It’s easy to see why a controlling shareholder contemplating a take-private transaction would want to reach out to obtain support from large minority shareholders before moving forward with a deal. The trouble is that – as Dell recently discovered – those contacts can create a big problem if the parties want to obtain business judgment review for the transaction under the MFW standard.
That point was brought home again by the Chancery Court’s decision last week in In re HomeFed Stockholder Litigation, (Del. Ch.; 7/20), which arose out of Jefferies Financial Group’s July 2019 acquisition of the 30% interest in HomeFed Corporation that it didn’t already own. A HomeFed director originally proposed a take-private deal to Jeffries in 2017, and the company put in place a special committee to negotiate with Jeffries in December of that year. The process was paused in March 2018, when Jeffries told the committee that it wasn’t interested in pursuing a deal.
Over the next 11 months, Jefferies discussed the potential deal with BMO, HomeFed’s largest minority stockholder. BMO’s support was essential to get a deal done with the approval of the minority stockholders, and in February 2019, it told Jeffries that it would support a 2-for-1 share exchange. After it received the “thumbs up” from BMO, Jefferies formally proposed acquiring the rest of HomeFed’s shares on those terms, conditioned on the approval of a special committee & a majority of the minority shareholders.
The plaintiffs sued the HomeFed board & Jeffries for breach of fiduciary duty, and the defendants responded that MFW should apply and that the transaction should be evaluated under the business judgment standard of review. Chancellor Bouchard disagreed, and declined to dismiss the plaintiffs’ claims. This excerpt from Steve Quinlivan’s recent blog on the case summarizes his reasoning:
Central to the case was whether Jefferies committed itself to the dual protections of MFW before engaging in substantive economic discussions concerning the transaction that anchored later negotiations and undermined the ability of the special committee to bargain effectively on behalf of the minority stockholders.
The court first considered whether the pause in negotiations in March 2018 put enough time and distance between subsequent negotiations around February 2019 so that the MFW protections were implemented in a timely manner. The court agreed with plaintiffs that the break in negotiations was not meaningful. The board never dissolved the special committee, negotiations were only paused, negotiations continued with BMO and BMO ultimately supported the exchange ratio.
The timing of the two sets of negotiations was not the fatal flaw however, but how the final negotiations progressed. Jefferies engaged in a series of discussions with BMO until Jefferies received an indication of support for a 2:1 share exchange from BMO—whose support was essential to get a deal done with minority stockholder approval—as well as from a financial advisor and key stockholder before Jefferies agreed to the dual MFW protections. To be more specific, Jefferies received these indications of support in early February 2019 but did not agree to the MFW protections until, at the earliest, February 20, 2019, when it amended its Schedule 13D.
The Court rejected defendants’ argument that Jefferies’ discussions with BMO before the February 2019 offer did not pass the point of no return for invoking MFW’s protections because those discussions were “preliminary” and only involved “an unaffiliated minority stockholder with no ability or authority to bind the corporation or any other stockholder.”
The Chancellor cited the recent Dell decision for the proposition that “MFW’s dual protections contemplate that the Special Committee will act as the bargaining agent for the minority stockholders, with the minority stockholders rendering an up-or-down verdict on the committee’s work.” He said that a special committee was “uniquely qualified to perform this task,” due to directors’ superior access to internal information, their ability to “deploy the board’s statutory authority” and to act as an “expert bargaining agent.”
Chancellor Bouchard also noted that directors also owe fiduciary duties & don’t suffer from the collective action problem of disaggregated stockholders. In contrast, minority stockholders are unencumbered by fiduciary duties and their individual interests may diverge from those of other shareholders – which makes negotiations with a large minority holder in a situation like this potentially problematic.
This Sidley memo (p. 6) provides insights into the antitrust merger review process during the Covid-19 crisis. We’ve touched on some of the memo’s key takeaways before – including regulatory skepticism toward the “failing firm” defense, heightened concerns about gun jumping & the fact that complex merger reviews are taking more time. However, the memo address several other topic that we haven’t covered. Here’s an excerpt on the potential increased risk of regulatory scrutiny of non-reportable deals:
– Transactions That Are Not Reportable Can Be Subject to Antitrust Scrutiny. A number of major jurisdictions including the U.S., UK and Canada have the ability to investigate and challenge transactions that are not reportable, either before or after they close. In ordinary circumstances the U.S. agencies on average challenge two transactions a year that were not reportable.
During past economic crises, that number has increased, in part because the agencies have greater resource availability due to the decline in filings. Parties to non-reportable strategic transactions that raise antitrust issues should consider the risk of antitrust scrutiny before signing. Buyers should also consider the risk of a post-closing investigation that could result in a divestiture order.
The memo cautions that regulatory authorities are applying the same standards as before, and are on the lookout for companies that may try to exploit the current crisis to complete an anticompetitive transaction.
