4.2 Covenants

Covenant: ‘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.

Carve-outs. The scope of a covenant can be limited or qualified. The most important one is to create exceptions or to be specific regarding its scope: a carve-out. 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.

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: 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 under common law usually provides for specific remedies in the event of a breach of a covenant.

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 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 were 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 markets of such licensees. Such stipulations are covenants.

Covenants in leases and goods-on-loan agreements. In a manufacturing equipment lease, the main objective of the lessor is to ensure that the lessee pays the rent in a timely fashion 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 the lessor’s instructions, to maintain the leased assets, to keep them 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 the lessee from being 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, respectively.

Covenants in M&A transactions. In mergers and (company) acquisitions 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 (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).

Pre-closing covenants in mergers and acquisitions. During the period between the signing and the closing of an M&A 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 or 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, for example:

  • Access to facilities and information rights. Whereas competition laws often prohibit the implementation of (irreversible) measures, a purchaser would like to have some access rights to the acquired companies’ manufacturing facilities. But the purchaser should not interfere with the business activities and must comply with all security and safety measures.
  • Undertaking to conduct the business in the ordinary course.
  • Approval rights. Various matters will be subject to the purchaser’s prior approval:
    • 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.

Covenants in credit agreements. 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 include:

  • Incurrence of debt. More debt means more interest and princi­pal payments.
  • Creation of encumbrances (‘negative pledge’). The more assets are pledged or otherwise collateralised, the fewer assets are available to satisfy the borrower’s unsecured claims and general obligations in the event of insolvency.
  • Line of business. Especially in leveraged finance, credit 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’) is restricted or prohibited.
  • Dividend distributions (‘leakage prevention’). Each euro distributed as dividend to shareholders reduces cash available for payment of interest. 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.