What are interim operating covenants in M&A?

Interim operating covenants are contractual obligations in the purchase agreement that govern how the target company operates between signing and closing. They typically require the seller to operate in the ordinary course of business, maintain existing contracts and relationships, preserve the workforce, and refrain from taking material actions without buyer consent. These covenants protect the buyer from receiving a fundamentally different business than the one it agreed to acquire.

What triggers a material adverse change clause?

A material adverse change (MAC) clause is triggered by events that substantially threaten the long-term earning power of the target company. Delaware courts have interpreted this standard narrowly, requiring deterioration that is durationally significant and measured in years rather than months. Standard MAC exceptions for industry-wide conditions, economic downturns, and changes in law further limit the clause's applicability. As a practical matter, MAC claims are difficult to prove and rarely succeed.

How should buyers monitor covenant compliance between signing and closing?

Buyers should establish a systematic compliance tracking process that includes regular reporting from the target, a consent request workflow with defined response timelines, and a centralized log of all material actions taken by the target. Tracking obligations from the purchase agreement alongside ongoing contract provisions identified during diligence ensures nothing falls through the cracks during the interim period.

What happens if the seller breaches an interim covenant before closing?

A seller's breach of an interim covenant gives the buyer several potential remedies depending on the purchase agreement terms. The buyer may have the right to terminate the agreement if the breach is material and uncured. More commonly, the buyer uses the breach as leverage to negotiate a purchase price adjustment, enhanced indemnification, or modified closing conditions. The practical outcome depends on how material the breach is and how motivated both parties are to close.

Signing to Closing: Interim Covenants and Compliance Monitoring in M&A

Signing to closing in M&A is the interim period between executing the purchase agreement and consummating the transaction. It is the most structurally vulnerable phase of any deal: the buyer has committed capital and resources, but does not yet control the target business. Interim operating covenants are the primary mechanism for managing that vulnerability, and monitoring compliance with those covenants is where many deal teams fall short.

Why the Interim Period Matters

Between signing and closing, the target company continues to operate. Employees come and go. Contracts renew or expire. Capital gets spent. Customers make decisions. The business the buyer agreed to acquire on signing day is changing every day until closing.

Interim operating covenants exist to control the rate and nature of that change. They draw a boundary around what the seller can do without asking permission, and they establish a consent mechanism for everything outside that boundary.

The challenge is practical, not conceptual. Most deal attorneys understand what covenants do. The difficulty is tracking compliance across dozens of specific obligations while simultaneously managing regulatory approvals, third-party consents, and closing deliverables.

Anatomy of Interim Operating Covenants

A well-drafted interim covenant section addresses several categories of seller conduct.

Ordinary Course of Business

The foundational covenant requires the target to operate in the ordinary course of business consistent with past practice. This standard is intentionally broad, covering everything from vendor payments to hiring decisions to capital expenditures.

The "consistent with past practice" qualifier matters. A target that historically made annual capital expenditures of $5 million cannot suddenly commit to a $20 million equipment purchase and claim it is ordinary course. The standard is calibrated to the target's historical operations, not the industry generally.

Specific Negative Covenants

Beyond the ordinary course requirement, purchase agreements typically include specific restrictions on material actions:

No amendments to organizational documents without buyer consent
No issuance of equity or changes to capitalization
No material contracts entered into, amended, or terminated outside ordinary course
No disposition of material assets outside normal inventory sales
No changes to compensation above specified thresholds
No settlement of litigation above specified amounts
No changes to accounting methods or tax elections
No incurrence of material debt outside existing credit facilities

Each restriction should include a materiality qualifier or dollar threshold to prevent the covenant from paralyzing normal business operations. A covenant that requires buyer consent for any contract amendment, regardless of value, will generate constant consent requests and slow the business unnecessarily.

