Post closing covenants

What Are Post-Closing Covenants?

Post-closing covenants are ongoing obligations or commitments that parties to an acquisition agreement must fulfill after a transaction has been completed, or "closed." These provisions, fundamental in corporate finance and mergers and acquisitions (M&A), typically outline specific actions that need to be taken, or refrained from, to ensure the smooth execution and continued compliance of the deal. They are designed to manage risks, ensure the integrity of the acquired business, and protect the interests of both the buyer and seller beyond the closing date. Post-closing covenants often address operational matters, financial conditions, and restrictive agreements, becoming a critical element of the definitive legal documentation.²²

History and Origin

The inclusion and complexity of covenants in M&A contracts have evolved significantly over time, mirroring changes in deal structures, financing markets, and legal landscapes. Historically, contracts were simpler, but as transactions grew in size and intricacy, the need for detailed post-closing stipulations became apparent to manage ongoing risks and responsibilities. The expansion of M&A contracts over decades, including the substantive new terms related to financing and cooperation covenants, reflects a rational reaction to new legal risks and market developments.²⁰, ²¹ The Sarbanes-Oxley Act, for example, imposed new requirements on public companies, leading to more elaborate contractual provisions.¹⁹ The increasing sophistication of these agreements, including comprehensive post-closing covenants, has been driven by attorneys learning from sequential transactions and adapting to changing environments.¹⁸

Key Takeaways

• Post-closing covenants are contractual obligations that remain in effect after a transaction is finalized.
• They are common in M&A deals, financing agreements, and real estate transactions to ensure continued compliance and risk mitigation.
• These covenants can be affirmative (requiring an action) or negative (prohibiting an action).
• Typical examples include non-compete clauses, non-solicitation of employees or customers, and agreements for ongoing cooperation or financial reporting.
• Failure to adhere to post-closing covenants can result in a breach of contract, potentially leading to disputes or legal remedies.

Formula and Calculation

Post-closing covenants do not involve a specific financial formula or calculation in the way that, for example, a financial ratio might. Instead, they are qualitative or quantitative contractual promises. While some covenants might be tied to performance metrics, such as an earn-out arrangement linked to future revenue or profitability, the covenant itself is the agreement to perform or provide something, not a mathematical formula. For instance, a covenant requiring the seller to assist in transferring environmental permits or refrain from competing is a clear obligation, not a calculation.¹⁷

Interpreting Post-Closing Covenants

Interpreting post-closing covenants involves understanding the specific actions or limitations they impose on the parties. These covenants are often highly tailored to the particular transaction and the ongoing needs of the buyer and seller. For a buyer, they provide assurances regarding the continuity of the acquired business, the transfer of essential assets, and protection against competitive actions by the seller. For instance, a covenant might require the seller to maintain a certain level of working capital for a period or provide assistance with customer transitions.¹⁶

Conversely, for the seller, post-closing covenants define the scope and duration of their responsibilities after the deal closes, limiting their future liability by clearly outlining their commitments.¹⁵ The clarity of drafting these covenants is paramount to avoid future disputes, particularly concerning earn-outs or restrictive agreements like non-competes.¹⁴ The interpretation relies heavily on the precise language within the covenant and the overall context of the loan agreement or acquisition agreement.

Hypothetical Example

Consider "Alpha Corp," a buyer acquiring "Beta Solutions," a software development firm. In their acquisition agreement, they include several post-closing covenants.

1. Non-Compete Covenant: Beta Solutions' founder, Jane Doe, agrees not to establish or work for any competing software development company within a 50-mile radius for five years following the closing. This protects Alpha Corp's newly acquired business from immediate competition by the seller.
2. Customer Transition Covenant: Jane Doe also covenants to provide up to 100 hours of consultation over the next six months to assist Alpha Corp in transitioning key client relationships, ensuring a smooth handover and customer retention.
3. Intellectual Property Transfer Covenant: Beta Solutions covenants to provide all necessary documentation and cooperate fully to ensure the formal transfer of all intellectual property rights to Alpha Corp within 30 days post-closing.
4. Tax Cooperation Covenant: Both parties covenant to cooperate on all necessary tax filings related to the transaction.

