What is a covenant? Broadly speaking, ‘cov­enants’ are the contractual devices ensuring that a party receives the benefits that it negotiated for in the business deal. In other words, covenants support the achievement of the purpose implied by the key provisions characterising the transaction.

In this section, a brief comparison will be made between covenants as opposed to conditions, various examples of typical covenants in different types of contracts will be discussed (one subparagraph will address M&A-related convenants and another subparagraph will address covenants in financial agreements). This section will finally address how a contract drafter can smoothen the effects of a covenant.

Covenants vs. conditions

Unlike conditions (and warranties) – which are statements of fact as at a specific point in time – covenants are ongoing promises by one party to take or not to take certain actions. But covenants and conditions are more related than it may seem at first sight. Compare the following examples:

1. Seller shall sell and deliver the Products to Purchaser, subject to the condition that Purchaser has paid the Purchase Price.

2. Seller hereby sells and delivers the Products to Purchaser, subject to the condition that Purchaser shall pay the Purchase Price within five days after the Signing Date.

3. Seller hereby sells and shall deliver the Products to Purchaser within five days after the Signing Date, subject to the condition that Purchaser has paid the Purchase Price.

4. Seller hereby sells the Products to Purchaser and Purchaser hereby purchases the Products against payment of the Purchase Price. Seller shall deliver the Products within five days after the date of this Agreement.

Example 1 does not contain an ‘act of purchase’ by the Purchaser and does not contain an unequivocal link between the Purchase Price being a “purchase price” and the sales. Example 2 has the same defects; the strict wording would not grant the Seller an action for performance against the Purchaser (i.e. the Purchaser could argue that despite Seller’s act of sale, the Purchaser’s act of purchase remains open until the Purchaser so decides). Example 3 is the same as example 2, except that the required order of performance of payment and delivery are changed. Example 4 is a proper sales provision without any explicit conditions (i.e. one may well argue that the sale is subject to the implied condition that the Purchase Price be paid).

Based on the wording used or missing in the examples (i.e. a reference to a “Purchase Price” and a failure to reflect that the products are “hereby purchased”, respectively) examples 1 to 3 may well need improvement. Whether they are more obligatory than a precise lawyer would prefer is a matter of (reasonable) interpretation. If they were written by a non-lawyer for a simple transaction between two individuals, it is quite possible that a court would determine that the main intentions of the parties as expressed in the examples are all the same: one party sells and the other party buys, against payment of a purchase price. If an amount has been paid and the Products have been delivered, a court will probably not invalidate the sale. Nonetheless, it emphasises the importance of drafting straightforward obligatory provisions in the active tense.

The relationship between conditions and covenants can also be explained in a different way. First, although a condition is not, as such, a ‘promise to act’ in a certain way, the stipulation of a condition often implies that the parties use reasonable endeavours that the condition will be satisfied in such manner that the object of that condition takes its anticipated effect. Accordingly, a condition may a contrario imply an obligation (i.e. a covenant) imposed on the party who is able to influence the satisfaction (positively or negatively) of that condition. Similarly, a covenant is not a key obligation and therefore many courts will refuse to permit a complete suspension or postponement of performance by the beneficiary of an obligation if the obligor fails to perform according to the covenant.

Second, if contractual obligations are drafted in the passive tense (i.e. without an actor or obligor being appointed) the distinction between covenants and conditions becomes fluid. This becomes clear when reading the American Restatement of Contracts:

“If in an agreement words that state that an act is to be performed purport to be the words of the person who is to do the act, the words are interpreted, unless a contrary intention has been manifested, as a promise by that person to perform the act. If the words purport to be those of a party who is not to do the act they are interpreted, unless the contrary intention has been manifested, as limiting the promise of that party by making performance of the act a condition.”

Although the distinction might not be of great relevance from a contract-drafting or even a practical perspective, it is important to be aware how conditions and obligations interact with each other.

Covenants in various contracts

Covenants in IP-related agreements. In a patent transfer agreement, the transferring party will transfer its invention. However, the transferee would like to maximise its use of the patented invention and also be made familiar with all technology know how connected to the patented invention.

