Once you have negotiated the terms of the deal and signed the definitive agreement, all eyes turn toward closing. However, certainty of closing is established in the definitive agreement, and it is prudent to minimize the impact that events following execution of the agreement may have on closing. After all, a buyer might find a better deal from another seller; a seller may be able to get a better price from another buyer. A purchase agreement should be negotiated with closing conditions (and corresponding termination rights) that balance certainty of closing with the need for an out if fundamental aspects of the deal deteriorate.
Bringing Down the Representations from Signing to Closing
The buyer can ensure that the fundamental aspects of the signed deal remain unchanged by requiring the seller to deliver a certificate bringing down to the closing the representations the seller made at signing. Understandably, the seller does not want the buyer to walk away simply because a representation may not be true and correct in some immaterial respect. There generally are two methods for the seller to limit the buyer’s ability to walk.
First, the bring-down can be made subject to a materiality standard (i.e., the representations must be true and correct in all material respects at closing) or even a “material adverse effect” (MAE) standard (i.e., the representations are true and correct except where the failure to be true and correct would not have a MAE). The buyer may view this type of qualification as problematic because it will lead to a double materiality qualification of some representations, but can balance this either by requiring that materiality be read out of the representations for purposes of the bring-down or by requiring that representations already qualified by materiality be true and correct in all respects. The buyer may wish to carve out certain fundamental representations and require that they be true and correct in all respects.
Second, the bring-down can be limited by requiring that representations that specify a date need only be true as of that date (i.e., they are not brought down). The savvy seller will qualify a number of representations as of the purchase agreement date. Doing so ensures the representations will always be tied to the purchase agreement date and not be brought down at closing. The knowledgeable buyer will identify these qualifications and revise them to be “as of the date hereof,” in which case the representations will be brought down since the “date hereof” will be translated to the date of the certificate the seller delivers.
Performance of Covenants
Setting a performance standard for pre-closing covenants is another way the parties can negotiate the tension between certainty of closing and the ability to walk. Typically, a closing condition based on the performance of pre-closing covenants is subject to a materiality qualification. However, a sophisticated party may require that critical covenants be performed in all respects before the closing. An example of this is a covenant requiring that letters of credit related to purchase orders be backed up or replaced prior to the closing. The decision as to which pre-closing covenants are critical depends on the deal, but the parties should be aware of the performance of these covenants as they negotiate closing conditions.
Updating Disclosure Schedules
A pre-closing covenant that is often heavily negotiated is the seller’s ability to update the disclosure schedules prior to closing and the impact those updates have on termination and indemnification rights. Not insignificantly, disclosure schedule updates can affect the bring-down of representations at closing. Of course, a distinction exists between schedule updates that correct representations made at signing and those that simply add disclosures related to matters that arose between signing and closing. The seller will prefer that updates be related to both and that the buyer be precluded from bringing indemnification claims after inaccuracies in the representations are cured or terminating the agreement. The buyer, on the other hand, will want updates to only address matters occurring between signing and closing and will not want updates to affect indemnification or termination rights. There are many ways to resolve this tension, and the parties must be willing to be creative to arrive at an outcome that is fair under the circumstances.
Line Item Outs
The parties can negotiate for specific outs, but these often will be resisted. For example, the buyer may seek to have due diligence, board approval or financing outs. A due diligence out allows the buyer to walk if something arises in due diligence after the deal is signed. If the buyer enters into a purchase agreement but still requires board approval for the deal, it may then seek an out if the board does not approve the transaction. A financing out allows the buyer to walk away if financing does not come through. From the seller’s perspective, due diligence and board outs should be avoided at all costs since they essentially create an option contract for the buyer. Incorporating a financing out is more common, especially with private equity buyers, but usually introduces the concept of a reverse breakup fee in the event the buyer cannot satisfy the financing contingency under certain circumstances. These are just a few examples of line item outs. The parties must be aware of the effect they can have on certainty of closing because they may position a party with significant leverage when it comes time for closing.
Third Party Hold-Ups
Closing conditions may also contemplate third party deliverables, giving a third party the power to block the closing. These may be essential to the deal, such as government approvals, key customer consents or landlord consents, in which case the parties may have to live with uncertainty. However, in some cases, a third party’s ability to hold up a deal can be mitigated, thereby enhancing certainty of closing. For example, employment, noncompetition and consulting agreements may all be delivered in connection with the signing of the purchase agreement, yet only be effective upon closing.
In this uncertain market, both buyers and sellers are increasingly interested in the potential impact that closing conditions can have on the closing of their transaction. Negotiating appropriate closing conditions and termination rights can enhance certainty of closing while preserving the ability to walk away under appropriate circumstances.