We’ve posted the transcript for our recent webcast: “Navigating De-SPACs in Heavy Seas.” This program provided a lot of great practical guidance on handling the increasingly complex and challenging De-SPAC process. Erin Cahill of PwC, Bill Demers of POINT BioPharma, Reid Hooper of Cooley and Jay Knight of Bass Berry & Simms addressed the following topics:
– Overview of the Current Environment for SPAC Deals
– Negotiating Key Deal Terms/Addressing Target Concerns
– The PIPE Market and Alternative Financing Methods
– Target Preparations to Go Public Through a SPAC
– Managing the Financing and Shareholder Approval Process
– Post-Closing Issues
This Cooley blog discusses a couple of recent Chancery Court decisions that have refused to dismiss claims that special committee members breached their fiduciary duty of loyalty by acting in bad faith. Here’s the intro:
Special committees, by design, are created to address conflicts and to insulate the board of directors from liability for the very conflicts that may invite judicial scrutiny of the fairness of the board’s decision. A well-functioning special committee will also mitigate the risk of personal liability for a company’s fiduciaries, reducing the likelihood of protracted post-closing litigation. Directors of Delaware public companies are typically exculpated for monetary liability for duty of care claims under their company’s charter.
In that case, the only hook for monetary liability against a director is a duty of loyalty breach, which requires the plaintiff to allege that the director was interested in the transaction, lacked independence in the transaction or acted in bad faith. A properly constituted special committee should eliminate the ability to allege both interest in the transaction or lack of independence, leaving only bad faith as a basis for breach of loyalty claims against directors serving on the committee.
The Delaware Court of Chancery has acknowledged that a “finding of bad faith in the fiduciary duty context is rare” but despite that acknowledgment, in two separate decisions this year (In Re Pattern Energy Group Inc. Stockholders Litigation (“Pattern Energy”) and The MH Haberkorn 2006 Trust, et al. v. Empire Resorts, Inc., et al. (“Empire Resorts”)), the court allowed bad faith claims against special committee members to survive a motion to dismiss. These decisions, which are described in more detail below, highlight the importance of a committee’s role in managing conflicts, particularly when it is made aware of potential wrongdoing by conflicted fiduciaries.
The blog reviews the facts and the Chancery Court’s decision in both of these cases, and stresses the critical importance of proper committee oversight of the activities of conflicted members of management or other fiduciaries. While conflicted fiduciaries aren’t prohibited from any participation in the sale process, the special committee must be attentive to the issues that their participation raises – most notably the possibility that the conflicted parties might try to tip the deal in favor ot their preferred buyer.
In order to manage these concerns, the blog makes a number of recommendations. Among other things, the authors suggests that conflicted fiduciaries should be excluded from committee deliberations, although they may participate in presentations to and respond to questions from the special committee. The committee should also ensure that conflicted fiduciaries aren’t put in position to control messaging to bidders or make significant negotiating decisions.
I think this was all the kind of good advice that most lawyers would have given to special committees before these decisions, but the fact that Delaware courts are raising the possibility of unexculpated personal liability for special committee members means that the audience may be more receptive to the message.
When I was a starting out as a deal lawyer, I heard a lot of folks on deal teams talking about “quality of earnings” assessments. I had no idea what they were talking about, and was afraid of looking stupid, so I didn’t ask. If you’ve got a suspicion that some of the younger folks who work with you might act the same way that I did – or if you are one of those younger folks – check out this Rock Center Partners blog. It provides a nice overview of quality of earnings diligence and why it’s important. Here’s the intro:
When a quality of earnings is prepared, it’s usually best summarized in a schedule. One that shows the amount of EBITDA that a target company initially reported, which is then adjusted to reflect the financial impact of issues that were identified in due diligence. In other words, by using a company’s reported EBITDA as the starting point, each issue that’s identified can then be quantified in terms of the financial impact that it would have on EBITDA. The issues can either be presented as increases or decreases to that EBITDA in order to arrive at a ‘normalized’ amount.
For the most part, there’s no specific rule for how normalized EBITDA should be calculated. Which means, there’s a certain amount of subjectivity in it. And while sometimes it’s pretty clear when something is misleading and should be shown in a different way for an investor, sometimes it’s not, and it can involve a bit of judgement. This is where having the right mindset to thinking about what should and shouldn’t be an adjustment becomes very important.
If you take the view that a business’ current level of EBITDA needs to be representative of what a buyer should be able to expect going forward in a business, then it’s usually pretty clear when something is misleading and should be adjusted. Except, sometimes it can be a little more technical than that. So, in this article, we’ll explain some of the different issues that can cause quality of earnings adjustments.
