Although the various programs providing direct financial support to business are the most well-known aspects of the CARES Act, the statute also rolls back some of the limitations on net operating loss carrybacks imposed in 2017 by the Tax Cuts and Jobs Act. According to this Accounting Today article, these changes to the treatment of NOLs could give a boost to M&A activity. Here’s an excerpt:
The CARES Act included several provisions allowing companies to claim net operating losses for past tax years, temporarily reversing some of the limitations in the Tax Cuts and Jobs Act. Those changes are likely to encourage more companies to pursue mergers and acquisitions once the market recovers from the economic downturn from the novel coronavirus pandemic.
Under the Tax Cuts and Jobs Act of 2017, net operating losses could no longer be carried back to prior tax years to offset taxable income, though they could be carried forward indefinitely from 2018 and on.. The CARES Act, which Congress passed in March to aid the economy in the wake of the COVID-19 pandemic, allows any NOL generated in a taxable year starting Dec. 31, 2017 and ending Jan. 1, 2021, to be carried back five years.
The article says that the CARES Act provisions essentially defer the effective date of the TCJA’s limitations to the beginning of 2021 – including provisions that limited the amount of NOLs that could be used to 80% of taxable income in any one tax period.
The article reviews various options for buyers and sellers when it comes to the treatment of NOLs in acquisition agreements, and points out that the change in ownership rules under Section 382 of the IRC that limit loss carryforwards do not apply to carrybacks.
Some public companies – particularly those in sectors that have been hit hard by Covid-19 & the collapse of energy prices – may be thinking seriously about an MBO or similar “take private” transaction. If you have a client that is exploring this option, check out this recent Hunton Andrews Kurth memo. It provides an overview of the federal securities law & state fiduciary duty issues associated with a take private deal, and discusses how the need to manage those issues will affect the transaction process.
Here’s an excerpt on structuring a competitive bidding process in the absence of a controlling shareholder:
In a take private transaction effected by a controlling stockholder, the target company may not have viable third-party alternatives, as the controlling stockholder may not be a willing participant in any such transaction. Nevertheless, it will be important for the Special Committee to discuss with its advisors the practicality of soliciting third-party alternatives and to assess the controlling stockholder’s interest in supporting third-party transactions.
Outside the controlling stockholder context, the Board or Special Committee has a variety of options to discharge its fiduciary duties in obtaining the best price reasonably available for the stockholders, as further discussed below. This is typically done through a “market check.” In some M&A transactions, the Board may choose to negotiate with a single bidder and then rely on a post-signing market check (sometimes referred to as a “window shop”) in which the Board can respond to bona fide unsolicited proposals and exercise its “fiduciary out” to recommend a superior proposal prior to the stockholder vote or completion of the tender offer. In the take private context, however, Boards and/or Special Committees may opt to conduct a pre-signing market check (i.e., a sale process) or facilitate a post-signing market check through a “go-shop” process.
A “go-shop” refers to a provision in the merger agreement that allows the target Board to solicit alternative bids and freely discuss a transaction with any third-party buyer during a limited period of time. Delaware courts have held that an effective go-shop provision can promote a competitive bid process. The “go shop” provision must permit a meaningful opportunity for the target to search for higher offers, and the target typically commences the “go shop” process by including a reference to the “go shop” provision in the press release announcing the execution of the merger agreement with the take private bidder.
The memo also reviews alternative transaction structures, federal disclosure requirements, the standards of review that the Delaware courts may apply to the transaction, the factors that will be used to determine whether a controlling shareholder or control group is present, and the use of special committees to mitigate conflicts of interest.
This recent Seyfarth memo provides an overview of creative ways to bridge valuation gaps between buyers and sellers. The memo discusses earnouts, but it addresses a number of other alternatives as well. Here’s an excerpt on equity rollovers:
Equity rollovers are a tool used almost exclusively by private equity buyers in platform acquisitions, and sometimes for tuck-in acquisitions. Equity rollover transactions typically involve rollover participants taking between 10% and 40% of the purchase price in the form of equity in the buyer.
Equity rollovers are generally restricted to founders and other members of the seller’s management team who are joining the buyer post-closing. This provides founders and management with a meaningful equity stake in the buyer to align their respective interests to grow and sell the target company.