These post-closing covenants ensure that Alpha Corp receives the full benefit of its acquisition, while Jane Doe's ongoing obligations are clearly defined.

Practical Applications

Post-closing covenants find widespread application in various financial transactions, primarily in mergers and acquisitions, private equity deals, and debt financing.

• M&A Transactions: In the context of M&A, post-closing covenants ensure a seamless transition of the acquired business. Common applications include:
  • Restrictive Covenants: The seller often agrees to non-compete clauses, non-solicitation of employees or customers, and non-disclosure of confidential information to protect the buyer's investment.¹³ These are critical for preserving the value of the acquired entity.¹²
  • Cooperation Covenants: Sellers may be required to assist with post-closing tax filings, transfer of licenses, or obtaining third-party consents.¹⁰, ¹¹
  • Earn-out Related Covenants: If part of the purchase price is contingent on future performance (an "earn-out"), the buyer might covenant to operate the business in a specific manner to not hinder the seller's ability to achieve the earn-out targets.⁹
• Financing Agreements: In commercial lending, particularly for larger corporate loans, post-closing covenants might require the borrower to provide additional collateral documentation, establish certain reserve accounts, or fulfill other administrative conditions after the loan has been disbursed.
• Real Estate Transactions: Although less common, some complex real estate deals might include covenants requiring the seller to complete outstanding repairs, transfer specific permits, or provide access for post-sale inspections.

These clauses are integral to the definitive agreement, such as the Merger Agreement - SEC.gov, outlining the enduring commitments of the parties.

Limitations and Criticisms

While essential for managing post-deal risks, post-closing covenants can lead to disputes if not drafted with absolute clarity. Ambiguity in the language, especially concerning performance metrics for earn-outs or the scope of restrictive covenants, can become a ripe area for future disagreements.⁸ For instance, the breadth and enforceability of non-compete clauses can vary significantly by jurisdiction and may be challenged if deemed overly broad or restrictive.⁷

Another limitation arises when unforeseen events or changes in market conditions impact the ability of a party to fulfill a covenant. While material adverse change clauses often cover such scenarios before closing, post-closing covenants typically have a higher threshold for non-performance. Disputes can also emerge regarding the interpretation of financial metrics or operational decisions that impact the conditions stipulated in the covenants.⁶ Litigations frequently arise from claims of a breach of contract related to these enduring obligations.⁵

Post-Closing Covenants vs. Pre-Closing Covenants

The primary distinction between post-closing covenants and pre-closing covenants lies in the timing of their enforceability and the actions they govern.

Pre-closing covenants serve as a bridge, ensuring that the target company's business remains largely unchanged between the signing of the agreement and the actual transfer of ownership.⁴ They protect the buyer from adverse actions by the seller during this interim period. Post-closing covenants, by contrast, focus on the buyer's long-term shareholder value and integration of the acquired entity, ensuring commitments like corporate governance standards or post-sale assistance are fulfilled.

FAQs

What happens if a party breaches a post-closing covenant?

If a party breaches a post-closing covenant, the non-breaching party typically has contractual remedies available, which may include seeking damages, specific performance (forcing the party to fulfill the obligation), or, in severe cases, termination of certain aspects of the agreement. The specific remedies are usually detailed in the acquisition agreement itself, often under the indemnification clauses.³

Are post-closing covenants always restrictive?

No, post-closing covenants can be both restrictive (negative covenants) and affirmative (positive covenants). Restrictive covenants prohibit certain actions, such as non-compete or non-solicitation clauses. Affirmative covenants require a party to take specific actions, such as providing ongoing assistance, making tax filings, or maintaining certain operational standards.²

How long do post-closing covenants last?

The duration of post-closing covenants varies widely depending on the nature of the covenant and the transaction. Some, like non-compete clauses, might have a specific time limit (e.g., 2 to 5 years). Others, such as those related to tax cooperation or indemnification for certain liabilities, may extend indefinitely or until a specific event occurs. The representations and warranties section of the contract often dictates their survival period.¹