Also, a transferor may want to avoid any infringement claims for the use of any remote elements in the patent that do not relate to the transferee’s business but was covered by the patented invention (as the patent was applied for in view of the transferor’s business): the transferor may seek a non-assertion or licence-back in connection with the transferred patent. Similarly, a licensor of trademarks or other intellectual property rights often requires from its licensees that they notify the licensor promptly of any infringements identified in the market of such licensee. Such stipulations are covenants.

Covenants in Lease or loan agreements. In a manufacturing equipment lease, the main objective of the lessor is to ensure that the lessee pays the rent timely and that it returns the equipment at the end of the lease. However, a lessor may want the lessee to operate and store the equipment in accordance with lessor’s instructions, to maintain the leased assets, to keep it insured and to allow periodical inspections by the lessor. The lessor, in addition to its concern regarding the value of the equipment, will want to prevent that the lessee will be unable to pay the rent timely. Likewise, the lessor might require that the lessee provides an ongoing security for the lease

The lessor, in addition to its concern regarding the value of the equipment, will want to prevent that the lessee will be unable to pay the rent timely. Likewise, the lessor might require that the lessee provides an ongoing security for the lease instalments. If the lease has a potentially significant impact on the lessee’s business, the lessor may even require periodical information about the lessee’s financial capability to continue paying the rent.

Each of the above examples of deal-related or unrelated purposes is accomplished by covenants that prescribe what the transferor or lessee must do, and cannot do, in respect of the transferred patent or leased equipment.

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.

Credit-facility-related covenants

In credit facilities and loan agreements, as in M&A transaction agreements, covenants can similarly be divided into three categories:

  • Covenants requiring action (i.e. promises to take a specified action);
  • Negative covenants (i.e. promises not to take specified actions); and
  • Financial covenants (i.e. promises to maintain certain levels of financial performance or not to take specific actions unless certain levels of fi­nancial condition or performance exist at the time).

Negative cove­nants are also referred to as restrictive covenants, because they restrict or prohibit certain actions (i.e. not permitting the creation of pledges over any assets of the borrower, or the undertaking not to grant any higher-ranking security rights over its assets compared to those of the lender).

Financial covenants. In their financing practice, banks have been developing great insight into the need to monitor their customers’ businesses. Those needs are satisfied by adequate financial covenants. Financial covenants restrict a borrower’s freedom to engage in activ­ities that may worsen its financial condition. These activities include the following:

  • Incurrence of debt. More debt means more interest and princi­pal payments, implying a greater impact on the company’s cash flow.
  • Creation of encumbrances (‘negative pledge’). The more assets are pledged or otherwise collateralised, the fewer assets are available to be used to satisfy the borrower’s unsecured claims and general obligations in the event of insolvency.
  • Line of business. Especially in leveraged finance, finance agreements will require that the borrower does not change the essential scope or nature of its business activities.
  • Sale of assets. Loss of income-generating assets could adversely affect the lessee’s cash flow. Sometimes also the assignment of receivables (factoring arrangement) is restricted or prohibited.
  • Dividend distributions (‘leakage prevention’). Each euro distributed as dividend to share­holders reduces cash available for payment of rent. Also, intra-company transactions with affiliates that do not participate in the financial arrangement may endanger the leakage of valuable assets or cash out of the reach of the lenders.
  • Investments. From a lender’s standpoint, cash spent on investments would be better spent on repaying amounts due to the lender.

Financial ratios in credit agreements. Financial covenants that require the covenanting party to periodically meet certain financial ratios are also used to ad­dress credit concerns. These ratios are set at levels de­signed as an ‘early warning signal’ in the event that the borrower is facing financial difficulties. Financial ratios are aimed at balancing the business decisions of a company’s management, in that the ratio established by a covenant requires that the company will at all times be capable of paying its debts, as should be determined on the basis of the company’s cashflow to debt ratio, a profitability (EBIT or PBIT) to interest indebtedness ratio, a current ratio (i.e. current assets to current liabilities) or a solvency ratio (e.g. borrowed money set off against equity). Such financial covenants will often also require that the borrower is of a certain ‘minimum net worth’.

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.