Sometimes you can’t blame deal lawyers for feeling like Bill Murray’s character in Groundhog Day – there are just some things that seem to happen over and over again in almost the same way on practically every deal. When it comes to public company deals, having to decide whether or not to disclose pending negotiations is defin itely one of those recurring events.
Assuming you’re not dealing with an auction or some other process where the seller has decided to hang a “for sale” sign on itself, nobody involved in the transaction wants the world to know that talks are going on until the parties are ready to announce a signed deal. Among other issues, premature disclosure may create problems for the buyer and the seller with key constituencies – like their employees, customers and in some cases, shareholders – that they would like to postpone until a later date when they have had time to map out a communications strategy.
The SEC cuts public companies some slack when it comes to disclosure of merger negotiations. In general, the Staff’s position is that even though MD&A’s “known trends” disclosure requirement might be read to require companies to address pending talks, if the company doesn’t otherwise have an obligation to disclose preliminary talks, then disclosure won’t be required in response to this line item in an Exchange Act report. (See, e.g., Securities Act Rel. No. 6835 (May 18, 1989)).
The SEC’s position is helpful, but this issue isn’t confined to Exchange Act reporting. Public companies have a duty to disclose material information under other circumstances as well, including situations involving leaks for which the corporation or insiders are responsible – and it’s these situations in which the disclosure issue usually arises.
Legally, there are two major issues to keep in mind in deciding whether you need to say something. The first is whether you’ve got a duty to disclose that you’re engaged in discussions. While there’s no general obligation to dispel rumors in the marketplace that you aren’t responsible for, the problem is that you’ll seldom be able to determine whether you’ve got responsibility for the leak or not – and there’s a pretty good chance that you might.
The second legal issue is whether information about the potential deal is “material.” That question, as everybody knows, is a function of its probability and its magnitude under the test announced by the Supreme Court in Basic v. Levinson. There are a lot of ways to look at Basic’s requirements, but it goes without saying that the further down the path you are, the more likely it is that information about your deal is going to be considered material.
While lawyers naturally tend to focus on the legal issues, business concerns frequently drive a decision to go public with negotiations. Companies may feel that their hands are forced by the media’s decision to run with a story on the rumored deal, or by inquiries from the Nasdaq or the NYSE about the reasons behind unusual market activity. Once information leaks, the need to manage the potential damage to key relationships may also make a compelling business case for disclosure. What’s more, there’s sometimes concern that speculation may cause the market to get carried away. That can lead to the unpleasant situation where the market price rises above the price levels that the parties are negotiating.
Once a decision to disclose pending talks is made, the next issue becomes, how much do you say? Often, people want to say as little as possible. The parties may decide not to identify the buyer, and sometimes, will avoid making any disclosure about the price as well. Sometimes, discussions about what you’re going to say can get pretty contentious, as the two sides may have conflicting views when it comes to the extent of disclosure that’s appropriate.
If you’ve got a relatively efficient market for your stock, and you don’t feel a need to reach out to other constituencies, a minimalist approach may work. Just bear in mind that the less you say, the less freely you can communicate with your key constituencies and the more you remain at risk for the consequences of market speculation. If you don’t say enough, you may find yourself needing to make a second announcement, which only further complicates everyone’s life.
When leaks happen, companies often find themselves in a completely reactive position, with very little time to think through all of the implications of their decisions about disclosure. That’s why I think the best advice is to address the possibility of leaks early on in the process, and chart out a course for managing the disclosure process if they do occur.
Advance planning won’t stop leaks from happening, but it will put everyone in a better position to respond to them if they do. Getting a jump on this issue may make it less painful when you hear the familiar sound of Sonny & Cher’s “I Got You Babe” coming through your clock radio, followed by a couple of morning DJ’s cheerily reminding you that “It’s Groundhog Day!”
Broc’s note: A great version of “I Got You Babe” is the one by UB40 and the Pretender’s Chrissie Hynde.
Reacting to this blog recently from John Jenkins, a member posed the question: why, given the virtually universal use of indemnification, does reliance matter? This member would characterize most claims as actions to enforce a covenant to indemnify for damages resulting from inaccuracies in representations and warranties, rather than claims for breaches of representations and warranties themselves – and he noted John’s somewhat oblique reference to specific indemnities and wondered if he had given any thought to the issue.
