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.
It sure seems like the “entire fairness” standard ain’t what it used to be. Back when I had hair, Delaware courts referred to the choice of whether to apply the business judgment rule or the entire fairness standard as often being “outcome determinative.” But more recently, some Delaware decisions have shown that entire fairness is a standard that sometimes can be navigated – even if the defendant retains the burden of proof to establish a deal’s fairness.
It looks like we can add the Chancery Court’s recent decision in Hsu Living Trust v. Oak Hill Capital Partners, (Del. Ch.; 5/20), to the list of those decisions. The case involved allegations that the controlling shareholder & its representatives on the board breached their fiduciary duties by causing the company to adopt a strategy designed to accumulate cash in anticipation of a redemption of the controller’s preferred shares.
The plaintiff established that implementation of this strategy provided unique benefits to the controller, so Vice Chancellor Laster decided that the plaintiff’s claims should be evaluated under entire fairness standard should apply. Nevertheless, the Vice Chancellor determined that the defendants satisfied their burden of proving that the challenged strategy was entirely fair. Steve Quinlivan’s recent blog on the case summarizes VC Laster’s reasoning:
As is well known, the concept of fairness has two basic aspects: fair dealing and fair price. The fair process dimension of the entire fairness inquiry examines the procedural fairness of the decision, transaction, or result being challenged. It considers the manner in which the challenged decision, transaction, or result came about.
The Court found the defendants fell short on this dimension of the analysis. The reasons appear to be that Oak Hill directed management’s actions and the lack of Board approval of the cash accumulation strategy. Noting that Hsu only challenged the cash accumulation strategy, and not the decision to redeem shares or the prices at which assets were sold, the Court found the lack of process was not fatal.
The reason was that although the two aspects –fair dealing and fair price — may be examined separately, they are not separate elements of a two-part test. The test for fairness is not a bifurcated one as between fair dealing and price. All aspects of the issue must be examined as a whole since the question is one of entire fairness.
The fair price dimension of the entire fairness inquiry examines the substantive fairness of the decision, transaction, or result being challenged. In the traditional formulation, it relates to the economic and financial considerations of the transaction under challenge, including all relevant factors: assets, market value, earnings, future prospects, and any other elements that affect the intrinsic or inherent value of a company’s stock.
The defendants proved at trial that the cash-accumulation strategy was entirely fair. The defendants proved by a preponderance of the evidence that the Company declined not because of the cash-accumulation strategy, but rather because of industry headwinds and relentless competition, most notably from Google, Inc.
The Vice Chancellor also found that the defendants had proven that an alternative strategy would not have produced greater value for the common stockholders. In reaching this conclusion, he noted that Oak Hill was also a substantial holder of the common stock and that, while it had an incentive to fund the redemption of its preferred stock, it also had an incentive to create value for the common.
This SRS Acquiom study reviews the financial & other terms of 1,200 private target deals that closed during the period from 2015 through 2019. Here are some of the key findings about trends in last year’s deal terms:
– The median size of management carveouts, while still rarely used, grew to 11.1% of merger consideration. Meanwhile, full acceleration of options vesting continued to decline in 2019 to 27%–a drop of 20% from 2016-2017.
– Post-Closing Purchase Price Adjustments (PPAs): separate PPA escrows continue to grow in popularity. In the past this has been strongly correlated with RWI, but it is gaining popularity even in deals without RWI policies. GAAP consistent with past practices is again the prevalent standard for PPA measurement, though GAAP alone is losing ground to other measures (such as non-US accounting standards).
– Earnouts have waxed and waned in popularity the last few years, increasing to 22% of non-life science deals in 2019 (compare 13% in 2018 and 23% in 2017, see slide 24). In addition, the median earnout potential as a percentage of the closing payment returned to 41%, after a recent low of 30% in 2018. Finally, offsets to earnouts for indemnity claims fell 8% to 68% of deals.
