On Monday, the 2nd Circuit issued its decision in In Re: Nine West LBO SEC. Litig., 20-3257 (2d Cir.; 11/23), in which it overturned the SDNY’s prior decision dismissing creditors’ claims seeking to recoup merger consideration paid to the company’s former director, officer & employee stockholders in connection with 2016 LBO. In so doing, the Court adopted a narrower reading of the scope of the safe harbor established by Section 546(e) of the Bankruptcy Code for transactions made through a financial institution.
The creditors efforts to recover merger consideration paid to public and insider stockholders on the basis that the transaction involved a fraudulent transfer. The defendants moved to dismiss the complaint, contending that the payments were protected by the Section 546(e) safe harbor. The Court affirmed the district court’s decision dismissing claims against the public stockholders but refused to dismiss claims against insiders.
Importantly, the manner in which payment of the merger consideration was paid differed between the two groups of stockholders. The public stockholders who held certificated shares & shares held in electronic form by DTC were paid through Wells Fargo, which served as the company’s paying agent for the merger, while the insiders were paid by the company through its payroll system.
The Court’s conclusion boiled down to its views on which defendants could properly be regarded as a “financial institution” for purposes of the safe harbor. The district court held that a bank customer qualified as a financial institution for purposes of the safe harbor when a bank is acting as an agent for a customer in connection with a securities contract (i.e,. the merger agreement), and that all transactions made pursuant to that contract are within the safe harbor. The 2nd Circuit disagreed:
We hold that § 101(22)(A) must be interpreted using a “transfer-by-transfer” approach based on: (1) the language of the statute, (2) the statutory structure, and (3) the purpose of the safe-harbor provision. First, the Bankruptcy Code defines a “financial institution” to include a “customer” of a bank or other such entity “when” the bank or other such entity “is acting as agent” for the customer “in connection with a securities contract”. It does not provide that a customer is covered when a bank has ever acted as a customer’s agent in connection with a securities contract.
In other words, the text creates a link between a bank “acting as agent” and its customer with respect to a transaction. To satisfy that link, the plain language of § 101(22)(A) indicates that courts must look to each transfer and determine “when” a bank “is acting as agent” for its customer for a transfer, assuming, of course, the transfer is made in connection with a securities contract.
In holding that the safe harbor did not apply to payments made to the company’s insider stockholders, the Court noted that Wells Fargo had “nothing to do” with those transfers, and that if it extended the safe harbor to those transactions, it would essentially make it limitless in its application. In reaching that conclusion, the Court said that if it held that the safe harbor applied that broadly, “we cannot imagine a circumstance in which a debtor would choose to structure an LBO without involving a bank.”
The Court’s last statement strikes me as pretty odd, because it seems to me that the most likely outcome of this decision will be to increase the demand for banks to serve as paying agents in LBOs and to make sure that every last penny of merger consideration is paid through them. Paying agents aren’t always banks, but now it looks like there’s a good legal reason for them to be. In other words, this decision ultimately may turn out to be the “Full Employment for Bankers Act of 2023.”
Earlier this month, in Smykla v. Molinaroli, (7th Cir.; 11/23) the 7th Circuit rejected disclosure claims premised on alleged misstatements and omissions in a proxy statement relating to the 2016 inversion transaction between Johnson Controls & Tyco International. Specifically, the plaintiffs claimed that Johnson Controls failed to disclose that it could have structured an alternative transaction more favorable to stockholders from a tax perspective than the one recommended by the board, and that this rendered the proxy statement’s disclosure about the deal materially false and misleading. This excerpt from the Court’s opinion summarizes why it rejected that argument:
The crux of plaintiffs’ argument in this litigation is that “there was another way to structure the merger that would have potentially avoided” the taxation of Johnson shareholders and that “the omissions regarding such an option were material.” Assuming there was, in fact, an alternative way to structure the merger, we take plaintiffs’ point that shareholders may have preferred a different deal than the one they got. But there is nothing in the Exchange Act that entitles investors to receive a list of alternative deal options that may provide a better return on their investment.