Generally, existing equity holders in the seller who are not founders or part of the management team (i.e., venture capital, private equity or angel investors) are excluded from the equity rollover since they have no ongoing role with the buyer postclosing and would rather exit the investment in the seller. Private equity buyers also like equity rollovers since they serve as a form of seller financing which reduces the buyer’s up-front cash payments at closing.
While equity rollovers are already common, the memo says that, in the future, they will likely be used as a way of allocating more risk to the seller in order to address the unpredictability of post-pandemic financial performance. The memo also suggests that the terms of and participation in equity rollovers may evolve to address post-pandemic considerations.
Other potential techniques for bridging valuation gaps discussed in the memo include the use of targeted management incentive bonuses by strategic buyers, and a “hybrid rollover” structure involving a purchase of less than 100% of the target’s equity with deferred purchase options for the remainder.
Morgan Lewis’s Sean Donahue recently tweeted about a new study that found evidence that activists are leaking information about upcoming campaigns to institutional investors prior to their launch. Here’s the abstract:
We document a network of information flow between activists and other investors during the 10 days prior to the announcement of a campaign. We use EDGAR search activity matched to institutional investor IP addresses to identify investors who persistently download information on an individual activist’s campaign targets in the days prior to that activist’s 13D disclosures.
This pattern of informed EDGAR access suggests leaked information from the activist to the unaffiliated institutional investor, who is not named in the 13D filing. We find that the presence of these informed investors is associated with higher pre-13D turnover, higher post-13D returns, and an increased likelihood of the activist pursuing and winning a proxy fight.
I suppose that, like Captain Renault in “Casablanca,” I could feign shock at this news, but we’re all grownups here. However, as this Institutional Investor article points out, if this pre-announcement information sharing gave rise to some kind of agreement by investors to support the activist, it could call into question the accuracy of statements in activist 13D filings.
One of the consequences of the Covid-19 pandemic is that buyers and sellers are increasingly finding themselves in situations where they need to find a way to bridge a valuation gap in order to get a deal done. One tried and true – if frequently troublesome – way of doing that is through the use of earnout provisions.
If you are considering an earnout, check out this recent article by Mintz’s Marc Mantell & Scott Dunberg, which updates the authors’ 2014 article & reviews how market practice on key earnout issues has evolved in recent years. Here’s an excerpt on contractual provisions addressing the buyer’s obligations when it comes to achieving earnout milestones:
Notably, there may be an upward trend in covenants requiring buyers to operate the business to “maximize” the earnout payments to sellers. As we noted in the 2014 article, the 2013 ABA Private Target Mergers and Acquisitions Deal Point Study, reported that only 6% of deals covered in that study included such a covenant.
However, the 2019 ABA Study reports that 17% of deals with earnouts included an express covenant requiring the buyer to run the business to “maximize” the earnout. This is a surprising result, as it appears to reverse the trend reflected in prior studies and could signal a strengthening of sellers’ bargaining power. However, based on our independent review of several publicly-filed acquisition agreements, including those in the 2019 ABA Study, many of these provisions invoke a “commercially reasonable efforts” or similar standard to the effect that the buyer’s obligation is to use commercially reasonable efforts to maximize the earnout payments, or some variation of this language.
The article also looks at how judicial interpretations of the implied covenant of good faith and fair dealing in the earnout context have evolved in recent years, as well as the impact of RWI on provisions relating to set-off rights.
The default rule in Delaware is that post-closing, the seller’s attorney-client privilege is transferred to the buyer in a deal structured as a merger. But what about an asset purchase? The Chancery Court recently addressed that question in DLO Enterprises, Inc. v. Innovative Chemical Products Group, LLC(Del. Ch.; 6/20). This Steve Quinlivan blog summarizes Vice Chancellor Zurn’s letter opinion:
The court initially noted that cases such as Great Hill Equity Partners IV, LP v. SIG Growth Equity Fund I, LLLP and Shareholder Representative Services LLC v. RSI Holdco were not applicable because those cases arose in the context of a statutory merger The court held in the asset purchase context, the seller will retain pre-closing privilege regarding the agreement and negotiations unless the buyer clearly bargains for waiver or a waiver right. Here, the buyers failed to explicitly secure pre-closing privilege waiver rights relating to the negotiation of the Purchase Agreement.
