Related Knowledge
When the pandemic hit our shores, it was followed by a flurry of public health orders which significantly affected businesses. At the time, we (and many others) flagged the possible challenges for commercial contracts and transactions, some of which are now being played out in the courts. The recent NSW Supreme Court decision of Dyco Hotels Pty Ltd v Laundy Hotels (Quarry) Pty Ltd [2021] NSWSC 504 demonstrates that even when the pandemic impacts the conduct or nature of a business, it may not be sufficient to result in a breach of a seller's pre-completion covenants or frustrate the relevant agreement.
A hotel business sale gone wrong: when COVID-19 is not very accommodating
On 31 January 2020, Dyco Hotels Pty Ltd (the Purchaser) entered into a contract with Laundy Hotels (Quarry) Pty Ltd (the Vendor) for the sale of a freehold hotel property in Pyrmont known as The Quarrymans Hotel, along with its associated hotel licence, gaming machine entitlements and hotel business. Settlement was due to occur at the end of March 2020.
The sale contract contained various standard obligations that were applicable between the date of signing and settlement, including clause 50.1, which required the Vendor to "carry on the Business in the usual and ordinary course as regards its nature, scope and manner".
On 23 March 2020, the NSW Government's Public Health (COVID-19 Places of Social Gathering) Order 2020 commenced, which forced the closure of all licensed premises including pubs and hotels except for the purpose of providing takeaway to customers off-premises or those using the hotel for accommodation. The Vendor responded by closing its doors and attempting to maximise sales by remaining in operation so far as the regulations allowed, including through implementing a takeaway food service.
In response, the Purchaser argued that the contract for sale had been frustrated, or alternatively that the Vendor breached the contract as it was not able to comply with clause 50.1.
Key issue #1: Conduct of carrying on business between exchange and completion, and the parties' understanding
A key question for the Court was to what extent, if at all, clause 50.1 obliged the Vendor to carry on the business in a manner contrary to the public health orders issued after the contract was made.
This, it said, turned on what a reasonable business person would have understood the contractual terms to mean, which would require consideration of the language used by the parties, the surrounding circumstances known to them and the commercial purpose or objects to be secured by the contract. The Court held that:
- the parties were both experienced in the operation of hotels in Sydney and so could be taken to have knowledge of the nature of the legal and regulatory environment within which hotels operate, including extensive and detailed legislative prescription and regulatory oversight - for example, the right to cancel or suspend licences, impose various penalties and interfere with hotel operations;
- on a true construction of the contract, the relevant clause did not oblige the Vendor to carry on the business in a manner contrary to the public health orders and the law; and
- as a result, the obligation was to carry on the business in the usual and ordinary course as far as it remained possible to do so in accordance with the law.
The Court noted that doing otherwise (that is, breaking the law) would place the future operation of the business pursuant to the hotel licence in some jeopardy, and diminish the goodwill of the business.
Therefore, it found that the Vendor did not breach its obligation to carry on the business in the usual manner.
Key issue #2: Potential frustration of the contract
In the alternative, the Purchaser alleged that the contract had been frustrated as the public health orders fundamentally changed the nature of the hotel business, and therefore the deposit should be returned.
This required the Court to consider whether these unexpected events gave rise to a fundamental commercial difference between the actual and contemplated performance of the contract, or a fundamentally different situation, such that it would not be just to hold the parties bound to the contract. Relevant considerations included the terms of the contract, the nature of the contract and any relevant surrounding circumstances.
In this case, the Court said that all of the components of the sale and purchase transaction remained transferable. Notably, the essential nature or purpose of the contract was a sale and transfer of particular assets for an agreed price, which could still be transferred (even if there was a temporary alteration in the nature of trading during the period between signing and settlement). The Court agreed with the Vendor that the obligations to carry on the business must not be regarded as of cardinal significance; rather, they were ancillary to the principal promises to sell and transfer the hotel assets and pay the agreed price. The Court also noted that the Vendor had given no warranties guaranteeing the future financial performance of the business, and that a reduction in value is a type of risk the Purchaser was apparently prepared to take.
The Court therefore held that the contract had not been frustrated and the parties remained bound by the contract. The Vendor was entitled to retain the deposit and received $900,000 in damages for loss of bargain.
What this means for your transaction in the current or post-pandemic world
Although brought on by an unprecedented once-in-a-century pandemic, the circumstances of this case:
- highlight the high watermark to prove frustration of an agreement; and
- remind parties of the need when drafting a contract to contemplate a reasonable range of scenarios that may arise in the pre-completion period. For example:
- a seller can argue for pre-completion conduct of business covenants to include carve-outs permitting it to take any action to the extent required by law or a government authority, or reasonably required to respond to an emergency, including to protect the health and safety of any person; and
- a buyer, if they are concerned about the need to walk away from a transaction in the event that the nature of the business changes in the pre-completion period, can consider negotiating material adverse change termination rights (being careful to consider whether or not known events should prevent the termination right from being triggered).