The member stated there are three main fact patterns:
1. Traditional breach of representation or warranty claim that can be analyzed under the existing case law relating to the reliance element – Ziff Davis or Galli v. Metz, which are fact specific and can lead to different results
2. Specific/special indemnity – indemnification for any loss relating to a specific issue – e.g., environmental problem, cost overruns on budgeted severance
3. Traditional indemnity for breach or inaccuracy of representation
John Jenkins responsed to this question as follows:
I’m not sure I’ve got a good answer to your question, although I think there are two reasons that reliance still matters:
1. I think that because of the indemnity right’s status as a remedy that is tied in some fashion to a “breach” (whether defined broadly to include inaccuracies or in more narrow terms) of a rep or warranty, courts that think reliance matters won’t view the covenant to indemnify as being an independent obligation. The existence of a right to indemnity is predicated on the rep, and therefore reliance on the rep remains an issue when a claim for indemnity is made.
2. The more fundamental problem is that you get it right, and the courts that adopt a reliance requirement don’t. You’re applying contract law principles to contract law issues, while the courts that are requiring a showing of reliance in these cases aren’t. They are importing the tort concept of reliance into contract claims, which doesn’t make sense to begin with:
“Transplanting tort principles into contract law seems analytically unsound. If a party to a contract purchases a promise, he should not be denied damages for breach on the grounds that it was unwise or unreasonable for him to do so. Indeed, Judge Hand admonishes: ‘To argue that the promisee is responsible for failing independently to confirm [the warranty], is utterly to misconceive its office.’ Metropolitan Coal Co. v. Howard, 155 F.2d 780, 784 (2nd Cir.1946). Thus, a claim for relief in breach of warranty is complete upon proof of the warranty as part of a contract and proof of its breach.” Ainger v. Michigan General Corp., 476 F.Supp. 1209, 1224-1225 (S.D.N.Y. 1979).
Once courts have crossed this particular Rubicon, it’s probably not too surprising that they would go on to ignore other principles of contract law, like the one that prompted your concerns.
If you read Robert Quaintance’s article (which is where the quote about specific indemnity rights came from), I think this is where some of his concerns are coming from. For example, he says that buyers that rely solely on express reservations of rights run the risk of running into a court that looks principally to Ziff-Davis, “where timing [of the buyer’s knowledge] seemed to matter a lot – and reservation of rights seemed not to matter very much – and holds that that if the buyer knew before signing that the seller’s representation was untrue, the buyer could not have been relying on that representation when it entered into the agreement.” In other words, the risk is that a court might approach the contract issues from a tort law perspective that elevates the “reliance” concept above the ability of the parties to bargain their own appropriate allocation of risk.
Last week, the Delaware Supreme Court affirmed – in Alliance Data Systems v. Blackstone Capital Partners V – the Chancery Court’s decision dismissing Alliance Data Systems suit against Blackstone acquisition entities for breach of their merger agreement.
As we have blogged, the Chancery Court had dismissed ADS’s claims that the Blackstone shell entities that had signed the merger agreement to acquire ADS had breached their obligations under the merger agreement and were obligated to pay ADS a $170 million “business interruption fee.” The Chancery Court found that those Blackstone entities had fulfilled their obligations under the merger agreement and had not promised to cause the Blackstone entities that control them to agree to terms demanded by the Office of the Comptroller of the Currency in order to obtain a required regulatory approval.
The Chancery Court’s decision was widely considered an affirmation of the typical private equity transaction structure in which PE managers/advisors seek to shield themselves and their investment funds from liability for breaches of the transaction agreement by forming shell acquisition vehicles to enter into the transaction agreement.
In the succinct ruling, the Delaware Supreme Court stated: “Upon consideration of the briefs of the parties and their contentions in the briefs and oral argument, it appears to the Court that the judgment of the Court of Chancery should be affirmed on the basis of and for the reasons set forth in its well-reasoned January 15, 2009 opinion.”