– For accuracy of seller’s representations, while “in all material respects” remains the standard in a bare majority of agreements, a “Material Adverse Effects” formulation continued to gain ground in 2019, increasing in “at signing” clauses from 31% in 2018 to 44% and remaining high at 48% of “at closing” clauses.
– Inclusion of both standalone and back-door “Material Adverse Change” conditions in a single agreement increased 10% from 47% in 2018.
– The median general survival period for indemnity escrows remains 15 months, but there is more variability in lengths than last year. Median escrow size for the year was 9.9% of transaction value, with an average of 8.9%. The average and median escrow/holdback size for non-RWI deals ticked up to 12.5% and 10.5%,respectively, in 2019.
There is plenty of other interesting stuff to review in this study, including more on financial terms, closing conditions, indemnification, dispute resolution and termination fee arrangements.
It’s rare that M&A news has me waxing poetic, but yesterday’s announcement that L Brands and Sycamore Partners decided to end their deal, coupled with the news that two billion dollar deals had fallen apart on that same day, has awakened my inner William Butler Yeats: “Things fall apart; the centre cannot hold; Mere anarchy is loosed upon the world. . .”
Overdramatic? Of course. Still, shortly after the Covid-19 crisis burst into flames in the U.S. in March, Bloomberg Law published an analysis indicating that deal terminations were actually lower than their prior year levels, and asking the question “where are all the M&A deal terminations?” Any hopes that M&A might successfully swim against the current were dashed in April, when Bloomberg published an updated analysis that answered its original question about deal terminations with a resounding “they’re here!”
These recent terminations are further indication that the deal market has fallen on hard times – and according to a recent Datasite & Mergermarket report on Q1 M&A activity, we’re unlikely to see an uptick in M&A in the near future:
Given the downturn in deals both for corporates and for sponsors, morale among dealmakers is unsurprisingly at a low ebb. Though some deal-related communications can and are being conducted virtually, this is a major departure from the norm. And while deals already in the works could be concluded, all new business is essentially on pause. “We’re not going to be signing anything in the midst of this tornado,” said a managing director at a private equity firm to Mergermarket.
The report says that the U.S. is likely to go through a period of severe economic upheaval which would have a knock-on effect for M&A. It suggests that the M&A and financing markets may well remain on hiatus for at least a few months. When you add in the fact that even if we get a break and the pandemic subsides in a few months, we’ll be in the middle of a presidential election campaign – which is not a great time to make a deal.
It isn’t unusual for one or more target shareholders to “roll” their equity interests over into the acquiring entity. But if the deal involves a controlling shareholder, when will the equity rollover result in minority holders becoming part of the control group that’s subject to fiduciary duties? The Delaware Chancery Court recently addressed that issue in Gilbert v. Perlman, (Del. Ch.; 4/20).
The case involved the rollover of investments held by the holder of an 11% interest in Connecture and the company’s chairman (who held less than 1%, but was also affiliated with the 11% holder). The plaintiffs alleged that, as a result of their participation in the transaction, they were part of a control group with the company’s majority stockholder. Vice Chancellor Glasscock rejected that allegation.
Citing Delaware precedent, the Vice Chancellor said that two elements must be established in order for a minority shareholder to be considered part of the control group. First, the minority holder must be connected to the controlling shareholder in a legally significant way (such as through a contract) to work together toward a common goal. Second, the plaintiff must also demonstrate that the minority holder’s participation was material “to the controller’s scheme to exercise control of the entity, leading to the controller ceding some of its control power” to the minority holder.
This Paul Weiss memo on the case says that although the Vice Chancellor felt that the plaintiffs established the first prong of the test, he concluded that they fell short when it came to the second:
Plaintiffs pointed to various factors indicating the existence of a control group, including that (i) SEC rules defined the minority and majority stockholders as “affiliates” and they filed a Schedule 13E-3 stating, among other things, whether they believed the merger was fair to the company’s unaffiliated security holders, (ii) the 11% stockholder entered into a voting agreement with the controller requiring it to vote its shares in favor of the merger, and (iii) the minority stockholders previously participated in two private placements alongside the controller.
