Yesterday, the SEC announced that it had adopted amendments overhauling the rules governing the financial information that public companies must provide for significant acquisitions & divestitures. Here’s the 267-page adopting release. Highlights of the rule changes include:
– Updating the significance tests in Rule 1-02(w) and elsewhere by revising the investment test to compare the registrant’s investments in and advances to the acquired or disposed business to the registrant’s aggregate worldwide market value if available; revising the income test by adding a revenue component; expanding the use of pro forma financial information in measuring significance; and conforming, to the extent applicable, the significance threshold and tests for disposed businesses to those used for acquired businesses;
– Modifying and enhancing the required disclosure for the aggregate effect of acquisitions for which financial statements are not required or are not yet required by eliminating historical financial statements for insignificant businesses and expanding the pro forma financial information to depict the aggregate effect in all material respects;
– Requiring the acquired company financial statements to cover no more than the two most recent fiscal years;
– Permitting disclosure of financial statements that omit certain expenses for certain acquisitions of a component of an entity;
– Permitting the use of, or reconciliation to, IFRS standards in certain circumstances;
– No longer requiring separate acquired business financial statements once the business has been included in the registrant’s post-acquisition financial statements for nine months or a complete fiscal year, depending on significance;
The changes also impact financial statements required under Rule 3-14 of Regulation S-X (which deals with acquisitions of real estate operations), amend existing pro forma requirements to improve the content and relevance of required pro forma financial information, and make corresponding changes in the rules applicable to smaller reporting companies under Article 8 of Regulation S-X.
I suppose you’re wondering if the SEC split along partisan lines once again – well, of course they did! Here’s Commissioner Allison Herren Lee’s dissenting statement. We’ll be posting memos in our “Accounting” Practice Area.
Prairie Capital recently published a report on the Covid-19 pandemic’s impact on the M&A market. The publication covers many topics, but I thought what it had to say about how the crisis has impacted deal structure & risk sharing was particularly interesting. Here’s an excerpt:
In the midst of the pre-pandemic seller’s market, all cash M&A deals were the market norm. Occasionally, rolled equity structures were used if the seller wanted to ride along with the buyer for a “second bite of the apple,” but generally, cash was king. Earn-outs and seller notes were reserved for deals where a full valuation could not be supported by the current cash flow, but the buyer still wanted to entertain the seller’s high valuation expectations. In a majority of the transactions, most – if not all – of the deal valuation risk was borne by the buyer.
Those were the “good old days” in the M&A market. However, because of the pandemic, we are in a new M&A environment. The results of the economic shutdown have seriously affected companies’ short-run financial results. Many potential company sell-side candidates will have good historical operating results through 2019 and then a significant change in 2020, with expectations of a return to normal in 2021 and beyond. The EBITDA adjustments described earlier can be used to explain 2020 and will have to be fully documented and supported. Nevertheless, these adjustments may not be as useful to support the return to normal projections provided by the seller.
When EBITDA adjustments or projected financial results are not fully accepted by the buyer, an earn-out or special escrow can be used to bridge the gap and create risk sharing between the buyer and the seller. It is anticipated that many of the pandemic-related EBITDA adjustments and projected performance will be at least partially challenged by buyers, which will lead to potentially larger deal escrows and earn-out provisions.
The seller’s market in M&A during the past several years has also been fueled by an extremely accommodating lending environment. The white paper suggests that lenders are likely to become much more conservative. Among other things, that means sellers will be asked more frequently to take back paper as part of the transaction.
Overall, the message is that the uncertainties created by Covid-19 have created a buyer’s market, and if sellers want to get a deal done now, they’re going to need to be more flexible & willing to accept deal terms that wouldn’t have been on the table just a few months ago.
Tune in tomorrow for the webcast – “Middle Market M&A: The Latest Developments” – to hear to hear Citizens M&A Advisory’s Charles Aquino, Mintz Levin’s Marc Mantell and Duane Morris’s Richard Silfen discuss the state of the middle market and issues dealmakers are confronting in 2020, including bridging valuation gaps, Covid-19’s implications for deal structure and process, and the evolution of deal terms in the Covid-19 environment.
The FTC recently blogged some reminders & tips on HSR filing fees. Paying the HSR filing fee in a timely manner is important, because the HSR waiting period doesn’t start running until the fee is paid. The FTC’s Premerger Notification Office can bounce a filing if the fee doesn’t show up in its account by the end of a two-day grace period, although it usually hasn’t done that. The blog says that’s about to change:
The PNO generally has not bounced filings when fees were received outside the two-day grace period, unless the delay affected the timing of the weekly merger screening review process. Going forward, in order to ensure consistency and give the agencies the maximum time allowed under the HSR Act to analyze the competitive effects of each transaction, the PNO will be strictly enforcing the two-day grace period.
The blog points out that it is up to the party paying the fee to determine when to initiate the wire so that the fee is received within the two-day grace period or earlier, and that the grace period isn’t meant to give filers extra time to initiate a wire or cover processing delays. Filers are urged to coordinate the filing fee process well in advance, and the blog offers tips on avoiding delays with wire transfers.