Indeed, the Supreme Court has been “careful not to set too low a standard of materiality, for fear that management would bury the shareholders in an avalanche of trivial information.” Matrixx Initiatives, Inc. v. Siracusano, 563 U.S. 27, 38, 131 S.Ct. 1309, 179 L.Ed.2d 398 (2011) (discussing Section 10(b) and Rule 10b–5(b) claims, which, like Section 14(a), require an inquiry into the materiality of an omitted fact and the “total mix” of information available to investors) (cleaned). Our inquiry, as described above, is limited to whether the proxy statement contained materially misleading statements or omissions regarding the deal that was before the shareholders.
The Court observed that if it adopted the plaintiffs’ position, it would in effect create a new rule requiring proxy disclosure of a “laundry list” of potential merger alternatives and the potential benefits and drawbacks of each of them. It said that this is not what Congress intended with the Exchange Act.
The Court also rejected allegations that the proxy statement was misleading because it failed to disclose the directors’ “true motive” in approving the transaction. It held that the directors weren’t required to disclose that they structured the merger, as the plaintiffs’ alleged, for their own benefit, and noted that courts typically reject claims like these because they involve an effort to bootstrap breach of fiduciary duty claims into disclosure claims actionable under the Exchange Act.
Family offices have become increasingly important players in the space traditionally occupied by private equity and venture capital funds. According to a recent Citi Private Bank Global Family Office Survey, family offices’ interest in participation in private equity through funds and direct investments remains strong despite economic uncertainties. These excerpts summarize some of the Survey’s key findings relating to private equity & direct investments:
– Against a backdrop of rising financial markets, unrealized recession fears and multi-year high bond yields, many family offices reassessed their asset allocation more than in recent years. Over half reported increasing fixed income allocations, 38% upped private equity allocations, while 38% cut public equity allocations.
– Direct investments remain strongly in focus, with 80% of family offices engaged. But while 66% said they were seeking opportunistic deals based on attractive valuations, some 38% had paused new direct investments due to economic uncertainty.
– While family offices increasingly noted challenges around direct investments, this has not resulted in a shift out of such holdings or towards private equity funds. About half of respondents planned to maintain their allocations to private equity funds (48%) and direct (47%). And they are slightly more bullish on direct (38%) than on funds (32%).
– Net sentiment – the percentage of those planning to add to their allocations minus those planning decreases – was most positive for global developed investment grade fixed income (+34%), private credit (+30%), cash (+27%) and direct private equity (+23%). It was most negative for crypto assets (-41%), real estate (-7%) and global developed investment high yield income (-6%)
The report also says that early stage & growth stage deals were the most popular investment opportunities for family offices in all regions, while leveraged buyouts were more sought after in North America and Europe, the Middle East and Africa than in Asia Pacific and Latin America.
This Gibson Dunn memo reviews some of the privacy and cybersecurity issues that buyers should keep in mind when conducting M&A due diligence. This excerpt discusses the potential applicability of the ever-growing number of state privacy laws:
Applicability of the California Consumer Privacy Act, as amended by the California Privacy Rights Act (the “CCPA”), is a critical part of the due diligence process, as the CCPA is enforced by active regulators (both the California Attorney General and the new California Consumer Privacy Agency), and provides a private right of action in the event of certain security incidents. Statutory damages can reach up to $750 per consumer per incident, and CCPA regulatory penalties can be as high as $7,500 per each intentional violation (or $2,500 for unintentional violation).
Outside of California, state privacy laws are developing in other jurisdictions as well—13 states have passed laws, with laws in Virginia, Colorado, Utah, and Connecticut taking effect just this year. Closely assessing the applicability of, and compliance with, these various state privacy laws is essential to identifying the legal risks involved for businesses operating and catering to customers in the U.S. As a first step acquirors should review the state-specific threshold requirements for applicability, which may include the target company’s gross annual revenue and/or the number of state residents’ information processed.
