covenant because CorePower had directed the company to close the studios and, as a franchisee, Level 4 had a consistent past practice of complying with CorePower’s directives. In Snow Phipps, then-Vice Chancellor (now-Chancellor) McCormack found that the target company in that case (a supplier of cake decorations to in-store bakeries), in scaling down its business in response to the pandemic (e.g., delaying the reordering of supplies, reducing employee headcount, and drawing down on its credit revolver), had made only “de minimis” changes; and, moreover, that the changes were consistent with those the company had made in the past during times of declining revenues. In AB Stable—the only one of the three cases in which the court found that the target’s pandemic responses had breached the ordinary course covenant—Vice Chancellor Laster found that the target (a luxury hotel company), in fully or partially having closed all of its hotels, had “departed radically from the normal and routine operation of the Hotels,” and had taken actions that were “wholly inconsistent with past practice” and that would be viewed by a “reasonable buyer” as having “significantly altered the operation of the business.”

The court rejected CorePower’s argument that Level 4 had “repudiated” the APA by closing the studios. CorePower cited a single email exchange with Level 4, as well as Level 4’s closure of its studios, as evidence of Level 4 having repudiated the APA. The court found that CorePower had mischaracterized the email exchange—read as a whole, it expressly reaffirmed Level 4’s commitment to closing. Further, the court stated that the closure of the studios could not constitute repudiation because repudiation requires a “voluntary act”—and Level 4 “did not voluntarily close its yoga studios; it was required to close them, first at the direction of its franchisor and then by government mandates.” Moreover, when Level 4 closed the studios, it expected that the closures would last at most six weeks, and “[s]uch temporary closures hardly evidence outright refusal and inability to perform,” the court wrote.

The court found that the pandemic did not constitute an MAE. The APA contained a representation and warranty by Level 4 that it had not suffered an MAE. Unlike most other acquisition agreements, the MAE definition did not specify any events to be excluded from constituting an MAE (such as common exclusions for changes in general economic or industry conditions, changes in law, force majeure events, and so on). The court stated that it was ignoring the expert testimony both sides had provided as to the impact that the pandemic ultimately had on Level 4. The only legally relevant issue, the court stated, was whether at the time CorePower decided not to close there was a basis for it to have concluded that the effects of the pandemic then were, or were reasonably expected to become, an MAE. The court observed that CorePower’s own words and deeds indicated that it believed the pandemic was not an MAE. First, about the same time that CorePower decided not to close, it had (unrelated to this transaction) certified to its lenders that it had not experienced an MAE—which, in the court’s view, suggested that it believed that Level 4 had not experienced an MAE from the pandemic, as the companies were “similarly situated.” Second, at the same board meeting at which CorePower decided not to proceed with the transaction, its management told the board that it expected that the closure of studios would last only six weeks—indicating that CorePower did not believe that the impact from the pandemic would have durational significance.

The court awarded specific performance and compensatory damages. The court rejected CorePower’s contention that specific performance would be “impractical” given that the acquisition was a “significant undertaking.” The court observed that these “sophisticated parties represented by sophisticated counsel” had expressly provided in the APA that specific performance would be an appropriate remedy in the event of a material breach. The Vice Chancellor emphasized that the court “has not hesitated” in the past to order specific performance of acquisition agreements, “even when doing so might involve a ‘significant undertaking,’” and stated that he saw “no reason to hesitate in this case.” The Vice Chancellor also ordered CorePower to pay compensatory damages relating to the delay in its performance. Under the terms of the APA, CorePower would have captured and incurred any profits and losses from and after each closing date for the studios to be delivered in that tranche. Thus, the $3.5 million of losses incurred by Level 4 while operating the studios after each closing date (as “a steward of CorePower’s assets”), that CorePower would have incurred if it had adhered to the APA, were for CorePower’s account. The court ordered CorePower to pay compensatory damages in that amount, plus pre-judgment and post-judgment interest, as well as prevailing party costs (but not attorneys’ fees).

Context matters. We note that, in AB Stable—the only one of the three pandemic-related cases in which the court held that the target’s pandemic responses breached the ordinary course covenant and the buyer was not obligated to close—the target’s conduct was apparently egregious, having included even outright  fraud in the sale process, and the buyer seemed to have acted in good faith and reasonably. By contrast, in Level 4 and Snow Phippswhere, as discussed, the court found the target did not breach the ordinary course covenant and the buyer was ordered to close—the reverse was true. The target apparently had acted in good faith and reasonably, while the court had a disfavorable view of CorePower’s conduct. The court stated that the evidence revealed that CorePower’s various arguments were a “pretext…to justify its decision to back out of the deal” after it had decided for other reasons that the deal was no longer in its best interests. Also, Vice Chancellor Slights wrote (in a footnote): “I confess that CorePower’s position that it should be excused from performing the APA, in part, because Level 4 followed CorePower’s instruction temporarily to close its studios…was received by the Court with the sour taste of hypocrisy.”

