United States: Certain Antitrust Implications of Pre-Closing Restrictive Covenants

Acquisition agreements typically contain covenants requiring the seller to operate the to-be-acquired business only in the ordinary course, consistent with past practice. Acquisition agreements also typically contain more specific covenants prohibiting the seller from engaging in particular activities — whether or not in the ordinary course — without the buyer’s prior approval.

These covenants are important to the buyer because they provide the buyer with a measure of assurance that, while the seller continues to own and operate the business, the status of various matters that formed the basis upon which the deal was struck will be preserved through the closing. However, care must be taken to assure that these covenants do not run afoul of U.S. antitrust laws, including the Hart-Scott-Rodino Antitrust Improvements Act of 1976 (the "HSR Act"). This article examines how covenants that impose pre-closing operational controls may raise compliance issues under the HSR Act during the waiting period imposed by the Act.

The HSR Act generally applies to transactions involving the acquisition of assets and/or voting securities exceeding $50 million in value in which the annual net sales or total assets of one party to the transaction are at least $100 million and those of the other party are at least $10 million. The HSR Act also applies regardless of the parties’ revenues or assets if the assets and/or voting securities to be acquired exceed $200 million in value. These value-based thresholds will be adjusted annually for fiscal years beginning after September 2004 based on changes in gross national product. In addition, the foregoing determinants of applicability are subject to numerous exceptions and exclusions. Consequently, it is imperative that antitrust counsel be consulted to determine whether the HSR Act applies to a particular transaction.

The HSR Act requires that the parties to a proposed acquisition (or their ultimate parent entities) file a "pre-merger" notification with the Department of Justice (the "DOJ") and the Federal Trade Commission (the "FTC"), and imposes a mandatory waiting period that must be observed before the acquisition may be consummated. The initial waiting period for a reportable transaction under the HSR Act is typically 30 days, although some transactions (e.g. g , acquisitions in bankruptcy and cash tender offers) are subject to a shorter waiting period. In addition, the reviewing agency has discretion to cut short the initial waiting period if the transaction does not raise serious antitrust issues. On the other hand, if the reviewing agency determines that its analysis will require more time or information, it may issue a "second request" for information. If so, the parties may not consummate the transaction until 30 days after they have substantially complied with the agency’s second request. Violations of the HSR Act can result in civil fines of up to $11,000 per day, and such fines have reached as much as $5.6 million for a single transaction.

The primary purpose of the HSR Act is to ensure that enforcement agencies have a meaningful opportunity to investigate a transaction before it closes in order to avoid the disentangling of operations that would be required to restore the status quo ante. Another purpose of the HSR Act is to maintain preacquisition levels of competition while the reviewing agency performs its investigation. As regards this second purpose, the level of competition may be reduced before the investigation is complete if the acquisition agreement imposes significant preclosing restrictions on the operations of the target enterprise. Consequently, covenants that impose such restrictions have in some circumstances been found to violate the HSR Act.

Regulations adopted under the HSR Act define an "acquiring person" as one who will hold the relevant assets or securities as a result of the acquisition. "Hold" is in turn defined as having "beneficial ownership" of the assets or securities. While the regulations do not define beneficial ownership, the FTC and DOJ have gone beyond traditional notions of beneficial ownership in recent years to challenge as transferring beneficial ownership agreements that give an acquirer operational control of the to-be-acquired assets. In such cases, the agreement itself is claimed to constitute an "acquisition" for purposes of the HSR Act, which violates the HSR Act by taking place upon signing of the acquisition agreement, when the statutory waiting period has not yet expired.

In March 1999, Computer Associates International, Inc. ("CA") and Platinum Technology International, Inc. (Platinum") entered into a merger agreement under which CA would purchase all Platinum’s outstanding equity through a $3.5 billion cash tender offer and . led the pre-acquisition notifications required by the HSR Act. Subsequently, the DOJ alleged that the merger agreement contained a number of covenants that violated the HSR Act by giving CA an unlawful degree of control over Platinum’s business. (The DOJ’s complaint also alleged that certain of the covenants violated the Sherman Act as unlawful agreements in restraint of trade.) CA eventually agreed to pay a $638,000 civil fine to resolve the HSR claim.

In connection with its case against CA, the DOJ filed a Competitive Impact Statement, 67 Fed. Reg. 41,472 (April 23, 2002) petitive Statement (the "Statement"), which sets forth some general principles for determining whether pre-closing covenants are likely to violate the HSR Act. In general, the Statement advises that covenants that are reasonable and necessary to protect the value of the to-be-acquired business pending the completion of the transaction do not violate the HSR Act. Conversely, covenants that allow the acquirer to exercise operational or management control over significant aspects of the target’s business may violate the HSR Act. The Statement also indicates that the HSR Act requires the parties to remain separate and independent economic entities during the waiting period.

