Interim Operating Covenants and Closing Conditions
In corporate acquisition transactions, there may be a period between signing the purchase agreement and closing the acquisition, that is, when the transfer of the target becomes effective. Transactions can be structured so that signing of the agreement and closing do not take place simultaneously for various reasons, such as the need to obtain corporate approvals, as well as consents and approvals by third parties, government regulators in the case of industries subject to oversight, and antitrust authorities, among others. During that interim period, the parties, and more significantly the seller, assume obligations to perform and abstain from performing certain acts, which are extensively negotiated and generally referred to as interim operating covenants.
Sellers, purchasers and their advisers are interested in this interim period and how it may affect the certainty of the closing. Purchase agreements should include appropriate conditions to closing and termination rights that should balance certainty of closing and the parties’ right to withdraw from the transaction under appropriate circumstances, when specific aspects of the transaction are impacted or affected.
Third-party consent and other corporate matters
In certain cases, it is necessary to obtain the consent of a third party with whom the target maintains a significant contractual relationship. The target company may have contracts with clients, suppliers and lenders that include change of control clauses (with different scopes and implications) that give those parties the right to unilaterally terminate their agreements in the event of a change in ownership structure. If the contracts are material for the target, the parties may decide to defer closing for purposes of obtaining the respective third-party consents during that interim period. In some cases, the agreement may include a condition to closing to that effect. However, counsel must consider the risk of giving such third parties more leverage than is warranted by allowing them to delay or preclude the M&A transaction
Additionally, there are cases in which closing is deferred because the parties need to obtain corporate approvals, implement internal restructuring, carve out business lines or assets from the business to be transferred. The purchase agreement may include completion of such actions as a condition to the obligation of buyer, seller or both to consummate the closing, though in some cases, a pre-closing covenant and acknowledgement may suffice.
It is also possible that the parties may become aware of an imminent event that could have a material impact on the price (e.g., the rendering of a judicial or arbitral decision, discussions as to a potential change in the local regulations applicable to the industry, and measures by other countries that may pose barriers for entry to usual export destinations). In those circumstances, the parties may decide to defer closing until such event takes place (or is permanently precluded) rather than turning to escrow accounts or price clawback mechanisms.
The regulation of private activity involves, among others, the creation of rules through the legislative function, as well as administrative tasks geared to controlling, assisting or channelling the conduct of private parties, for the purpose of ordering and fostering the development of private activity, including through: recording (registries), promoting (privileges, subventions, subsidies), guiding (controls, authorisations) and supervising (inspections).
There are industries where, given the importance of the public interest involved, the government alters the natural and spontaneous conduct of the market by imposing certain demands or requirements for entry and operation of economic agents.
In those industries, a change of control of a supervised entity or the transfer of a supervised business (in the case of asset deals) usually requires obtaining authorisation from the relevant government regulator, which is granted once the latter has carefully reviewed the professional, technical, economic and other background of the new agent seeking to enter the market or enhance its position within that market. Government oversight may be a matter of lawfulness (compliance with the rule) or of merit (opportunity and advisability).
The same is true in the case of concession agreements executed with the government when the transaction involves a change in control of a company that contracted with the government and whose background was taken into account by the latter to award the concession to that particular company. Therefore, government agency authorisations are often required for the shares of the concessionaire entity to be sold.
In Uruguay, in line with regulations throughout the region, various industries require authorisations from the respective regulators for the transfer of shares of regulated companies. The list of such industries includes the financial sector (including banks, finance companies, etc.), insurance companies and telecoms, among others.
For example, in recent years, the Uruguayan financial market has had various cases of transfers or attempts to transfer shares of regulated entities that involved deferred closings in order to obtain authorisations by the Central Bank of Uruguay (BCU). For the purposes of evaluating requests for share transfer authorisations, the BCU assesses matters of law, opportunity and advisability. That process requires the submission of extensive information that includes economic, technical and business reputation background of the purchaser, as well as business plans with respect to the target company. Moreover, the BCU verifies that, in the recent past, the party that will come to hold effective control of the target has not had significant growth, either organically or inorganically (via acquisitions), that there is a memorandum of understanding between the regulator at the place of origin of the party who will exercise effective control and the BCU, and that the regulator in the jurisdiction of origin exercises consolidated supervision.
