Covid-19 and ‘ordinary course’ covenants in M&A transactions
Covid-19 and ‘ordinary course’ covenants in M&A transactions
There is almost always an interval between parties signing a deal and closing it in M&A transactions. This can happen for different reasons. For example, it may be necessary to obtain board or third party approvals, or secure financing, before the deal can be closed. Another common reason for a delay between the signing and closing of an M&A transaction is the requirement of regulatory approval. During this interim period between signing and closing the buyer faces the problem that the company is still controlled by the seller and the possibility that the company’s condition will deteriorate prior to completion.
This is why M&A agreements generally contain provisions regulating how the seller conducts company business between signing and closing (in addition to provisions on purchase price adjustment, closing warranties and so-called MAC clauses). To the extent permitted under competition law and observing the no gun-jumping principle, an operating covenant sets out how the seller is to operate the company in the ordinary course of business and defines measures which require the prior consent of the buyer.
I. Impacts on agreements already entered into
In light of Covid-19, buyers now face the additional problem that pandemic-specific measures may have to be taken prior to closing in order to protect the target company against the consequences of the virus. These measures can include, for instance, the replacement of a supplier, a capital injection, an application for short-time allowances or staff cuts. In the absence of an explicit agreement making these measures subject to prior approval, do they constitute the ordinary course of business? Is it necessary to interpret the ordinary course of business concept ‘dynamically’ to the extent that, in an unprecedented global crisis, unusual measures are necessary to ensure business continuity in the ordinary course of business?
To answer this question it is necessary to interpret the ordinary course covenant in the M&A agreement. The main criterion under generally accepted rules of interpretation is the parties’ intention. However, it will be difficult in practice to ascertain the parties’ exact understanding of the term ‘ordinary course of business’ at the time when the M&A agreement was signed. Most M&A agreements contain standard clauses and the term ‘ordinary course of business’ usually plays a subordinate role in the transaction negotiation process. As a result, there will be few or no e-mails, telephone calls etc. which can be used as the basis for interpretation.
Since there is also no relevant case law on the issue of what exactly constitutes ‘ordinary course of business’ and the competition authorities have not yet issued a statement on the extent to which measures in response to the Covid-19 pandemic constitute ‘ordinary course of business’, the only option is to base the interpretation on comments and materials pertaining to other provisions of German law which use the term ‘ordinary course of business’, albeit in a different context.
The government’s explanatory memorandum on the new § 111a, Par. 2 of the German Stock Corporation Act [Aktiengesetz] AktG includes a number of points of reference which could be used to define the term. For example, it states that transactions are not transactions with related parties if they are entered into in the ordinary course of business at arm’s length market terms. The government’s explanatory memorandum additionally states that the ordinary course of business constitutes ‘typical, repetitive and everyday business transactions’. Therefore, it comprises business activities which are commonly undertaken by the company in terms of content, scope and frequency, as well as usual terms and conditions.
Opinions in literature pertaining to § 52, Par. 9 AktG, according to which the regulations on post-formation agreements do not apply if the assets are purchased in the normal course of the company’s business, provide another point of reference. In this case the definition depends on the company’s business purpose. The general precept is that ordinary course of business is not defined in terms of an objective general benchmark but in accordance with the company’s individual circumstances. Accordingly, the acquisition of properties would constitute the ordinary course of business for a real estate company, but not for a manufacturing enterprise.
This rules out any dynamic interpretation of the ‘ordinary course of business’.
The following therefore applies to agreements already entered into:
- Measures which were ordinary for the company before the Covid-19 outbreak, such as the replacement of suppliers due to supply chain problems, will continue to be deemed as having been implemented in the ordinary course of business and not require the buyer’s consent, unless explicitly otherwise agreed.
- Measures which were not ordinary for the company before the Covid-19 outbreak are still not classified as the ordinary course of business and are subject to the buyer’s consent. This will presumably apply to the majority of typical Covid-19 response measures, such as taking out loans, staff cuts, applications for short-time allowances etc. The rule of thumb is that measures which were already included in the list of extraordinary transactions subject to approval before the Covid-19 outbreak must still be deemed to be outside of the ordinary course of business.
Sellers face the potential dilemma of being forced to take measures which breach the operating covenant to ensure the company’s business continuity, with the result of the buyer claiming damages or terminating the agreement.
We therefore recommend sellers who have already signed M&A agreements to contact the buyer as soon as possible and discuss any planned measures. The buyer will generally approve measures that are necessary to protect the company because the survival of the company is obviously in the buyer’s interests.
II. Impacts on contract drafting
When drafting contracts it is important from the seller’s perspective to ensure that the operating covenant provides sufficient scope for action. All measures which are necessary during the Covid-19 pandemic should be exempted from buyer approval. To avoid misunderstandings, the covenant should also include provisions ensuring approval exemption for specific measures that are subject to approval. There are two possible options in this respect. The covenant can either state that all measures in response to the Covid-19 pandemic are part of the ordinary course of business or include a general exemption from the approval requirement for such measures.
On the other side of the coin, a buyer who accepts approval exemptions should aim to agree a definitive catalogue of measures, possibly with specific thresholds, for Covid-19. This would require the parties discussing specific measures which may be necessary in connection with Covid-19 before the agreement is signed. This was difficult at the beginning of the outbreak, but the longer the Covid-19 crisis lasts, and when the end hopefully comes into sight soon, the easier it will become. The buyer should also obtain an undertaking from the seller to provide comprehensive information in connection with the measures taken by the company in response to the Covid-19 pandemic, even in cases when buyer approval is not necessary.
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