Post-Closing
Covenants

DEFINITION

A post-closing covenant is a binding agreement appearing in a main transaction agreement that governs relations between or among parties after closing has occurred. Relevant to both simultaneous and staggered sign/close transactions.

KEY COVENANTS

An appropriate set of post-closing covenants will depend on a transaction’s structure, due diligence findings, and each party’s goals. Experienced counsel will advise on a framework tailored to the transaction.

When they appear, the following post-closing covenants are usually the most material: (i) non-competition and non-solicitation; (ii) post-closing tax support and cooperation; and (iii) transition obligations.

NON-COMPETITION & NON-SOLICITATION

In most transactions where the target is a private company, a buyer will require the sell-side to agree to non-competition and non-solicitation provisions.

When the target is a public company, a buyer cannot obtain restrictive covenants from public equityholders. However, the buyer may be able to obtain limited restrictions from key executives and major stakeholders (like institutional sponsors or founders). Because these covenants cannot bind all sellers, they will not appear in the main transaction agreement. Instead, they will exist as standalone, ancillary agreements.

• NON-COMPETITION

Non-competition provisions will prevent a counterparty from starting, working for, or otherwise aiding a business competitive with the one sold for a specified post-closing period. There may be limited carveouts, including for passive private investments and minor holdings in public securities.

Key points of negotiation focus on: (i) the scope of what qualifies as competitive (e.g., the definition of a competitive business); (ii) the duration of the non-compete; (iii) its geographic scope; and (iv) exceptions, if any.

• NON-SOLICITATION

Non-solicitation clauses will prevent a counterparty from soliciting or hiring, as applicable, employees, customers, suppliers, or other key relationships of a target business for a specific length of time after closing. There are standard exceptions to employee non-solicits.

Negotiations will generally focus on: (i) who the restrictions should cover (e.g., all customers versus only key accounts, or all employees versus only management); (ii) duration; and (iii) whether any exceptions other than customary ones are warranted.

POST-CLOSING TAX SUPPORT & COOPERATION

The exact nature of post-closing tax covenants will depend on whether the transaction is an equity or asset transaction. However, post-closing tax covenants will typically address, at a minimum:

• HISTORIC RETURNS

Rules governing the sell-side’s ability to amend tax returns and elections relating to the pre-closing period.

• PRE-CLOSING AND STRADDLE RETURNS

Who will prepare and file tax returns for periods before closing or that straddle closing (i.e., tax years that begin before closing, but end after it).

• REVIEW AND CONSENT RIGHTS

What review, comment, and consent rights non-preparing and non-filing parties will have over those tax returns before they are filed.

• TRANSFER TAXES

How transfer taxes (e.g., sales, use, stamp, registration, or similar) will be allocated.

• TAX CONTESTS

How audits relating to pre-closing and straddle periods will be coordinated.

• PAYMENT RESPONSIBILITY

Who is responsible for paying what taxes, and when.

• TRANSACTION-SPECIFIC ELECTIONS

Tax covenants will address any elections the parties have negotiated. For example, if parties agree to use a Section 338(h)(10) election to treat an equity transaction as an asset transaction for tax purposes, the covenants will stipulate the actions required to accomplish that result.

Note that in a simultaneous sign/close transaction, a pre-closing reorganization may be required to achieve certain tax objectives. If pre-closing reorganizations take place, the main transaction agreement will confirm the exact steps that were implemented prior to closing.

TRANSITION OBLIGATIONS

Post-closing covenants in mergers and acquisitions may include agreements addressing: (i) the target company’s workforce; (ii) post-closing transition services; and (iii) what happens if certain assets or liabilities are accidentally left behind or received by the wrong party after closing.

• EMPLOYEES AND BENEFIT PLANS

The parties may agree that a buyer will provide certain commitments with respect to a target company’s pre-closing workforce for a period of time—usually one year—following closing.

These commitments may address: (i) base salaries and wages; (ii) bonus opportunities; and (iii) employee benefits (including any severance), in each case during the stated period.

Generally, the covenants will require a buyer to provide a minimum level of pay, bonus, and employee benefits to the target’s pre-closing employees who continue their employment after closing; usually, at least what these employees received immediately before closing.

The provisions do not prevent a buyer from replacing benefits or terminating continuing employees. Instead, if plans are replaced, any applicable service credits are usually carried over. If terminations take place, the buyer may be required to provide severance benefits at least commensurate with the target’s pre-closing severance policies (if any).

These covenants will not apply to employees hired after closing or, in the case of a merger, the portion of the combined company’s workforce that the target did not employ before closing.

Finally, the covenants should be clear that they do not give any employees or other non-parties the right to sue a buyer or any other transaction party.

• TRANSITION SERVICES

If a target company requires post-closing support from the sell-side after closing to maintain its operational integrity, the parties will need to negotiate transition services.

Where these services are limited—e.g., transferring a domain name’s ownership or assisting with vehicle registration changes—it may be possible to include a covenant in the main transaction agreement.

However, if significant or extensive support is required, a separate transition services agreement is customary. A TSA will include a business-friendly exhibit listing the expected services. Financial and legal terms are included in the agreement’s body.

• WRONG POCKETS AND MISDIRECTED FUNDS

Depending on the transaction, it may be appropriate for post-closing covenants to address scenarios where: (i) retained assets or excluded liabilities are accidentally transferred to a buyer; or (ii) purchased assets or assumed liabilities are mistakenly retained by a seller. A wrong pockets provision requires the parties to fix these errors following closing.

For example, a buyer purchases a target company in an asset sale. The target’s vehicle fleet includes a mix of delivery trucks and vehicles used by executives. One of these vehicles is used by the seller and was to be retained by the seller following closing. However, due to a clerical error, the vehicle’s registration was transferred to the buyer at closing. Under a wrong pockets provision, the parties would re-register the vehicle in the seller’s name, without any additional consideration or contracts.

A misdirected funds clause requires a party to forward payments or other funds received by it in error to the correct party.

For example, parties agree that one of a target company’s bank accounts will be retained by the seller. The account receives payments from certain customers. Before closing, the parties ask the customers to begin sending payments to a new account that the target will retain after closing. However, a customer continues to deposit funds into the original account following closing. A misdirected funds provision would generally require the seller to remit these payments to the target.

Wrong pockets and misdirected funds clauses are more typical in complex asset transactions, but in some situations they may appear in equity transactions or streamlined asset transactions, too.

PITFALLS

• RESTRICTIVE COVENANTS NOT ENFORCEABLE

The enforceability of non-competition and non-solicitation covenants changes frequently. Because laws shift quickly, consulting a qualified lawyer is essential whenever negotiating these restrictions.

• INCREASING PURCHASE PRICE FOR CONTINGENT BENEFITS

If a seller is to retain the benefit of a pre-closing asset—such as an expected tax refund relating to the pre-closing period—simply increasing the purchase price by the amount of the anticipated benefit is usually not advisable.

• SEQUENCE FAILURE

If the transaction requires a pre-closing reorganization—like one required to achieve agreed-upon tax objectives—the purchase agreement’s provisions around structure must match the structure deck, including its exact sequence of events. Failing to align documentation with the steps plan can undermine the transaction’s desired outcome, in particular tax planning.

• TSA AMBIGUITY

If transition services are required, the transition services agreement or purchase agreement should describe them with specificity. Complete and exact descriptions, as opposed to general ones, should be provided wherever possible. In addition, the services should be listed not in legalese but in business-friendly language capable of immediate execution.