Closing conditions

What Are Closing Conditions?

Closing conditions are specific stipulations outlined in a contractual agreement, typically in a merger and acquisition (M&A) deal, that must be satisfied before the transaction can be finalized. These conditions, belonging to the broader category of corporate finance and contract law, are designed to protect the interests of both the buyer and seller by ensuring that certain material facts and circumstances remain consistent from the time the agreement is signed until the deal closes. If a closing condition is not met, the aggrieved party generally has the right to terminate the agreement without penalty.

Closing conditions are essential in complex transactions, providing a framework for managing unforeseen events or changes that could impact the value or feasibility of the deal. They serve as safeguards, giving parties the ability to walk away if the underlying premises of the agreement are fundamentally altered. The specific closing conditions included in a deal are often heavily negotiated and vary based on the nature of the transaction and the industries involved.

History and Origin

The concept of closing conditions evolved alongside the increasing complexity of commercial transactions, particularly in mergers and acquisitions. As deals became larger and involved more intricate due to diligence processes and regulatory oversight, the need for contractual safeguards to bridge the period between signing and closing became apparent.

A significant element of closing conditions, the "material adverse effect" (MAE) clause, has played a prominent role in various high-profile M&A disputes. This clause typically allows a buyer to terminate an acquisition if events or changes occur that would have a material adverse effect on the target company's business or financial condition. One notable example highlighting the interpretation and application of an MAE clause was the attempted acquisition of Twitter (now X) by Elon Musk in 2022. Musk sought to terminate the agreement, arguing that Twitter had made materially inaccurate representations regarding spam accounts, which he claimed constituted a material adverse effect. Twitter denied these claims, asserting that it had not breached any representations or obligations and had not suffered, nor was likely to suffer, a company material adverse effect.¹⁵ This dispute ultimately went to court before Musk reversed course and completed the acquisition at the original price.¹⁴

Key Takeaways

• Closing conditions are contractual prerequisites that must be satisfied before a transaction can be completed.
• They protect both buyers and sellers from unforeseen changes or events between signing and closing.
• Common closing conditions include the accuracy of representations and warranties, regulatory approvals, and absence of material adverse effects.
• Failure to meet a closing condition typically grants the non-breaching party the right to terminate the agreement.
• These conditions are crucial in managing risk in complex financial transactions like mergers and acquisitions.

Interpreting the Closing Conditions

Interpreting closing conditions involves a careful analysis of the specific language used in the agreement and the context of the transaction. Conditions are often categorized into several types:

• Bring-down conditions: These require that the representations and warranties made by each party at the time of signing remain true and accurate as of the closing date.¹³ If there's a significant deviation, the party benefiting from the representation may have grounds to terminate.
• Covenants: These are promises made by the parties to perform certain actions or refrain from certain actions between signing and closing. For instance, a seller might covenant to operate the business in the ordinary course.¹² Failure to adhere to these covenants can be a basis for not satisfying a closing condition.
• Regulatory Approvals: For many transactions, especially larger ones, obtaining necessary government and regulatory approvals is a critical closing condition. This often involves reviews by antitrust authorities like the Federal Trade Commission (FTC) to ensure the merger does not harm competition.¹¹
• No Material Adverse Effect (MAE): This is a broadly defined, but frequently litigated, condition that allows a party to terminate if an event or series of events occurs that has a significant negative impact on the target company's business, financial condition, or results of operations.¹⁰ The threshold for an MAE is generally high, requiring a substantial and long-term adverse impact.⁹

Understanding these categories and their specific phrasing is crucial for assessing the likelihood of a transaction closing and identifying potential points of contention.

Hypothetical Example

Consider a hypothetical scenario where "Acme Corp." agrees to acquire "Beta Solutions Inc." for $100 million. Their definitive acquisition agreement includes several closing conditions.

One key closing condition is that "Beta Solutions Inc.'s net working capital must be no less than $5 million at the time of closing." This is a quantitative condition designed to ensure Beta Solutions maintains a healthy short-term financial position.

In the period between signing and closing, Beta Solutions Inc. experiences an unexpected supply chain disruption, causing a significant delay in receiving payments from several large customers. As a result, its net working capital drops to $3 million just before the scheduled closing date.

Upon reviewing the pre-closing financial statements, Acme Corp. identifies that the net working capital condition has not been met. Acme Corp. now has the right to either:

1. Terminate the agreement: Walk away from the deal without incurring penalties, as Beta Solutions Inc. failed to satisfy a fundamental closing condition.
2. Renegotiate terms: Propose a lower purchase price or other adjustments to account for the reduced working capital, thereby waiving the unmet condition.
3. Waive the condition: Proceed with the acquisition at the original terms, accepting the lower working capital. This is less likely in practice without some form of compensation.

This example illustrates how closing conditions provide a crucial mechanism for risk allocation and protection in M&A transactions, allowing parties to respond to changes that occur after the agreement is signed but before the acquisition is finalized.