Recently, The Corporate Library and the IRRC Institute teamed up to study whether private equity buyout firms institute more shareholder-friendly corporate governance structures in their IPO companies than non PE-backed IPO companies. The study – “What Is the Impact of Private Equity Buyout Fund Ownership on IPO Companies’ Corporate Governance?” – examined the ownership, board characteristics, takeover defenses and compensation policies of 90 companies that went public during 2004-06 (48 were PE-backed; 42 were not). [By the way, we recently blogged on TheCorporateCounsel.net about governance trends for all types of IPOs.]
The study found that PE-backed IPOs do not have superior corporate governance procedures as compared to non PE-backed IPOs. On the contrary, the study found that the PE-backed IPOs exhibit – in a higher proportion than average – a number of features that have the potential to benefit executives at the expense of shareholders, including takeover defenses and boards whose independence may be compromised.
But before you decide to stop investing in PE-backed IPOs, consider that this study did not review any performance metrics of these companies and, as pointed out in this DealBook blog, PE firms are themselves large shareholders after the IPO and are therefore incentivized to ensure the long-term success of the company. For more on the study, see Larry Ribstein’s Ideoblog and The Corporate Library’s Blog.
We note that one of our DealLawyers.com board advisors, Frank Aquila of Sullivan & Cromwell, weighed in recently on the state of corporate governance in this BusinessWeek article.
Frank argues that the recent market environment and reform efforts may serve to diminish the power of CEOs. He notes: “If we are to move beyond the current financial crisis, we will need business leaders who are permitted to take actions that will have a positive impact beyond the next quarter or next fiscal year. But at a time when businesses need long-term, strategic decision-making the most, the new corporate order actually impedes decisive action.”
Recently, I announced a “cool deal cube contest” as part of our ongoing “Deal Cube Chronicles.” John Newell of Goodwin Procter takes the prize with this cube. John notes:
Here is an old JPMorgan advertisement from the late ’80s that explains this cube. In a nutshell, it is that the cube/tombstone from the “tombstone of the unknown deal.” I made a joke to a senior guy at Bowne of Boston after a public deal cratered and he made a couple of these babies.
Recently, I also received this story from a member:
During a drafting session for a follow-on offering in which we were underwriters’ counsel, we commented that the CFO was referred to in his bio as a certified pubic accountant. Company counsel expressed surprise because they had copied the language verbatim from the original IPO prospectus. There followed 1-1/2 seconds of uncomfortable silence, after which we flipped through a copy of the IPO prospectus and confirmed the worst.
There is some consolation in the fact that a search of the term “certified pubic” on EDGAR yields 142 hits (and counting).
As the proxy season gets underway in Japan – where the majority of companies hold their meetings during the last two weeks of June – defensive measures are the hot topic once again this year. This report is from the RiskMetrics Group:
The most controversial issue of the 2009 Japanese proxy season will continue to be the introduction and renewal of “poison pills” and other types of takeover defenses. In the wake of attempts to take over companies including Hokuetsu Paper, Bull-Dog Sauce, and Sapporo Holdings – as well as the successful proxy challenge at Aderans Holdings – many companies have introduced defensive measures because of fears of being acquired.
However, these fears may be overblown because the difficulties of successfully managing a company after a hostile acquisition will help to ensure that the number of such cases will be limited. Nevertheless, several hundred companies will introduce or renew a poison pill this year. More than one in seven Japanese issuers already have a pill in place as of May 1, according to RiskMetrics data.
Notwithstanding investors’ skepticism toward takeover defenses, companies that have put their pills to a vote usually have had no difficulties in winning approval, thanks to the support of cross-shareholders and other management-friendly parties. One exception is Works Applications, which was forced to withdraw a pill proposal after the company could not garner enough shareholder support.
According to RiskMetrics data, about 30 companies have removed poison pills to date. However, this includes companies where pills became unnecessary due to organizational changes such as becoming listed subsidiaries of larger companies; RiskMetrics data shows that only about 10 companies, including Shiseido, Nissen Holdings, and Rohm, removed pills because they came to believe that the defenses were not in the best interests of shareholders.