Forum selection clauses are common in acquisition agreements, but to what extent may they bind a non-signatory? The Chancery Court recently addressed that question in Highway to Health v. Bohn, (Del. Ch.; 4/20), and this recent blog from Francis Pileggi reviews the Court’s decision. Here’s an excerpt:
The most noteworthy aspects of this pithy decision are: (i) a reminder that Delaware enforces forum selection clauses; and (ii) that a non-signatory can be bound by a forum selection clause if a three-part test is satisfied. See footnotes 46-47 and accompanying text. The directors of a Delaware company sought a declaratory judgment against non-residents of Delaware regarding a dispute about stock-appreciation-rights (SAR) that, by contract, required the board to fulfill fiduciary duties towards the SAR holders.
The three-part test requires one to demonstrate that: (i) the forum selection clause is valid; (ii) the non-signatories are third-party beneficiaries; and (iii) the claims arise from their standing relating to the agreement. Slip op. at 15. The third element of the test was not satisfied based on the facts of this case because the agreement containing the forum selection clause was not the same agreement that gave rise to the substantive claims brought by or against the non-signatories.
The blog also notes that the decision also analyzes Delaware’s long-arm jurisdiction statute, and explains why the “specific jurisdiction” requirements under the statute were not satisfied.
The Covid-19 pandemic has added several additional layers of complexity to the due diligence process. This Latham memo identifies some of the issues buyers should consider when undertaking legal due diligence for an acquisition in the era of Covid-19, and highlights for sellers some of the types of due diligence questions they should expect. Here’s an excerpt on diligence issues associated with government assistance programs:
Buyers should determine whether the target has applied for or obtained any financial aid or other assistance or relief under the array of federal, state, and local programs adopted in response to COVID-19, such as the CARES Act and similar non-US programs. If the target has done so, buyers should ensure that the target has complied with the requirements of the applicable program and implemented controls and procedures to maintain ongoing compliance.
As with health, safety, and other laws, orders, and guidelines enacted or issued in response to COVID-19, buyers should continue to monitor developments under these programs and understand the target’s obligations and other implications arising from any relief it may have obtained, as well as any opportunities for the target to obtain additional relief, either before or after the closing of the transaction. Buyers should also consult with their tax advisors in light of the complexity and evolving nature of certain tax law changes implemented in response to COVID-19 and their potential impact on the target.
The memo covers a wide range of issues directly and indirectly impacted by the pandemic. These include compliance with laws and regulations related to Covid-19, employee health and safety, pension plan liabilities, supply chain management, contract performance and force majeure issues, compliance with debt obligations, securities law compliance and regulatory communications.
This Winston & Strawn memo reviews the handful of Covid-19 related deal termination lawsuits that have been brought thus far and says that there are lessons that can be drawn from these cases. This excerpt addresses the strategies buyers have used to overcome the obstacles to success with MAE claims under Delaware law:
– Even where the acquisition agreement contains an express MAE provision, buyers are relying on the separate theory that the seller took action in response to COVID-19 that breached the standard covenant to operate the business in the normal course between signing and closing (L Brands and Level 4 Yoga). In the context of government-mandated shutdowns in response to the pandemic, however, there is a clear tension between that obligation and the seller’s obligation to be in compliance with government orders, creating a classic “Catch-22” that the courts will have to resolve.
– In some more recently signed deals, the parties have expressly contemplated the risk of uncertainty stemming from COVID-19 and appeared to allocate it to buyer through a negotiated purchase price reduction or an MAE carve-out. Yet certain buyers are nevertheless attempting to invoke the MAE provision, along with the covenant to operate the target company in the ordinary course, to justify nonperformance (L Brands, KCAKE). Nor is a “pandemic carve-out” in an MAE clause necessarily dispositive; the scope and applicability of any such carve-out will be fiercely debated (L Brands).
– Instead of expressly relying on the MAE provision, one buyer is asserting that sellers failed to provide required pre-closing financial information that takes into account the anticipated effects of COVID-19 on the company’s financial condition (Oberman).
– One buyer has simply refused to close for a self-declared period in order to determine whether an MAE has taken place (Bed Bath & Beyond).
The memo notes that these cases highlight an issue that predated the pandemic – although certain events may be excluded from the MAE definition, they may still affect the seller’s compliance with various reps & warranties and covenants and may implicate closing conditions. It recommends proactive efforts by sellers to comply with these obligations to the extent possible, and to seek buyer consent when taking actions that may be required to respond to the pandemic, but may be inconsistent with obligations imposed by interim operating covenants.
