SRS Acquiom recently released a multi-year study on post-closing M&A purchase price adjustments & indemnification claims covering nearly 600 private deals for which it served as shareholder representative. The study analyzes data for transactions with escrows that were fully released during the period from Q3 2018 through Q3 2020. This excerpt lays out some of the study’s highlights:
– 79% of deals with a purchase price adjustment (PPA) mechanism had an adjustment, and 50% of deals with a PPA mechanism had a buyer-favorable claim for adjustment.
– Parties may wish to err on the side of creating a larger PPA-specific escrow fund. The average size of buyer favorable PPA claims frequently represents a large percentage of PPA-specific escrow funds .
– Fraud claims are by far the largest category of indemnification claims, and the only claim category for which the median claim size exceeds the escrow (294%). Other claim categories may exceed the escrow in some instances—often because they are alleged in conjunction with fraud—but absent an allegation of fraud claim sizes are generally much smaller than that as a percentage of escrow.
– The size of claims for undisclosed liabilities and relating to financial statements, which are often coupled with fraud claims, as a percentage of escrow has remained high in recent years.
– The trends in size and frequency of the claims in deals with representation and warranty insurance (RWI) are similar to those found across all deals. Claims in deals with RWI tended to be more concentrated in smaller transactions, whereas in the full data set midsize deals tended to have more claims.
The study says that public and financial buyers generally made the most claims, but that likely reflecting the patterns of deals using RWI, the percentage of escrow claimed by public buyers is lower than in other buyer categories.
It’s fair to say that the last few years haven’t been kind to discounted cash flow analysis when it comes to Delaware appraisal proceedings. Generally, Delaware courts in recent years have typically used the deal price or other market-based measures as the most reliable indicators of fair value in situations where the process appears to have been sound. But the Delaware Supreme Court’s recent decision in SourceHOV Holdings v. Manichean Capital, (Del.; 1/21), is a reminder that DCF still has a role to play in situations where there are significant questions about the process.
In Manichean Capital, the Court upheld a prior Chancery Court decision holding that under the circumstances of that case, a DCF analysis was the appropriate method for determining the fair value of the dissenting shares. This Shearman blog explains the Court’s reasoning:
The Court of Chancery had explained that the circumstances surrounding the business combination that triggered the appraisal rights “disqualif[ied] market evidence as reliable inputs for a fair value analysis,” leaving the court to consider competing expert opinions on a DCF valuation. Moreover, the Court of Chancery largely adopted petitioners’ analysis, which it found more reliable than that of respondent’s expert.
Explaining its reliance on a DCF analysis instead of market evidence, the Court of Chancery highlighted that the company’s “deal process (or lack thereof) undermine[d] any reliance on deal price as an indicator of fair value.” In particular, the court noted that the company’s board did not hold a single formal board meeting to consider the transaction or solicit offers from other parties after it received the initial overture. The court also noted that the privately held company’s equity was not traded in an efficient market and, therefore, its unaffected market price could not be relied upon as an indicator of fair value.
Naturally, the Court had to grapple with two competing expert reports that reached very different conclusions with respect to the DCF analysis. It noted that the company’s expert’s use of a novel approach in calculating its equity beta raised credibility issues not present in the petitioners’ expert report, which used the more standard approach of calculating the company’s beta based on publicly traded comparable companies.
The Court ultimately accepted the petitioners’ approach to the DCF analysis, with the exception of an adjustment for the size premium, which resulted in an appraised value of $4,591 per share, or approximately 9.4% higher than the $4,177 per share deal price.
The WSJ recently reported that CFIUS has beefed up its enforcement team and is taking a hard look at venture investments by China-based entities, including deals that closed months or even years ago. The article says that dealmakers better get used to this kind of scrutiny when it comes to Chinese investments in tech startups:
The Committee on Foreign Investment in the U.S., or CFIUS, has over the past two years built out a new enforcement arm of roughly two dozen people tasked with rooting out old investment deals that involve sensitive technologies and could pose a threat to national security, according to current and former government officials and national-security lawyers. The team has its sights on venture-capital investments, even small-dollar deals, where the money can be traced back to China, these people say.
CFIUS, which reviews foreign investment in U.S. companies and real estate for potential national-security risks, is positioned to become a linchpin in President Biden’s strategy to curb China’s technology ambitions. Recent hires to its enforcement team include professionals from venture-capital firms, investment banks and technology backgrounds, according to people involved in the effort. This CFIUS group has sent letters to several dozen companies and made calls requesting information about transactions with foreign investors, said lawyers, investors and national-security officials.
The article notes that CFIUS unwound two venture investments by China-based entities last year, and that its willingness to unravel a closed investment has led some startups to seek CFIUS approval in advance of closing.