Most poison pills introduced in 2005 were so-called “trust-type” plans, where warrants are issued to a trust bank, to be transferred to all shareholders (other than a would-be acquirer) in the event the pill is triggered. These plans require a shareholder vote under Japanese law. Since 2006, the vast majority of poison pills have been so called “advance warning-type” or “advance notice-type” plans. In these cases, the board announces a set of disclosure requirements it expects any bidder to comply with, as well as a waiting period between the submission of this information and the launch of the bid. As long as the bidder complies with these rules, the company “in principle” will take no action to block the bid and allow shareholders to decide. The exceptions are where the bid is judged to be clearly detrimental to shareholders, such as in cases of greenmail, asset stripping, and coercive two-tier offers. Usually, such judgments are made by a “special committee” or “independent committee,” but the committee’s decision is usually subject to being overruled by the board. At some companies, the decisions are made by the board with no committee input at all.
Advance warning-type defenses do not require shareholder approval, although in most cases, companies are choosing to put them to a shareholder vote, as it is believed that doing so will put the company in a stronger position in the event of a lawsuit. However, the primary problem is not the terms of the poison pills themselves – these are often superior to those of U.S. companies due to relatively high trigger thresholds, clear sunset provisions, and an absence of “dead hand” provisions. Rather, the main problem is with Japanese companies’ insider-dominated boards and insufficient disclosure. The presence of a critical mass of independent directors is essential to ensure that a takeover defense is used not merely to entrench management, but contributes to the enhancement of shareholder value.
Notwithstanding management fears, some of the companies implementing pills are in fact not especially vulnerable, because founding families, business partners, or other insiders own more than a third of outstanding shares. This is enough to veto any special resolution, such as an article amendment or a merger, meaning that even if a hostile bidder is able to accumulate a sizable stake in such a company, that bidder will be unable to force any major restructuring moves opposed by the insiders. It is difficult to see what shareholders of such a company stand to gain from a poison pill.
Many of the poison pills introduced in the past few years will be up for renewal in 2009. In evaluating these renewals, investors should examine the company’s share price performance, relative to its peers, since the pill was first put in place. Where the company has underperformed the market, it will be difficult to argue that shareholders have benefited from the pill.
Some companies, while not putting a poison pill on the ballot, will seek to pave the way for the eventual introduction of a pill through measures such as increasing authorized capital. Investors should expect to see other article amendments designed to ward off hostile takeovers, such as the elimination of vacant board seats that could be filled by shareholder nominees, and the tightening of procedures for removing a director.
During this podcast, Mary Beth Kissane of Walek Associates analyzes how companies should be monitoring shareholder activist activity, including:
– How do hedge funds have such a solid activism record?
– What should companies do to prepare for an activist attack?
– Who within the company owns the “monitoring activists” task?
– Who within the company should be dealing with the financial press?
– Who is the “financial press” these days? Bloggers included? Social media?
I want to expand on John Jenkins’ recent blog on first drafts to capture a broader – and perhaps more important – point: The initial draft of the acquisition agreement should reflect the ongoing substantive discussions among members of the acquiror’s transaction team regarding risk allocation, purchase price considerations and the overall negotiating strategy.
Perhaps the purchase price is so “good” and any significant risks deemed to be so remote (or containable) that a “seller-friendly” (or “middle-of-the road”) draft is appropriate; on the other hand, perhaps the target has certain significant, uncontainable risks and/or the acquiror perceives it is paying a full purchase price, that the agreement should be aggressively drafted, with broad representations and warranties and indemnification obligations (assuming it is a private deal).
In short, every deal is different, and the role the acquiror’s counsel plays is critical: he must ensure that his client is making an informed judgment with respect to price and terms.
Webster’s Dictionary defines the term “sandbagging” to mean “to conceal or misrepresent one’s true position, potential, or intent especially in order to take advantage of…to hide the truth about oneself so as to gain an advantage over another.” In the world of M&A, the term sandbagging generally refers to the ability of the beneficiary of a representation and warranty to rely on that rep – and sue for its breach – notwithstanding the fact that the beneficiary knew that it was untrue when it was made.
Many buyers will assert that they ought to be able to rely on a representation despite knowing that it was incorrect when made. The justification for pro-sandbagging position is that representations and warranties serve a risk allocation function in M&A, and the parties have a right to bargain to allocate that risk as they see fit.
