Houlihan Lokey has put together this presentation providing an overview of earnouts. If you have a deal where an earnout might be on the table, it’s worth taking a look at and sharing with any client who isn’t familiar with the objectives, potential benefits & downside risks of an earnout provision. Because I’m an earnout skeptic and this is my blog, here’s an excerpt addressing some of the potential downsides:
– A poorly crafted earn-out can result in mismanagement of the Business and can create contentious post deal disputes. As Vice Chancellor Laster of the Delaware Chancery Court (the “Court”) observed in Airborne Health:
“[A]n earn-out…typically reflects [a] disagreement over the value of the [B]usiness that is bridged when the [S]eller trades the certainty of less cash at closing for the prospect of more cash over time…But since value is frequently debatable and the causes of underperformance equally so, an earn earn-out often converts today’s disagreement over price into tomorrow’s litigation over the outcome.”
– The challenge in crafting an earn earn-out is to reconcile the parties’ competing priorities and their desire to shift as much post closing risk as possible to the other party.
– Buyers will want to (i) control the post closing activities of the Business and (ii) minimize the future earn earn-out payments.
– Sellers will want the Buyer to (i) actively pursue the growth of the Business and (ii) maximize the future earn earn-out payments.
– Structuring an earn earn-out usually involves complex accounting, valuation, and tax issues that require the involvement of expert ad visors.
– As it is impossible to anticipate and address every scenario that could impact the earn earn-out, there is usually a “trust me” aspect to the negotiation.
Other topics addressed include structuring an earnout, dispute resolution, valuation and tax considerations. The presentation also includes a section on contingent value rights.
This Dorsey & Whitney memo says that Congress is considering bipartisan legislation that would prioritize review of foreign investments in the food sector. Among other things, the proposed Food Security is National Security Act of 2021 would treat foreign investments in the food, beverage and agriculture (FB&A) sector the same way in which investments in companies with critical tech or personal data are treated under the current CFIUS regime.
The memo says that it’s too early to tell whether the legislation will be enacted, but points out that CFIUS has long been active in reviewing foreign investments in the FB&A sector. As this excerpt explains, investments in FB&A companies may already implicate existing areas of national security concern:
Increasingly, U.S. FB&A companies may also be technology companies. Some of the technologies relied upon or developed by FB&A companies are, or may become, “critical technologies” controlled for U.S. export purposes. For example, U.S. FB&A companies’ use of unmanned aerial vehicles and certain robotics continues to grow. The U.S. Department of Commerce has also been exploring whether to control various emerging technologies under its Export Administration Regulations (“EAR”).
Many of the emerging technologies that the Commerce Department is considering controlling – such as biotechnology; artificial intelligence/machine learning; position, navigation, and timing (“PNT”) technology; logistics technology; and robotics – are also technologies that are increasingly relied upon within the FB&A sector. CFIUS will thus continue to be keenly interested in foreign investments in or acquisitions of FB&A companies that work with such new technologies. As the FB&A sector continues to adopt such technologies to increase productivity, CFIUS will likely become more concerned about foreign investment in or acquisitions within the sector, particularly if the foreign persons are from countries that CFIUS views as U.S. adversaries.
The memo also points to FIRRMA’s expansion of the scope of transactions under CFIUS’s jurisdiction to include real estate, the national security implications of the JBS cyber-attack, and the increasing collection of significant volumes of sensitive personal data by companies in the sector as other reasons for heightened CFIUS scrutiny of foreign investments in FB&A companies.
The question of the legality of a dividend or repurchase under Delaware law is one that often arises in leveraged recaps and other transactions involving large distributions to shareholders. The answer usually depends on whether the company has sufficient “surplus” within the meaning of Section 154 of the DGCL. The Delaware Supreme Court has held that what matters in the surplus calculation is the present value of the company’s assets & liabilities, not what’s reflected on the balance sheet. Since that’s the case, valuations are often used to determine the amount of available surplus.