Consolidated supervision is a consequence of the practical reality that financial sector regulators face with institutions that are part of internationally active and highly diversified groups, which conduct interrelated transactions using capital and resources of different members of the group. Given the concern that a financial institution may be negatively impacted by losses suffered by other entities of the same group, banking regulators internationally – including the BCU – use consolidated supervision, where a single supervisor oversees all entities of a group to obtain an overall vision of the group’s strength and of all risks that may affect it as a whole and, hence, the local entity as well.
In cases of nontraditional players in the financial sector, including investment funds, the set of strict requirements has on occasion made it impossible to reach closing and caused exclusion of the Uruguayan portion of a regional or global target business to be transferred. While only a couple of financial sector transactions were not achieved over the past 10 years, the number is relevant in a financial market as small as Uruguay’s.
Until April 2020, Uruguay was one of the few exceptions to the antitrust control regimes in place in Latin American countries. Under the system in effect until then, concentration notices by companies to the Uruguayan Antitrust Commission (Comisión de Promoción y Defensa de la Competencia) were only for informative purposes, given that unless the transaction would lead to a ‘de facto monopoly’ (understood as 100 per cent of the relevant market), it did not require authorisation by the Uruguayan Antitrust Commission for perfection.
New Uruguayan regulations (Law 19,833 and Decree 194/020) repealed that regime and moved to a prior control regime that is more generally applied in the region and globally. Parties to transactions that exceed a certain turnover threshold – a combined local turnover over approximately US$65 million in any of the past three fiscal years – must obtain Uruguayan Antitrust Commission approval prior to closing. Local turnover must include the parties’ turnover ‘in Uruguayan territory’, including their parents, controlled and sister companies, also including taxes.
As for time frames, which are vital for M&A transactions subject to obtaining government agency authorisations, the regulations provide that upon a request for authorisation the Uruguayan Antitrust Commission will have 60 days to issue its decision, and it may authorise the transaction, deny it or subject it to fulfilment of certain conditions. Until the Uruguayan Antitrust Commission considers that the parties have fulfilled their duty of filing correct and complete documentation, it can request further documents and clarifications from the parties. Therefore, in practice this means that the 60-calendar-day period can be de facto extended by the Commission.
Non-response by the Uruguayan Antitrust Commission upon lapsing of the said term shall be interpreted as tacit authorisation.
If the parties close the transaction before obtaining regulatory approval, the Uruguayan Antitrust Commission can impose economic penalties for ‘gun-jumping’. In addition, the transaction may be considered an invalid contract from a contract law perspective.
These amendments to Uruguayan regulations became effective as of April 2020 and hence there are still no administrative precedents to inform their enforcement. The Uruguayan Antitrust Commission is currently working on additional merger control guidelines that should provide more clarity around the enforcement of the new regime.
Application of antitrust rules until closing
When the signing and closing of transactions are not simultaneous, the parties are subject to general antitrust rules prohibiting anticompetitive conduct until closing. The scope of pre-closing exchanges of information, coordination and integration activities are relevant to antitrust authorities, especially in the case of merging parties who are competitors, given they may engage in conduct that impacts competition in the market.
During the interim period, it is usual for the parties to agree on performance of certain activities geared to completing the transaction. Along this line, it is commonly accepted in the context of corporate acquisitions for the parties to share information for due diligence purposes and to plan the integration process. Moreover, the parties may prepare to carry out some integration activities in non-competitively sensitive areas, such as systems integration, etc. Such activities and other interim convents to operate the business in ordinary course, will not be considered gun-jumping as long as they do not imply effective control over the target by the buyer.
The parties will be in violation of antitrust rules if, during the interim period, they share competitively sensitive information regarding prices, costs or volumes until closing. They will likewise be in violation if they enter into or otherwise reach price agreements for supply of products, agreements for production or supply of products, or for allocating clients or markets for the production or supply of products. There are no local precedents on this matter.
