COVID-19 public health orders did not frustrate hotel business sale, despite financial hangover

Kathryn Schultz
Practical Guidance Senior Legal Writer – Mergers & Acquisitions

The NSW Supreme Court has held that the sale of a hotel business was not frustrated by COVID-19 public health orders restricting its ability to trade. Parties concerned about maintaining flexibility to exit a transaction should consider more specific options, such as a carefully-drafted material adverse change clause.

Background

In January 2020, Dyco Hotels Pty Ltd (Dyco) and Quarryman Hotel Operations Pty Ltd contracted to buy the Quarrymans Hotel in Pyrmont, Sydney, together with the associated hotel business, from Laundy Hotels (Quarry) Pty Ltd (Laundy). Staggered completion was planned for Monday 30 and Tuesday 31 March 2020.

The contract included the customary obligation for Laundy to “carry on the [b]usiness in the usual and ordinary course as regards its nature, scope and manner” between signing and completion. It also specified that the sale constituted the supply of a going concern, with Laundy undertaking to carry on the enterprise until the day of the supply (ie completion).

On 23 March 2020, the Public Health (COVID-19 Places of Social Gathering) Order 2020 required hotels to shut except to sell takeaway or provide accommodation. Quarrymans shut at noon and re-opened for limited takeaway on 26 March. It did not reopen until 1 June after restrictions eased.

In an attempt to exit the deal, Dyco argued Laundy was not ready, willing and able to complete because it was breaching the ordinary course and going concern undertakings, with which it was bound to comply despite the public health orders. As a result, the contract was frustrated, and the purchasers’ deposit should be returned.

Laundy argued that the business had continued to trade as a going concern, despite being restricted to takeaway. When Dyco refused to complete, Laundy terminated for breach and cross-claimed damages for loss of the bargain.

Vendor was not obliged to carry on the business in a manner contrary to the public health orders

Both parties had considerable experience operating hotels in Sydney, and were aware of the prescriptive legal and regulatory environment for such hotels. Regulators could cancel or suspend licences, or impose penalties or closure orders.

To the extent that the usual and ordinary manner of conducting the business ceased to be lawful, Laundy was not required to break the law, but to continue carrying on the business as far as it remained possible to do so in accordance with the law. Requiring Laundy to breach the orders would not preserve the business’s goodwill, and could jeopardise its licence and future operations.

Sale contract was not frustrated

A contract can be discharged by frustration even if it can be performed without breach. The question was whether the orders gave rise to a “fundamental commercial difference” between the actual and contemplated performance of the contract, or a “fundamentally different situation” for which the parties did not provide, so that it would not be just to hold them to the contract – or, whether the contract was wide enough to apply to the new situation.

Darke J accepted that the orders had a significant effect on Laundy’s performance of the obligations to carry on the business, with very limited trading and uncertainty about how long the restrictions would last. However, these obligations were ancillary to the main purpose of the contract – the sale and transfer of particular assets for an agreed price. Dyco agreed to pay that price without a warranty about future financial returns, meaning this was a risk of a type it was prepared to take – even if the actual circumstances were unforeseen.

As a result, the Court focused on the effect on the actual performance of Laundy’s obligations. Darke J rejected the argument that the business’s goodwill had been “wiped out”. Its value fell by about $1 million – a considerable amount, but less than 9% of the purchase price. Although Dyco’s “predicament” was understandable, the contract itself was not frustrated. Laundy was entitled to serve the notice to complete, and (upon Dyco’s refusal) terminate the contract.

Takeaways

The case demonstrates the limits of the frustration doctrine in the context of economic shocks arising from COVID-19. Buyers concerned about flexibility to exit a transaction should instead consider seeking warranties as to future performance (if possible, given bargaining power) or including a material adverse change clause calling out specific areas of concern.

A copy of the judgment is available here.

For more information contact your Relationship Director about our Practical Guidance Mergers & Acquisitions module or visit our Practical Guidance website.