(c) Covenants in M&A transactions

In M&A transactions, covenants will protect the purchaser’s interests prior to completion (i.e. covenants force a seller and the acquired companies to conduct the business in the ordinary course and to obtain the purchaser’s approval for important or extraordinary matters), as well as its commercial deal after completion in an active sense (i.e. the seller is required to take care of transaction-related interests or to continue to disentangle the acquired business) and in a passive sense (i.e. the seller should refrain from using its knowledge or business relationships to compete with the business it sold).

Disentanglement covenants. In addition, various matters related to the historic positioning of the acquired companies as part of seller’s group need to be addressed. The disentanglement is usually not completed on the closing date. For that reason, the following matters are commonly provided:

  • Financial disentanglement: all securities, suretyships and collateral granted by the acquired companies for the benefit of the seller’s group and vice versa should be terminated (and replaced). This includes financial arrangements of any kind: cash pooling arrangements with the bank, security rights under credit facilities, currency exchange swaps or foreign currency hedge arrangements, surityship undertakings and parent guarantees by the selling shareholder, credit arrangements with suppliers that service both the sold companies and the remaining subsidiaries of the seller etc.
  • Employee’s rights: although the position of employees does not change as a direct consequence of a change of control, many selling companies would like to ascertain that the employees will indeed keep their employment. Also, employee codetermination laws and regulations (or the mere existence of a works council) have had the effect that a seller and purchaser often agree on a certain (or an unchanged) level of employment after closing of the transaction. A covenant could therefore address matters such as:
    • the number of FTE during the next few years;
    • the continuous availability of certain specific facilities of the seller (e.g. an employee mobility centre);
    • the replacement of an employee share or option participation scheme by a reasonable alternative;
    • certain minimum requirements for the benefit of senior staff (who are not covered by a collective labour agreement);
  • Pensions: whilst the pension rights of employees are also well-protected under European legislation, it is sometimes recommended that a purchaser takes over certain pension arrangements of the seller or arranges for a pension scheme that is substantially similar to that of the seller (e.g. defined benefit scheme, defined contribution scheme, capital contribution policy).
  • Intellectual property rights: if IP does not constitute a significant part of the M&A transaction, some more basic aspects are dealt with in the covenants:
    • the cessation of the use of seller’s trademarks and trade names in the acquired companies business (i.e. usually such use is allowed until three months after closing) including the removal of nameplates and logos, and, less typical but for a sense of mutuality, of the acquired companies’ trademarks, trade names and logos by the seller;
    • the transfer of certain domain names and trade mark registrations (i.e. such transfer could be formalised on closing but the actual transfer registration process takes some time and is so different from country to country with so little interest by either party to have it done on closing that filling out the forms is typically a post-closing affair if it happens at all);
    • an undertaking not to permit the lapse of any IP-registration.
  • Insurances: a seller will sometimes want to ascertain that certain business risks of the sold companies continue to be covered by insurance.
  • Authorisations: in multi-party agreements, covenants may consist of authorisations or a (conditional) power of attorney to undertake certain actions on behalf of one or more parties.
  • Taxation: Although often addressed in a separate schedule or tax agreement, tax matters obviously require a sort of ‘covenant’ in the context of an M&A transaction. Matters that may need to be addressed include the seller’s and acquired companies’ respective liability for any taxes, a termination of regional tax unities, the entitlement and reimbursement of tax benefits, communications with tax authorities and the conduct of any tax-related disputes.
  • Intra-company agreements: in order to ascertain that the purchaser does not acquire a loss-making business because the seller has arranged highly unfavourable terms and conditions for itself, the ordinary course supplies by the acquired companies to the seller’s other subsidiaries are often terminated. Please note that these agreements contribute to the value of the acquired companies and are not, as such, of a transitional nature.
  • Transitional services: the sold companies are often highly dependent on the availability of various services and facilities provided by their former holding company. To a lesser extent, this may also apply to services or facilities (if only in certain countries) hosted by the sold companies for the benefit of their former affiliated companies. For that purpose, a share or asset purchase agreement will typically contain a transitional services agreement that provides for an uninterrupted continuation of various services. The typical aspects to be addressed are the legal entities that are formally entitled to (responsible for) the service, the duration of each such service (i.e. not all services can be terminated easily), the service fee, payment and invoicing arrangements, particularities related to the service and the contact persons after closing. For ICT matters, which might include the availability of enterprise software systems, more elaborate arrangements are often necessary.

Pre-closing covenants. During the period between the signing and the closing of the transaction, the business of the acquired companies would typically be continued in the ordinary course of business. Anticipated investments (e.g.the renewal or maintenance of equipment and production installations) may or may not continue as planned. The purchasers will likely want to prepare, to reconfirm or to further elaborate their business plan for the acquired companies. Also, suppliers and customers contact their counterparts in the sold business asking for a clarification of the transaction (and certainty about their ongoing position). Some contracts contain change-of-control provisions, which may even trigger renegotiation of the pricing or other terms and conditions. As with everything in life, issues arise in the ordinary course of business. Because each such issue might affect the value of the acquired companies or the possibility of integrating the acquired business into the business of the purchaser, pre-closing covenants would be agreed, probably with some involvement of the purchaser. Such pre-closing covenants might address, for example:

  • Access to facilities and information rights. Whereas competition laws prohibit the implementation of various (irreversible) measures, a purchaser would like to have some access rights to the acquired companies’ manufacturing facilities or offices and to certain (non-strategic) information. The seller will want to make sure that the purchaser does not interfere with the business activities and that the purchaser will comply with all security and safety measures.
  • Undertaking to conduct the business in the ordinary course. It is appropriate for a seller to procure that the acquired companies undertake their business as usual.
  • Approval rights. Various matters will be subject to the purchaser’s prior approval. They may include:
    • entering into agreements (distinguishing between ordinary course contracts, non-ordinary course contracts, unusual contracts or commitments under atypical terms and conditions, and contracts with a conflict of interest);
    • matters related to the acquired companies’ assets (i.e. no disposals or grants of pledges other than in the ordinary course of business and no unanticipated deviation from capital-expenditure-related investment plans);
    • matters related to the corporate structure, taxation and finance (including financial reporting), preventing a transfer of any entities, any amendments to corporate constitutional documents, tax-revaluations etc.;
    • employment-related matters, such as a change of the terms of employment (including of any collective labour agreements), the removal of (key) employees other than for urgent cause, or the employment of additional personnel;
    • IP-related matters (if not addressed otherwise);
    • an undertaking not to enter into, amend or terminate any joint ventures, partnerships, licences or important lease agreements.
    • settlement of claims and disputes and the conduct of any pending litigation.
  • A duty to inform. Obviously, between signing and closing, the purchaser wants to be informed about all matters that might affect the value of the acquired companies, any of the warranties becoming incorrect and generally any business decisions by the acquired companies. It will also want to receive periodical management reports and quarterly or annual financial statements.