Affirmative Covenants

The purchase agreement also imposes affirmative obligations on the seller:

Maintain insurance coverage at current levels
Preserve business relationships with customers, suppliers, and employees
File tax returns on time and in the ordinary course
Provide the buyer with access to the business, properties, and records
Notify the buyer promptly of any material developments

These affirmative covenants create ongoing monitoring obligations for both parties.

Material Adverse Change: The Nuclear Option

MAC clauses provide the buyer with a termination right if the target experiences a material adverse change between signing and closing. In theory, this protects the buyer from being forced to close on a fundamentally different business than the one it agreed to acquire.

In practice, MAC clauses are rarely invoked successfully. Delaware courts have set a high bar, requiring the adverse change to be durationally significant and substantial enough to threaten the target's long-term earning power. Standard MAC exceptions for industry-wide conditions, general economic downturns, changes in law, and the effects of the transaction itself further narrow the clause.

The practical lesson is that MAC clauses are a backstop, not a primary risk management tool. Covenant compliance monitoring is far more effective at protecting the buyer during the interim period. A buyer that discovers a covenant breach in real time can address it before it becomes material. A buyer that relies solely on the MAC clause is waiting for damage to accumulate.

Building a Compliance Monitoring System

Effective compliance monitoring requires structure. The deal team needs a system that tracks every obligation, assigns responsibility, and surfaces issues before they become problems.

Extract and Catalog Every Obligation

Start by extracting every interim covenant obligation from the purchase agreement. Catalog each obligation with its scope, any materiality thresholds or dollar limits, the party responsible for compliance, and any notice or consent requirements.

This is where structured extraction tools add significant value. Rather than manually reading through covenant provisions and building a tracking spreadsheet from scratch, deal teams can extract structured obligations directly from the purchase agreement.

Establish a Consent Request Workflow

The buyer will receive consent requests throughout the interim period. The seller wants to enter a new customer contract. An employee at the VP level is leaving and needs to be replaced. A lease is coming up for renewal. Each request needs a defined workflow:

Receive and log the consent request with supporting documentation
Route to the responsible deal team member based on subject matter
Analyze the request against the covenant terms and deal thesis
Respond within the agreed timeline to avoid claims of unreasonable withholding
Document the decision and any conditions attached to the consent

Monitor Ongoing Compliance

Beyond consent requests, the deal team should establish regular compliance reporting. This typically includes:

Weekly or biweekly calls with the target's management team
Monthly financial reporting compared to historical baselines
Prompt notification of any material developments or potential breaches
Ongoing review of the target's contract activity against the covenant restrictions

Track Third-Party Consent and Regulatory Milestones

The interim period also requires tracking third-party consents identified during due diligence and regulatory approval timelines. These items run in parallel with covenant monitoring but have their own deadlines and dependencies.

A centralized tracking system that combines covenant obligations, consent requests, third-party consents, and regulatory milestones gives the deal team a complete picture of interim period risk.

When Breaches Happen

Despite best efforts, breaches occur. The question is how the deal team responds.

Immaterial breaches are common and usually resolved through notice and cure. The seller inadvertently exceeds a spending threshold, corrects the issue, and the parties move on. The purchase agreement should include a cure period for this reason.

Material breaches require a different analysis. The buyer must evaluate whether the breach affects the deal thesis, whether it is curable, and whether the appropriate remedy is termination, price adjustment, or enhanced indemnification. The answer depends on the specific facts and the parties' motivation to close.

Patterns of minor breaches can be more concerning than a single material event. Repeated small violations may indicate that the seller is not taking the covenants seriously, which raises questions about other compliance obligations and the reliability of the seller's representations.

From Interim Monitoring to Post-Closing Integration

The compliance monitoring infrastructure built during the interim period has value beyond closing. The obligation tracking system, consent workflows, and reporting cadences translate directly into the post-closing integration process. Contract provisions identified during diligence, covenant compliance issues flagged during the interim period, and regulatory conditions attached to approvals all become inputs to the integration plan.

Deal teams that treat the interim period as an isolated phase miss this connection. The best practice is to design the monitoring system with integration in mind from the start.