The phrase ‘ordinary course of business’ is ubiquitous in modern commercial agreements. Many everyday contracts include variants in language that require the business to operate in a manner that is consistent with the operation of the business prior to signing.
Our studies of sale agreements and similar overseas studies like the American Bar Association’s Private Target M&A Deal Points Study show the frequency of such clauses (approximately 97% of sale agreements), indicating that they often appear alongside the qualifications of:
- ‘best efforts’ (80%);
- consistent with past practice (85%); and
- various carve outs (47%) including scheduled matters, e.g. paying bonuses, distributions, emergencies and payment of indebtedness (45%).
Ordinary course covenants will include a carve-out for actions taken with the buyer’s consent. Usually (60%) the carve-out will be framed so that the buyer cannot unreasonably withhold its consent.
Ordinary course covenants are rarely defined. Most parties instead rely on the ‘plain meaning’ of these clauses. But what exactly does it mean to operate a business in the ordinary course when facing a disruptive and unexpected event such as the COVID-19 pandemic? More specifically, what actions or inactions of a business in response to unusual circumstances fall within the bounds of ‘ordinary course of business’?
The real world problem
In three recent cases, Fairstonein Ontario, Canada; AB Stablein Delaware, USA; and Dyco v Laundyin New South Wales, courts have been asked to look at incidents where the buyer wants to abandon the transaction. In these cases the buyers have sought to walk away from the sale on the basis that the businesses’ operational responses to the pandemic constituted a breach of a covenant requiring the businesses to operate in the ordinary course.
For a plaintiff to succeed in abandoning a transaction in the case of an ordinary course covenant they need to prove that the buyer is able to abandon the deal because steps taken by the seller were outside the ordinary course of business.
Many of these ordinary course agreements also include material adverse effect or material adverse change (MAE) clauses (consistently 95% of sale agreements). MAE clauses are a common means of allocating the risks presented by adverse business or economic developments occurring between the signing and the closing of an acquisition. MAEs usually (in 97% of cases) include carve-outs dealing with economic conditions, changes in law, changes in accounting, industry conditions, etc.
MAE carve-outs exclude material effects caused by (i) worldwide, national, provincial or local conditions or circumstances, including emergencies; (ii) changes in the markets or industry in which the target operates; and (iii) the failure of the target to meet any financial projections.
The carve-outs applied in the cases in Ontario, Delaware and NSW were subject to further qualification that relevant events did not have a materially disproportionate adverse impact on the target business relative to its industry peers. In these cases, although the pandemic had a material and adverse effect on the target business, the MAE carve-outs meant that the target business had not been disproportionately affected relative to its peers. Therefore the pandemic and its related effects did not constitute an MAE for purposes of the relevant MAE clauses.
Ordinary course of business
The phrase ‘ordinary course of business’ has commonly been considered in Australia in the context of insolvency law but the definition of the phrase in that context is not particularly helpful in a contractual context.
In a contractual context the phrase might be interpreted to mean that acting in the ordinary course of business meant doing what was ordinary during a pandemic (as the court found in the Ontario decision). However, if it is interpreted to mean that the seller needs to maintain the normal and ordinary routine of the business even during a pandemic or crisis (as the court held in Delaware case), the seller will likely breach the ordinary course covenants when responding.
In Australia, courts will try to ascertain the parties’ intention by reference to what is ‘usual’ or ‘past’ practise of the target when trying to ascertain whether the target is carrying on its business in the ordinary course, and whether it must carry on the business (as defined) in the ordinary course and consistent with usual or past practice. In the NSW case the court looked at the phrase in the context of the sale of a hotel. Contracts for the sale of The Quarryman’s Hotel were exchanged on 31 January 2020. On 23 March 2020, the NSW Government introduced rules that required the hotel to close its doors and restrict trading to takeaways. On 26 March 2020, the hotel started takeaway sales of food and beverages. The sale agreement included the following provision: ’… from the date of this contract until completion, the vendor must carry on the business in the usual and ordinary course as regards its nature, scope and manner …’.
The court found that the obligation to carry on the business in the usual and ordinary course – as stipulated in the sale agreement – was to be read as ‘according to law’, hence the deal was able to continue. This analysis aligns with the Ontario court’s approach that the phrase means doing what is usual in the context of extraordinary circumstances.
Consent requirement in ordinary course covenants
In Fairstone, the Ontario court found that even if conduct was outside the ordinary course the buyer would have had to provide its consent for the conduct to go ahead because it would have been unreasonable for the buyer to withhold consent in the circumstances. In contrast, in AB Stable the Delaware court rejected the suggestion that the buyer had to consent to changes in business activity since it could not have reasonably refused to consent given the impacts of the COVID-19 pandemic.
Interplay with MAE provisions
In AB Stable, the court found that the ‘ordinary course’ covenant applied independently and on top of the MAE closing condition. So even though seller COVID-related closing risks were shifted to the buyer through the negotiated MAE exclusion for ‘natural disasters or calamities,’ the buyer was still able to avoid closing the transaction because the seller took ‘non-ordinary’ remedial action outside of the ordinary course of business without first seeking buyer’s consent.
In Fairstone, the court found that the MAE and ordinary course covenant had to be read together. It seems that this means two things. One, that the language of the MAE will help courts frame what the ordinary course covenant is meant to mean and two, that courts will be reluctant to let a buyer use a breach of the ordinary course covenant as a backdoor way of using circumstances that would not have triggered the MAE clause.
Where to from here?
The Delaware and Ontario decisions are fully discussed here and here and are instructive both in terms of the important and different facts in each case and the thoughtful but different approaches to similar problems. Both provide useful guidance on the interpretation of MAE and ordinary course covenants. But the lesson for the parties in this jurisdiction is really about how best to allocate risk when extraordinary events supervene on a deal before completion. The disruptions caused by the COVID-19 pandemic and the risk of future business disruptions from unexpected events has indelibly changed deal participants’ and practitioners’ perception of the M&A landscape.
Firstly, exclusions from MAE clauses for industry-wide negative events can materially limit the effectiveness of otherwise broad language in an MAE.
Secondly, there are serious issues with trying to make an ordinary course covenant do the heavy lifting of an MAE provision. Courts will be reticent to allow a buyer to walk away from its bargain when the purpose of the clause is ancillary to the principal promises to sell and transfer the target business and pay the agreed price.
Parties should also consider drafting with precision whether a buyer can withhold its consent to the target taking action (or failing to take action) that would otherwise constitute a breach of the ordinary course covenants.
This publication is introductory in nature. Its content is current at the date of publication. It does not constitute legal advice and should not be relied upon as such. You should always obtain legal advice based on your specific circumstances before taking any action relating to matters covered by this publication. Some information may have been obtained from external sources, and we cannot guarantee the accuracy or currency of any such information.