“You keep using that word. I do not think it means what you think it means.” – Inigo Montoya, The Princess Bride
Very few deal lawyers have escaped extended battles over whether a client is obligated to use its “best efforts,” “commercially reasonable efforts,” “reasonable best efforts” or some other defined level of “efforts” in performing its contractual obligations. But according to this blog from UCLA’s Steve Bainbridge, Mandy Patinkin’s character in The Princess Bride is right – we have no idea what we’re talking about when we talk about “best efforts.”
So what do phrases like “best efforts,” “commercially reasonable efforts” & the like really mean to the courts interpreting them? By way of explanation, Steve offers up this quote from his upcoming casebook:
Although practitioners generally believe that efforts standards differ, there is no general agreement in case law as to whether the various clauses in fact reflect different standards. Courts often use the same analysis in determining whether an efforts clause has been breached, regardless of the specific level of effort prescribed in the agreement. Specifically, courts frequently consider the facts and circumstances of the case and require that the parties act diligently, reasonably, and in good faith in complying with an efforts clause.
Here’s a recent blog from Keith Bishop with a California perspective on the meaning of a “best efforts” clause.
– John Jenkins
I recently flagged a Nixon Peabody blog about how the Chancery Court’s ESG Capital Partners decision highlighted significant enforceability issues for “side-letters” with private equity fund investors. Now the firm’s followed up with another blog offering some practice points for addressing this issue. Here’s an excerpt:
The ESG Capital Partners Case serves as an important reminder that private fund managers, investors and practitioners should always consider the following points to ensure enforceability of side letter agreements:
1. Integration Clauses (also known as “entire agreement” clauses)—make sure that each of the fund’s governing agreements include an integration clause that specifically references the fact that the side letter agreement will be a part of the entire agreement of the parties.
2. Subscription Agreement Provisions—in addition to the integration clause, the subscription agreement should also make clear that each applicable investor has received a copy of its side letter agreement (together with all other fund documentation) and is making its investment in the fund in reliance on the terms of all such agreements.
3. LPA Provisions—make sure that the Fund’s LPA specifically references the existence of side letter agreements, and specifically authorizes the general partner to enter into side letter agreements that supplement or alter the terms of the limited partnership agreement. Limited partner investors need to confirm this point as part of their legal diligence processes instead of assuming that a fund manager has this authority. This language would be in addition to the typical “most favored nations” provision included in each investor’s side letter agreement as further evidence that all investors were made aware that certain supplemental and preferential terms may be granted to some but not all investors in the fund;
4. PPM Provisions—make sure that the fund’s private placement memorandum references the fact that the fund may issue side letter agreements, and that it includes a risk factor highlighting the risk that such side letters may be issued to certain limited partners and not others, and that their terms may supplement or alter the terms otherwise provided in the fund’s LPA.
5. Preferential Rights—make sure that any supplemental rights granted to a limited partner in a side letter agreement do not materially or adversely affect the other limited partners in a way that would require an amendment to the fund’s LPA. When unclear, investors or sponsors should seek out advice of counsel.
– John Jenkins
This Fried Frank memo discusses the Chancery Court’s recent decision in In re Paramount Gold and Silver Stockholders Litigation (Del. Ch.; 4/17), which left unanswered the question of whether fully informed shareholder approval under Corwin would result in business judgment rule review for a board’s decision to adopt deal protections that ran afoul of Unocal.
The plaintiffs contended that a royalty agreement between the parties to a pending merger was a deal protection that could not pass muster under Unocal – which views deal protections as “defensive measures” subject to heightened scrutiny for reasonableness & proportionality.