For example, the breadth of the CCPA’s applicability is particularly broad—any business that has over $25M in revenue a year, and processes personal information of a California resident, will be subject to the law. Notably, any business that says they do not collect personal information—a refrain not uncommon in this area—is likely wrong, if they do business in California or outside the U.S. Indeed, unique amongst the state laws, but more similar to the GDPR, the CCPA applies to information collected from B2B partners, employees, and others not traditionally seen as “consumers,” making these laws relevant to nearly every transaction.
Other topics addressed in the memo include the potential applicability of E.U./UK GDPR and other international laws, sector-specific privacy and cybersecurity laws, outdated or missing privacy notices, the target’s practices regarding storage of sensitive personal information, and its cybersecurity protocols, policies and procedures, and insurance arrangements.
We’ve previously blogged about the DE Court of Chancery’s opinion in Crispo v. Musk (Del. Ch.; 10/23) stating that existing approaches to so-called “ConEd language” — each of which attempts to give a target the right to seek expectancy damages on behalf of their stockholders — may not be enforceable. We’ve also covered some of the potential solutions that have been contemplated since the decision, all of which are rife with complications. This Hunton memo discusses even more issues with the various proposed alternatives, including:
– Whether a majority vote of stockholders can authorize the target to act as agent for all stockholders
– What would happen if the breach and termination occurred before the stockholder vote
– The fact that there wouldn’t be a stockholder vote in an acquisition structured as a tender offer
We promised to share other proposed solutions, and these Gibson Dunn and Hunton memos raise another possibility — that is, that a DGCL amendment could specifically allow targets to act as agents for their stockholders. Of course, this possibility presents a timing issue. When the DGCL is amended, it usually isn’t effective until the summer, so this still wouldn’t address the near-term problem confronting practitioners. But it is a welcome possibility nonetheless!
Programming Note: This blog will be off tomorrow and Friday, returning next Monday. Happy Thanksgiving!
Question 126.03: This existing CDI regarding counting the 10 calendar days for Rule 14a-6 was amended to clarify that the explanation in the interpretation assumes that the preliminary proxy statement is submitted before 5:30 pm Eastern and receives the submission date as the EDGAR filing date.
Questions 139.07 to 139.09: These new CDIs clarify the treatment for overvoted, undervoted and signed but unmarked universal proxy cards under Rules 14a-4 and 14a-19.
– In the case of an overvoted proxy card, which cannot be voted in accordance with the shareholder’s specifications, a soliciting party cannot rely on discretionary authority to vote the shares represented by the overvoted proxy card on the election of directors. The shares can be counted for purposes of determining a quorum and can be voted on other matters on the proxy card for which there is no overvote.
– In the case of an undervoted proxy card, the shareholder has specified its choices for the election of directors, and a soliciting party cannot rely on discretionary authority to vote the shares represented by the undervoted proxy card for the remaining seats.
– As long as the form of proxy states in bold-faced type how the proxy holder will vote where no choice is specified, a soliciting party can use discretionary authority to vote shares represented by a signed but unmarked proxy card in accordance with the party’s voting recommendations because the shareholder has not specified any choices.
Question 132.03: A soliciting party can’t satisfy Rule 14a-12(a)(1)(i) through a legend that only includes a general reference to filings made by the soliciting party or the participants since general references don’t sufficiently advise shareholders where they can obtain participant information. Legends must clearly identify the specific filings including by filing date, the specific locations of the participant information in the filings by section headings or captions and include active hyperlinks when possible.
Question 151.02: When an acquisition doesn’t require shareholder approval but the registrant seeks approval for the authorization of additional shares that may be issued upon the conversion of the securities issued in the acquisition, the registrant would have to include information about the acquisition called for by Schedule 14A in the proxy statement because authorization of additional shares is necessary to meet its obligation under the convertible securities issued as consideration.
