Foundations for Corporate M&A Professionals
Designing Interim Operating Covenants
An interim operating covenant restricts the seller's ability to make big changes to the business before closing.
Generally this covenant requires the target to operate its business in the “ordinary course”, meaning the seller agrees to maintain the company's financial health and operational stability until the buyer takes ownership.
Typically these provisions prevent the seller from:
- Making significant capital expenditures
- Issuing new debt or dividends
- Changing executive compensation
- Entering into or terminating material contracts
- Making acquisitions or selling assets
Foundations for Corporate M&A Professionals
Governance before Closing
Interim operating covenants are not intended to fully control the seller until closing. But they should outline what is allowed and prohibited so the business is materially similar at close.
They should also be clear on how much ‘effort’ is required to stay aligned with ‘past practice’ (i.e. maintaining specific levels of inventory, marketing spend, etc.) and agreed to a standard like “commercially reasonable efforts”.
Typical these provisions allow the seller latitude to make decisions on:
- Routine hiring, promotions, and terminations
- Standard legal matters and any actions required by law or contract
- Maintenance of assets and pre-approved capital expenditures
- Marketing, pricing, and sales campaigns
Foundations for Corporate M&A Professionals
Breaching an Interim Operating Covenant
To determine whether a seller has breached the covenent, the courts look at what was agreed and what actions would be considered in the “ordinary course of business”, including the company’s historical practices as well as other similarly situated companies in the industry.
The covenant may include exceptions for responding to unforeseen situations that require immediate action and justify a departure from usual procedures.
In some cases the carve-outs in the definition of “material adverse effect” may be applied to the interim operating covenants so the impact from instability is addressed in a consistent manor.
If it is determined that the seller took inappropriate actions and breached the covenant, the buyer typically has the right to:
- Walk away from the transaction
- Demand a price adjustment
- Pursue damages and other legal remedies
Advanced Topics for Corporate M&A Professionals
Setting the Materiality Threshold
Generally a materiality threshold is negotiated based on the dollar value and / or the nature of the breach.
Some agreements use thresholds based on a percentage of EBITDA, revenue, or total assets. For example, changes exceeding 2%-5% of annual EBITDA or revenue might be considered material.
Materiality thresholds might also encompass non-financial items, such as deviations from business strategy, material adverse changes in governance, or entering non-ordinary course business arrangements. In those areas, the courts have allowed 'zero-tolerance' provisions.
Advanced Topics for Corporate M&A Professionals
Negotiating the Consent Process
The consent process specifies the way sellers should request permission from the buyer as well as the amount of time the buyer has to respond if they have an objection (say 2-3 days).
In-house counsel will likely include a “commercially reasonable efforts” standard to define how hard the seller should work to get the buyers permission before a decision needs to be make.
Savvy corporate M&A teams will make sure they have time to respond and that a lack of responce does not grant the seller permission.
Notable cases on Interim Operating Covenants in M&A transactions
AB Stable VIII LLC v. MAPS Hotels and Resorts One LLC (Delaware, 2020)
The Delaware court clarified the meaning of "ordinary course of business" in this case by ruling that the seller breached the covenant by deviating from its pre-pandemic practices, even though its actions were reasonable in the context of the pandemic. Following AB Stable deal teams are negotiating more precise covenants, including exceptions for extraordinary events or market disruptions to ambiguity as well as "reasonableness" standards to allow for flexibility in responding to unforeseen circumstances.
Akorn, Inc. v. Fresenius Kabi AG (Delaware, 2018)
This case is one of the most significant rulings on the impact of a breach of interim operating covenants. Fresenius sought to terminate its agreement to acquire Akorn, citing material adverse changes (MAC) and breaches of Akorn's interim covenants, including failures in regulatory compliance and data integrity issues during the interim period. The Delaware Court of Chancery ruled that Fresenius could walk away from the deal because Akorn had breached the covenants, as the company's operations materially deviated from ordinary course, severely impacting its value.
Cooper Tire & Rubber Co. v. Apollo (Mauritius) Holdings Pvt. Ltd. (Delaware, 2014)
In this case, Apollo sought to back out of a merger with Cooper Tire, citing significant disruptions in Cooper's business operations during the interim period. The court found that Cooper's inability to maintain control over its Chinese subsidiary, as required by the interim operating covenants, amounted to a material breach. Although the merger failed, the case underscores the importance of operational control during the interim period, including over third parties that are outside their control.
