Freshfields Discusses Compliance with Interim Operating Covenants in Signed M&A Deals

Against the backdrop of unexpected developments arising from the COVID-19 pandemic, parties with signed, but not yet closed, M&A transactions are taking a closer look at potential openings for claims of breaches and failures of closing conditions.  It seems the initial instinct has been to look for a “material adverse effect” (“MAE”), but given that most MAE definitions exclude effects resulting from macro- and industry-wide developments, as well as changes in law, that do not disproportionately impact the target company, those looking to rely on pandemic-induced MAEs may have their work cut out for them.

We suspect that the area where there will be more good faith disputes in pending transactions, and the greatest need for creativity in negotiations of not-yet-signed agreements, will be in the interim or “ordinary course” operating covenants.  Compliance with these provisions is typically brought down in the closing conditions subject to a mere “in all material respects” standard, which does not carry with it any of the carve-outs that are typically seen in the definition of MAE and which render the MAE clause immune from most pandemic issues.

There are qualifiers, however, often built into interim operating covenants and the details of how these qualifiers work is where the action will lie.  For example, an “except as required by law” qualification, should provide a target with a pass for closing down many operations in jurisdictions where non-essential workers are required to stay home.  An exception for “consents (not to be unreasonably withheld)” should provide a pass for actions that are intended to accomplish the objective of these covenants—preserving the target company’s business and the ability of the buyer to consummate the transaction—although there can be tensions between these objectives.  For example, a large drawdown on a line of credit by a target may help preserve the business, but it may also impede or frustrate the buyer’s acquisition financing plans.

The Delaware Court of Chancery explained in Cooper Tire & Rubber v. Apollo that there may be a further avenue that provides the target with potentially quite a bit of leeway for deviating from the ordinary course covenants.

That dispute arose out of agreement by Apollo (Mauritius) Holdings Pvt. Ltd. (“Apollo”) to acquire Cooper Tire & Rubber Company (“Cooper Tire”). In direct response to the merger announcement, a labor union at Cooper Tire’s Chinese facility, CCT, publicly opposed the merger for being too highly leveraged, and subsequently went on strike.  The strike caused the shut-down of the facility and, in response, Cooper Tire decided to suspend payments to suppliers who continued to ship supplies while the strike was ongoing.

Apollo alleged, among other things, that Cooper Tire failed to satisfy its conditions to closing by breaching the interim operating covenant. Specifically, Apollo claimed that the strike at CCT and Cooper Tire’s response resulted in a breach of Cooper Tire’s obligation to operate its and its subsidiaries’ businesses in the ordinary course consistent with past practice after signing and to use its commercially reasonable efforts to preserve intact its business organization and maintain existing relations and goodwill with suppliers.

In response, Cooper Tire argued that:

  • the definition of “Material Adverse Effect” explicitly carved out any negative effect of the announcement or pendency of the merger (including the strike and its consequences, which all arose in response to the announcement of the merger); and
  • the inclusion of the words “except as … otherwise expressly contemplated by [the Merger Agreement]” in the lead-in to the interim operating covenants qualified each of those covenants by the express carveouts in the MAE definition.

In other words, Cooper Tire claimed that it would be illogical for Apollo to be unable to abandon the merger by claiming the strike had resulted in an MAE, but to have the very same set of facts allow Apollo to avoid closing due to a breach of the interim operating covenants.

Despite Cooper Tire’s arguments, Vice Chancellor Glasscock held that Cooper Tire had not satisfied the conditions to closing as a result of the situation at CCT.  In rejecting Cooper Tire’s arguments, Vice Chancellor Glasscock noted there were two separate clauses in the MAE definition:

  • the first clause covered any material adverse effect on the business, results of operations or financial condition of Cooper Tire, its subsidiaries and its joint ventures, all qualified by express carveouts, including any negative reaction to the announcement of the merger; and
  • the second clause covered any event that would reasonably be expected to prevent or materially delay or impair the ability of Cooper Tire to perform its obligations and close, without any qualifications or carveouts.

The Court observed that even if the strike was carved out of the first clause, it was not carved out of the second, unqualified clause of the MAE definition, which addressed the ability of Cooper Tire to perform its obligations, including those in the interim operating covenants.  Thus, the MAE definition did not include any language that contemplated non-performance of the interim operating covenants as a result of an adverse reaction to the announcement of the merger, such as the strike.

The Court went on to find that Cooper Tire did not operate in the ordinary course as a result of the strike and therefore held that Cooper Tire failed to perform its covenants in all material respects and the conditions to Apollo’s obligation to close in the merger agreement were not satisfied.  Apollo was relieved of its obligation to close and Cooper Tire was not entitled to any reverse termination fee.

The negative implication of the Cooper Tire decision is that, if the second part of the MAE definition (about materially impeding the ability of the seller to perform its obligations) was qualified by carve-outs that had picked up the strike (as the first part of the MAE definition did), then Cooper Tire could have relied on the “except as otherwise contemplated by this Agreement” qualification to the interim operating covenants to pull in these carve-outs to apply to the requirements to operate in the ordinary course.

Thus, Cooper Tire provides some useful insight into how courts may review alleged breaches of interim operating covenants and their potential interplay with the definition of MAE. Parties need to pay careful attention to the “except as otherwise contemplated by this Agreement” lead-in and consider what provisions are being pulled in.  Since Cooper Tire, it has become more common to qualify the “no material delay or impediment” part of the MAE definition by the same carve-outs that apply to the first part of the MAE definition (about adverse effects on the business).  It is advisable for parties to consider legislating more carefully in their agreements to what extent the definitional nuances of MAE are intended to qualify the interim operating covenants.

The primary issues in this “hot button” area of M&A agreements going forward will be:

  • The Cooper Tire Approach. To what extent do provisions in the MAE definition qualify the obligations under the interim operating covenants as a result of the “except as otherwise expressly contemplated by this Agreement” lead-in language.
  • Incorporation of Force Majeure Concepts. To what extent are force majeure style exceptions built into the interim operating covenants.  Parties should start considering provisions beyond “except as required by law.”  What about “except as deemed advisable in good faith in response to pandemic measures to preserve the business”?
  • More Precision to the Reasonableness of Withholding Consent and to Exceptions to the Covenants. Parties will need to consider drafting with greater specificity in their agreements as to when it is, and is not, reasonable for a buyer to withhold its consent to the target taking action (or failing to take action) that would otherwise constitute a breach of the interim covenants and what types of circumstances triggered by our “new normal” need to be spelled out in the exceptions in the disclosure schedules and in the covenants themselves.

Interim operating covenants may just be the most important provisions in pending and future M&A agreements as our world changes and the need for enhanced attention and innovation appears justified.

This post comes to us from Freshfields Bruckhaus Deringer LLP. It is based on the firm’s memorandum, “Why Parties Now Need to Focus on Interim Operating Covenants and How to Do So,” dated April 12, 2020, and available here.