This Fried Frank memo calls out a “new trend” in Delaware earnout decisions:
Most earnout litigation has focused on whether the buyer has breached its general efforts obligations, or any specific covenants, with respect to its running of the business during the earnout period. Historically, in most cases, the court has found in favor of the buyer—concluding that the buyer conceivably had legitimate business reasons for running the business as it did, rather than having had a bad faith intent to frustrate the earnout. However, the most recent decisions appear to indicate a possible change in the court’s direction—with the court holding in favor of the seller in six of the seven cases.
The alert also argues that the recently reported increase in earnout usage is misleading. Instead, if you take out de-SPAC transactions, the rate of earnout usage is consistent and even a bit down.
Recent reports of a dramatic increase in the use of earnouts in M&A deals (excluding deals for development stage target companies, such as in the life sciences sector) appear to be based on the inclusion in those studies of de-SAPC mergers purportedly including earnout provisions. In the current formulation of de-SPAC mergers, however, the “earnout” provisions generally do not function as actual earnouts. That is, they do not function to bridge valuation expectations between buyers and sellers by providing the target stockholders with additional consideration if, post-closing, certain financial targets or milestone events are met by the acquired company. Rather, they typically function simply as an additional compensation “sweetener” for the SPAC sponsors and insiders (usually, if the combined company’s post-closing stock price reaches a specified target).
When de-SPAC mergers are excluded from the database of deals, the use of earnouts in 2023 to date has been about consistent with their use in the most recent years since the pandemic emerged. In 2023 to date, about 37% of M&A deals (excluding development-stage company deals and de-SPAC mergers) have included an earnout. This compares to 43% of such deals in 2022, 33% in 2021, and 36% in 2020. Prior to these pandemic-affected years, the historic rate of usage of earnouts in such deals was roughly in the range of 20-30%; and, in 2019 and 2018 (the two years just before the pandemic), the rate of usage was about 20%. Thus, current usage of earnouts remains above the historic, pre-pandemic rate—reflecting continued economic, valuation and financing uncertainties—but the rate has remained roughly consistent in 2023 with the rate in the most recent years (being somewhat down from 2022 and only slightly up from 2021 and 2020).
Similarly, earnout litigation has also not significantly spiked, according to the alert. Of course, that doesn’t mean that earnouts don’t still come with a high likelihood of post-closing disputes that might be expensive and time-consuming. This Cooley blog discussing commentary from Chancellor Kathaleen St. J. McCormick and Vice Chancellor Paul Fioravanti during a panel at the October 2023 Berkeley Fall Forum on Corporate Governance reminds us that “earnout disputes tend to be more heavily litigated than other cases and tend not to settle.” Apparently, earnout litigation has taken up a considerable amount of the Chancery Court’s time since 2016.
While the recent decisions siding with sellers may put pressure on buyers to settle rather than litigate — which it sounds like the Chancery Court would welcome — the memo reminds us that prior decisions may not be very predictive of future results given the continued emphasis on the importance of the specific language and context:
At the same time, however, and importantly, because the judicial result in all cases is heavily dependent on the specific language in the parties’ acquisition or merger agreement and the specific factual context, and because earnout provisions often are not sufficiently specific, litigation relating to earnouts carries a relatively high degree of uncertainty as to the outcome.
John has recently put the finishing touches on the annual update for the Practical M&A Treatise. This 848-page resource covers a broad range of topics, including the mechanics of an M&A transaction, documentation, disclosure, tax, accounting, antitrust, contractual transfer restrictions, successor liability, antitakeover & fiduciary duties of directors and controlling stockholders. The new edition features updates on:
– Delaware case law addressing the terms of acquisition agreements, including interpretive issues relating to language defining assumed and retained liabilities, and the implications of an unqualified representation on a buyer’s ability to terminate a transaction
– Fiduciary duties of directors, officers and controlling stockholders, poison pills, disclosure issues and standards of review
– The continuing evolution of the Rep & Warranty Insurance market and its implications for claims under RWI policies
– The status of sale of business non-competes in Delaware and the implications of the FTC’s proposed limitations on non-competes
– The impact of the first year under the universal proxy card rules on proxy contests
– The evolving antitrust regulatory and enforcement environment, and developments under the federal securities laws, including the lessons from the first year under the universal proxy rules
The Practical M&A Treatise is available online as part of our new upgraded DealLawyers.com membership. It’s also incorporated into our “Deal U Workshop” – an essential online course for more junior M&A lawyers, with nearly 60 podcasts and 30+ situational scenarios to test your knowledge. Sign up online, email sales@ccrcorp.com, or call 1-800-737-1271 to get access today.