The blog then walks through the kind of issues and adjustments that buyers need to focus on, including non-compliance with GAAP, non-recurring items, seller add-backs, reserve reversals & changes in reserve methodologies.
In In Re BGC Partners Derivative Litigation, (Del. Ch.; 9/21), the Delaware Chancery Court found that when it comes to deciding whether members of a special committee are “independent” in the context of a transaction with a controlling stockholder, the percentage of their income that’s represented by board fees and their personal admiration for the controller may need to be taken into account.
The case involved the $850 million acquisition of a business by BGC Partners from an affiliate of Cantor Fitzgerald. Both the target and Cantor were allegedly controlled by Howard Lutnick, who also served as BGC’s Chairman & CEO, and the plaintiffs contended that his greater economic interest in Cantor resulted in him pushing BGC to overpay for the target. The transaction was approved by a four person special committee of the BGC board, but the plaintiffs challenged the independence of two members of that committee, Steven Curwood and William Moran.
This Fried Frank memo points out that Vice Chancellor Will cited some unusual factors in addressing the independence issue. As to the first director, Steven Curwood, the Vice Chancellor concluded that his independence was appropriately called into question because his director fees constituted over 50% of his income. This excerpt from the memo explains the Vice Chancellor’s reasoning:
The court noted that it was “mindful of the public policy concerns at play when wealth is used as a factor in analyzing independence”—however, the court emphasized, when director compensation is “personally material” to the director it may compromise his independence from the company’s controller. Curwood’s compensation represented “a majority” of his income; and Curwood had testified that this compensation allowed him to pursue his passion of a career in public radio and still be able to “feed his family.” It would be “difficult to imagine more personally motivating factors,” the court commented. The defendants argued that Curwood was not actually dependent on the compensation from this directorship as he had “many other options” to earn income. The court concluded that whether that was true, and Curwood’s “subjective belief” about it, were facts-intensive matters to be addressed at trial.
As to the second director, William Moran, the Vice Chancellor concluded that his statements praising the controller were sufficient to call his independence into question at the pleading stage. Here’s another excerpt from Fried Frank’s memo addressing her reasoning:
The court found that Moran may have been non-independent given his “respect” for Lutnick, which was “considerable.” Moran called Lutnick an “inspiration” and stated that he might get “teary-eyed” speaking about what a “wonderful human being” Lutnick was and how proud he was to be associated with him. The court stated that there is a reasonable inference that “reverence” for a person might color a director’s judgment as to matters involving that person.
The defendants argued that Moran’s high praise for Lutnick was related to Lutnick’s various charitable responses to the loss of lives of many Cantor Fitzgerald employees in the 9/11 disaster, and that his comments should be considered in light of the emotionally charged nature of that event. The court reasoned that whether Moran’s views about Lutnick would have affected his impartiality in evaluating a litigation demand, and whether Moran actually bargained for the benefit of the company and its stockholders despite his reverence for Lutnick, were facts-intensive issues to be addressed at trial.
The Vice Chancellor ultimately denied the defendants motion to dismiss the plaintiffs’ derivative complaint alleging breaches of fiduciary duty, and refused to shift the burden of proving entire fairness to the plaintiff, holding that the plaintiff had sufficiently pled that the two directors may not have been independent of the controller.
Bloomberg Law just published this analysis of pending M&A transactions, and the results indicate that there are a whole bunch of deals announced in 2021 and in 2020 that have yet to close. Here’s an excerpt:
According to Bloomberg data, more than 21,000 global deals announced since the start of 2020, valued at a total $2.5 trillion, remain pending in the period between signing and closing. Of the $4.1 trillion dollars in global M&A deals announced so far in 2021, for which definitive agreements have been entered into, $2 trillion have reached completion, $208 billion have been terminated, and $1.9 trillion remain pending and have yet to close. For the $3.7 trillion in deals announced in 2020, $2.8 trillion have reached completion, $179 billion were terminated, and $699 billion still have yet to close.
The sizable number of 2021 deals that still haven’t closed isn’t all that surprising – after all, regulatory clearances, shareholder approval and the satisfaction of closing conditions often take quite some time. But the fact that transactions representing nearly 20% of 2020’s total announced deal value hadn’t closed by the end of this year’s third quarter was a little surprising, at least to me. I can only imagine what things might look like this time next year if regulators continue to turn up the heat on M&A.