These behaviours by the parties prior to closing may be in violation of general antitrust prohibitions set forth in Section 2 of Uruguayan Law 18,159, which generally prohibits anticompetitive behaviour, and Section 4 BIS of that law, which prohibits hardcore cartels under a per se standard.
In Uruguay, there are no precedents of antitrust enforcement regarding anti-competitive exchanges of information in the context of M&A transactions. However, in other jurisdictions, including the United States and Brazil, there is frequent enforcement of gun-jumping and similar rules, which, in extreme cases, may delay or even preclude closing of an M&A transaction.
Efforts covenants are typical in cases of deferred closings subject to obtaining approval by third parties, such as authorisation by government agencies in regulated industries and antitrust authorities.
Given that approval depends on a third party alien to the contract, the party seeking the approval agrees to use its ‘best efforts’, ‘commercially reasonable efforts’ or other standard to secure such approval. From a civil law perspective, such clauses involve an obligation of means and not of results, and are likely to be construed to require a higher standard than ordinary diligence. In Uruguayan law, as is the case in other civil law jurisdictions in Latin America, there are no legal provisions or case law that could clarify the scope of this clause and its implications for the party assuming an obligation under same. In common law jurisdictions, like the United States, there is plenty of case law that informs the limits of each of these standards. Such case law has often been used as background to analyse the intended scope of such terms.
Depending on the requirements demanded by the regulatory authorisation process that is the subject of this clause, agreements tend to specify – and it is advisable that they do so – which party will be responsible for filing, the extent of cooperation required by each party, who pays any filing costs, and the consequences or impact on the transaction if the authorisation is not granted or if obtaining the authorisation goes beyond the deadline date set by the parties.
Given that antitrust rules requiring prior clearance by the Antitrust Authority are relatively new in Uruguay, it has not been usual to include ‘hell-or-high-water’ provisions in purchase agreements, requiring that the buyer takes all the risk of a negative antitrust decision in the transaction. The common practice in Uruguay is that the parties agree to make the antitrust filing jointly (as it requires input from both buyer and seller) and agree to use their respective best efforts to obtain the authorisation by diligently responding to information requests from the authority. Perhaps because the merger control regime is so new, it has not been typical that any of the parties commits to unconditionally accepting any material conditions imposed by the Uruguayan Antitrust Authority or by any other authority in order to close the transaction. Rather, if the Uruguayan Antitrust Authority imposes any material conditions, such situation has generally been included in the purchase agreement as one of the cases in which one or both parties (depending on the condition imposed) have the right to walk away from the transaction. The practice in agreements governed by the laws of a common law jurisdiction is very specific and nuanced and has been developed through many years of case law. This may, in the future, inform the drafting of agreements relating to Uruguayan targets. ‘Materiality’ in this case is often left as an undefined concept in the purchase agreement, although it could be possible to negotiate monetary thresholds or other parameters to determine materiality.
Pre-closing covenants are a key element in M&A transactions with deferred closings. They are basically commitments to do something (affirmative covenants) or to refrain from doing something (negative covenants) that, for the most part, fall upon the seller or target, although there are also transactions where the purchaser agrees to pre-closing covenants, such as obtaining approval by government agencies in the case of regulated industries, or securing financing to fund the purchase price and in cases where equity of buyer is being used as consideration or the transaction is structured as a merger of equals.
Covenants typically made by the target are intended to protect the purchaser so that it can acquire the business at closing in conditions substantially similar to those existing when the agreement was signed and that were evaluated by the purchaser in a due diligence process. Negotiation of pre-closing covenants can take significant time and effort, insofar as it is vital for the purchaser to ensure that during this period there will not be material changes in the business, and for the seller to retain as much flexibility as possible in operating its business pre-closing. Also, the condition of the business upon closing may be determinative of purchaser’s liability to obtain financing (see Chapter 12 of this guide on acquisition finance).