In addition to setting out the foregoing general principles, the Statement addresses the particular covenants contained in the CA/Platinum merger agreement and indicates, in the DOJ’s view, which of them violated the HSR Act and which of them did not. The DOJ found acceptable the customary covenant that Platinum carry on its business "in the ordinary course in substantially the same manner as heretofore conducted." Other covenants the DOJ found acceptable required Platinum to obtain CA’s consent before taking any of the following actions:

• declaring or paying dividends or distributions on Platinum stock

• issuing, selling, pledging, or encumbering any Platinum securities

• amending the Platinum organizational documents

• acquiring or agreeing to acquire other businesses

• mortgaging or encumbering any of Platinum’s intellectual property or other material assets outside the ordinary course

• making or agreeing to make large new capital expenditures

• making material tax elections or compromising material tax liabilities

• paying, discharging, or satisfying any claims or liabilities outside the ordinary course

• commencing lawsuits other than routine collection of bills

The covenants that the DOJ found to violate the HSR Act:

• permitted CA employees to be placed at Platinum headquarters to review and approve customer contracts

• restricted Platinum’s right to set discounts for software products and consulting services without CA approval

• limited Platinum’s right to negotiate terms of customer contracts without CA approval

• limited Platinum’s right to enter into fixed-price contracts without CA approval

• limited Platinum’s right to offer Y2K remediation services without CA approval

• permitted CA to collect competitively sensitive information, including the identity of Platinum’s prospective customers and the specific price, discounts, and contract terms offered to each customer

• permitted CA to make day-to-day management decisions, including decisions related to recognition of revenue and participation at industry trade shows

Unfortunately, the general principles set forth in the Statement do not provide meaningful guidance regarding the permissible scope of restrictive covenants during the HSR waiting period. The identification in the Statement of particular covenants that, in the DOJ’s view, did or did not violate the HSR Act is somewhat more helpful.

An analysis of the Platinum covenants and the DOJ’s determinations regarding them suggests a distinction based on whether the covenant restricts the ordinary conduct of business or restricts only conduct that is to varying degrees extraordinary or that relates to matters other than the conduct of business. A common theme among the covenants that the DOJ found unacceptable in the Platinum agreement is that they affected aspects of the ordinary course of Platinum’s business (e.g., covenants granting control over the negotiation, review, and approval of contracts, pre-approval of discounts to particular customers, and control over Platinum’s Y2K business). In contrast, the covenants that the DOJ found acceptable generally related to business decisions that were outside the ordinary course of Platinum’s business (e.g., covenants granting control of stock issuances, dividend payments, charter amendments, acquisitions of other businesses, and the incurrence of debt). Notably, the covenants that required CA’s approval for the encumbrance of assets and the payment or discharge of claims and liabilities, both of which the DOJ found acceptable, expressly carved out those activities to the extent they related to the ordinary course of business. Similarly, the covenant requiring CA’s approval to commence lawsuits, also deemed acceptable, excepted out lawsuits for the routine collection of bills.

At first blush, the DOJ’s approval of the customary covenant requiring that Platinum carry on its business "in the ordinary course in substantially the same manner as heretofore conducted" might appear to contradict the principle that controls relating to the ordinary course of business are more likely to violate the HSR Act. However, it is noteworthy that this covenant did not give CA discretion to approve or be involved in any of Platinum’s decisions or activities. Rather, the restrictions it imposed were defined by, and consistent with, Platinum’s historic business practices.

The determination by the DOJ that the covenant regarding CA’s access to Platinum’s competitively sensitive information violated the HSR Act is analytically suspect. Whether and the extent to which acquisition parties may exchange competitively sensitive information before closing for purposes of planning post-acquisition integration would seem to be conceptually distinct from whether an acquirer has prematurely acquired an impermissible degree of operational control. Sharing of competitively sensitive information would seem more properly to be within the purview of the Sherman Act (the requirements of which are beyond the scope of this article), and there do not appear to have been any HSR enforcement actions that have been based solely on pre-closing exchanges of sensitive information.

The law with respect to "gun jumping" under the HSR Act is poorly defined, and the financial and other detriments associated with inadvertent violations of the HSR Act are significant. At the same time, buyers in acquisition transactions have a very substantial interest in protecting the value of an acquisition by placing restrictions on the seller’s actions between the signing of the acquisition agreement and the completion of the transaction. The confluence of these factors presents a substantial challenge to transaction parties and their counsel to avoid violating the HSR Act while protecting a buyer’s legitimate interests. Successfully surmounting this challenge requires careful consideration of the relevant circumstances, the exercise of expert judgment regarding application of the HSR Act to the circumstances presented, and close coordination between the M&A and antitrust lawyers working on the transaction.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.