While that’s a pretty common practice, there’s not a lot of Delaware case law on how the board’s valuation decisions will be assessed. That’s kind of disconcerting, particularly since directors face the prospect of personal liability for unlawful dividends or stock repurchases. Fortunately, the Chancery Court’s recent decision in In re The Chemours Company Derivative Litigation, (Del. Ch.; 11/21), provides some guidance to boards engaging in this process. Here’s an excerpt from this Faegre Drinker memo on the decision:
In this case, the board approved both dividends and stock repurchases at a time when the company also faced legacy contingent environmental liabilities that conceivably could render Chemours insolvent.
The court deferred to the board’s determination that there was sufficient surplus to permit these transactions, even though the board looked beyond GAAP-metrics to evaluate its contingent liabilities. The court held that it “will defer to the Board’s surplus calculation ‘so long as [the directors] evaluate assets and liabilities in good faith, on the basis of acceptable data, by methods that they reasonably believe reflect present values, and arrive at a determination of the surplus that is not so far off the mark as to constitute actual or constructive fraud.” This standard is consistent with the court’s prior guidance that the DGCL “does not require any particular method of calculating surplus, but simply prescribes factors,” total assets and total liabilities, “that any such calculation must include.”
As for reliance on experts, the court held that, under the DGCL, utilization of and good faith reliance on experts “fully protects” directors from personal liability arising from their surplus calculation. In reaching this conclusion, the court rejected the argument that the directors were required to second-guess the GAAP-based reserves calculated by the experts — an analysis that permitted the board to significantly reduce the size of these liabilities on Chemours’ balance sheet.
The memo goes on to provide some thoughts on the key takeaways from the decision, including the need for the board to carefully compile and review accurate data on assets & liabilities, and to retain an expert in any situation where the calculation of surplus may be an issue.
Given the surge in HSR filings last fall & some of the fire-breathing statements coming out of the FTC in recent months, you’d expect to see a significant uptick in the agency’s merger enforcement activity. According to the most recent edition of Dechert’s merger investigation timing tracker, that doesn’t seem to have happened:
Given FTC warnings about a “surge” of HSR filings last Fall, which led the FTC and DOJ to suspend grants of early termination of the 30-day HSR waiting period in February, the data depict what might feel like the calm before a storm.
Assuming that the increase in overall HSR filings will lead to at least some uptick in the number of significant U.S. merger investigations, we would expect to begin seeing an increase in the number of significant U.S. merger investigations concluded as we reach a year after the initial surge begun. We have not seen that surge yet. To the contrary, the FTC did not file a single complaint or consent decree in the third quarter.
The report suggests that one of the reasons behind the absence of an enforcement surge is that the number of significant U.S. merger investigations concluded in 2021 is still behind historical averages. The disconnect between the surge in HSR filings last year and the lower number of completed investigations this year provides reason to believe that the duration of investigations is “ticking upwards.”
According to the report, the upshot of all this is that parties to a significant deal should in the U.S. should plan on at least 12 months for the agencies to investigate their transaction and should also plan for another 7-9 months if they want to preserve their right to litigate an adverse agency decision.
A recent article by Bloomberg Law’s Grace Maral Burnett provides some thoughts on the evolution of acquisition agreements since the onset of the pandemic, and speculates on what issues might be addressed in those agreements next year. Here’s an excerpt:
As the pandemic continues to evolve, contract provisions will continue to do the same. One of the newer issues, which has only recently begun to show up in publicly available agreements, is Covid-19 vaccines. With government and corporate vaccine mandates increasing in prevalence, and the administration of Covid-19 booster shots just getting under way, agreements will increasingly need to address the vaccines—potentially in a wide range of provisions from representations and warranties to post-closing covenants. (By way of example, the definition of “fully vaccinated” could at some future time include the notion of booster shots or new health measures that protect workers against future variants, potentially impacting a variety of representations, covenants, and other provisions.)
With some pandemic issues, what we have seen is less evolution and more vacillation: the easing, then tightening, then easing again of health measures like masking and social distancing due to a variety of reasons, including the availability of new data and the emergence of new virus variants. Also, businesses are navigating a patchwork of conflicting guidance and best practices. This continuing state of change will undoubtedly impact how provisions, such as those regarding the ordinary course of business vis-à-vis Covid-19 and Covid-related exceptions to access-to-information covenants, are drafted. It could also impact how reasonableness is interpreted, as well as which, if any, reasonableness requirements parties elect to include in their references to Covid-19 responses.
