Pre closing covenants

Pre-closing covenants are contractual agreements that define the obligations and restrictions of parties involved in a merger or acquisition (M&A) during the period between the signing of the definitive agreement and the actual closing of the transaction. This interim period, often referred to as the "interim period" or "pre-closing period," can range from a few weeks to several months, especially in complex deals requiring regulatory approvals or third-party consents. Pre-closing covenants fall under the broader category of Corporate Finance and are critical components of an Acquisition Agreement. They primarily serve to preserve the value and integrity of the target company.²⁹

What Are Pre-Closing Covenants?

Pre-closing covenants are contractual promises that parties, typically the seller and the target company, make to the buyer regarding how the target business will be conducted before the transaction closes. These covenants are a subset of the broader contractual promises, known as covenants, common in various financial and legal agreements. In the context of Mergers and Acquisitions, these provisions are crucial because a significant time gap often exists between the "signing" of a deal (when the parties agree to the terms) and the "closing" (when the transaction is legally completed and ownership transfers).²⁸ During this interim period, the buyer has a vested interest in ensuring that the target company's condition does not deteriorate and that its operations continue in a manner consistent with what was represented during Due Diligence.²⁷

Pre-closing covenants generally aim to maintain the status quo of the target company and prevent actions that could reduce its value or negatively impact its commercial integrity.²⁶ They can be either positive covenants (requiring certain actions) or negative covenants (prohibiting certain actions).²⁵,²⁴

History and Origin

The concept of covenants is deeply rooted in contract law, serving as fundamental promises between parties to an agreement. In the realm of M&A, the prominence of pre-closing covenants evolved as transactions became more complex, and the time lag between signing and closing expanded. This expanded interim period necessitated mechanisms to protect the buyer's investment during a time when the seller still controls the target company but has less incentive to manage it for long-term value. Early M&A agreements might have relied more heavily on Representations and Warranties as of the closing date, but the recognition of potential value erosion or operational changes between signing and closing led to the widespread adoption of specific pre-closing commitments.

Modern M&A practice has increasingly scrutinized the scope and enforceability of these covenants, particularly in light of antitrust considerations and the need to balance buyer protection with regulatory "standstill" obligations that prevent premature integration or influence. For instance, the European Court of Justice (ECJ) has ruled on cases where overly broad pre-closing covenants were deemed to violate merger control standstill obligations, leading to significant fines. Such rulings underscore the ongoing evolution and legal refinement of how these covenants are drafted and interpreted to ensure deal certainty while adhering to regulatory frameworks.²³, [Harvard Law School Forum on Corporate Governance]

Key Takeaways

• Value Preservation: Pre-closing covenants are designed to protect the buyer's anticipated value of the target company during the period between signing and closing of an M&A transaction.
• Operational Continuity: They typically mandate that the seller operates the business in the ordinary course and refrain from making material changes without the buyer's consent.²²,²¹
• Risk Mitigation: These covenants serve as a critical risk mitigation tool, preventing adverse changes to the target's financial health, assets, or operations.²⁰
• Enforceability: Breach of pre-closing covenants can lead to various remedies, including the right to terminate the acquisition agreement, claims for monetary damages, or adjustments to the purchase price.¹⁹,¹⁸
• Types: Covenants can be positive (requiring action) or negative (prohibiting action), covering aspects like maintaining financial records, preserving customer relationships, or restricting major capital expenditures.¹⁷,¹⁶

Interpreting the Pre-Closing Covenants

Interpreting pre-closing covenants involves understanding the specific language of the Acquisition Agreement and the commercial context of the transaction. The most common pre-closing covenant requires the seller to operate the target business "in the ordinary course of business."¹⁵ The interpretation of "ordinary course" can be subjective and is often heavily negotiated, sometimes requiring express carve-outs or definitions within the agreement. For instance, what constitutes an "ordinary" action for one company might be "extraordinary" for another. If an action falls outside the ordinary course, it typically requires the buyer's consent.

Other covenants might specify concrete restrictions, such as prohibitions against:

• Incurring new debt or granting liens.
• Selling significant assets.
• Making changes to executive compensation or employee benefit plans.
• Entering into or terminating material contracts.
• Altering Financial Statements or accounting policies.¹⁴

The intent behind these interpretations is to ensure that the buyer acquires the business in substantially the same condition and value as when they agreed to the deal, based on their Due Diligence findings.

Hypothetical Example

Imagine TechInnovate, a growing software company, agrees to be acquired by Global Systems Inc. for $100 million. The Acquisition Agreement is signed on January 1st, but the closing is set for April 1st to allow for regulatory review and integration planning.

Between January 1st and April 1st, the pre-closing covenants come into effect. One key covenant states that TechInnovate must operate "in the ordinary course of business" and not make any capital expenditures exceeding $50,000 without Global Systems' prior written consent. Another covenant requires TechInnovate to maintain its existing customer contracts and not enter into any new contracts valued over $200,000 without Global Systems' approval.

In February, TechInnovate's CEO identifies an opportunity to purchase a new, advanced server system for $150,000 to improve their service delivery. Because this expenditure exceeds the $50,000 threshold defined in the pre-closing covenants, TechInnovate's CEO must seek approval from Global Systems. If Global Systems approves, the purchase can proceed. If not, TechInnovate is obligated to defer the purchase or risk breaching the agreement, which could jeopardize the entire acquisition. This process ensures that Global Systems has control over significant decisions that could impact the value or future operations of TechInnovate before the transfer of ownership. Compliance with such covenants is often a Closing Conditions for the deal.