With valuations taking a big hit and the turmoil that the pandemic has created for many portfolio companies, many sponsors that might otherwise have sought an exit this year are biding their time until more favorable conditions return. This recent McKinsey report says that sponsors are using this additional time to prepare for an exit. Here’s an excerpt on some of the “hard pivots” that portfolio companies are taking to enhance their value:
As we mentioned, the recession has revealed material weaknesses in some business models, such as those of specialty retailers that mistakenly saw themselves as essential to consumers and of retailers that lack bargaining power with suppliers. After solving their immediate liquidity issues, forward-thinking sponsors are making the hard choices now to pivot to a stronger and more resilient business model.
One technology company preparing for exit sold predominantly into the real-estate and hospitality sectors. It had generally priced on a pay-per-use model, which was attractive to many customers. It had previously resisted attempts to move to a fixed-fee software-as-a-service (SaaS) model, as many similar companies have done. Although it has sufficient cash on hand to withstand a protracted downturn, it is now taking the plunge, moving many of its customers to fixed-price or take-or-pay contracts that will provide an even greater cushion in the next downturn (and will probably support better financing).
Some portfolio companies are also diversifying revenues to reduce cyclicality and improve resilience. For an infrastructure-services company focused on logistics and installation of capital equipment, this means a shift toward recurring revenues tied to services in operations and maintenance. Similarly, an industrial-equipment company shifted its mix to include more digitally enabled services.
This July-August Issue of the Deal Lawyers print newsletter was just posted – & also sent to the printer (try a no-risk trial). It includes articles on:
– M&A Transactions & PPP Eligibility and Forgiveness Considerations
– Strategic Acquisitions of Distressed Companies in the COVID-19 Environment
– Due Diligence: “That Deal Sounds Too Good to Be True”
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There hasn’t been much for dealmakers to cheer about in recent months, but this Deloitte report suggests that there may be some reason for optimism about what lies ahead in M&A:
When the COVID-19 pandemic swept into the US, it curbed deal-making significantly. Between February and March, the number of announced deals dropped from 2,349 to 1,984, with deal value decreasing from just over $151 billion to about $130 billion. Instead of launching new deals, the urgent priority for many finance leaders was to resolve any in-progress transactions, re-evaluating their strategic assumptions and taking appropriate actions to safeguard their financial positions.
Now, as finance leaders move past the recovery phase of the pandemic and conceive plans for thriving in a changed economic landscape, M&A is poised to play a central role. In April, Deloitte conducted a snap poll of 2,800 US companies, and 70% of the respondents indicated they will continue with M&A and, in some cases, accelerate their deal activities over the next 12 months. In addition, 31% of the 156 CFOs who responded to Deloitte’s Q2 2020 North American CFO Signals™ survey said they expect to acquire distressed assets or businesses over the next year.
The report addresses offensives & defensive rationales for M&A activity, and notes that plenty of buyers are well positioned to move on attractive opportunities. The S&P 1200 companies have a record $3.8 trillion in cash reserves & the wherewithal to service debt in a “dovish” monetary environment. That’s in addition to the $2.4 trillion war chest that PE firms have ready to be deployed.
Remember when the Delaware Supreme Court issued a sharply worded opinion reversing Vice Chancellor Laster’s decision to adopt an “unaffected market price” approach to fair value in his Aruba Networks appraisal decision? Well, last Thursday, in Fir Tree Value Master Fund v. Jarden, (Del.; 7/20), the Court unanimously upheld Vice Chancellor Slights’ decision to use that same valuation standard in an appraisal proceeding involving Jarden Corporation.
Chief Justice Seitz’s 43-page opinion rejected the petitioners’ argument that the Court’s decision in Aruba Networks “foreclosed as a matter of law the court’s use of unaffected market price to support fair value.” Instead, he said that the neither Aruba nor the Supreme Court’s other recent appraisal decisions ruled out using any recognized valuation methods to support fair value:
In DFC, Dell, and Aruba we did not, as a matter of law, rule out any recognized financial measurement of fair value. Instead, we remained true to the appraisal statute’s command that the court consider “all relevant factors” in its fair value determination. Although subject to academic debate, we have also recognized the efficient capital markets hypothesis in appraisal cases. The Vice Chancellor got the “takeaway” exactly right from our recent appraisal decisions: “[w]hat is necessary in any particular [appraisal] case [] is for the Court of Chancery to explain its [fair value calculus] in a manner that is grounded in the record before it.”
So, it appears that the Court’s hostility toward the Chancery’s use of the target’s unaffected market price to determine fair value in Aruba Networks had more to do with Vice Chancellor Laster’s approach to the valuation process in that case than it did with any fundamental concerns about the use of that standard to determine fair value.