These covenants come in many ‘flavours’ and they depend, among other things, on the particularities of the company and the industry in which it belongs to. It is common to include a covenant of the seller requiring it to maintain operation of the business in its ordinary course and in a manner consistent with the target’s past practice until the acquisition takes place or the contract terminates pursuant to the terms of the purchase agreement. Common exceptions to this covenant are the performance of specific actions required to comply with conditions to closing (i.e., termination of agreements with related parties) and actions required by law or judicial or government orders.
In addition to the general obligation to operate the business in the ordinary course, purchase agreements usually include covenants that establish acts that the seller must in all cases refrain from performing during the interim period, except only with the purchaser’s written consent, including, among others, the following:
- discontinue lines of business or other strategic changes at the level of the business plan;
- settle legal actions having a material impact on the business or exceeding a certain monetary threshold;
- Commit Capex;
- incur significant additional indebtedness; and
- increase salaries of personnel beyond legally mandatory adjustments.
Also, it is not uncommon to include a covenant whereby the seller agrees not to solicit, provide information to, or negotiate an alternative sale transaction with a third party other than the buyer (‘no shop’ clause).
Covenants are also negotiated to establish affirmative obligations for the seller. A frequent covenant requires the seller to keep the purchaser informed and to give it access to information allowing it to continue auditing the company and its course of business during the interim period between signing and closing. The scope of such a covenant tends to be heavily negotiated by the seller to prevent such access from interfering in practice in the operation of the business, or potentially from being challenged by a regulator in cases of regulated entities.
Covenants on public announcements are also commonly stipulated in purchase agreements. The parties mutually agree in advance upon the timing and content of any public announcement of the transaction to the financial sector, any authority, employees or the general public. An usual exception is when such announcement is required by applicable laws or regulations, for example, when the transaction has to be communication within certain period to the authorities or the stock exchange.
The closing of a transaction can be simultaneous with signature of the purchase agreement or take place after an agreed period of time, once certain conditions defined by the parties have been met. Both sellers and purchasers are interested in the potential impact that these conditions can have on certainty of the closing.
The conditions for closing a deal depend largely on the particularities of the transaction. Nonetheless, the following clauses establishing the following conditions are usual:
- For the benefit of both parties:
- All authorisations and consents by government authorities and stockholders that were necessary for moving ahead to closing have been obtained.
- There are no legal impediments affecting the parties or precluding their ability to move ahead with closing.
- The representations and warranties the other party made at the date of signing of the agreement remain unchanged at the closing date. This can be achieved subject to a standard of materiality by establishing that the representations and warranties the party made at the time of signature are correct and true in all material aspects (changes of scant relevance do not have an impact). It is usual for the purchaser to require certain fundamental representations to be correct and true in all aspects, such as representations on good standing of the seller and the target, ownership of the transferred interests, and, increasingly, representations on corruption, sanctions and money laundering.
- Compliance with pre-closing covenants by the other party, including deliverables at closing, such as ancillary agreements (transition services agreement, employee matters agreement, tax matters agreement, etc.), certificates of good standing of the parties, evidence of obtaining the consents and approvals of third parties and government authorities, endorsement and delivery of share certificates, resignations of members of the board of directors at the closing date, etc.
- For the benefit of buyers:
- Absence of a material adverse change.
- Key customer consents or landlord consents that are relevant for the operation have been obtained.
- The planned financing was obtained.
- Certain agreements may include specific conditions tied to the specific issues of the business discussed while negotiating price or resulting from findings in due diligence.
Update of disclosure schedules
The seller’s representations and warranties, and the disclosure schedules related to them, are relevant to the scope of the seller’s liability and the indemnity clauses. Non-compliance by the seller of a representation and warranty often triggers the seller’s obligation to indemnify the purchaser per the terms set forth in the agreement.
Representations and warranties are statements of facts made by the seller regarding the seller, the transferred business and the target and usually cover a variety of issues, including relevant corporate aspects such as proper organisation of the entity and ownership of the shares to be transferred, as well as operational matters like those related to workforce, intellectual property, regulatory compliance, tax, financial aspects, etc. The disclosure schedules are key in determining the true scope of the representations and warranties of the seller and a usual element in purchase agreements.
