Mintz recently issued a client memo addressing ESG considerations for M&A transactions. The memo reviews valuation & risk mitigation issues that need to be addressed during the due diligence and negotiation process, the impact of investor expectations, and post-closing governance and integration considerations. This excerpt discusses potential ESG-related risks and ways to mitigate them:
ESG issues from both a financial and reputational perspective can be quantified in several forms. Financial issues may leave investors exposed to sanctions or fines, but this risk can be mitigated through the due diligence process. Reputation issues may include negative press or social media commentary, which can lead to revenue loss and a drop in consumer confidence. Reputation-related post-merger liabilities can be mitigated if there is a greater understanding of the target’s culture and workforce, and this can be developed through social media, reports from third-party providers, and desktop news searches. If an ESG issue has been identified during the due diligence process, the investor can request protection via the purchase agreement in the form of representations and warranties or Material Adverse Effect (MAE) clauses.
Acquisition safeguards for public companies should also include adherence to the proposed SEC Climate Disclosure Rules, along with awareness of any additional SEC requirements for ESG disclosure. The buyer and target should have respective reporting structures in place to address the proposed requirements for disclosures in registration statements and annual reports. For example, a company will need to disclose the greenhouse gas emissions they are directly responsible for, in addition to emissions from their supply chains and products.
Companies without these reporting structures in place may create a barrier in the acquisition process or a reason for a price discount because the structures may prove cumbersome to set up. The due diligence process in M&A transactions should include a buyer and target’s data management, audits, and standard reporting methods or templates in order to ensure both accuracy and efficiency in their climate-related disclosures.
Private equity has become one of U.S. antitrust regulators’ prime targets during the Biden administration, and this Freshfields blog says that European regulators appear ready to follow the DOJ & FTC’s lead. Here’s an excerpt:
The focus on PE in the US may inspire other regulators, in particular across the Atlantic. In Germany, a draft law is being discussed which would grant the Federal Cartel Office broad powers to address perceived “disruptions” of competition. Those powers are likely to include oversight of cross-ownerships and interlocking directorates. In 2020, the European Commission requested a study on the effects of common shareholdings by institutional investors and asset managers on European markets.
While no major enforcement action has been taken since the report, the headlines generated by the DOJ may inspire the European Commission to have a renewed look at these issues in Europe. And in the UK, while the Competition and Markets Authority has recognized that highly leveraged private equity acquisitions are unlikely in themselves to impact competition, it has demonstrated a willingness to follow the European Commission in pursuing private equity owners for potential antitrust violations by their portfolio companies, as demonstrated most recently in relation to its case against excessive pricing for thyroid drugs.
The blog also points out that EU’s proposed new merger notification forms would compel disclosure of all material shareholdings (including non-control stakes) and directorships in competitors or businesses operating in vertical markets. Holdings by customers and competitors would also have to be disclosed.
These new disclosure obligations are expected to prompt greater scrutiny during merger review of the effect on competition of minority positions in portfolio companies that compete with or operate in markets that are adjacent to the target’s and will likely increase regulators’ demands for “ring-fencing” measures.
Projections about a portfolio company’s financial performance are a customary part of any private equity investment, but because the parties involved are sophisticated and reliance upon projections is usually disclaimed in the purchase agreement, sellers often discount the liability risks associated with them. The Chancery Court’s recent decision in In re P3 Health Group Holdings, (Del. Ch.; 10/22), is a reminder that even with sophisticated investors & reliance disclaimers, faulty projections remain fair game for fraud claims.
The case arose out of a follow-on investment in a portfolio company controlled by a private equity fund. The investor alleged that it was fraudulently induced to make its investment based on inflated EBIDTA projections. According to the complaint, those projections showed that the company would generate more than $12 million in EBITDA in 2020. Instead, the company generated negative $40 million in EBITDA for that year. Yeah, that’s a, uh, pretty big miss – and in Vice Chancellor Laster’s view, its magnitude supported a pleading stage claim that the projection was knowingly false:
The fact that a projection does not come to fruition, standing alone, often will be “legally insufficient to support a fraudulent inducement claim.” See Edinburgh Hldgs., 2018 WL 2727542, at *12. That is because “allegations of fraud by hindsight are not enough to state a cognizable claim of misrepresentation . . . .” Noerr v. Greenwood, 1997 WL 419633, at *5 (Del. Ch. July 16, 1997) (internal quotations omitted). But that does not mean that a court cannot consider the failure to meet a projection when evaluating whether a plaintiff has pled facts supporting an inference that the projection was knowingly false.
