Pre-Closing
Covenants

DEFINITION

A pre-closing covenant is a binding agreement appearing in a main transaction agreement that governs relations between or among parties during the interim period. Only relevant to a staggered sign/close transaction.

KEY COVENANTS

Pre-closing covenants come in many varieties. The exact set of pre-closing covenants appropriate for a transaction will depend on, among other things, the transaction’s structure, due diligence findings, and the nature of actions that need to be completed to close the transaction. Experienced counsel can help negotiate and implement a package of pre-closing covenants that balances risk with practicality.

Below are the pre-closing covenants often subject to considerable negotiation due to their importance to all deal parties.

• IOCs

The aim of well-drafted interim operating covenants is to prevent value leakage that undermines the deal a buyer bargained for—but also give a seller the flexibility it needs to operate the target business between signing and closing.

In broad strokes, IOCs generally require the seller to operate the target business in the ordinary course and obtain the buyer’s consent for extraordinary actions.

For example, extraordinary actions may include: (i) amendments to organizational documents; (ii) unapproved reorganizations, equity issuances, or recapitalizations; (iii) capital expenditures not included in diligenced financial plans; (iv) incurring new debt or granting new guarantees; (v) changes to material agreements, or entering into new ones; (vi) alterations to accounting practices or tax returns; (vii) increasing salaries above specified thresholds or paying unexpected bonuses; (viii) hiring new employees with significant compensation; and (ix) starting new business lines or engaging in unapproved mergers, acquisitions, or dispositions.

• REGULATORY APPROVALS

If regulatory (like antitrust) approvals are required, the pre-closing covenants will include agreements: (i) establishing a deadline (e.g., five or ten business days after signing) for submitting the materials needed to obtain the approvals, (ii) setting a procedure for how those materials will be prepared and on what basis they can be submitted, and (iii) stipulating what happens if the applicable regulatory authorities make follow-up inquiries. The parties may also address responsibility for filing fees and other expenses incurred in connection with the approvals.

• DEBT FINANCING COOPERATION

If the buyer will be obtaining third-party financing as part of the transaction, the buyer will need assistance from the target business to help complete credit documents, including relevant disclosure schedules, pledge agreements, and account-control agreements.

The debt cooperation covenant will list required assistance, set reasonable limitations on it, and—in certain scenarios—provide for expense reimbursement.

If a marketing period is relevant, the buyer may need the target’s management to participate in marketing activities like preparing a confidential information memorandum (CIM) and attending road show meetings.

• EXCLUSIVITY

The pre-closing covenants will typically include exclusivity provisions preventing the seller and the target business from seeking or accepting bids from other potential buyers during the interim period.

These exclusivity provisions are usually more robust than those found in LOIs and IOIs. However, in certain situations like where a public company is involved, they may include fiduciary out provisions that allow the target business to evaluate and accept superior proposals if received.

• PRE-CLOSING REORGANIZATIONS

If the target company must undergo a pre-closing reorganization, including to achieve the tax objectives in the final transaction structure, a pre-closing covenant will address how the reorganization will take place. The covenant will assign responsibility to the parties, as appropriate, and often attach the final structure deck (or a version of it) to the main transaction agreement as a definitive guide and binding commitment to what must take place before closing.

PITFALLS

• IMPRACTICAL IOCs

All IOCs should be viewed through a practical lens.

On the sell-side, this often means reviewing them with the employees who will be required to conform their ordinary-course practices to them.

On the buy-side, this means maintaining flat consent rights over actions that, if taken, would fundamentally alter the negotiated deal. These include changes to organizational documents, capitalization tables, and debt portfolios.

• LATE-STARTING REGULATORY FILINGS

Regardless of the post-signing deadline for making required regulatory filings, preparing those filings should begin prior to signing to ensure timely submission. Most regulatory filings require data requests and detailed review. If preparation starts too late, covenants may be breached.

• NOT ADDRESSING DEBT EXPENSE REIMBURSEMENT

Parties may negotiate that a buyer will reimburse a target company for out-of-pocket expenses (like accounting fees and legal costs) the target incurs while complying with the debt cooperation covenant.

If a reverse termination fee is negotiated, the parties should also consider whether the debt cooperation reimbursement is on top of, or precluded by, the RTF.

Failing to address this point leaves ambiguity that is unhelpful in a financing failure.

• NO EXCLUSIVITY

Sometimes parties are under the mistaken assumption that an exclusivity or other no-shop provision in LOI or IOI removes the need for a similar clause in a main transaction agreement with a deferred closing.

This is not the case. No-shop provisions in LOIs and IOIs nearly universally terminate when a definitive transaction agreement is signed, regardless of whether closing is simultaneous with signing.