The article discusses a number of different issues about the direction deal agreements may take. For example, it raises the question of when in the “new normal” parties won’t feel the need to address the pandemic in “ordinary course” covenants, and the potential impact of a – God forbid – worsening of the pandemic on MAE clauses, where pandemic exclusions have become customary.
This Wilson Sonsini memo provides an overview of the UK’s new National Security and Investment Act, which becomes effective in January 2022. Here’s the intro:
The United Kingdom’s National Security and Investment Act (NSI Act) is scheduled to come fully into force on January 4, 2022. The NSI Act will create a new framework for the UK government to review so-called “trigger events,” which include acquisitions and investments in which one party acquires “control” of a qualifying entity or a qualifying asset on national security grounds. Acquirers in certain trigger events will be obligated to notify and obtain clearance from the UK government prior to completing such trigger events. In addition, the UK government will have new powers to review and, in some instances, impose mitigation measures upon—or even block—trigger events to address national security risk.
The NSI Act represents a sea change in the UK government’s approach to scrutinizing transactions on national security grounds. Once fully implemented, the NSI Act will create new challenges for parties acquiring or investing in UK companies and assets, as well as non-UK companies and assets that have a UK nexus.
The memo provides an overview of the new law, and addresses supplemental legislation that identifies 17 high-risk sectors that present an elevated risk to the UK’s national security.
Earlier this week, the DOJ announced that it had filed a lawsuit to block Penguin Random House’s pending $2.175 billion acquisition of Simon & Schuster. Why? Here’s what the DOJ’s press release has to say about that:
While smaller publishers occasionally win the publishing rights to anticipated top-selling books, they lack the financial resources to regularly pay the high advances required and absorb the financial losses if a book does not meet sales expectations. Today, Penguin Random House, the world’s largest publisher, and Simon & Schuster, the fourth largest in the United States, compete head-to-head to acquire manuscripts by offering higher advances, better services and more favorable contract terms to authors. However, as the complaint alleges, the proposed merger would eliminate this important competition, resulting in lower advances for authors and ultimately fewer books and less variety for consumers.
The complaint alleges that the acquisition of Simon & Schuster for $2.175 billion would put Penguin Random House in control of close to half the market for acquiring publishing rights to anticipated top-selling books, leaving hundreds of individual authors with fewer options and less leverage. According to its own documents as described in the complaint, Penguin Random House views the U.S. publishing market as an “oligopoly” and its acquisition of Simon & Schuster is intended to “cement” its position as the dominant publisher in the United States.
Courts have long recognized that the antitrust laws are designed to protect both buyers and sellers of products and services, including, as relevant here, authors who rely on competition between the major publishers to ensure they are fairly compensated for their work. As the complaint makes clear, this merger will cause harm to American workers, in this case authors, through consolidation among buyers – a fact pattern referred to as “monopsony.”
This was all pretty standard fare until the last paragraph – because as this Axios article notes, monopsony is a pretty unusual claim in an antitrust enforcement proceeding, and one with some significant potential implications. Here’s an excerpt:
The main harm being alleged in the complaint is a harm to workers — authors who could end up receiving less money when there are fewer bidders for their work. “This is the DOJ saying they are prepared to bring at least some labor side monopsony cases,” says Rebecca Haw Allensworth of Vanderbilt Law School. “Even though the statutes and the case law would support the idea, it is a departure from how things have been going in the past 40 years.”
This focus on monopsony as an area of concern for the antitrust laws has been derided as “hipster antitrust” by its critics, but the DOJ’s lawsuit is just the latest sign that the concept is becoming mainstream. If you’re interested in an in-depth look at how that happened, check out this recent blog by the FTC’s former General Counsel.
This Weil blog takes a look at how market practices regarding fraud carve-outs in acquisition agreements have evolved in recent years, and says that while more parties are including definitions of fraud in their contracts than they have in the past, not all of those definitions are equally protective of selling stockholders.
The blog reviews some problematic carve-out language that has appeared in recent agreements, but goes on to conclude that most recent agreements seem to appropriately limit the definition of “fraud” to “just the morally egregious variety respecting the bargained for representations and warranties expressly negotiated as the actual factual predicates for the deal.” In other words, the type of fraud that would vitiate a contractual non-reliance clause is limited to true intra-contractual fraud.
