Kramer Levin recently published a memo on “sandbagging” that covers the various contractual approaches parties can take to the issue & the default rules that New York and Delaware will apply in the event that an acquisition agreement is silent on whether sandbagging is permitted. One aspect of the memo that I thought was particularly interesting was a section addressing sandbagging and rep & warranty insurance:
It is increasingly common for the parties to an acquisition to obtain representation and warranty insurance. These policies typically have their own form of anti-sandbagging clause: an exclusion from coverage if the insured had knowledge of the applicable breach, as commonly supported by a “no claims” declaration whereby buyer declares that, as of the time the policy is bound and at closing, it does not have such knowledge of a breach.
But such exclusions typically are drafted narrowly, excluding coverage only when a buyer had actual knowledge of the breach — not just knowledge of the facts underlying or causing the breach, and not covering any form of constructive knowledge or knowledge that would have been obtained upon due inquiry. And they are likely to exclude coverage only if a narrowly defined group of named deal team members had the requisite knowledge.
In addition, an insurer’s rights and obligations under the policy are (with some exceptions) typically derivative of those under the acquisition agreement. Thus, an insurer defending a claim could potentially invoke whatever sandbagging arguments would have been available to the seller under the acquisition agreement.
The memo finds it notable that pro-sandbagging clauses appear to be significantly more common in deals covered by representation and warranty insurance. In that regard, SRS Acquiom’s most recent Deal Terms Study found a pro-sandbagging clause in 59% of private target deals for which it identified an RWI policy, compared to only 33% of deals in which it did not identify such a policy.
A recent blog from Freshfield’s Ethan Klingsberg offers up some predictions on M&A for the upcoming year. One that may come as a surprise to many dealmakers is his view that sellers should no longer assume that institutional investors will support a cash deal just because the deal price represents a nice premium over market. As this excerpt explains, a lot of this has to do with the price at which those investors acquired their positions:
We will be entering a different environment in 2023 – where long-term, institutional shareholders have acquired their shares over the last several years at prices that not only are significantly higher than prices that represent a healthy premium to current trading prices, but also far exceed the ranges where financial analyses of the newest internal, management forecasts are putting both intrinsic values and future stock prices.
Against this backdrop, we are not necessarily going to be able to rely on institutional shareholder enthusiasm for cash sales of companies just because the transactions satisfy the traditional criteria of meaningful premia to recent trading prices and falling within the ranges of intrinsic values and future stock prices derived from internal management forecasts. The uncertainty and downsides that will be characterizing the forecasts that managements present to boards at the outset of 2023 will be fueling this tension between the approaches of boards and the approaches of institutional shareholders to sales of companies in 2023.
The blog says that even companies with solid sale processes who have upgraded their shareholder engagement efforts, improved IR messaging, enhanced transparency about long-term targets and made timely, shareholder-friendly governance concessions may face real challenges in getting their institutional investors to sign-off on cash deals.
Sullivan & Cromwell recently published its annual report on 2022 shareholder activism and activist settlement agreements. The publication addresses a wide range in activism trends and the terms of settlement agreements between companies and activists. One of the many interesting observations in the report is the way last year’s market volatility and macroeconomic shocks have influenced activist strategies:
Although activists have not been deterred by the market volatility, these underlying macroeconomic conditions appear to have driven changes in activists’ objectives. Campaigns targeting corporate strategies and operations (including demands for cost-cutting measures) have significantly increased this year, while the absolute number of capital allocation and M&A-related campaigns (historically the most common campaign objectives) has declined.
Market conditions briefly rebounded over the summer, leading to a short-lived uptick in the number of M&A-related campaigns (particularly, attacks on announced deals) and capital allocation campaigns (including campaigns demanding the return of cash to shareholders at companies that built up cash reserves during the pandemic).
However, with higher interest rates in effect for the foreseeable future, slower M&A markets and impending laws and regulatory proposals that could impact M&A activity and/or corporate cash reserves, activists may reduce or shift their capital allocation or M&A demands as we enter the 2023 proxy season. For example, the Inflation Reduction Act, which takes effect on January 1, 2023, will impose a nondeductible 1.0% excise tax on public company share repurchases that involve more than $1 million in the aggregate per tax year, which could make share buybacks a less desirable capital allocation strategy for activists.