Private equity deals often involve a lot of contingencies, and the fund’s financial downside is usually limited to some kind of reverse breakup fee. In these situations, PE funds have traditionally reassured sellers that walking away from a deal would damage the fund’s reputation & ability to do future deals. This Axios article says that may have been true in the past, but in the Covid-19 era, not walking away from a deal may do more damage to a PE fund’s reputation:
Private equity investors have historically taken a dim view of peers that renege on signed merger agreements, believing that an honorable reputationcan be the difference between winning and losing the next deal or next fund. What’s new: Not only have stigma worries dissipated, but some buyers now feel honoring their pre-pandemic word would diminish their reputation.
Driving the news: Broken buyouts are becoming nearly as prevalent as new ones. Just within the past 48 hours, we’ve learned that: Carlyle bailed on its $900 million deal for a 20% stake in American Express Global Business Travel. Kohlberg & Co. walked away from its $550 million deal for cake decorations company Decopac, owned by Snow Phipps.
It’s one thing to buy a company that eventually loses value,” says a private equity investor whose firm is largely sitting on the sidelines. “It’s quite another to buy a company that you need to write down by 50% the minute you close. That’s a tougher sell to limited partners.”
So, when push comes to shove, it looks like some PE funds have decided that it’s better to risk reputational damage with sellers (and a lawsuit) than to risk reputational damage with their investors. On the other hand, maybe they just figure that anybody that’s a seller in this environment needs PE buyers too much to worry about whether their buyer tried to get out of pre-Covid-19 deals.
Unfortunately, it’s probably fair to say that many – if not most – of the M&A deals that are likely to get done in the near future are going to involve distressed targets. This Sidley memo reviews some of the unique risks associated with distressed deals, as well as some of the structuring alternatives that are available.
Risks that buyers face in acquiring an insolvent business include fraudulent conveyance and successor liability issues, but this excerpt points out that buyers may have very little contractual recourse to address these un-bargained for liabilities:
Unfortunately, notwithstanding these increased risks, it is typical that the buyer has relatively limited recourse for unwanted liabilities under the purchase agreement. It is uncommon for the purchaser of assets out of bankruptcy, for example, to receive any significant representations and warranties, let alone any post-closing recourse. Even in structures that fall short of a bankruptcy, representations and warranties, as well as post-closing recourse, are more limited than transactions involving healthy companies.
A mixture of factors contributes to this, among others: (1) the buyer’s desire to quickly close the transaction before employees find other employment, customers leave, the business disintegrates and the value of the transaction is lost; (2) a discounted purchase price; and (3) given the discounted purchase price, the relatively small amount reasonably available for escrow and indemnification.
Rep & warranty insurance may help address contractual shortcomings, and bankruptcy law may also provide the buyer with additional protections.
The memo addresses various bankruptcy & non-bankruptcy structures that may be used to effect a distressed acquisition. It reviews the differences between a Chapter 11 transaction & a Section 363 sales, and discusses non-bankruptcy alternatives such as an assignment for the benefit of creditors and a “friendly foreclosure.”
Last month, I blogged about the EU’s efforts to protect suppliers of essential products from opportunistic foreign buyers. This Davis Polk memo says that this tighter scrutiny of foreign direct investments is by no means limited to the EU and its member states. In recent years, many countries have begun to implement their own CFIUS-like regimes for reviewing FDI, and that process is being accelerated by the Covid-19 crisis.
While the specifics of regulations governing FDI vary from jurisdiction to jurisdiction, this excerpt identifies some of the common themes that investors should be aware of:
– It’s not just about defense. In some countries, the FDI screening only applies to certain sectors (e.g., France, Italy and Japan) while others catch all economic sectors (e.g., Australia, Canada and China). Germany operates two FDI screening regimes in parallel: one applies to all sectors while the other is specific to defense.
– It’s not about specific nationalities. Some investors’ home states may be perceived as potentially more threatening to the host country than others. But this will generally tend to affect the outcome of the screening, rather than determine which transactions are caught by the initial filing obligation. Nevertheless, the FDI regimes of certain EU Member States (e.g. France, Germany and Spain) contain stricter rules for non-EU/EFTA investors.
– Investors will usually need to be proactive in seeking clearance. In most countries operating an FDI regime, filing is mandatory. Most of the mandatory jurisdictions are suspensory: the relevant authority’s approval has to be obtained prior to closing. Other countries, such as the UK, leave it to the parties to decide whether to notify (although with the risk of the transaction being “called-in” by the relevant authority).
– The process will often trigger an additional regulatory workstream. Most jurisdictions operate a clear separation between FDI screening and the antitrust merger control process. However, in some jurisdictions (e.g. Australia, Russia, China and – currently – the UK), FDI-related and antitrust issues are assessed within the same framework.
– FDI screening rules are often very broadly drafted: Much discretion is frequently left to governments, enabling them to “cherry-pick” transactions of interest. For instance, many jurisdictions do not define key concepts (such as, “national defense”, “key infrastructures”, “media”, etc.) and/or have open-ended provisions.
The memo points out that the regulatory landscape for FDI is rapidly evolving, and provides some practical advice to help companies considering a foreign acquisition to successfully navigate the applicable regulatory regimes.