The court concluded that the royalty agreement was not a deal protection, but noted that Unocal’s continued application to deal protections in a transaction that had received fully informed & uncoerced shareholder approval was an open issue. Here’s an excerpt summarizing Chancellor Bouchard’s analysis:
The defendants had argued that the Unocal heightened scrutiny standard of review did not apply to the deal protections in this case because the stockholders had approved the transaction in a fully informed, uncoerced vote and Corwin business judgment review therefore applied. The plaintiffs had countered that application of Corwin to the deal protection issue could not be squared with the 1995 holding in Santa Fe Pacific Corp. Shareholder Litigation, where the Delaware Supreme Court held, in the context of a post-closing action for damages, that stockholder approval of the transaction did not constitute ratification of the deal protection measures that had been put into place and were effective before the stockholder vote.
The Chancellor noted that Corwin does not discuss or expressly overrule this “apparent tension” with Santa Fe. The Chancellor reasoned that the issue did not have to be addressed in this case because the issue raised by the defendants here was that Corwin could not apply because the deal protection device was unreasonable under Unocal. Having concluded that that was not so, the court did not have to reach the issue whether Corwin has the potential to, in effect, cleanse a fee that could be found unreasonable under Unocal. It is thus uncertain whether a post-closing challenge to deal protection devices under Unocal would or would not survive if Corwin were applicable.
Given the distance that Delaware courts traveled on the effect of shareholder ratification to get to Corwin in the first place, I’d be surprised if they ultimately concluded that Corwin couldn’t cleanse a deal with a Unocal problem, but it remains an open issue for now.
Update: Stan Keller of Locke Lord weighed in with some thoughts about why the Unocal issue isn’t a slam-dunk:
“Keep in mind that while theoretically, under the Delaware agency analysis, a Corwin vote could result in business judgment review of deal protections that ran afoul of Unocal, those very same deal protections are likely to be found to be coercive, thus negating the Corwin result. The disclosure is also likely to be problematic absent essentially fessing up to the Unocal violations.”
Stan’s point on coercion is particularly well-taken in light of Vice Chancellor Slights’ extensive discussion of the coercion issue in the Saba Software case, which I blogged about earlier this month.
– John Jenkins
Earnouts always seem like such a good idea at the time. This K&E memo is a reminder of just what a post-closing mess they frequently turn out to be. The memo looks at two recent Delaware cases – Chancellor Bouchard’s decision in Shareholder Representative Services v. Gilead Sciences (which I blogged about a few weeks ago) & Vice Chancellor Laster’s decision in Shareholder Representative Services v. Valeant. The cases illustrate that when it comes to earnouts, there are all kinds of ways to get into trouble.
The trouble with the Gilead case was the use of an ambiguous term to define a contractual payment milestone. That ambiguity compelled the Chancellor to look at extrinsic evidence in order to interpret the term’s meaning. Here’s the key takeaway from that decision:
The lesson for buyers and sellers is to leave no room for ambiguity as to what type of approval satisfies a milestone. Both industry and colloquial terms used in defining a milestone (on the assumption of “everyone knows what we mean here”) are susceptible to misinterpretation when litigated years later.
Parties may want to use clear examples in the contract itself (e.g., under a “for the sake of clarity…” introduction) of what will, and what will not, satisfy the milestone. Also, in case a court determines that a contract is ambiguous, parties should ensure that documents outside the agreement, like summaries for boards, term sheets, pre-contract letters of intent, etc., don’t shorthand the description of the milestones and are instead very clear on the intended hurdle.
That makes sense. But will this approach keep you out of trouble with earnouts? Based on the court’s approach in Valeant, maybe not. That case involved explicit provisions laying out what the buyer’s post-closing efforts obligations were when it came to causing the earnout to be triggered – but that still wasn’t enough to keep the buyer out of hot water:
The agreement did have fairly developed and explicit definitions of the required post-closing diligent efforts from the buyer, delineating both general standards for the required efforts plus four specific requirements on matters like minimum spending and staffing. The sellers alleged that the buyer’s high pricing of the acquired product, while not contrary to any of the general standards or specific requirements, violated the implied covenant of good faith by being unreasonable and therefore causing sales to be lower than anticipated. The court acknowledged that the contractual provisions were detailed and even covered “commercialization” of the product.