If that’s your argument, and your agreement is governed by Delaware law, then it looks like the law is on your side. In Cobalt Operating LLC v. James Crystal Enterprises LLC, No. Civ.A. 714-VCS (Del. Ch.; 7/20/07), Vice Chancellor Strine held that a breach of contract claim arising out of an acquisition agreement does not depend on the buyer establishing justifiable reliance:
Due diligence is expensive and parties to contracts in the mergers and acquisitions arena often negotiate for contractual representations that minimize a buyer’s need to verify every minute aspect of a seller’s business. In other words, representations like the ones made in the Asset Purchase Agreement serve an important risk allocation function. By obtaining the representations it did, Cobalt placed the risk that WRMF’s financial statements were false and that WRMF was operating in an illegal manner on Crystal.
So sandbag away, right?
Not so fast. It isn’t entirely clear that Vice Chancellor Strine’s position in Cobalt Operating is the last word on this issue under Delaware law. The Delaware Supreme Court affirmed the Vice Chancellor’s decision last year, but it did so in summary fashion, and it didn’t address a long line of cases from Delaware and other jurisdictions holding that “according to sound Delaware law, a plaintiff must establish reliance as a prerequisite to a breach of warranty claim.” Kelly v. McKesson HBOC, Inc., C.A. No. 99C-09-265 WCC (Del Super.; 1/17/02).
Perhaps it’s fitting that the Delaware courts leave us scratching our heads a bit on this issue, because frankly, the case law in this area is a bit of a mess across the country. The trend seems to be toward the kind of position enunciated by Vice Chancellor Strine, and the leading case is probably the New York Court of Appeal’s decision in CBS, Inc. v. Ziff-Davis Publishing Co., 553 N.E.2d 997 (NY 1990). (Here is a survey of the state of the law on this issue in various jurisdictions, as of 2002.)
Still, courts are still pretty far from giving buyers a license to intentionally sandbag. First of all, not everybody is with the program – some states still have an express reliance requirement. For example, if your agreement is governed by Minnesota law, the Eighth Circuit has held that you’ll need to demonstrate justifiable reliance in order to proceed with a claim for a breach, and you won’t be able to do that if you knew of the inaccuracy when the representation was made. Hendricks v. Callahan, 972 F2d 190 (8th Cir. 1992).
What’s more, cases following the Ziff-Davis line make it clear that the facts count. For instance, it may matter whether the buyer knew of the misrepresentation before signing (see Galli v. Metz, 973 F.2d 145 (2d Cir. 1992)), or whether the information about the inaccuracy of the information came from the seller or from a third party (see Rogath v. Siebenman, 129 F.3d 261 (1997)).
Since the case law remains somewhat opaque, lawyers often recommend that buyers negotiate for language stating that the seller’s representations and indemnity obligations won’t be affected by the buyer’s due diligence or its knowledge or suspicion that a rep is false. That kind of language puts buyers in a much better position to argue that they bargained for the risk allocation that’s embodied in the agreement.
That’s good advice, and it’s advice that many buyers appear to be taking. The 2006 Deal Points Survey of private company transactions indicates that approximately 50% of private deals contained “pro-sandbag” language, while only 8% contained an “anti-sandbag” clause that would preclude a buyer from making a claim with respect to a rep it knew was false. Still, 41% of the deals surveyed were silent on this issue, and the case law suggests that there may be more risks to this approach than most buyers realize.
That brings up another point. Maybe the most important advice for a buyer is that intentionally sandbagging the other side is a very risky tactic. As one commentator who analyzed the Ziff-Davis line of cases put it: “sandbag at your peril – if you have knowledge of a breach before signing and do not seek a specific indemnity, you risk losing your rights, even if you have attempted to preserve them.” Robert Quaintance, Jr. “Can You Sandbag? When a Buyer Knows Seller’s Reps and Warranties Are Untrue,” 5 The M&A Lawyer 9 (March 2002).
Let’s face it, the optics of strategic sandbagging look pretty bad, and as the case law suggests, there are all sorts of ways for courts to distinguish situations involving what it thinks is unfair behavior from those more benign situations in which general right to allocate risk through representations and warranties has been upheld. So when it comes to strategic sandbagging, caveat emptor – let the buyer beware.