There’s a new study out that slams private equity funds’ lack of transparency and the metric typically used to measure their performance. The study says that reliance on “internal rate of return,” or IRR, as the Holy Grail of fund performance is potentially misleading and an impediment to determining whether these funds outperform the public markets. Here’s an excerpt from this Institutional Investor article:
Investors in private equity face high costs and increased risks because of structural issues in the industry that hinder transparency. For example, investors generally don’t measure returns and fees based on information on the underlying portfolio companies. Instead, investors have data, such as cash flows, to calculate what’s called the internal rate of return, or the IRR, of the fund. That means, “the true investment risk within their PE portfolios is largely unknown,” according to the paper.
Measuring performance with internal rates of return also makes it difficult for investors to compare the returns of different private equity funds and to contrast the strategy with what they would have earned in the public markets. Monk and his co-authors argue that the measure is heavily influenced by returns earned early in a fund’s life. As an example, the report cites private equity funds from the 1970s and 1980s, whose returns earned since inception are exceptional because of this property. “This is not only misleading as an indicator of their contemporary performance, but it forms a performance moat around the top private equity firms against which emerging managers and strategies struggle to appear competitive,” wrote the authors.
The authors argue for the use of what they refer to as “organic finance” to assess PE investments. The authors characterize organic finance as “an emerging investment philosophy underpinned by greater information transparency between investors and the sources of investment return (base assets).” The key to organic finance is greater transparency when it comes to providing investors with the data needed to calculate valuations, returns, risks, fees, performance attribution, and other performance categories of base assets.
Sounds great in concept, but right now investors don’t seem real interested in analyzing whether investments in PE funds really make economic sense. According to this PitchBook article, money is pouring in to private equity – particularly into “mega funds” raising more than $5 billion. What’s the attraction? PitchBook analyst Rebecca Springer says it’s their IRR:
When it comes to the question of whether mega-funds generate better returns, she said that overall, they have beaten smaller funds in recent years. “They are less likely to underperform and less likely to overperform relative to smaller funds,” she said. The resonating shockwaves of the pandemic are still being felt throughout private equity. Springer said the surge in mega-funds isn’t a COVID-19-specific trend, but that the pandemic probably did give the funds a tailwind.
“Mega-fund IRRs (internal rates of return) bounced back more quickly than smaller fund IRRs after Q2 2020. The larger portfolio assets of mega-funds may have been more resilient to pandemic effects and are more likely to be marked-to-market against public company comps, which meant these funds shared in the stock markets’ rapid recovery,” she said.
The authors contend that IRR is an illusion when it comes to appropriately assessing PE fund investments. If so, it’s one that private equity investors seem to find pretty comforting right now.
This Morris James blog reports on yet another Delaware decision involving claims of contractual fraud. The Delaware Superior Court ‘s decision in Aveanna Healthcare v. Epic/Freedom LLC (Del. Super.; 7/21) reached the usual conclusions about the usual issues – a reliance disclaimer isn’t going to absolve a party of fraudulent statements within the contract itself, and an owner that knowingly causes a misrepresentation can’t avoid liability just because it isn’t a party to the contract.
The transaction involved the sale of two companies. The purchase agreement contained representations by the companies – but not by the seller & its owner – as to the accuracy of their financial statements. Following the closing, the buyer found evidence that the seller had allegedly falsified those financial statements to inflate the purchase price for the companies. The sellers moved for a judgment on the pleadings, but the Court denied that motion. This excerpt from the blog summarizes the Court’s decision:
The Court held that, under its own terms, the anti-reliance clause at issue expressly was applicable to extra-contractual representations, not the intra-contractual representations concerning the companies’ financial statements; its plain language thus mirrored the result impliedly compelled by Delaware public policy. The Court also rejected the seller’s argument that the fraud claim was based on extra-contractual statements merely because alleged evidence of the alleged fraud came from documents (here, internal company emails discovered post-closing) outside of the purchase agreement.
The Court also held that certain owners could not avoid fraud liability simply because the company made the representations at-issue in the purchase agreement. Reviewing Delaware cases on this issue, the Court reasoned that under the Court of Chancery’s 2006 ABRY Partners decision and its progeny, sellers may be liable for fraud if they knew the representations were false when made. Here, the buyer had sufficiently pleaded the seller’s knowledge.
The decision wasn’t a complete victory for the buyers, because the Court declined to dismiss counterclaims by the sellers arising out of the buyer’s alleged failure to comply with contractual obligations to release certain tax refunds and amounts held in escrow.