Practice Points

  • Merger agreement parties should not underestimate the extensive time, cost and uncertainty involved in litigating a dispute. In this case, the court’s decision that the buyer had to close came after a 5-day trial, roughly two years after the buyer asserted a right not to close.
  • A target should consider seeking some level of flexibility in the acquisition agreement for taking non-ordinary course actions in response to extraordinary events occurring pending closing. Such flexibility may be appropriate at least for any specified ongoing (or actually anticipated) extraordinary event. While the target always can seek the buyer’s consent to take any non-ordinary actions, the buyer’s incentives may be skewed in this context. As the cases discussed above highlight, following an extraordinary event, a buyer may want to terminate, or renegotiate the price for, the transaction. Thus, unlike the target—whose incentives generally will be to preserve the business to avoid an MAE (that would permit the buyer to terminate the transaction) and to ensure a functioning business in the event the transaction does not close—the buyer may be incentivized to trigger an MAE or to withhold consent to increase its leverage to renegotiate the deal. At the same time, a target’s incentives also may be skewed, as it will be taking actions essentially for the buyer’s account. We would suggest that one way to balance these competing concerns would be to permit the target to take “reasonable” actions (or to require that the buyer not withhold consent “unreasonably”), with parameters specified as to what would be reasonable (such as, for example, taking actions that other similarly situated companies are taking or have taken in similar circumstances). These issues, and how market practice in drafting merger agreements has (and has not) evolved in response to them, are explored in depth in our article forthcoming in the Yale Law Journal Forum, A Proposed Post-Pandemic Framework for Ordinary Course and MAE Provisions in Merger Agreements: Reviewing Recent Market Practice Changes and Addressing Skewed Incentives.
  • Drafting ordinary course covenants—use of the phrase “consistent with past practice.” The court has reaffirmed in each of AB Stable, Snow Phipps and Level 4 Yoga, that it will interpret a covenant requiring operation of the business in the “ordinary course consistent with past practice” as meaning that the court can look only at how the company itself has operated in the past (both generally and under similar circumstances). When the qualifying phrase “consistent with past practice” does not appear, the court can also “look to how comparable companies are operating or have operated” (both generally and in similar circumstances).
  • A buyer should be mindful that its involvement in the target’s operational decisions pending closing possibly could have implications for the court’s determination as to whether the target breached its ordinary course covenant. Merger agreement parties should consider specifying in the agreement whether and to what extent actions taken by the target at the direction of the buyer, or actions taken by the target after seeking and obtaining the buyer’s consent, would be considered in making the determination. As discussed above, Level 4 Yoga did not address how or whether a buyer’s directives to a target, absent the unusual features in the case, would affect the ordinary course analysis; however, a buyer should be mindful of the potential issue.
  • Drafting MAEs—particularly in the private equity context. Merger agreement parties should keep in mind that an MAE is whatever the parties define it as—and there may be circumstances under which a buyer and target would consider it appropriate to specify a lower or different standard (with respect to what level of impact and/or durational significance would be required). The court stated in Level 4 Yoga that the “durational significance” component of the MAE analysis was particularly important in this case because CorePower was pursuing the acquisition as part of “a long-term strategy.” We note, as we have in previous Briefings, that private equity buyers should consider seeking to draft the MAE definition to specify (or arguing that the court should apply) a lower standard for durational significance in the context of acquisitions by private equity buyers given their typically shorter investment horizons.
  • Parties to a pending merger agreement should be mindful that their words and deeds following the occurrence of an extraordinary event may be considered by the court in determining whether, at the time a buyer decided to terminate an agreement on that basis, it actually believed the event was material and had durational significance. In this case, the court considered (a) the buyer’s (unrelated) certifications to its lenders and (b) management presentations to the board. In other cases, the court has considered, for example, contemporaneous emails or other communications by officers and/or directors.
  • Significance of a separate MAE condition in addition to the MAE representation and warranty. The court stated that practitioners “need not wonder or question whether they’ve been wasting their time” negotiating, as is typical, a separate MAE condition in addition to an MAE representation. In our experience, many practitioners consider the condition and the representation to be functionally equivalent. The court pointed out, however, that while the parties can define MAE however they want to for purposes of a closing condition, if a party is relying on breach of a representation to justify not closing, then the breach must have been material (with “materiality” having its usual legal meaning—i.e., that the breach “go[es] to the root or essence of the agreement between the parties, or touch[es] the fundamental purpose of the contract and defeat[s] the object of the parties entering into the contract.”). We note that this distinction would not be relevant in most cases, but should be kept in mind if there is not a separate MAE condition and/or the parties define “MAE” in an unusual way.
  • Addressing unusual agreement provisions. Where parties structure an acquisition in an unusual way (such as, in this case, with no closing conditions and no express termination rights), they should consider, for clarification purposes, stating in the agreement what their intention is in doing so.
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