In spite of that, the court held that it could not dismiss an argument that pricing was separate from commercialization (stating that that term “maps imperfectly onto the idea of pricing”), therefore leaving room for an implied covenant claim arising out of the buyer’s pricing decisions. The court made a similar finding about the buyer’s decision to sell the product through a particular pharmacy channel.
The memo recommends that the best way to minimize the risk of controversy is to be as clear and specific as possible in drafting payment milestones and efforts obligations. To reduce the risk of judicial gap filling through an implied covenant of good faith, it also suggests that the parties “may wish to err on the side of over-inclusiveness and repetition” – and also include language indicating that the explicit terms of the contract are intended to override any such implied covenant.
Mergermarket recently issued its Global and Regional M&A Report for the 1st quarter of 2017. Here’s an excerpt with some of the highlights:
– Global dealmaking so far has remained resilient in the face of an uncertain year, with 3,554 deals worth US$ 678.5bn announced in the first quarter representing an 8.9% increase in value compared to the same period last year (4,326 deals, US$ 622.9bn). Due to ongoing uncertainty regarding upcoming European elections, transactions will be viewed as more precious, with larger sums being invested in fewer deals. This is reflected in the average size of disclosed value deals (US$ 403.4m), which reached its highest Q1 level on Mergermarket record (since 2001) due to nine recorded mega-deals (>US$ 10bn), up from eight in Q1 2016.
– A stand out trend has been the number of Consumer mega-deals announced, with a record three deals valued over US$ 10bn resulting in the sector deal value (395 deals, US$ 136.1bn) reaching its highest valued Q1 since 2008 (497 deals, US$ 180.2bn).
– A reversal of fortunes was seen for Chinese dealmakers investing abroad, who after a record-breaking 2016 have had their ambitions thwarted by strict regulation imposed on transactions valued over US$ 2bn. Chinese dealmakers invested in 75 deals worth US$ 11.8bn outside their borders in the first quarter, dropping 85.6% in value compared to Q1 2016 (96 deals, US$ 82bn) and 72.1% compared to Q4 (87 deals, US$ 42.3bn) to reach its lowest quarterly value since Q3 2014 (US$ 9.0bn) and deal count since Q1 2015 (61).
– Political uncertainty in Europe appears to have affected activity from international dealmakers pursuing deals in the region. Largely as a result in the previously mentioned drop in Chinese activity, Q1 inbound M&A (262 deals, US$ 71.7bn) dropped 39.0% by value compared to Q1 2016 (315 deals, US$ 117.5bn), marking the lowest Q1 since 2014 (US$ 55.8bn).
The report also includes the legal advisor league tables for the 1st quarter.
– John Jenkins
Here’s an excerpt from this “Proxy Insights” article (pg. 6):
Using data from Proxy Insight, it is possible to compare the policies of investors with their actual voting record. While investors typically oppose the priciple of golden parachutes, caveats in their policies often result in much higher support for the issue than might be expected. This is highlighted in Table 1, where 8 out of 10 investors supported more than half of all golden parachute resolutions they voted on, indicating that there are at least some investors paying lip service to good governance through their policies, yet taking a very different approach in practice.
This could help to explain the fact that, despite their divisive nature and tendency to provoke a fair amount of shareholder opposition, golden parachute proposals still rarely fail. Of the 438 golden parachute proposals that Proxy Insight has collected, all but 30 proved to be successful with the average level of support for these being 83%.
– Broc Romanek
In case anyone out there is worried that we have seen the last of greedy executives, check out this recent US District Court-SDNY opinion by Judge Jed Rakoff. You cannot read this first paragraph of the case without taking an interest!
Why would the executives (and former principals) of a paddle-board division of a sports and recreation company cause the company to make a one-time $60,500 purchase of one million stickers that the executives themselves immediately attempted to repurchase from the company for approximately $4 million?
The answer is that they thereby hoped to stick the company with a $10 million “earnout” payment to the executives, thus netting themselves a cool $6 million. Thanks, however, to the age-old doctrine of good faith and fair dealing, and similar legal protections, in the end it is these executives who are stuck.