Section 8.9 of the Purchase Agreement gave buyers waiver rights over the privilege relating to Assets and Assumed Liabilities transferred to buyers. The question presented to the court was whether deal communications related to Assets and Assumed Liabilities. Section 1.2 of the Purchase Agreement defined Excluded Assets to include the sellers’ “rights under or pursuant to this Agreement and agreements entered into pursuant to this Agreement.” Section 8.9’s privilege waiver for Assets did not reach deal communications because Sellers’ rights under or pursuant to the Purchase Agreement were carved out as an Excluded Asset under Section 1.2.
In addition to documents relating to pre-closing deal communications between the sellers and their counsel, the case also involved documents reflecting such communications that were currently in possession of buyer because these documents were left in email accounts acquired by the buyer. As to this latter category of documents, the Vice Chancellor requested supplemental briefing on the proper test to assess whether sellers waived privilege for these communications.
This Freshfields report takes an in-depth look at how the Covid-19 pandemic could influence M&A over the longer term. The report provides a thoughtful and wide-ranging analysis of a variety of topics relating to the future of M&A. For example, this excerpt discusses a potential boom in private credit investing post-pandemic:
We also expect a surge of interest in private credit investing among LPs and sponsors. Special situations and tactical opportunities funds are built for times of volatility, and made huge gains in the wake of the financial crisis thanks to their flexibility to invest across asset classes. No one did better than Apollo, which at the height of the credit crunch poured more than $1bn into debt from plastics manufacturer LyondellBassel. This was converted into equity when the company filed for bankruptcy and years later, after LyondellBassel was reborn through a successful listing, Apollo walked away with a $10bn profit. According to Bloomberg it remains the most successful private equity investment of all time.
Not all private credit plays flip into overall ownership in this way. But sponsors may not need traditional ‘control’ in order to succeed under current market conditions. The usual route by which sponsors exert influence over their investments (i.e. acquiring a majority of the share capital and installing their own directors) are less important in times of high financial stress. Against the backdrop of COVID-19, private investors who provide a financial lifeline for struggling businesses will carry a lot of influence in the boardroom – and could find themselves wielding as much power as they do when they own large chunks of shares.
Other matters addressed in the report include the consequences of the pandemic’s disparate impact on various sectors of the economy, its influence on activism, its contribution to the growth of economic nationalism, and its effects on deal terms & processes.
In its recent decision in Midcap Funding X Trust v. Graebel Companies, (Del. Ch.; 4/20), the Delaware Chancery Court relied upon a contractual disclaimer of reliance to dismiss fraud, misrepresentation and mistake claims arising out of the course of negotiations of a settlement agreement relating to $13 million of outstanding receivables.
The parties entered into the settlement agreement under the terms of which the defendants agreed to deliver funds to the plaintiff. The plaintiffs subsequently discovered that the defendants had already billed and/or collected a larger amount of receivables than previously stated, which contradicted representations made by the defendants during the course of the settlement negotiations.
The plaintiffs filed a lawsuit in the Chancery Court alleging that the defendants actions constituted misrepresentation, fraudulent concealment, breach of the implied covenant of good faith and fair dealing, mistake, and unjust enrichment. Vice Chancellor Zurn dismissed those allegations, and this excerpt from a recent Morris James blog on the case summarizes her reasoning:
The Court rejected these claims and granted Defendants’ motion to dismiss as to those counts. Specifically, the Court found that Plaintiffs failed to state a valid claim for misrepresentation, fraudulent concealment, and mistake because the settlement agreement contained anti-reliance and integration clauses, which precluded those causes of action.
The Settlement Agreement stated each party “is not entering into this Agreement in reliance upon any representations, promises or assurance other than those expressly set forth in this Agreement.” The integration clause also stated that the Settlement Agreement “supersedes any prior contracts, understandings, discussions, and agreements among the parties.” As the Court explained, “the [n]egotiations leading up to the Settlement Agreement,” were outside “the four corners of the Settlement Agreement” and were thus barred by the contract’s plain terms which “disclaim[ed] reliance on [] extra-contractual representations.”
