Tag: Covenants

Lazard v. Qinetiq: Important Lessons for Structuring Earn-Outs

David W. Healy and Douglas N. Cogen are partners and co-chairs of the Mergers & Acquisitions Group at Fenwick & West LLP. The following post is based on a Fenwick publication by Mr. Healy and Mr. Cogen. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

A recent Delaware Supreme Court case authored by Chief Justice Strine upholds the literal meaning of an earn-out provision that limited the buyer from taking action “intended to reduce or limit an earn-out payment.” The court rejected the argument that buyer’s actions, which it likely knew would reduce the likelihood of an earn-out payment, met the intent-based standard the parties had agreed on in lieu of various affirmative post-closing covenants that had been rejected by the buyer. The court also rejected the seller’s argument that it could rely on the implied covenant of good faith and fair dealing to impose an objective standard and thereby avoid the burden to prove that the buyer intentionally violated such provision. The case has implications for buyers’ and seller’s negotiating strategies around post-closing operations covenants related to earn-outs and as to the impact of such covenants on the interpretation of the implied covenant of good faith and fair dealing. The case is Lazard Technology Partners, LLC, v. Qinetiq North America Operations LLC, April 23, 2015, Strine, L., 2015 WL 1880153, and it can be found at http://business.cch.com/srd/LazardTechnology-v-Qinetiq.pdf.


State Contract Law and Debt Contracts

The following post comes to us from Colleen Honigsberg and Sharon Katz, both of the Accounting Division at Columbia Business School, and Gil Sadka of the Department of Accounting at the University of Texas at Dallas.

In our recent JLE paper, State Contract Law and Debt Contracts, we examine the association between state contract law and debt contracts. A recent stream of papers in finance and economics studies the role debt contracts play in mitigating agency problems between equity and debt holders (for example, Baird and Rasmussen, 2006; Chava and Roberts, 2008; Roberts and Sufi, 2009; Nini, Smith, and Sufi, 2009). This area of literature examines both the contract terms and the implications of covenant violations. While these studies generally treat contract law as a uniform product across states and assume that all contracts are enforced in a similar fashion, in practice lenders and borrowers select the state law that will govern the contract. Because the legal rights of both parties vary depending on the law chosen, the state contract law may be associated with enforcement. To examine this relationship, we first categorize each state’s contract law by whether it is favorable or unfavorable to lenders, and then we examine the characteristics of the contracts and the relevant parties across states. Lastly, we test whether the contract terms, frequency of covenant violations, and repercussions of covenant violations are related to the state contract law.


Does Corporate Governance Make Financial Reports Better or Just Better for Equity Investors?

The following post comes to us from Shai Levi of the Department of Accounting at Tel Aviv University, Benjamin Segal of the Department of Accounting at Fordham University and The Hebrew University, and Dan Segal of the Interdisciplinary Center (IDC) Herzliyah and Singapore Management University. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

Financial reports should provide useful information to both shareholders and creditors, according to U.S. accounting principles. However, directors of corporations have fiduciary duties only toward equity holders, and those fiduciary duties normally do not extend to the interests of creditors. In our paper, Does Corporate Governance Make Financial Reports Better or Just Better for Equity Investors?, which was recently made publicly available on SSRN, we examine whether this slant in corporate governance biases financial reports in favor of equity investors. We show that the likelihood that firms will manipulate their reporting to circumvent debt covenants is higher when directors owe fiduciary duties only to equity holders, rather than when they owe fiduciary duties also to creditors. Covenants limit the amount of new debt that the firm issues, for example, and by that reduce bankruptcy risk, and allow creditors to avoid bankruptcy costs, and to recover more from the borrowing firm in case it approaches insolvency. When managers manipulate financial reports to circumvent these debt covenants, they transfer wealth from creditors to shareholders. Our results suggest that when corporate governance is designed to protect only equity holders, firms’ financial reports serve equity holders’ interests at the expense of other stakeholders. We find that when the legal regime requires directors to consider creditors’ interests, firms are less likely to use structured transactions designed to skirt debt covenant limits, particularly if the board of directors of the firm is independent.


Non-Compete Provisions in CEO Contracts

The following post comes to us from Michael S. Katzke, a founding partner of Katzke & Morgenbesser LLP, and is based on a Katzke & Morgenbesser publication by Mr. Katzke and Henry I. Morgenbesser.