The blog provides examples of the type of these intra-contractual fraud definitions found in the vast majority of recent transactions, and says that despite their variations, well crafted fraud definitions share a similar focus:
Unlike other defined terms for Fraud (which include both intra-contractual and extra-contractual fraud), a Fraud definition that is limited to intra-contractual fraud can hardly be said to have done damage to the basic premise of the no-reliance clause—i.e., a no reliance clause only disclaims reliance on extra-contractual statements and representations to begin with, so carving out from that disclaimer of reliance any intentional fraud respecting only the written representations and warranties seems to be a non-event.
The blog also says that drafters need to bear in mind that fraud carve-outs can create liability for innocent sellers, because the carve-out applies to indemnification claims against all sellers, and effectively eliminates the cap on indemnity or other protections. That makes it important to clarify that the carve-out only removes those limitations for the persons actually engaged in the fraud.
This Sidley blog discusses a recent bench ruling in which the Chancery Court temporarily enjoined a vote on a merger until curative disclosure had been made, but refused to enjoin the transaction in its entirety, despite evidence that the deal may have violated a charter provision requiring equal treatment of the holders of both classes of the target’s common stock.
The transaction involved the proposed acquisition of QAD, which has a dual class structure, by Thoma Bravo. Under the terms of the proposal, each class of shares would receive the same consideration, but one of the company’s founders and a Class B holder, Pam Lopker, would be permitted to roll over equity into the acquiring entity. The plaintiffs contended that this violated charter provisions entitling the holders of each class of stock to receive “an amount and form of consideration per share no less favorable than the per share consideration” provided to the holders of the other class.
They also contended that the special committee put the founder’s interests ahead of other shareholders in the negotiation process, and that the company’s proxy statement failed to disclose these conflicts, and that these omissions made an informed vote impossible. As the blog discusses, the Chancery Court agreed, and while it granted the plaintiffs’ motion to enjoin the vote temporarily in order to provide additional disclosure, the merger itself was another story:
The Court refused to enjoin the merger entirely. While the Court noted the plausibility of the plaintiff’s contract claim for the breach of the charter provision, it determined that enjoining the merger risked substantial harm to QAD stockholders given the 20% premium offered and the absence of any rival bidder. The Court noted that a contract claim would survive the merger, and it expressed confidence that “after-the-fact money damages” have “some value as a remedial instrument in this case.”
The blog goes on to explain that this has become Delaware’s preferred approach in recent years, particularly where no competing deal has surfaced:
This approach is consistent with a long line of cases in Delaware that have compelled additional disclosure but refused to enjoin a transaction outright for fear that it would jeopardize shareholders’ ability to enjoy the benefits of an otherwise beneficial deal. Such refusals are often in spite of potential violations of fiduciary duty or breaches of contract. As the Delaware Supreme Court has explained, where there is no claim by a rival bidder that it was unable to make a bid, and shareholders are fully informed of all the facts and not coerced, “the Court of Chancery should be reluctant to take the decision out of their hands.”
An asset buyer won’t be responsible for any liabilities that it didn’t explicitly or implicitly assume, but there are a handful of situations where a buyer may face successor liability under state law. These traditional theories of successor liability generally come into play when the business or the ownership of the predecessor has been continued in its entirety. But this Dechert memo addressing recent federal court decisions provides a reminder that when it comes to federal common law, successor liability doctrines cast a wider net. This excerpt summarizes the federal approach to successor liability:
Federal appellate courts, including the Third, Sixth, Seventh, and Ninth Circuits, have carved out an exception to this general rule and recognized that “when liability is based on a violation of a federal statute relating to labor relations or employment, a federal common law standard of successor liability is applied that is more favorable to plaintiffs than most state-law standards to which the court might otherwise look.”
Under this approach, successor liability may be found even in the context of a true asset sale if (1) the successor had notice of the claim, (2) there is “substantial continuity in the operation of the business before and after the sale,” and (3) the predecessor cannot provide the relief sought.
The memo says that federal appellate courts have applied this framework to federal labor & employment claims arising under the Fair Labor Standards Act (FLSA), Title VII, the Family and Medical Leave Act (FLMA), and the Employee Retirement Income Security Act (ERISA), among others.