IBP, Inc. v. Tyson Foods, Inc. (Delaware, 2001)
This case involved Tyson Foods’ attempt to back out of its acquisition of IBP, citing alleged financial discrepancies and a downturn in IBP’s business during the interim period. The court ruled that IBP had not breached its interim operating covenants because its actions remained within the ordinary course of business, and the economic downturn was not sufficiently material to justify Tyson's termination of the deal. This case established the standard that interim covenants must be evaluated in the context of what is "ordinary" for the business and industry.
Hexion Specialty Chemicals, Inc. v. Huntsman Corp. (Delaware, 2008)
Hexion tried to terminate its agreement to acquire Huntsman, alleging that Huntsman's deteriorating financial performance breached its interim covenants. However, the Delaware Court of Chancery found that Huntsman’s performance, while poor, was still consistent with its ordinary course of business. The ruling reinforced that interim operating covenants require adherence to “ordinary course” in the context of the company’s overall business conditions, even during financial downturns.
Alliance Data Systems Corp. v. Blackstone Capital Partners V L.P. (Delaware, 2008)
This case involved Blackstone's attempt to terminate its acquisition of Alliance Data Systems (ADS) by claiming breaches of interim covenants due to regulatory issues. The Delaware Court of Chancery ruled that ADS had not materially breached its interim covenants and rejected Blackstone’s claims. This decision highlighted the difficulty of proving a material breach of interim covenants and the importance of clear, contractually defined standards.
Applications in M&A transactions
How has its interpretation of the phrase "ordinary course of business" been challenged in recent court cases, particularly AB Stable v. MAPS Hotels and Resorts One?
AB Stable established a strict interpretation, stating that "ordinary course" means adhering to the company's past practices and not allowing for deviations, even when responding to extraordinary events like the COVID-19 pandemic.
The court found that the seller breached the covenant by making significant operational changes, such as closing hotels, reducing staff, and limiting services, even though these actions were responses to the pandemic and in line with industry trends.
This ruling emphasized that the "ordinary course" obligation is "flat, absolute, and unqualified," especially when accompanied by the phrase "consistent with past practice."
Thus, past practices -- and not the actions of industry peers -- are the yardstick for what constitutes an "ordinary course".
How do efforts-based qualifiers, such as “commercially reasonable efforts,” affect the interpretation of interim operating covenants?
Efforts-based qualifiers, like "commercially reasonable efforts," are designed to soften the strictness of operating covenants, by indicating that a party is only required to attempt, rather than fully guarantee compliance.
In the context of AB Stable, the lack of such qualifiers played a key role in the court's interpretation of the contract as creating an absolute obligation to operate in the ordinary course.
Interestingly, post-AB Stable, some legal observers believe having an efforts-based qualifier would be more analogous to permitting parties to look at the actions of other industry participants for purposes of determining what constitutes ordinary course, and that they would impact the standard of compliance. This is a shift from the previous belief that efforts-based qualifiers only address whether absolute compliance is needed, or whether a party just needs to make reasonable attempts at compliance.
What are some common types of interim period covenants and how do they impact both sellers and buyers?
Conduct of Business: Sellers are required to conduct the business in the ordinary course, maintaining consistent management and decision-making without significant operational changes. This ensures the value of the company doesn't diminish and the buyer receives the business as agreed.
Financial Practices: Sellers must maintain current levels of working capital, adhere to accounting principles, and not take on additional debt without consent. These covenants ensure that the target’s financial health remains stable..
Asset Maintenance: Sellers must maintain both physical and intangible assets, preserving the business's value..
No Material Adverse Changes: Sellers are obligated to avoid actions that could materially and adversely impact the business..
Compliance with Laws: Ensuring ongoing compliance with all relevant laws and regulations..
Notification and Consent: Sellers often must notify buyers of key events and seek consent before taking specific actions like entering new contracts or changing employment terms for key personnel..
Employee and Management Retention: Sellers may covenant to retain key employees, often offering retention bonuses, to ensure talent stays through the transition.
How do interim operating covenants interact with representations and warranties, and what remedies are available for breaches of these covenants?
Representations and warranties are factual assertions that sellers make about the business being sold as of the signing date, and interim operating covenants act to ensure that those representations and warranties remain true at closing.
Breaches of these covenants can trigger various remedies, including:
Indemnification: The seller may have to compensate the buyer for losses caused by a breach.
Purchase Price Adjustments: If a breach causes a financial issue, the purchase price may be adjusted.
Escrow Funds: A portion of the purchase price is sometimes held in escrow to cover potential breaches.
Termination of the Agreement: A material breach can give the buyer the right to walk away from the deal, though this is not always a buyer's first remedy.
Specific Performance: The non-breaching party may seek a court order to compel the breaching party to fulfill their obligations, though that is a less common remedy.