In his opinion, Vice Chancellor Glasscock acknowledged that these allegations were sufficient to satisfy the first prong of the control group test, finding the allegations supported an inference that there was a legally significant connection among the stockholders beyond mere parallel interests in supporting the merger.
However, the court reasoned that the second prong was not satisfied because the majority stockholder could approve the merger “entirely on its own” without minority participation, and plaintiffs did not allege anywhere in the complaint that the controller’s “sharing or material self-limiting of its control powers” to obtain participation of the minority stockholders for its “perceived self-advantage.”
The court said that the complaint “describes nothing [the controller] needed or ceded to the [minority stockholders], other than the bare right to roll over shares,” and the controller’s willingness to dilute its interest by permitting the rollover was not enough to satisfy this second prong.
Many private companies find themselves in need of financing & may be thinking about tapping fund investors in order to meet their need for capital. This Sidley memo has some thoughts on what they’re likely to face when it comes to financing terms during the Covid-19 crisis. This excerpt says that companies should expect to see more “staggered” financings:
We expect to see more “staggered financings” or “financings in tranches” as a way for investors to de-risk transaction and bridge the gap between valuation disagreements. In staggered financings, companies and investors negotiate a set of funding milestones, which can be based on the development of a certain technology, satisfaction of a certain business plan or other financial projections provided during due diligence.
A staggered financing would provide for the same valuation for each tranche of the investment, irrespective of a company’s changed circumstances from the milestone achievement. As a result, the investor is able to better control the valuation at which it invests because the company will have achieved the milestones that were the basis for the investor’s agreement to the valuation in the first instance.
The memo also says that investors are likely to seek more demanding preferred stock terms, including enhanced liquidation preferences, participation rights, greater IPO valuation protection, broader voting rights, a greater prevalence of redemption rights and shorter redemption periods. Companies also should expect to see more “pay-to-play” provisions under the terms of which investors may lose rights if they don’t participate in subsequent financing rounds.
Earlier this week, the Treasury Department took a break from firing its cash howitzer just long enough to implement an interim rule requiring those entities that submit notice of a proposed transaction to CFIUS to pay a filing fee for the privilege. The fee goes into effect on May 1st, (i.e., today), and the fee amount fee is based on the size of the transaction. No fee is required for deals with a value of less than $500K, while deals with a value of $750 million or more will have to pay a fee of $150K.
If this all seems kind of sudden, it is. As this Dorsey & Whitney memo points out, the Treasury’s rulemaking process here leaves much to be desired:
On March 9, 2020, CFIUS published a notice of proposed rulemaking to establish filing fees for “covered transactions” under the Regulations Pertaining to Certain Investments in the United States by Foreign Persons found in 31 CFR Part 800 (“Part 800”) and for “covered real estate transactions” under the Regulations Pertaining to Certain Transactions by Foreign Persons Involving Real Estate in the United States (“Part 802”). The proposed rule created a new Subpart K to Part 800 and 802.
Under the proposed rule, CFIUS was accepting comments on the proposed filing fees only until April 3, 2020. CFIUS appears to have received only five comment letters. Importantly, the timing of the release of the proposed rule and the date on which comments were originally due coincided with the time that virtually all U.S. companies were very distracted by the adverse effects of the COVID-19 pandemic. CFIUS itself acknowledged the impact of the COVID-19 pandemic on public comments and so has extended the new comment period until June 1, 2020.
Despite requesting additional comments, given the growing volume of CFIUS’s work and the added government resources that must be devoted to that work, on April 27, CFIUS determined that implementing filing fees in line with the 2018 FIRRMA authorization was appropriate at this time.
Not for nothing, but Uncle Sam can probably use the cash right about now too. The fee requirement only applies to formal written notices filed with CFIUS and not to the mandatory declarations created under FIRRMA. But the memo points out that if the parties to a mandatory declaration ultimately file a formal written notice, they would be required to pay the applicable filing fee.