While activist demands for M&A and buybacks may be down in the current environment, the report says that there was a significant uptick in campaigns calling for management changes in 2022. For the first 10 months of the year, 54 campaigns were launched against U.S. companies demanding the removal of officers, compared to 37 in 2021 and 42 in 2020. The report notes that last year’s total was the second highest number of campaigns demanding management changes in the first 10 months of any year since Insightia began tracking this data in 2010.
We’ve blogged a few times about bylaw amendments that companies are considering in light of the advent of the universal proxy era. Some of these changes are fairly non-controversial, but those involving substantive changes to advance notice bylaws have provoked a strong reaction from activist shareholders and their advisors. This recent Debevoise memo reviews the general categories of terms being addressed by these amendments & says that companies should proceed with caution, because a lot of key constituencies haven’t weighed in on them yet:
While we are seeing a number of companies amend, or explore amending, their bylaws, some caution is warranted. Organizations such as Institutional Shareholder Services, Glass Lewis, the Council of Institutional Investors and many major institutional investors are still formulating their positions with respect to bylaw amendments adopted in the wake of the universal proxy rules.
The memo says that once proxy advisors and institutions weigh in on specific bylaw changes and after newly adopted bylaws are battle-tested during the 2023 proxy season, strategies for bylaw amendments may evolve.
Last week, the FTC issued a proposed rule that would ban the use of non-compete agreements in most settings. However, the FTC does propose to allow them in connection with the sale of a business. Of course, the devil is in the details. Let’s start with the text of the FTC’s proposed carve-out, which is set forth in Section 910.03 of the proposed rule and appears fairly straightforward:
The requirements of this Part 910 shall not apply to a non-compete clause that is entered into by a person who is selling a business entity or otherwise disposing of all of the person’s ownership interest in the business entity, or by a person who is selling all or substantially all of a business entity’s operating assets, when the person restricted by the non-compete clause is a substantial owner of, or substantial member or substantial partner in, the business entity at the time the person enters into the non-compete clause. Non-compete clauses covered by this exception would remain subject to Federal antitrust law as well as all other applicable law.
Embedded within that definition are a few defined terms, the most notable of which is the term “substantial owner, substantial member or substantial partner.” Section 910.01 defines these terms to include only “an owner, member, or partner holding at least a 25 percent ownership interest in a business entity.” That’s a pretty limited universe of people, and in many settings may exclude a number of folks that a buyer has a legitimate interest in seeking a non-compete from as part of the deal.
Another thing to bear in mind is that the FTC proposes to define the term “non-compete clause” functionally, and the proposed rule says that it includes any contractual obligation that “has the effect of prohibiting the worker from seeking or accepting employment with a person or operating a business after the conclusion of the worker’s employment with the employer.” The way the FTC appears to interpret this language suggests that it could potentially cast a very wide net.
In that regard, one of the examples of these de facto non-competes that the FTC cites in the proposal is a provision requiring workers to reimburse the employer for training costs where those payments are not reasonably related to the costs the employer incurred for training the worker. That’s a crappy thing to do and certainly an impediment to changing jobs, but if that’s the standard for what’s regarded as a “prohibition” from seeking employment, what about things like a haircut under a buy-sell agreement that’s triggered by a resignation, or equity awards with cliff vesting tied to a period of continued employment?
Picking up where she left off with her decision in the Multiplan case almost exactly one year ago, Vice Chancellor Will last week declined to dismiss breach of fiduciary duty claims against the board and sponsors of a SPAC arising out of a de-SPAC merger, and held that the transaction should be evaluated under the entire fairness standard.
In Delman v. GigAcquisitions3 LLC (Del. Ch.; 1/23), the plaintiff alleged that the SPAC’s and sponsor breached their fiduciary duties by causing the SPAC to enter into a value decreasing acquisition of Lightning eMotors, a manufacturer of electronic vehicles. In support of his claims, the plaintiff pointed to alleged disclosure shortcomings in the proxy statement by which Gig3 sought to obtain stockholder approval of the deal. In response, the defendants moved to dismiss.