In negotiating the terms of a CEO employment arrangement, arguably the most important term for the board of directors of the employer is the non-competition (or non-compete) provision. A recent study by three business and law school professors (Bishara, N., Martin, K, and Thomas, R., When Do CEOs Have Covenants Not to Compete in Their Employment Contracts? (October 18, 2012) Ross School of Business) has found that, in spite of concerns by commentators that CEOs often have bargaining leverage over employers, there has been a significant upward trend over time in the use of non-compete provisions in new and restated CEO contracts. The study found usage of non-competes peaked in 2008 (89%) and in 2010 was at approximately 79%, up from 60-65% in the early 1990s.


Exit Consents in Restructurings – Still a Viable Option?

The following post comes to us from David J. Billington, partner focusing on international financing transactions and restructuring transactions at Cleary Gottlieb Steen & Hamilton LLP. This post is based on a Cleary Gottlieb memorandum; the full text, including footnotes and appendices, is available here.

Exit consents are often used as a restructuring tool by issuers of bonds. Issuers invite bondholders to exchange their existing bonds for new bonds (usually with a lower principal amount). In order to participate in the exchange, bondholders must agree to vote in favour of a resolution that amends the terms of the existing bonds so as to negatively affect (or, in Assénagon, [1] substantially destroy) their value. This is referred to as ‘covenant-stripping’. If the issuer does not achieve the majority needed to pass the resolution, the covenant-strip and the exchange do not happen. But if the resolution is passed, each participating holder’s bonds are exchanged for the new bonds, and the terms of the old bonds are amended to remove most of the protective covenants. This incentivises bondholders to participate in the exchange: accepting the new bonds (even though they will usually have a lower face amount than the existing bonds) may be preferable to being ‘left behind’ in the old bonds, which will cease to have any meaningful covenant protection.

Facts of the case

Anglo Irish Bank Corporation Limited (the “Bank”) suffered severe financial difficulties as a result of the financial crisis, and was nationalised in January 2009. As part of its restructuring, the Bank proposed an exchange offer whereby:


CEO Employment Contracts and Non-compete Covenants

Randall S. Thomas is a John Beasley II Professor of Law and Business at Vanderbilt Law School.

In our recent working paper, When Do CEOs Have Covenants Not to Compete in Their Employment Contracts?, we undertake the first comprehensive study of contractual restrictions on CEOs’ post-employment competitive activities. The large random sample of nearly 1,000 CEO employment contracts for 500 companies was selected from the S&P 1500 from the 1990s through 2010. We find that about 70% of CEO contracts have post-employment competitive restrictions. We also find more covenants not to compete (CNCs or noncompetes) in longer-term employment contracts and at profitable firms. In addition, our study uses a nuanced state-by-state CNC strength of enforcement index to test the variance of CEO noncompetes across jurisdictions.


Accounting Standards and Debt Covenants

The following post comes to us from Peter Demerjian of the Goizueta Business School at Emory University.

In the paper, Accounting Standards and Debt Covenants: Has the “Balance Sheet Approach” Led to a Decline in the Use of Balance Sheet Covenants?, forthcoming in the Journal of Accounting and Economics as published by Elsevier, I examine whether the “balance sheet approach” has led to a decline in the use of balance sheet covenants. Debt contracts, and especially private loan agreements, frequently include accounting-based debt covenants. Many of these covenants require the borrower to maintain a threshold level of some financial ratio or measure. A broad range of financial measures are employed in these financial covenants. Some are written on earnings from the income statement; the borrower may be required to maintain a minimum level of earnings relative to their interest expense (interest coverage) or their total debt (debt-to-earnings). Similarly, covenants are also written on values from the balance sheet; these include covenants requiring a minimum level for the book value of equity (net worth) or a maximum amount of debt in the capital structure (leverage). If the borrower fails to maintain a covenant threshold, the debt enters technical default. In technical default, the creditor has the option to attempt action against the borrower; a common consequence is renegotiation with stricter contract terms.


Capital versus Performance Covenants in Debt Contracts

The following post comes to us from Hans Christensen and Valeri Nikolaev, both of the Department of Accounting at the University of Chicago.

In the paper, Capital versus Performance Covenants in Debt Contracts, which was recently made publicly available on SSRN, we propose a simple classification of financial covenants into two distinct groups: performance covenants and capital covenants. Performance covenants rely on measures of profitability and efficiency whereas capital covenants rely on information about sources and uses of capital, i.e., balance sheet information. We argue that capital covenants align incentives between borrowers and lenders by limiting the amount of debt in the borrower’s capital structure. In contrast, performance covenants act as tripwires that transfer control to lenders when performance deteriorates and hence incentive conflicts between shareholders and lenders become more acute.