Practical Applications

Closing conditions are pervasive in various financial transactions, serving as vital risk mitigation tools. Their practical applications include:

• Mergers and Acquisitions (M&A): As discussed, they are fundamental in M&A deals, ensuring the target company's state remains consistent. Conditions related to due diligence, regulatory approvals, and the absence of material adverse changes are standard.⁸ The Federal Trade Commission (FTC) outlines a rigorous merger review process, which must be completed before many large mergers can close, underscoring the importance of regulatory closing conditions.⁷
• Real Estate Transactions: In real estate, closing conditions might include satisfactory property inspections, the buyer securing financing (a mortgage contingency), clear title, and appraisals meeting certain values.
• Lending Agreements: In corporate lending, conditions precedent (a form of closing condition) might require the borrower to provide updated financial statements, demonstrate compliance with existing loan covenants, or obtain specific third-party consents before funds are disbursed.
• Venture Capital and Private Equity Investments: Investors often include closing conditions related to the target company achieving certain milestones, the completion of a specific round of equity financing, or key management personnel remaining with the company.
• Joint Ventures and Partnerships: Agreements forming joint ventures typically include conditions regarding the contribution of assets, regulatory filings, and the establishment of governance structures.

These conditions are essential in managing the interim period between agreement and closing, which can be extended, particularly in larger or more complex deals.

Limitations and Criticisms

While closing conditions are critical for risk management in financial transactions, they also come with certain limitations and criticisms:

• Ambiguity and Interpretation: Terms like "material adverse effect" can be inherently vague, leading to disputes over whether a condition has truly been triggered.⁶ The interpretation often depends on specific facts, industry context, and legal precedent, which can result in costly and time-consuming litigation.
• "Walk Away" Risk for Sellers: Broad closing conditions, particularly MAE clauses, can give buyers significant leverage to terminate a deal, even if the underlying business issues are not catastrophic. This creates uncertainty for sellers and can impact their ability to negotiate favorable terms.
• Negotiation Complexity: The negotiation of closing conditions can be extensive and contentious, adding to the overall complexity and time required to finalize an agreement. Each party aims to draft conditions that protect their interests, often leading to prolonged discussions and legal fees.
• Information Asymmetry: During the period between signing and closing, the seller typically has more immediate access to information about the target company's day-to-day operations. This information asymmetry can make it challenging for the buyer to fully monitor the fulfillment of certain conditions.
• Regulatory Hurdles: Conditions related to regulatory approvals, such as antitrust clearances from bodies like the Securities and Exchange Commission (SEC), can introduce significant delays and uncertainty.⁵ Regulatory reviews can be lengthy and may require divestitures or other remedies, impacting the deal's original strategic rationale.⁴
• Market Fluctuations: While some MAE clauses attempt to exclude general market downturns, extreme market volatility or industry-specific shocks can still create a gray area, potentially leading to disputes about whether a condition related to business performance has been breached.
• Enforcement Challenges: Even when a closing condition is clearly breached, enforcing the right to terminate or seeking damages can be a complex and expensive legal process. For example, in the case of Elon Musk's attempt to terminate his acquisition of Twitter, the legal battle hinged on the interpretation of the MAE clause and representations regarding spam accounts.³

These limitations highlight the importance of carefully drafting and negotiating closing conditions to ensure clarity and mitigate potential disputes, relying on experienced legal counsel.

Closing Conditions vs. Pre-Closing Covenants

While closely related and often found in the same sections of a definitive agreement, closing conditions and pre-closing covenants serve distinct purposes.

The critical distinction is that pre-closing covenants are ongoing obligations, whereas closing conditions are checks that must be satisfied at the moment of closing. A breach of a pre-closing covenant by one party often leads to the failure of a corresponding closing condition for the other party, allowing them to exit the deal.²

FAQs

What happens if a closing condition is not met?

If a closing condition is not met, the party benefiting from that condition usually has the option to terminate the transaction. They can also choose to waive the condition and proceed with the deal, or they might try to renegotiate the terms of the agreement, such as adjusting the purchase price.

Are closing conditions always specific and measurable?

While many closing conditions are specific and measurable (e.g., obtaining a certain regulatory approval or maintaining a minimum cash balance), some, like the "material adverse effect" clause, can be broad and subjective. This subjectivity can lead to disagreements and potential litigation, as parties may interpret "materiality" differently.¹

Can closing conditions be waived?

Yes, closing conditions can be waived by the party they are designed to protect. A waiver typically occurs if the unmet condition is deemed not significant enough to warrant terminating the entire deal, or if the parties agree to an alternative solution or compensation.

How do closing conditions protect buyers?

Closing conditions protect buyers by ensuring that the company they are acquiring maintains its value and operational integrity between the signing of the agreement and the actual closing of the deal. They allow the buyer to walk away if there are significant negative changes, undisclosed liabilities, or if essential third-party or government approvals are not secured.

How do closing conditions protect sellers?

Closing conditions protect sellers by ensuring the buyer is committed to the transaction and has the financial and regulatory capacity to complete it. For example, a condition requiring the buyer to secure financing ensures the seller isn't left without a deal due to the buyer's inability to pay. They also ensure the buyer meets their contractual obligations and does not arbitrarily terminate the agreement.