Early this month, John blogged about Chancellor McCormick’s decision regarding a mootness fee petition in Crispo v. Musk (Del. Ch.; 10/23). As John shared, the opinion found that approaches to so-called “ConEd language” — each of which attempts to give a target the right to seek expectancy damages on behalf of their stockholders — may not be enforceable. John noted that the opinion suggested one potential fix — that is, expressly conveying third-party beneficiary rights to stockholders that only vest in exceptionally narrow circumstances and for the limited purpose of seeking lost premium damages — which might be preferable to the court finding an implied right to third-party beneficiary status.
This Milbank blog discusses another option hinted at in the opinion. This option relates to the “agency” approach to the expectancy damages problem, which the opinion said “rested on shaky ground” since “there is no legal basis for allowing one contracting party to unilaterally and irrevocably appoint itself as an agent for a non-party for the purpose of controlling that party’s rights.” Chancellor McCormick suggests a charter amendment may address this, but as the blog discusses, this option too has some hair on it:
The Chancellor in a footnote offers a ray of hope by noting that a charter amendment could permit the target to act as the stockholders’ agent in collecting lost stockholder premia. While at first blush one might think that this solution could be implemented seamlessly at the time of a merger vote, there are three issues with that approach.
First, both parties would be at risk of a breach (or alleged breach) prior to the vote, potentially unleashing during that period the parade of horribles that arise when stockholders are given directly exercisable third-party beneficiary rights.
Second, in a tender offer, there typically would be no stockholders meeting scheduled at which a charter amendment could be approved. Accordingly, the charter amendment would preferably be in place before any merger agreement is entered into – meaning that ISS and Glass Lewis may have to get on board pretty quickly with what should prove a very popular proposed charter amendment. (In a macro sense, it might be easier to move the Delaware legislature to action than to have hundreds of new stockholder proposals to evaluate and vote on.)
Finally, there is a technical problem that the charter amendment would need to address – the fact that damages typically are thought to accrue at the time of the breach, while damages would not be paid until a much later time, when the target would have a different stockholder base. So the charter amendment would need to establish whether any damages collected would need to be distributed to stockholders, and either provide a mechanism for damages to be distributed to the stockholders who were stockholders at the time of the breach, or, more likely, establish that third party beneficiary claims accruing to the stockholders at the time of the breach would be deemed transferred along with any stock transfer.
The blog concludes that necessity is the mother of invention: “In any event, there will no doubt be many solutions proposed, and perhaps many charters amended, over the next several months as practitioners come to grips with the fact that they have not in fact solved the ConEd riddle.” When we get wind of these inventions, we’ll share them here.
WTW’s Global Executive Compensation Analysis Team recently conducted a study of the 100 largest U.S. mergers from 2018 to 2022 focused on the use of special synergy awards. Of the companies surveyed:
– 14% granted special synergy awards to NEOs
– Of that 14%, 5% granted special synergy awards to NEOs and had synergy goals in their STI programs
– 23% only included synergy goals in their STI programs
The WTW team stressed that these special awards are only appropriate in limited circumstances — the annual executive compensation package should generally provide sufficient alignment with long-term strategy. When used, the disclosure of these awards needs to clearly articulate their purpose and highlight that they are non-recurring. With respect to the circumstances and structure of these awards, when used:
– 79% were granted in mergers that exceeded the median deal value of the survey ($13.8 billion)
– They were typically in the form of PSUs, but performance shares, performance stock options, performance cash awards or a combination were also used
– The vesting periods were typically between three and four years
– 57% included synergy and financial goals and 43% used only synergy goals (cost reduction or revenue improvement)