The Court also held that, as a result of the anti-reliance provisions, the Plaintiffs’ consequent “failure of justifiable reliance [was] fatal to [the] claim for mutual mistake” and unilateral mistake because the claims were premised on “extracontractual representations and omissions.”
The blog also notes that the Vice Chancellor dismissed the good faith and fair dealing claim because she concluded that plaintiffs’ theory “was premised on obligations that the contract did not create, and that were inconsistent with the Settlement Agreement’s terms.” VC Zurn dismissed the unjust enrichment claim because she found that the relationship between the parties was governed by the settlement agreement.
Many companies have received loans under the SBA’s Paycheck Protection Program, and with those borrowers likely to come under close scrutiny from regulators in the upcoming months, potential buyers of a PPP borrower need to take a hard look at issues that may arise as a result of the target’s participation in the program.
This Womble Bond memo provides an overview of due diligence issues that may arise when acquiring a company at various stages of the PPP process – from application through the period following an application for loan forgiveness. This excerpt addresses the issues that arise at the stage many parties may find themselves in during the upcoming months – the period between signing and applying for loan forgiveness:
The period between when an applicant receives a loan (now, a borrower) and applies for forgiveness is the period in which many borrowers are operating right now. Most companies that are eligible and have decided to participate in PPP have already received their funds. The primary challenge sellers and buyers face at this time is assessing how an M&A transaction may impact a borrower’s ability to participate in forgiveness.
The issue is, under the SBA’s current rules, the borrower must wait eight weeks before applying for forgiveness and the lender has up to sixty days to then certify the forgiveness amount (some lenders are saying the certification process should not take that long). What happens if a borrower would like to close an M&A transaction during that time? Is all or a portion of the loan eligible for forgiveness? Should the PPP loan be treated as a bridge loan to be repaid at closing?
During the period after disbursement and before forgiveness is applied, the CARES Act and the SBA’s guidelines are generally not as relevant as the loan documents (typically consisting of a promissory note and one or two consents or certifications) the borrower entered into with its lender. Those documents are where you would find any change of control provisions and prohibitions on change of ownership, the nature of business, assigning the loan documents or the obligations arising thereunder, or selling assets outside the ordinary course.
The memo points out that the loan documents will require the lender’s consent to any transaction that would result in the occurrence of one or more of these events, and that if it is not forthcoming, the borrower will be ineligible for loan forgiveness and the loan will need to be repaid at closing.
I’ve previously blogged about the revival of traditional “poison pill” rights plans as a result of Covid-19 crisis-related market volatility, but companies with significant net operating losses to protect may want to consider adopting an NOL rights plan. This WilmerHale memo discusses the reasons for considering such a plan and its features. This excerpt highlights how the terms of an NOL rights plan differ from those of a traditional rights plan:
Threshold. First, in NOL rights plans, the applicable beneficial ownership threshold at which an acquisition will trigger the right of the company shareholders (other than the acquiring person) to purchase or receive additional shares is set just below 5% (typically 4.99% or 4.9%) as Section 382 aggregates changes in ownership by 5 percent shareholders to determine whether an ownership change has occurred. A traditional shareholder rights plan has a much higher threshold (typically 10-20%).
Definition of Beneficial Ownership. Second, “beneficial ownership” in NOL rights plans is typically defined, at least in part, by reference to Section 382, in addition to beneficial ownership as defined under securities laws and other indicia of ownership used in traditional shareholder rights plans. Stock ownership for purposes of Section 382 is determined based on a complex set of rules that take into account principles of constructive and beneficial ownership that differ from those rules under securities laws.
Exemption Provisions. Many NOL rights plans also contain exemption provisions that are not typically found in traditional shareholder rights plans. Since the purpose of an NOL rights plan is to deter acquisitions of a company’s stock that would cause a Section 382 ownership change and impair the company’s NOLs, these exemption provisions generally give the board of directors discretion to exempt a particular stock purchase from triggering the stock purchase rights if the board determines that the purchase would not endanger the company’s NOLs.
The memo also points out that the duration of NOL rights plans is often different than the duration of traditional rights plans. Many traditional rights plans are now limited to a period of one year or less. In contrast, NOL rights plans generally provide for their termination after three years or a shorter period if the NOLs will expire earlier. An NOL plan also generally terminates if the board determines that the company has used all of its NOLs.