The fact that a business has missed a near-term projection by a large margin supports several possible inferences. Many of those inferences are innocent. Perhaps the nature of the business made forecasting difficult. Perhaps an external event affected the outcome. But at least one possible inference is that the near-term projection was knowingly false. At the pleading stage, Hudson is entitled to the inference that is favorable to its claim.
By now, you’re probably wondering whether there was a reliance disclaimer in the purchase agreement that covered the projections. The answer is that there was, but it included a fraud carve-out that excluded from the disclaimer “claims or allegations arising from or relating to fraud or intentional misrepresentation.” Along the same lines, Vice Chancellor Laster rejected the defendants’ claims that a standard integration clause providing that the transaction documents represented the parties’ entire agreement and “supersede and preempt any prior understandings, agreements or representations by or among the parties hereto” was sufficient to preclude fraudulent inducement claims.
The opinion also provides a useful overview of the elements of a fraudulent inducement claim, and the Vice Chancellor walks through the application of each of them to the factual allegations in the complaint. What’s really remarkable though is that VC Laster accomplishes all of this in an opinion that’s less than 17 pages in length – which may be a personal best for him in terms of brevity!
The decision establishes a bright-line test for bringing Rule 10b-5 disclosure claims, limiting standing to plaintiffs who “bought or sold shares” of the company about which the alleged misstatements were made. Because the alleged misstatements in this case had been made by the target company about itself prior to the merger, investors who, after announcement of the planned merger had purchased shares of the acquiror (but not shares of the target company), did not have standing to bring Rule 10b-5 disclosure claims against the target.
The court rejected the plaintiffs’ argument that, based on precedent, it had standing given the “significant” and “direct” relationship between the acquiror and the target (including the acquiror’s incorporation of the misstatements into its press releases and registration statement relating to the merger, as well as the direct impact of the misstatements on the acquiror’s stock price).
The memo discusses the Court’s decision in detail and observes that since claims for a target’s pre-merger statements generally cannot be brought against the buyer, the buyer’s stockholders may be unable to assert federal disclosure claims relating to pre-closing misstatements by the target, even if they impacted the buyer’s stock price.
A target’s compliance with laws governing political involvement is an area that doesn’t typically get a lot of attention during M&A due diligence, but this Pillsbury memo says that’s a big mistake, because compliance shortcomings with respect to federal, state or local political laws can result in serious legal and reputational consequences. This excerpt discusses the potential fallout from failing to comply with applicable “pay-to-play” laws:
“Pay-to-play” laws and regulations are additional considerations for entities who transact business with state or local governments. They vary widely by jurisdiction, but typically require entities with state or local government contracts to disclose, limit or avoid political contributions to candidates who could be positioned to influence the award of a government contract. These contribution restrictions can extend to contributions by the contracting entity’s parent and subsidiaries, its PAC(s), its executives, and in some jurisdictions, even to family members of covered persons. A single prohibited contribution by a covered person can force an entity to forfeit a government contract and expose it to civil penalties.
If a target entity has contracts with government entity customers, a due diligence review should determine if all applicable contribution parameters have been adhered to and whether there is a process in place for ensuring compliance. If the acquiring entity also maintains government contracts, it should determine whether the target entity’s PAC is registered in any states that will raise pay-to-play concerns.
Other potential political law compliance issues addressed by the memo include PACs & political contributions, general and procurement lobbying, gifts & conflicts of interest, and foreign agent registration.
Last week, the Treasury Dept. issued its first ever CFIUS Enforcement & Penalty Guidelines. According to the Treasury’s press release announcing the guidelines, they are intended to “provide the public with important information about how CFIUS will assess whether and in what amount to impose a penalty or take some other enforcement action for a violation of a party’s obligation, and factors that CFIUS may consider in making such a determination, including aggravating and mitigating factors.”
Section 721 of the Defense Production Act of 1950 authorizes the Committee to impose monetary fines and pursue other remedies for violations of that section & related regulations, mitigation orders and agreements. This Simpson Thacher memo summarizes the three types of conduct that the Guidelines say may constitute a violation:
– Failure to File. Failure to timely submit a mandatory declaration or notice, as applicable.