FTI Consulting recently published its Q2 Activism Vulnerability Report, which provides an overview of the state of play in shareholder activism & ranks the vulnerability of various industries to activist campaigns. This excerpt says that there have been some changes at the top of the list:
For the first time since the Q3 2020 report, the Utilities sector is not the most vulnerable sector to shareholder activism, as defined by FTI’s Activism Vulnerability Screener. Both the Aviation & Airlines sector and the Media & Publishing sector have overtaken the Utilities sector in terms of total vulnerability to shareholder activism. The Aviation & Airlines sector faces continued COVID-19 challenges, as business travel remains depressed when compared to pre-pandemic levels; the near-term future for both business and personal travel remains murky due to the surging Delta variant.
The Regional Banks and Automotive sectors were the largest movers up the vulnerability rankings, each moving up eleven spots. The Real Estate sector, on the other hand, was the largest downward mover in the vulnerability rankings, moving lower by fourteen spots. The S&P Real Estate Select Sector Index is the top performing sector index year-to-date after a challenging 2020 in which it was the second worst performing sector index. The Real Estate sector was particularly stalled by COVID-19 and the ensuing stay-at-home orders but has rebounded as vaccination rates increase and both corporations and citizens return to normalcy.
This Sidley memo explores some of the issues associated with the rise of “fraud on the board” claims in Delaware, including the potential culpability of the defrauded directors. This excerpt explains:
Are the directors who have been deceived by an uncandid colleague simply victims, or have they breached their fiduciary duty for failure to anticipate and deal with a lack of candor caused by a conflict of interest? The answer “yes” is what the plaintiffs in Haley asserted explicitly. In that case, the plaintiffs argued that the uncandid CEO/director’s fellow directors “… breached their fiduciary duties by failing to oversee [the CEO’s] negotiations.” 235 A.3d at 715. Similarly, the Court of Chancery in PLX, after declaring that the uncandid director breached his fiduciary duty, added “… and induced the other directors to breach theirs.” 2018 WL 5018535, at *47.
This approach of victim-at-fault echoes the holding and language of the Rural Metro case. While that case related to a financial advisor’s undisclosed conflict of interest, the language of the opinion was broader in scope. “Another part of providing active and direct oversight [of a sales process] is acting reasonably to learn about actual and potential conflicts faced by directors, management, and their advisors.” In re Rural Metro Corp. S’holders Litig., 88 A.3d 54, 90 (Del. Ch. 2014).
The authors suggest that the board can protect itself by learning from Rural Metro and engaging in some degree of investigation and heightened oversight of potential conflicts involving fiduciaries, particularly in situations where an independent director has certain attributes that make conflict or lack of candor somewhat likely. Examples of these include when the director is a representative of a hedge fund or other evidence suggests a short-term bias, and when the director has a close relationship with another director who is clearly conflicted.
The terms of the preferred stock issued to PE & VC investors typically include a tightly drawn mandatory redemption obligation that kicks in after a period of time or upon the occurrence of certain events. In Continental Investment Fund v. Tradingscreen, (Del. Ch.; 7/21), the Chancery Court was confronted with a claim by preferred stockholders that a company that lacked sufficient funds to fully satisfy its mandatory redemption obligations violated the terms of the preferred stock.
As a result of the alleged default, the plaintiffs contended that they were entitled to interest from the date of the breach in 2013 through the date in 2020 when the company finally satisfied those obligations. Vice Chancellor Laster disagreed, holding that the company did not violate the terms of the preferred due to its inability to fully redeem the preferred. This Morris James blog summarizes the Vice Chancellor’s decision:
The Court concluded that the company met its redemption obligations in 2013 by redeeming all of the shares that it could. A special committee aided by a financial advisor evaluated the number of funds available for redemptions, including whether the company could obtain debt financing to pay more, and the amount of cash the company needed to continue to operate as a going concern and remain solvent for the foreseeable future. Ultimately, the committee determined that the company could use $7.2 million for redemptions and that the company should keep $20 million cash, an amount the committee thought was needed to retain and attract business in the company’s industry (i.e., providing electronic trading solutions to institutional investors around the world).
In reaching its conclusion, the Court observed that the Committee’s determination was “a judgment-laden exercise entitled to deference” absent a showing of bad faith, unreliable methods or data, or fraud. The defendants did not have the burden to show that paying more would have rendered the company insolvent. Rather, the preferred stockholder had the burden to prove the existence of additional funds legally available to redeem its shares. The Court also rejected the argument that the committee erred by reserving funds for two years of operation, rather than one, reasoning that directors have the discretion to evaluate the appropriate time horizon and resources required for their particular corporation to continue as a going concern.