After rejecting the defendants’ contentions that the plaintiff’s claims – which were premised on his reliance on the challenged disclosures to refrain from exercising his redemption rights – were derivative in nature or represented nonactionable “holder” claims, the Vice Chancellor addressed the substance of the fiduciary duty claims. This excerpt from Sullivan & Cromwell’s memo on the decision reviews the Vice Chancellor’s approach to those claims:
In denying defendants’ motion to dismiss, the Court held that the SPAC sponsor’s “interests diverged from public stockholders in the choice between a bad deal and a liquidation” by virtue of the sponsor’s founders’ shares which it purchased for nominal consideration and could not redeem for $10.00 per share, unlike the shares held by the SPAC’s public stockholders. If the sponsor failed to complete a transaction and the SPAC was liquidated, the sponsor’s shares would be worthless, while the public stockholders “would receive their investment plus interest from the trust in a liquidation.”
According to the Court, this typical SPAC structure created a “unique benefit” for the sponsor “in the choice between a bad deal and a liquidation” that was not shared by the public stockholders. Although the Gig3 directors, unlike the MultiPlan directors, were compensated for their services in cash, and the Court found the Gig3 directors lacked any self-interest in the de-SPAC transaction, the Court nonetheless held that at least a majority of the directors lacked independence due to their “close ties” to the SPAC sponsor and his “enterprise of entities.”
The Vice Chancellor therefore concluded that the transaction should be evaluated under the entire fairness standard. Furthermore, she concluded that even if there was no defect in the proxy statement’s disclosure, Corwinwould be unavailable to cleanse the transaction. As the Sullivan & Cromwell memo explains, that conclusion again resulted from conflicts inherent in the typical SPAC structure:
According to the Court, the public stockholders’ vote on the de-SPAC transaction does not reflect their “collective economic preferences” because the “public stockholders could simultaneously divest themselves of an interest in” the SPAC’s target by redeeming their shares, while still voting in favor of the transaction.
Further, the Court reasoned that “redeeming stockholders remained incentivized to vote in favor of a deal—regardless of its merits—to preserve the value of the warrants” they received as part of their purchase of the SPAC’s “IPO units.” These IPO units consisted of one share of common stock and three-quarters of a warrant to purchase a share of common stock at an exercise price of $11.50 per share. If the de-SPAC transaction failed and the SPAC liquidated, the warrants would expire worthless.
Vice Chancellor Will’s decision reinforces her earlier decision in Multiplan and strongly suggests that SPAC sponsors & boards are going to find it very hard to avoid entire fairness scrutiny in the event that their actions in connection with a de-SPAC transaction are challenged by disappointed stockholders.
One of the questions raised by the 1% excise tax on stock repurchases by the Inflation Reduction Act was how it would apply to SPAC redemptions. The IRS recently issued Notice 2023-2, which provides initial guidance on the application of the excise tax, and this excerpt from a Ropes & Grey memo says that the IRS’s guidance answers some important questions about the treatment of SPAC redemptions:
Following the enactment of the Excise Tax, there was legal and market uncertainty regarding whether the Excise Tax would apply to SPAC redemptions, and notably whether the Excise Tax might apply to SPAC liquidations, as well as who would economically bear the cost of the Excise Tax. In reaction, many SPACs whose term would have expired in early 2023 opted to accelerate their liquidation into 2022, or opted to seek an extension during 2022 so that the redemptions associated with the extension process would occur during 2022. However, uncertainty remained for SPAC sponsors and shareholders regarding liquidations that may occur after 2022, including who would bear the incidence of the Excise Tax if it reduced the amount available to be redeemed from the trust account or otherwise available to the combined company following a de-SPAC.
Significantly, the Notice clarifies that the Excise Tax will not apply to complete corporate liquidations within the meaning of Section 331. There is reason to believe that this exception is intended to apply to the wind up of a SPAC. Nonetheless, it may be unclear whether the wind up of a SPAC would constitute a liquidation under Section 331 without careful attention to planning with respect to the liquidation. In general, the Notice also helpfully provides protection for de-SPAC transactions to the extent shares issued by the SPAC during the year exceed repurchases otherwise subject to the Excise Tax.