– Non-Compliance with CFIUS Mitigation. Conduct that is prohibited by or otherwise fails to comply with CFIUS mitigation agreements, conditions or orders (“CFIUS Mitigation”).
– Material Misstatement, Omission or False Certification. Material misstatements in or omissions from information filed with CFIUS, and false or materially incomplete certifications filed in connection with assessments, reviews, investigations or CFIUS Mitigation, including information provided during informal consultations or in response to requests for information.
The Guidelines also state that aggravating and mitigating factors will be taken into accounting in determining whether to assess a penalty. Potential aggravating and mitigating factors include the impact of an enforcement action on ensuring accountability and future compliance, the level of harm associated with the violation, whether the violation was negligent or intentional, efforts undertaken to respond and remediate the violation (including self-reporting), and the sophistication of the parties & their compliance record.
The September-October Issue of the Deal Lawyers newsletter was just posted and sent to the printer. This month’s issue includes the following articles
– Maximizing Value for Stakeholders: Strategies for Uncertain Times
– How to Navigate the Decision of Exercising Drag-Along Rights During an M&A Process
– Should Companies Amend Their Bylaws for Universal Proxies?
– Will Post-Signing Valuation Changes Revive Appraisal Arbitration?
– M&A Board Minutes: The Risks of “Spin”
The Deal Lawyers newsletter is always timely & topical – and something you can’t afford to be without in order to keep up with the rapid-fire developments in the world of M&A. If you don’t subscribe to Deal Lawyers, please email us at firstname.lastname@example.org or call us at 800-737-1271.
Kroger & Albertsons’ announcement of their proposed merger last Friday was followed almost immediately by wailing and gnashing of teeth over the deal’s antitrust implications by everyone from Public Citizen to the U.S. Senate. The fact that the parties’ announcement included plans to divest 100 to 375 stores through a spinoff suggests that this reaction likely didn’t come as a big surprise to them. Since Kroger & Albertsons know that their deal will face some pretty stiff antitrust headwinds, I thought it might be interesting to take a look at the merger agreement and see what it had to say concerning their obligations when it comes to regulatory approvals.
The relevant language appears in Section 6.3 of the agreement, which addresses “Regulatory Matters,” and while it lashes Kroger & Albertsons together pretty tightly, it isn’t a “hell or high water” provision. For example, Section 6.3(d) only obligates Kroger to use its “best efforts” to take “any and all actions necessary to avoid, eliminate, and resolve any and all impediments under any Antitrust Law,” and as this Harvard Governance Blog post points out, a true “hell or high water” clause will impose an unconditional obligation to take such actions. Furthermore, Section 6.4(d) contains the following proviso:
provided, further, however, that nothing contained in this Agreement shall require Parent or the Company to take, or cause to be taken, or commit to take, or commit to cause to be taken, any divestiture, license, hold separate, sale or other disposition, of or with respect to assets of the Company or any of its Subsidiaries, or Parent or any of its Subsidiaries, if doing so would result in a Material Divestment Event.
Section 1.1 of the agreement defines a “Material Divestiture Event” to mean the divestiture of “in excess of 650 Stores.” That number includes however many stores end up being part of the spinoff and if the antitrust cops insist on anything bigger than that, Kroger won’t have to go along with it under Section 6.3.
What may be more interesting is whether the FTC or DOJ take the bait on divestitures. Traditionally, one of the concerns with putting a specific upside number on a divestiture obligation is the concern that the government’s response will be “yes, please – do that.” Of course, the Biden Administration’s approach to antitrust merger review & remedies is anything but traditional, so it seems unlikely that the parties’ commitment to divestitures will be sufficient to placate them.
Then again, the FTC & DOJ are probably not their intended audience. My guess is that Kroger & Albertsons fully expect a challenge from regulators and know that although divestitures may not move the needle with them, recent experience suggests that courts still look favorably on this kind of conduct-based remedy for potential antitrust concerns.
The terms of the asset purchase agreement defining assumed and excluded liabilities are among the most carefully drafted & heavily negotiated provisions of the agreement. Since that’s the case, the Delaware Chancery Court’s recent decision in ITG Brands v. Reynolds American, (Del. Ch.; 9/22), interpreting an asset purchase agreement’s assumption of liabilities language is worth reading.
