How Buyers, Sellers Guard Against Covenant Breaches in M&A

The Bottom Line

• A breach of the conduct of the business covenant addressing the target company’s operations in the period between signing and closing of the transaction could result in significant value destruction.
• A buyer may be unaware of a breach of the conduct of the business covenant until after closing, and in a “no survival” deal, the buyer could be left without recourse.
• To protect itself, a buyer may choose to augment the “absence of changes” representation or negotiate for a limited survival period for the conduct of the business covenant.

In almost every transaction with an interim period between signing a definitive agreement and closing a transaction, a “conduct of the business” covenant governs operations of the target’s business. This interim operating covenant typically includes both affirmative and negative covenants and is heavily negotiated.

Sellers argue for looser restrictions on the theory that they need freedom to continue to operate the business, particularly when the interim period is lengthy or there’s a question about whether the deal may ultimately close (such as in the event of failed financing or the absence of required regulatory approvals).

Alternatively, buyers prefer tighter restrictions to ensure the business they acquire at closing is in the same condition as the business they based the purchase price on at the time of signing.

This push-pull dynamic is familiar to anyone who negotiates mergers and acquisitions transactions and generally resolves itself within the confines of market accepted limitations and permissions.

Historically, a buyer would receive a post-closing indemnification right that would include breach of pre- and post-closing covenants. As a result, if the buyer were to discover after closing that the conduct of the business covenant had been breached, the buyer could make a claim against the seller (typically capped at the purchase price). The types of damages that could be awarded may be limited, but the buyer would have had a claim to make.

Increasingly, sellers have successfully pushed for “no survival” deals, meaning that all the representations and warranties and any pre-closing covenants terminate at closing, with no liability for the seller. Exceptions may be made for fundamental representations, pre-closing taxes, and fraud, but the seller generally “walks away” with no further liability.

To provide for recourse in the event of an untrue representation, buyers in these “no survival” transactions typically procure a representations and warranties insurance policy—shifting liability from the seller to the insurers. While this may prove an adequate solution to the lack of recourse for untrue representations and warranties, RWI policies don’t address covenant breaches.

Covenant Breaches

For many pre-closing covenants, there’s an adequate remedy prior to closing, and many pre-closing covenants address matters required to cause the closing itself to occur. Most notably from a remedy standpoint, when the buyer knows of the breach, it can assert the closing condition—generally, the standard is whether the seller has complied “in all material respects” with the covenant—wasn’t satisfied, and as a result, that the buyer doesn’t have to close.

To highlight just one recent example, in his quest to terminate his obligation to acquire Twitter, Elon Musk alleged multiple material covenant breach allegations, including breach of the conduct of the business covenant. For other covenant breaches, such as confidentiality, a buyer may be entitled to equitable relief.

“No Survival” Revival

From a seller’s perspective, when a buyer knows of the pre-closing breach and chooses to close over it, the buyer should be prohibited from subsequently asserting a claim for damages when it could have chosen not to close the transaction.

But what is the buyer’s remedy in a “no survival” deal in the event of a breach of the conduct of business covenant that’s only discovered after closing, resulting in significant value destruction?

The seller could have agreed to amendments to a material contract with the largest customer of the business that decreased the profitability of the contract. In that instance, the effect might not be fully (or at all) picked up in the working capital adjustment to the purchase price, and the buyer’s go-forward projections may be harmed significantly.

Or the seller could fail to make the capital expenditures called for by the business’s annual budget. In that case, cash would be higher or debt lower at closing, resulting in the buyer paying a higher purchase price at closing. The buyer would then need to make the required expenditures (not to mention potential harm to the business resulting from the delay as a result of payoffs being pushed into the future or intervening cost increases).

For many prongs of the covenant, it’s easy to imagine a breach that would both reduce the value of the business and not be adequately addressed by the post-closing purchase price adjustment provisions. Absent a disclosure of breach from the seller, it may prove impossible for a buyer to discover such breaches prior to closing.

Buyer Protection Strategies

A buyer has various paths to try to address this issue.

Focus on an “absence of changes” representation. This speaks to the absence of certain changes in the business since the date of the most recent (typically, audited) financial statements. It often (though not always) addresses items that would have been prohibited under the conduct of the business covenant if taken after the signing date.

Because this representation was originally meant to bridge the period from the financial statements date to the signing date, the seller’s draft often includes express language limiting the scope of this representation to events occurring between the balance sheet date to the signing date (but not through the closing date).

A buyer wanting to ensure recourse for events that would violate the conduct of the business covenant could revise this representation to speak as of both the signing and closing dates, and, if absent from seller’s draft of the representation, expressly address items that would have been prohibited by the conduct of the business covenant if taken after the signing date. This means a covenant breach could also give rise to a claim under the RWI policy for a corresponding breach of the representation.

This is a partial but not perfect solution because the claim would be subject to the RWI policy’s retention amount (whereas under traditional indemnification constructs, covenant breaches are recoverable from the first dollar of loss). And RWI policies customarily exclude coverage for breaches that arise during the interim period and that the buyer discovers before closing. If a buyer discovers the breach and chooses to close despite the significance of the issue, RWI coverage would be unavailable.

Provide for a limited survival period for the conduct of the business covenant. While one can’t argue that it’s an accepted market practice for the interim operating covenant to survive the closing in a “no survival” deal, having considered the issue, a buyer may decide to push to revise the “no survival” clause to allow for limited survival.

One of the reasons sellers argue for “no survival” deals is the need (particularly among private equity sellers) to distribute funds to investors without the overhang of lengthy and sometimes uncapped (or high-capped) liabilities. But in most transactions, sellers still agree to a post-closing purchase price adjustment provision, and the result of those adjustments may require the seller to refund a portion of the purchase price to the buyer.

These adjustment provisions typically give the buyer 60 to 120 days after closing to review the financials of the business and deliver its view of what the closing statement (and resulting purchase price) should have been based on the actual financials of the business on the closing date. To support the seller’s potential liability for any resulting purchase price adjustment, a sizable escrow is often set aside at closing.

Were there to be a breach of the conduct of the business covenant, it’s likely the buyer would discover it in this post-closing financial review period related to the purchase price adjustment.

In light of the significant risk of value destruction, another reasonable alternative is for the buyer to require the conduct of the business covenant survive for at least as long as the purchase price remains subject to adjustment—particularly if the buyer is unsuccessful in obtaining the revisions to the “absence of changes” representation and/or RWI coverage isn’t available for that representation.

This wouldn’t meaningfully extend the seller’s liability holdback period—if the seller wants to start distributing sale proceeds in advance of such survival period, the parties could even negotiate to make the adjustment escrow account available in satisfaction of such liabilities.

Assuming the escrow account is appropriately sized, and setting aside the philosophical argument against allowing a party to cap its liability for an occurrence it controls, a buyer could even consider limiting its recourse for breach to the amount in escrow (or even further, to the retention amount under the RWI policy) and still be in an improved position as compared to the typical “no survival” deal.

Whether a buyer negotiates for a limited survival period for the conduct of the business covenant or instead incorporates the relevant provisions into the “absence of changes” representation, spending time in the agreement negotiation phase to evaluate the ramifications of a breach and negotiate appropriate protections will leave the buyer in better stead in the unfortunate event a breach occurs.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Sara Duran is partner at Sidley focusing her practice on complex corporate and transactional matters.

Danielle Sismour is managing associate at Sidley and a member of the corporate group, focusing on the representation of buyers and sellers in complex business transactions.

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