This Dechert memo reviews the Delaware Supreme Court’s recent decision in Morris v. Spectra Energy Partners, (Del. Sup.; 1/21), which adopted the test established by the Chancery in In Re Primedia S’holders Litig. (Del. Ch.; 5/13) for determining when shareholders whose derivative claims have been extinguished by a merger have standing to bring a direct claim challenging the merger based on the seller board’s failure to obtain sufficient value for a material derivative claim.
Under the Primedia test, a court must consider three things: First, was the underlying claim viable enough to survive a motion to dismiss? Second, was its value material in context of the merger? And third, was the buyer unwilling to pursue the claim? The Chancery Court applied the Primedia test to the claims in Spectra Energy, and held that the equity holders did not have standing to pursue a direct claim.
The Chancery Court dismissed the case because it determined that the amounts involved were not material to the overall consideration paid in the merger. In reaching that conclusion, the Court applied two discounts to determine the value of the derivative claim. First, it applied an 83% discount based on the size of the public equity holders beneficial interest in the derivative claim. Second, it applied a further 75% discount to the value of the claims based on the likelihood of their success on the claim.
The Supreme Court adopted the Primedia test, but held that the Chancery Court had erred in determining that the claim was immaterial. This excerpt from the memo reviews the Court’s reasoning:
The Delaware Supreme Court recognized that the Chancery Court has the authority to dismiss a direct shareholder claim for lack of standing if the claim is “meritless” or “immaterial.” Nevertheless, in this case, the Delaware Supreme Court held that the Chancery Court erred in finding the underlying derivative claim was “meritless” or “immaterial” for two reasons.
First, the Delaware Supreme Court emphasized that “the court must accept [Plaintiff’s] factual allegations as true and draw all reasonable inferences in his favor.” In other words, “if it is reasonably conceivable that the plaintiff could recover the damages claimed in the complaint, the court must accept that allegation as true for purposes of the motion to dismiss for lack of standing.” The Delaware Supreme Court therefore held that, apart from making this threshold determination about plaintiff’s allegations, a trial court may not apply “a further litigation risk discount at the pleading stage . . . on a motion to dismiss for lack of standing.” Accordingly, the Delaware Supreme Court found that it was error for the Chancery Court to apply a 75% litigation risk discount based on the court’s assessment of Plaintiff’s chances of success at 25%.
Second, the Delaware Supreme Court clarified that the Chancery Court must assess the materiality of the claim based on a consistent comparison of the claim to the value of the merger consideration. And so, it was error for the Chancery Court to compare, on the one hand, the value of the claims to a
limited group of equity holders, to the entity’s total equity value as determined by the merger. Materiality should instead be calculated by comparing the value of the claim to the subset of affected equity holders to the specific consideration those equity holders received in the merger, or by comparing the total value of the claim to the entity as a whole to the total consideration provided in the merger.
The Court concluded that if the derivative claim was discounted to an amount representing the public equity holders interest in the potential recovery, the Chancery Court should have compared that interest to the public equity holders interest in the merger consideration to assess its materiality. Applying that standard, the Court held that the claim was material and that the plaintiff had standing to pursue it.
Yesterday, the FTC & DOJ announced that the agencies “will be reviewing the processes and procedures used to grant early termination to filings made under the Hart-Scott-Rodino Act.” While it’s unknown what the long term results of that review may be, one immediate result is that the agencies will not grant early terminations for an unspecified period. Here’s an excerpt from the FTC’s announcement:
For this period, the agencies will not grant early terminations. We anticipate that this temporary suspension will be brief. The agencies implemented a similar temporary suspension of early termination grants in March 2020, following the Premerger Notification Office’s establishment of its e-filing system.
“We, as an agency and a country, are in unprecedented times, and our obligation is to be responsive to these circumstances, in this case by temporarily suspending early termination,” said Rebecca Kelly Slaughter, Acting Chairwoman of the Federal Trade Commission. “The law provides 30 days for the agencies to review the competitive implications of transactions. Given the confluence of an historically unprecedented volume of filings during a leadership transition amid a pandemic, we will presume we need those 30 days to ensure we are doing right by competition and consumers.”
“We support the FTC’s decision to temporarily suspend early termination grants to ensure appropriate review of transactions during this challenging transition period,” said Richard A. Powers, Deputy Assistant Attorney General and Senior Supervisory Official of the Department of Justice’s Antitrust Division.
Not everyone was on board with this decision. The two Republican FTC commissioners issued a statement objecting to the decision to suspend early termination grants, contending that “absent exigent circumstances, an indefinite suspension of the ET process—with no clarity regarding when and under what circumstances it will resume—is unwarranted.”