– Broc Romanek
The busted deal involving The Williams Cos & ETE has put the potential impact of a closing condition tied to a lawyer’s ability to deliver a tax opinion on the front burner. This Cleary memo surveys post-Williams/ETE mergers in order to assess how dealmakers have addressed the “deal certainty” issues that situation created.
The memo finds that a number of alternative approaches have been adopted to reduce the risks associated with an opinion condition. As this excerpt notes, they include the following:
– Text of tax opinions & representation letters are agreed to before signing.
– Text of tax opinions & representation letters are agreed to before signing, and alternate counsel is identified at signing.
– Tax opinions are required at closing, but if a party’s chosen advisor is unwilling to issue the opinion, the party must accept the opinion issued by the counterparty’s advisor; plus acquirer pays termination fee if opinions not issued.
– Tax opinions are required at closing, but acquiror’s obligations are conditioned on it receiving both opinions.
– Covenant to try to restructure, if necessary.
The memo identifies specific transactions that have adopted each of these alternative approaches, and notes that in two public company mergers, the parties dispensed with tax opinion closing conditions altogether. One of those deals provided for opinions to be obtained, but did not condition either party’s obligation to close on their receipt. The other contained no mention of tax opinions.
– John Jenkins
This Bloomberg article says that the current M&A boom may leave lots of companies with a very bad hangover in the form of big goodwill impairment charges. According to the article, the fundamental problem is that buyers are simply paying too much for deals:
In the past two years, takeover targets have sold for a median of 11x EBITDA — essentially 11 years of profit — whereas the multiple was only about 7-9x in the years leading up to the recent merger frenzy. Transactions are getting ever-bigger and more expensive, pushing total goodwill to $6.9 trillion for the companies on which Bloomberg holds data. Corporate America accounts for more than half that amount.
Goodwill now accounts for more than 1/3rd of net assets at S&P 500 companies, & has risen by 2/3rds since 2007. People sometimes shrug-off goodwill impairments, since they represent non-cash charges, but the article points out that these write-downs have real consequences for the companies and investors involved:
Some folks argue that goodwill impairments don’t really matter because no cash leaves the business and they’re inherently backward-looking. We disagree. These types of charges signal that cash flows won’t be as strong as a company once hoped. While shareholders may see this stuff coming, they’re caught off-guard sometimes. In addition, impairments deplete shareholder equity, which makes lenders and bondholders nervous. Companies that financed takeovers with lots debt are particularly exposed.
– John Jenkins
Arnold & Porter Kaye Scholer recently issued reports on US Merger Enforcement & EU Merger Enforcement during 2016. Here’s an excerpt from the intro to the US report:
2016 marked another year of robust M&A activity and another year of active merger enforcement in the United States. In many ways, 2016 continued the trends seen in 2015, in particular, greater scrutiny of certain transactions and a continued willingness by the authorities to litigate to stop transactions perceived as anticompetitive.
Despite this atmosphere of aggressive enforcement, the FTC & DOJ continued to carefully scrutinize each transaction, analyzing the individual facts and potential antitrust risks. The DOJ and FTC permitted the vast majority of deals to proceed either unconditionally (such as the sale of GE Appliances to Haier Group and Marriott International’s acquisition of Starwood Hotels & Resorts), or with conditions to remedy the competitive concerns.
And here’s an excerpt from the intro to the EU report:
The European Commission continued to pursue longer and more data-intensive investigations in 2016. At the same time, Commissioner Margrethe Vestager signaled a desire to implement reforms that lessen the burden of investigations, particularly for non-substantive transactions.
Last year was notable in particular for the first prohibited merger since Commissioner Vestager took office in 2014, Hutchison 3G UK/Telefónica UK, and the abandoned Baker Hughes/Halliburton transaction that went through an intensive Phase II review. And while the total number of Phase II investigations decreased slightly from last year, there were still a significant number that materialized. Only a single transaction was cleared without any remedies in Phase II in 2016.
– John Jenkins