The case involved whether ITG Brands, which purchased several cigarette brands from Reynolds, was responsible for payments required to be made under a tobacco health settlement with the State of Florida. The asset purchase agreement obligated ITG to use its reasonable best efforts to join the settlement agreement, but more than seven years after the closing, it had not done so. A Florida court held that Reynolds remained liable for settlement payments post-closing, and Reynolds filed an action in the Chancery Court to compel ITG to assume this liability.
Reynolds argued that the settlement was an assumed liability under the terms of the asset purchase agreement. ITG alleged that the Florida court’s decision that it was not responsible for settlement payments should be binding on the Chancery Court, and that its obligations under the asset purchase agreement were limited to using its best efforts to join the settlement. After holding that the Florida court’s decision wasn’t binding on the Court, Vice Chancellor Will went on to conclude that the settlement agreement was an assumed liability under the asset purchase agreement. This excerpt from Shearman’s blog on the decision summarizes the Vice Chancellor’s reasoning:
The Delaware Court noted that liabilities that “‘aris[e], directly or indirectly, out of … the use of the Transferred Assets’” were assumed by the buyer. The Court explained that the Florida settlement liability “‘aris[es],’ at least ‘indirectly,’ from ‘the use of the Transferred Assets.’” The Court explained that the purpose of the APA was for the buyer to acquire assets (which included among other things, goods, intellectual property, books, records and files) that would enable it to sell the acquired cigarette brands, and that the buyer necessarily uses these assets for its sales. The Court highlighted that “[i]f [the buyer] stopped using the Transferred Assets, it would not be able to sell [a]cquired [b]rands cigarettes. And if [the buyer] sold no [a]cquired [b]rands cigarettes in a post-[c]losing year, [the seller] would have no liability to Florida” under the settlement.
Vice Chancellor Will also concluded that the provisions of the agreement requiring the buyer to use “reasonable best efforts” to join the Florida settlement agreement did not conflict with or override the language of the agreement allocating the Florida settlement liability to ITG. Instead, she viewed that provision as a contractual “belt and suspenders” that was intended to make the buyer directly responsible for the post-closing obligations under the settlement.
As we’ve watched PE sponsors increasingly reshuffle their deck of portfolio companies through secondary buyouts, some prominent commenters have expressed concern that private equity investments may be taking on many of the characteristics of a Ponzi Scheme. This excerpt from a Washington Post article published earlier this year indicates that this has become a concern for, among others, the CIO of Europe’s largest asset manager:
Vincent Mortier, chief investment officer of Amundi SA, Europe’s largest asset manager, questioned how private equity firms can keep their performance aloft even as the market for initial public offerings slumps:
The vast majority of deals are currently done between private equity players… One private equity player will sell to another one who is happy to pay a high price because they have attached a lot of investors. When you know you are able to exit your stake to another private equity house for multiple of, let’s say, 20, 25 or 30 times earnings, of course you won’t mark down your book… That’s why I’m talking about a Ponzi because it’s a circular thing.
Mortier’s concerns were recently echoed by Mikkel Svenstrup, the CIO of Denmark’s largest pension fund, but a recent PitchBook article says that these concerns are overblown:
Put simply, a Ponzi scheme is a fraud where early investors are paid with funds obtained from later investors. This could mean investing in a company or technology that has no intrinsic value on the promise of substantial returns, and ending up with nothing. While investing in PE always carries the risk of losses, any comparison to the above is flawed.
Mortier and Svenstrup’s fears over a rush of secondary buyouts seem to me a tad overblown. Sure, this year has seen some particularly large deals, including Bain Capital and Hellman & Friedman’s $17 billion acquisition of Athenahealth from Veritas Capital and Evergreen Coast Capital. But PitchBook data shows that secondary buyouts accounted for less than 31% of exits this year in terms of volume; sales to corporations are still the preferred method.
These figures are in line with previous years, so concerns of a sudden increase in secondary buyouts don’t appear to be supported.
Furthermore, PE’s main strategy for buying companies, whether it be from each other or another party, remains buy-and-build, i.e. firms acquiring and adding smaller companies to an existing platform. Unlike a Ponzi scheme, where the investment remains static and therefore produces no returns, PE investors are expanding their portfolio companies’ operations to generate value and increase returns.
That being said, the article acknowledges that these critics have a point when it comes to portfolio company valuations, which lack transparency and can enable PE sponsors to show a high valuation —at least to outsiders—even in the midst of market turmoil. The SEC thinks they have a point too, and its proposed overhaul of the private fund adviser rules is intended in part to promote greater transparency when it comes to valuations and investor returns.