The announcement coincides with Sen. Amy Klobuchar’s (D – MN) introduction of sweeping antitrust reform legislation. Among other things, the legislation – which may garner some bipartisan support – would make it more difficult for big deals (particularly tech deals) to obtain antitrust clearance. This excerpt from a recent article in “The Hill” explains:
The first proposal of the lengthy legislation is focused on making anticompetitive mergers more difficult by amending the Clayton Act. It would add a risk-based standard to the foundational antitrust law and clarify that mergers that create a monopsony violate it. The bill introduced by Klobuchar, the top Democrat on the Senate Judiciary subcommittee on antitrust, would also seek to shift the burden to parties seeking a merger to prove that they would not create a risk of lessening competition.
The legislation lists out several categories of mergers that would pose such a risk, including acquisitions by a dominant firm with 50 percent market share, acquisitions of disruptive firms by competitors and mega-merger transactions valued at $5 billion or more.
The timing of the FTC & DOJ’s announcement and the introduction of Sen. Klobuchar’s legislation appears to be coincidental, but both actions send the message that a lot of things that have long been taken for granted when it comes to M&A antitrust review are now being looked at with a fresh set of eyes.
Demands from investors and other stakeholders for companies increase to increase their focus on ESG issues have grown exponentially in recent years. While most of the attention has been focused on various ESG metrics and disclosures, a recent Wachtell memo on M&A in 2021 devotes a section to ESG – and suggests we’ve reached an inflection point when it comes to ESG & M&A. Here’s an excerpt:
ESG has reached an inflection point, with boards of directors, investors and other market participants and observers focusing on questions regarding corporate purpose and recognizing the critical importance of environmental, social and governance factors in the sustainability and long-term
value creation potential of the corporation and, ultimately, broader economic prosperity. As ESG is increasingly incorporated into strategic and operational decision-making, it will likely become increasingly salient in the context of mergers and acquisitions.
For example, as investor focus, and corporate accountability, around ESG metrics continue to increase, those metrics are likely to play a more important role in pre-signing due diligence and the assessment of the pro forma impact of a potential M&A transaction. With growing attention to the importance of human
capital to the success of the firm (including the SEC’s amendment to Regulation SK requiring companies to describe their human capital resources), deal-related synergies that are tied to workforce changes may face increased scrutiny, particularly for companies that have received government assistance during the pandemic.
Meanwhile, companies seeking to enhance the sustainability of their businesses, for example by switching to cleaner technologies or improving product safety, may find that ESG factors drive their acquisition or disposition strategies. In addition, ESG-related elements of the deal story may feature more prominently in transaction announcements and roll-outs, alongside traditional talking points like economic synergies, in the years to come.
As an example of a deal’s ESG elements featuring more prominently in announcements & rollouts, the memo cites the way that ConocoPhillips & Concho highlighted the combined entity’s status as the first U.S. based oil & gas company to adopt a Paris-aligned climate risk strategy.
Bloomberg published an interesting opinion piece by Chris Bryant that suggests the SPAC boom may be driven by the fact that, unlike traditional IPOs, sponsors of a de-SPAC merger transaction can discuss projections under the protection of the PSLRA’s safe harbor for forward-looking statements. Here’s the intro:
Former Facebook Inc. executive Chamath Palihapitiya is very open about why he’s such a fan of special purpose acquisition companies (SPACs), compared with taking a company public the usual way.
“In a traditional IPO you can’t show a [financial] forecast and you can’t talk about the future of how you want to do things, you’re just not allowed,” he said in a recent interview. He was referring to laws that exclude initial public offerings from so-called “safe harbor” protections covering forward-looking corporate statements. “Because the SPAC is a merger of companies, you’re all of a sudden allowed to talk about the future,” he told another YouTube questioner. “When you do that you have a better chance of being more fully valued.”
I have a feeling we’ll likely find out fairly soon just how much protection courts are willing to say the safe harbor provides to de-SPAC transactions. SPAC sponsors face an increasing risk of litigation surrounding de-SPAC transactions. Several of the lawsuits that have been filed so far have challenged optimistic statements about the target’s future performance, and recent case law suggests that courts can be pretty resourceful when it comes to finding ways around the safe harbor.
The FTC’s announcement of the new HSR thresholds beat Groundhog Day this year. Of course, that means that we at DealLawyers.com are getting a jump on our own harbinger of spring – the annual inundation of law firm memos about the new HSR filing thresholds. This year’s winner of the annual “first memo in my inbox” contest is Greenberg Traurig. Here’s an excerpt from their memo with the details on the new HSR thresholds, which actually declined this year:
The initial threshold for a notification under the HSR Act will decrease from $94 million to $92 million. For transactions valued between $92 million and $368 million (lowered from $376 million), the size of the person test will continue to apply. That test will now make the transaction reportable only where one party has sales or assets of at least $184 million (lowered from $188 million), and the other party has sales or assets of at least $18.4 million (lowered from $18.8 million). All transactions valued in excess of $368 million are reportable without regard to the size of the parties. The new thresholds will apply to any transaction that will close on or after March 4, 2021.
