(e) Carve-outs and baskets: exceptions to covenants

The scope of a covenant can be limited or qualified in a few respects. The most important one is to create exceptions or to be specific regarding its scope. Two basic types of exceptions can be distinguished and will be addressed in this paragraph: carve-outs and baskets.

Carve-outs. A carve-out is formulated as an exception and functions as a removal, or carve-out, of part of the restriction imposed by the covenant. For example:

Borrower shall not sell any of its assets, except for any equipment that has reached its end-of-life status or a status of technical obsolescence.

Baskets. A basket, on the other hand, is an allowance that establishes the right to deviate from the covenant’s restrictions by some specified amount. The purpose of a basket is to give the restricted party a limited ability to deviate from a covenant’s restrictions. The above exception could be converted into a basket, as follows:

Borrower shall not sell any of its assets, except for any equipment that has reached its end-of-life status or a status of technical obsolescence up to an aggregate amount not exceeding EUR 15,000,000.

Similar baskets are found in the pre-closing covenants in share purchase agreements, where the purchaser requires the seller to obtain prior approval for certain types of transactions. The example shows that further distinguishing between the nature of the underlying transaction is helpful in finding a middle ground:

Except to the extent provided in a budget of Acquired Companies that has been fairly disclosed to or approved by Purchaser, Seller shall not permit Acquired Companies to do any of the following pending the Closing without the prior written approval of Purchaser (which approval shall not be unreasonably withheld or delayed):

(a) enter into an agreement or a series of related agreements which are in the ordinary course of business for an aggregate amount in excess of EUR 250,000;

(b) enter into an agreement or a series of related agreements which are not in the ordinary course of business for an aggregate amount in excess of EUR 50,000;

(c) enter into any abnormal or unusual agreements or commitments, including any which (i) are unlikely to become profitable, (ii) are of an unusually long-term nature or which cannot be terminated within 24 months, (iii) contain a payment term or potential liability exposure deviating significantly from Acquired Companies’ contracting policy as at the Signing Date, or (iv) would otherwise likely have a financial impact after the (initial) term of the contract;

(d) enter into any agreement in which a member of Seller’s Group has an interest.

Remedies for breach of a covenant. In most agreements that are subject to a European continental law, it is unnecessary to include a remedy in a covenant. Unlike in civil law jurisdictions, the default remedy under common law for breach of contract is that the harmed party is entitled to damages but not a priori to specific performance, which is an equitable remedy granted at the discretion of the court. In the European continental legal systems, the opposite applies (see paragraph 2.2(a)): by default, a party can ask for specific performance (and if that is not practicable or adequate, damages can be claimed). Because an entitlement to damages often does not protect the harmed party’s interests adequately, an agreement that is drafted in view of the law of a common law jurisdiction usually provides for specific remedies in the event of a breach of a covenant.