The memo discusses the guidance’s application to SPAC liquidations, extensions, de-SPAC transactions and valuation issues associated with redemptions. It notes that although some open questions remain regarding the treatment of other repurchases by a SPAC, including redemptions in connection with an extension, the Notice overall provides helpful guidance for SPACs.
Liz’s change in status has prompted us to rethink how we email our blogs to you each morning. At the end of the month, we’re going to change over from our current practice of having our blogs come from the email address of one of our editors. Going forward, all of our blogs will be sent from Editorial@TheCorporateCounsel.net. Our objective is to establish a sender address that won’t need to be changed every time there’s a change on the editorial masthead, which hopefully means that this will be the last time we have to ask you to take the time to whitelist our email addresses.
We know that whitelisting is kind of a pain in the neck, so we’ve put together this whitelisting instruction page to help you and your IT department understand what actions you may need to take in order to ensure there’s no disruption in delivery. We’re going to begin to send blogs from the Editorial@TheCorporateCounsel.net address over the course of the next several weeks, so please be sure to whitelist the new address at your earliest convenience. We’re going to do this incrementally across our sites, and we’ll keep you apprised of when we plan to make the change for a specific site.
There are a couple of things that I also want to mention about this change. First, the name of the author of a blog will always appear in the email, so if you want to respond to the author, you can just click on the author’s name and their email address will pop up. Second, Editorial@TheCorporateCounsel.net isn’t a black hole. If you hit reply, your message will go to a folder that I’ll have access to. I’ll check that every few days and forward your email to the appropriate editor. Finally, thanks for your patience and cooperation.
The SPAC industry received an unwelcome present on Christmas Day when the WSJ announced that the party was officially over:
During the boom in blank-check companies, their creators couldn’t launch them fast enough. Now they are rushing to liquidate their creations before the end of the year, marking an ugly conclusion to the SPAC frenzy.
With few prospects for deals soon and a surprise tax bill looming next year, special-purpose acquisition companies are closing at a rate of about four a day this month, nearly the same pace they were being launched when the sector peaked early last year.
Roughly 70 special-purpose acquisition companies have liquidated and returned money to investors since the start of December. That is more than the total number of SPAC liquidations in the market’s history, according to data provider SPAC Research. SPAC creators have lost more than $600 million on liquidations this month and more than $1.1 billion this year, the data show.
The Journal says that many more SPACs had announced plans to liquidate by the end of 2022, and that one reason for the rush to get those done was the impact of the 1% excise tax on buybacks that became effective on January 1, 2023.
This recent article from “Mergers & Acquisitions” says that small deals outperformed the overall M&A market in 2022 and are poised to do so again next year. This excerpt explains some of the reasons for that:
M&A for small companies worth between $100 million and 500 million increased by 27 percent in 2022 compared to pre-pandemic levels (2015-2019), according to data published by EY. That’s a noteworthy trend in a year that has seen anemic deal flow.
The EY team believes this trend is sustainable. “We expect to continue to see this strong flow of smaller deals throughout 2023, as CEOs remain cautious as a result of ongoing geopolitical tensions and heightened uncertainty,” says Andrea Guerzoni, EY’s global vice chair of strategy and transactions. “Deal financing challenges on the back of higher interest rates, increased costs of financing, and regulatory scrutiny will also make smaller deals more attractive.”
Tech CEOs are particularly keen on small deals heading into 2023. A recent EY report found that 72 percent of tech CEOs plan to pursue M&A in the next 12 months, compared to an average of 59 percent across all sectors. A significant correction in tech valuations could be the reason for this. CEOs with ample liquidity and cash could use this correction to consolidate their position in the market.
Another reason that smaller deals may continue to prosper that the article doesn’t touch on is that under current market and financing conditions, PE buyers have shown a preference for smaller “bolt-on” deals for their existing portfolio companies rather than large platform acquisitions.