The thresholds for Section 8 of the Clayton Act’s prohibition on interlocking directorates were also lowered this year & are effective as of January 21, 2021:
Section 8 prohibits a “person,” which can include a corporation and its representatives, from serving as a director or officer of two “competing” corporations, unless one of the following exemptions applies:
– either corporation has capital, surplus, and undivided profits of less than $37,382,000 (lowered from $38,204,000);
– the competitive sales of either corporation are less than $3,738,200 (lowered from $3,820,400);
– the competitive sales of either corporation amount to less than 2% of that corporation’s total sales; or
– the competitive sales of each corporation amount to less than 4% of each corporation’s total sales.
Changes in the HSR & Clayton Act thresholds are based on changes in GDP. The memo points out that this is the only the second time since Congress amended the HSR Act in 2000 to require the annual adjustment of notification thresholds. The last time a downward adjustment was made occurred in 2010.
In Surf’s Up Legacy Partners, LLC v. Virgin Fest, LLC, (Del. Super. 1/21), the Delaware Superior Court rejected efforts by a seller’s managers to dismiss the buyer’s fraud claims against them – despite the seller’s efforts to limit liability through exclusive remedy & non-recourse provisions in the purchase agreement. In a recent blog about the decision, Weil’s Glenn West points out that the absence of a non-reliance provision played a key role in the outcome – and that all three provisions are necessary to mitigate the risk of fraud claims.
The buyer’s fraud claims against the seller’s managers were aided by the language of the fraud carve-out itself. The carve-out to the agreement’s exclusive remedy provision didn’t limit the sources of alleged misrepresentations that could serve as the basis for a fraud claim, and applied not just to fraud by one of the parties to the deal, but by any person – including specifically “an officer or manager of any Seller or Buyer in connection with the consummation of the transactions contemplated by this Agreement.”
Despite the language of the fraud carve-out, the seller pointed to the provisions of the non-recourse clause – which contained no such carve-out – and said that the buyers were to have no recourse to the seller’s managers for any claims arising under or related to the purchase agreement. They contended that this language trumped the fraud carve-out to the deal’s exclusive remedy clause.
As this excerpt from the blog explains, not only did the court not buy that argument, it said there was nothing that the parties could do by contract to insulate anyone from intentional fraud claims:
The human manager defendants asserted that the nonrecourse clause trumped the exclusive remedy clause’s Fraud carve-out. Not so said the court—the exclusive remedy provision stated that “nothing herein shall … preclude any party from seeking any remedy against any Person based upon Fraud by any other Party.” And according to the court, the “herein” referred to was the entire APA, not just the exclusive remedy provision itself; thus, the exclusive remedy provision’s Fraud carve-out trumped the non-recourse provision: “while the parties generally agreed the No Recourse Provision would bar ‘tort’ claims against the Managers, they also expressly agreed the APA would not bar the bringing of fraud claims.”
But importantly for our purposes, the court went further and stated that the parties “could not have contacted otherwise … [because] Delaware courts refuse to enforce contracts purporting to condone—or at least insulate—intentional fraud.” The court thus suggested that, even if the exclusive remedy provision’s fraud carve-out had not been deemed to have trumped the nonrecourse clause’s bar on tort claims against nonparty human agents of the entity parties, an intentional fraud claim could still have been brought against the human managers of the selling entity party to the APA based on Delaware public policy.
The blog says that this result shouldn’t come as a surprise to anyone familiar with the Chancery Court’s decision in Abry Partners, and points out that in Delaware, the one fraud claim that an exclusive remedy provision can’t be drafted to eliminate “the [s]eller’s exposure for its own conscious participation in the communication of lies to the [b]uyer” in the written agreement itself. The blog points out that the asset purchase agreement in this case lacked an important third leg necessary to maximize the protection available to individuals – a non-reliance provision:
Unlike exclusive remedy provisions and nonrecourse clauses, there do not appear to be any Delaware public policy exceptions to the effectiveness of a well-crafted and properly placed non-reliance clause. There was no non-reliance clause in the APA being considered in Surf’s Up Legacy Partners; thus both extra-contractual and intra-contractual fraud claims were at play.
In order to effectively mitigate the risk of “untethered fraud claims,” the blog says that all three of these provisions “need to work together against knowledge of the public policy restrictions on their full effectiveness.”