Practical Applications

Pre-closing covenants are integral to nearly all M&A transactions that involve a gap between signing and closing. They are vital in ensuring deal certainty and protecting the buyer's investment. Their applications span various aspects of the target company's operations:

• Operational Management: They guide the seller on how to run the business, requiring continuation of "ordinary course" operations, such as maintaining inventory levels, sales practices, and employee relations.¹³
• Financial Stewardship: Covenants often restrict major financial decisions, like incurring new debt, issuing new equity, or making significant capital expenditures, thereby preserving the target company's balance sheet for the buyer.¹²
• Asset Protection: They prevent the seller from disposing of material assets, intellectual property, or other key resources outside of normal business activities.¹¹
• Legal and Regulatory Compliance: Covenants may require the seller to maintain Legal Compliance with all applicable laws and regulations and to cooperate in obtaining necessary Regulatory Approval. For instance, regulatory bodies like the Federal Trade Commission (FTC) often impose specific requirements or consent decrees during the pre-closing period, which can dictate how a target company must operate or divest assets to ensure competitive markets. [FTC Press Release]
• Customer and Supplier Relationships: They often include provisions to maintain relationships with key customers, suppliers, and other business partners to prevent erosion of goodwill or contractual stability.¹⁰

These covenants are meticulously drafted and negotiated to address specific risks identified during the Due Diligence process and to reflect the unique characteristics of the target business and the deal structure.

Limitations and Criticisms

While essential for buyer protection, pre-closing covenants are not without limitations or potential criticisms.

One primary limitation is the inherent tension between the buyer's desire to control the target company's operations and the seller's obligation to continue managing the business, particularly if the closing is delayed. Overly restrictive covenants can hinder the target company's ability to respond to market changes or seize new opportunities during the interim period, potentially causing harm to the business that the buyer eventually acquires.⁹ This can also lead to disputes over what constitutes "ordinary course of business," as seen in various legal battles.

Another criticism arises in the context of antitrust law. Pre-closing covenants, especially those granting buyers significant control or information rights over a competing target, can be viewed as "gun-jumping" violations, where the buyer effectively exercises control before obtaining necessary regulatory clearances. Regulators actively monitor such clauses, and severe penalties can be imposed if covenants are deemed to lead to premature integration or anti-competitive coordination.⁸

Furthermore, the effectiveness of pre-closing covenants depends heavily on the buyer's ability to monitor compliance and the remedies available for breach. Proving a Breach of Contract can be challenging, and while a material breach may allow the buyer to terminate the deal, this often comes with significant legal costs and lost opportunities. The legal interpretation of what constitutes a "material adverse change" (MAC) in conjunction with covenant breaches is a frequent point of contention in M&A litigation, as demonstrated in cases like Akorn v. Fresenius, where the Delaware courts grappled with whether breaches of covenants amounted to a MAC that would allow a buyer to walk away from a deal. [New York Law Journal] Even when breaches are clear, recovering damages can be a protracted process, potentially involving Indemnification claims.

Pre-Closing Covenants vs. Post-Closing Covenants

Pre-closing covenants and Post-Closing Covenants both establish obligations for parties in an M&A transaction, but they differ significantly in their timing and purpose.

The key distinction lies in the transfer of control. Pre-closing covenants manage the period when the seller still controls the business, ensuring it remains in an expected state for the buyer. Post-closing covenants, conversely, manage the continuing relationship and responsibilities after the buyer has assumed control, dealing with aspects like ongoing integration, future financial performance, or potential liabilities.⁵

FAQs

What is the primary objective of pre-closing covenants?

The primary objective of pre-closing covenants is to protect the buyer's investment by ensuring that the target company maintains its value and operational integrity during the period between the signing of the acquisition agreement and the actual closing of the transaction. They prevent the seller from taking actions that could harm the business or deviate from the agreed-upon state.

Can pre-closing covenants be waived?

Yes, pre-closing covenants can often be waived by the party they are designed to protect, typically the buyer. If a covenant is not strictly adhered to, the buyer may choose to waive the breach, often in exchange for a purchase price adjustment or other concessions, rather than terminating the deal. This is especially true if the breach is not material or if proceeding with the transaction is still strategically beneficial.⁴

What happens if a pre-closing covenant is breached?

If a pre-closing covenant is breached, the consequences depend on the materiality of the breach and the terms of the acquisition agreement. Minor breaches might lead to discussions and potential indemnification. However, a material breach can give the non-breaching party (usually the buyer) the right to terminate the deal, claim monetary damages, or seek specific performance to compel compliance.³,² The agreement often includes specific Closing Conditions that must be met, including compliance with covenants.

Are pre-closing covenants always necessary in M&A deals?

Pre-closing covenants are necessary in virtually all M&A deals where there is a time gap between the signing of the definitive agreement and the closing.¹ If the signing and closing occur simultaneously (known as a "simultaneous sign and close"), pre-closing covenants are generally not required because there is no interim period during which the target's condition could materially change.

How do pre-closing covenants relate to shareholders?

Pre-closing covenants are primarily obligations of the selling entity (the company itself and/or its existing Shareholders) towards the buyer. While the covenants typically restrict actions taken by the company's management, the ultimate responsibility for ensuring compliance often rests with the seller's Shareholders who benefit from the sale and are therefore motivated to ensure the deal closes.