We’ll be posting memos in our “Appraisal Rights” Practice Area. But for now, check out Prof. Ann Lipton’s analysis of the decision over on “Business Law Prof. Blog.”
I don’t think it will come as a surprise to many public companies to learn that their investors are becoming more open to listening to pitches from activist shareholders, but IR Magazine’s report may still raise some eyebrows with its conclusions about just how willing they are to hear activists out:
Almost two thirds of investors say they are open to talking to activist investors about a company they have a position in, according to recent research from IR Magazine. While many companies continue to experience volatile share prices and balance sheet concerns – with a significant increase in the number of companies adopting poison pills this year – investors are more likely to support an activist campaign now than they were three years ago.
This is according to IR Magazine’s Shareholder Activism research report, which was released last month. Almost two fifths (39 percent) of investor respondents say they are more likely to support an activist campaign than they were three years ago, with almost half of European and Asian respondents agreeing with this statement.
The silver lining for company boards & management is that the number of investors siding with activist investors remains relatively low. The report says that only 22% of buy-side respondents have been involved in an activist campaign since 2017, with 5% leading the campaign and 17% supporting or partnering with an activist investor.
Public companies acquiring divisions or product lines have often had to seek Corp Fin’s sign-off on the use of abbreviated acquired company financial statements in connection with those acquisitions. That process introduces an additional element of potential delay & uncertainty to these “carve-outs,” but this Cooley blog says that the SEC’s new rules on acquired company financial statements provide some real help. This excerpt from the intro summarizes the implications of these changes for buyers:
The new rules permit buyers to file abbreviated financial statements in these types of carve-out transactions without prior SEC consent, as long as certain criteria are met. Eliminating the need to obtain this relief from the SEC will save buyers time and legal and accounting expense. More importantly, the new rules may better position a buyer in an auction process where the buyer needs to know that it will be able to satisfy its SEC filing obligations if its bid prevails.
Under the current rules, a potential buyer is often forced to choose among several less than ideal options in an auction process, whether it be (i) seeking permission from the seller to request the SEC exemption on a contingent basis during the process, (ii) including a contingency in its bid for obtaining this SEC relief or (iii) accepting the risk that it might not be able to satisfy the financial statement requirements and become non-compliant with SEC filing requirements (therefore losing S-3 eligibility).
While buyers will still need to make arrangements with sellers to prepare & audit the abbreviated financial statements, the blog notes that the new rules eliminate much of the uncertainty for many carve-outs. That’s because they provide that abbreviated financial statements may be used without prior SEC approval if certain conditions are met, including the absence of separate historical financials for the acquired business. The acquired business also must represent 20% or less of the seller’s total assets & total revenues on a consolidated basis for its most recently completed fiscal year.
This Sidley memo (pg. 2) discusses how the implications of the Covid-19 crisis may require buyers & sellers to scrutinize earnout provisions with a “new lens,” whether they are negotiating new deals or potentially renegotiating existing ones. This excerpt addresses some of the considerations associated with using a “sliding scale” earnout instead of the more customary all or nothing arrangement:
Earnouts are often structured with all-or-nothing payment terms such that seller receives nothing if the earnout threshold is not met. It is difficult to forecast appropriate earnout benchmarks, and, when a company is performing well or creating value but these all-or-nothing terms are still unattainable, a seller (or former equity holders of seller who are current key employees of the target) may lose motivation to drive company performance.
Further, key employees of seller may terminate their employment with buyer in the absence of other significant retention mechanisms. Thus, when a company is performing well, but below an earnout threshold, value is lost when both parties would have continued to perform if a lower payout than was previously negotiated were available. In these scenarios, making a reduced earnout payment may be less costly to buyer than the loss of aligned incentives to drive future company performance or the loss of key employees. Similarly, if a threshold for performance is set too low, for example, because the longer-term impacts of COVID-19 are overestimated, seller may take its foot off the gas when it is clear that an earnout will be achieved, even if better performance is achievable.
Given the unexpected downturn in the economy caused by the COVID-19 pandemic, earnouts that were negotiated in 2018 and 2019 assuming in-line 2020 performance may be unachievable now and, without renegotiation, can result in value loss to both buyers and sellers. In some of these situations, buyer may still want seller’s ongoing assistance to navigate the current conditions and may be willing to pay an earnout, albeit in a lesser amount than originally negotiated, or amend the earnout metrics to incentivize continued assistance driving future value.
When earnouts are structured with a sliding scale payout (i.e., setting a floor for minimum performance and a ceiling for a maximum payment, with the payment based on a performance formula) or multiple payment thresholds (i.e., setting multiple payout levels in steps based on performance), this can help preserve some of the value that would have been lost in all-or-nothing payout structures.
The memo notes that if the buyer selects an appropriate floor and ceiling for its earnout obligations, a sliding scale or multiple payment structure may increase the likelihood that the parties’ objectives remain aligned.