In affirmative disclosures schedules, the seller discloses information that is required in the relevant representation and warranty. For example, often purchase agreements include representations and warranties that require the seller to identify certain information in the disclosure schedules that will inform the scope of the relevant representation and warranty. Examples include:
- lists of stockholders and any subsidiaries;
- employees and employee benefit plans;
- intellectual property that is registered by the target;
- government permits, approvals or authorisations that may be necessary depending on the type of activity, etc;
- insurance policies;
- real properties either owned or leased;
- litigation or legal actions; and
- material contracts.
In turn, what are known as negative disclosures are exceptions or limitations to what is represented by the seller, thus excluding such items from the relevant representations and warranties. For example, a seller can state in the representations and warranties that the target company does not have any contracts with change of control clauses except as established in the corresponding disclosure schedule. The risk assumption with respect of the disclosed matters shifts from seller to buyer.
During the interim period between signing and closing the target company in the transaction will continue its operations, executing new contracts with clients and suppliers, hiring or terminating relationships with employees or contractors, dealing with legal issues that may arise, etc. Considering the foregoing, an aspect that is usually negotiated by the parties is the possibility for the seller to update the disclosure schedules and the effects this may have on closing certainty and post-closing indemnification.
Depending on the case and on the negotiations, there are situations where updating is permitted and others where it is not. In cases where updating of disclosure schedules is permitted, such updates for the most part refer to matters that may occur between signing of the agreement and closing of the deal (to reflect post-signing information). Less common, because they are more resisted by purchasers, are updates whereby the seller discloses facts, issues or events that existed prior to signing and that should have been included by seller in the initial schedules delivered with the agreement.
These are contract areas that can give rise to tension between the parties and their respective interests, and pose a challenge for negotiators to achieve reasonable creative results depending of the circumstances of the transaction.
It is common in purchase agreements to include an obligation of the parties to deliver at closing a bring down certificate under which they represent and warrant that all the representations and warranties made in the purchase agreement are true and correct as of closing, and such bring-down of the representations is usually a closing condition. Parties often discuss whether seller is allowed to update the disclosure schedules prior to closing and how such updates may impact buyer’s right to walk away from closing or to claim indemnity after closing. To prevent minor or insignificant inaccuracies of the representations and warranties to prevent closing, the seller may try to include a materiality standard so that only material changes allow for the termination of the purchase agreement. In the event of any breach or inaccuracy below such standard, closing will occur, and the buyer may have an indemnity claim against the seller for a breach of the representations and warranties. When updates to the disclosure schedule are allowed and the seller discloses a change and the buyer chooses to proceed with closing anyway, it is usually agreed that such disclosure will not limit the seller’s liability with respect to the representations and warranties made at signing, although the parties can negotiate a specific solution for such situation at closing.
When there is a period of time between the signing of the purchase agreement and the closing of the transaction, the parties have to agree on the situations that shall give rise to the termination of the agreement. If any of those situations occur and one of the parties exercises its termination right, closing will naturally not take place.
The most used termination triggers in purchase agreements are the receipt of a notice sent by the authorities enjoining or otherwise prohibiting the transaction. Sometimes, the occurrence of a material adverse effect or the breach by any of the parties of their material obligations under the purchase agreement (often including a cure period for such breaches) is also an automatic termination event. Some of these conditions may be waived by a party. Sometimes specific obligations of the purchase agreement are listed so that only the breach of such obligations are grounds for termination.
It is also frequent to include that the purchase agreement can be terminated if closing does not take place before a certain date (often referred to as the ‘outside date’ or the ‘drop-dead date’). However, this right to terminate is typically drafted such that it is not available to the party whose failure to fulfil its obligations or the conditions has been the cause of the failure of the closing to occur.
Breakup or termination fees can be agreed upon in the purchase agreement in connection with lack of regulatory approvals or financing commitments. That practice is fairly typical in New York law governed agreements and in other jurisdictions in Latin America, especially where antitrust enforcement has a strong history, but are not typically included in Uruguay.