Pre-closing covenants: balancing buyer protection with antitrust risk

published on 18 April 2024 | reading time approx. 4 minutes

Pre-closing covenants are clauses commonly found in share purchase agreements (SPA). They serve to protect the purchaser by maintaining the status quo of the target company during the period between signing and closing. However, they may conflict with the stand-still obligation under merger control law as well as the cartel prohibition. In practice, pre-closing covenants are frequently drafted too broadly. A recent judgement by the ECJ against an acquirer shows that significant fines can be imposed. This article explains what needs to be taken into account when drafting pre-closing covenants from an antitrust law perspective.

Relevance of pre-closing covenants

During the period between signing and closing, the condition of the target company may deteriorate, which could negatively impact the acquirer. Pre-closing Covenants are used by the purchaser of a company to prevent any actions that could reduce the value of the target company or damage its commercial integrity until closing of a transaction. To achieve this, they often require the seller to run the target business in an orderly manner within the scope of ordinary or past business practice. Additionally, the acquirer may hold veto rights or reservations of consent for specific measures of the target company.

Standstill obligation and cartel prohibition

Such clauses may conflict with provisions of antitrust law that are subject to fines and which must (also) be considered in the period between signing and closing:

First, for transactions subject to merger control, it is mandatory to observe the merger control standstill obligation (e.g., Art. 7 EU Merger Regulation). Mergers must only be implemented after receiving approval from the relevant antitrust authorities. According to case law, the standstill obligation may also cover partial and de facto implementation measures. Actions taken by the parties involved in a concentration that result in a permanent change in control over the target company may satisfy the requirements for implementation under merger control law. This may also be triggered by pre-closing covenants.

Second, the cartel prohibition applies (e.g., Art. 101 TFEU). If the parties to a concentration are (potential) competitors, they must not coordinate their competitive behaviour until the time of closing. This includes the (unfiltered) exchange of competitively sensitive information.

ECJ: too far-reaching pre-closing covenants violate standstill obligation

The European Court of Justice (ECJ) recently made a decision regarding pre-closing covenants (9 November 2023, C-746/21, Altice). The EU Commission had fined the acquirer in a transaction (the telecommunications company Altice) over EUR 100 million for violating the standstill obligation. The violation was caused by certain pre-closing covenants in the SPA and pre-closing integration planning measures.

The ECJ essentially confirmed the decision: pre-closing covenants may be allowed as an ancillary agreement to a company purchase agreement, especially to preserve the value of the target company. However, according to the ECJ, the extensive reservations of consent and information rights in the SPA in favour of Altice exceeded what was necessary to preserve the value of the target company. They gave Altice, as the acquirer, the possibility to exercise decisive influence over the target company. It was not demonstrated that these rights were necessary to preserve the value of the target company.

The ECJ deemed certain provisions in the SPA as critical, including:

a) catalogue of contracts and matters requiring prior approval by the acquirer, which

is far-reaching and covers a wide range of topics,
also covers matters within the ordinary course of business and
contains financial thresholds that are set too low;

b) reservation of consent for the appointment and dismissal of executives;

c) reservation of consent for changes to the pricing policy and terms and conditions vis-à-vis customers.

According to the ECJ, the application of the pre-closing covenants was not required to establish a violation. The agreement of such pre-closing covenants in the SPA alone constitutes an implementation and therefore a violation of the standstill obligation.

The ECJ also decided that exchanging competitively sensitive information excessively between the acquirer and the target company after signing contributed to the unlawful implementation of the transaction.

Consequences for M&A practice

Pre-closing covenants, including catalogues of matters requiring approval between signing and closing, are still permissible. However, the parties must demonstrate that such provisions are necessary to preserve the value of the target company. The criterion often applied in practice, whether a measure is part of the ordinary course of business or not, is only a good (although not decisive) indication of whether a measure is likely to significantly impact the value of the target company.

As a general rule, pre-closing covenants that pertain to interventions in day-to-day business, to measures from the ordinary course of business, or to the filling of management positions are likely to be particularly critical. It is also advisable to be cautious with veto rights regarding the business plan and financial planning. After the ECJ ruling, parties should pay particular attention to the financial thresholds for measures of the target company that require approval from the acquirer. These thresholds are often set too low in practice. The figures must be set high enough so that the respective measure would have a significant impact on the value of the target company. Unfortunately, case law only offers limited guid-ance on the quantitative criteria that can be used to determine appropriate thresholds. Here, the parties have to manage a difficult balancing act between the legitimate protection of the acquirer and the limits and risks under antitrust law.

Conclusion

The ECJ's Altice decision makes it clear that the antitrust authorities and courts interpret the standstill obligation in a broad way. This also pertains to the acquirer exerting influence on the target company during the period between signing and closing, especially with regards to pre-closing covenants and integration planning. When drafting a company purchase agreement, the parties should observe the limits of antitrust law and avoid including overly far-reaching reservations of consent, veto, and information rights of the acquirer. Precautions should be taken to prevent excessive sharing of information during integration planning. It is necessary to increase the awareness of the employees involved accordingly.