Seyfarth Shaw recently published the 2020 edition of its “Middle Market M&A SurveyBook”, which analyzes key contractual terms for more than 100 middle-market private target deals signed in 2019. The survey focuses on deals with a purchase price of less than $1 billion. Here are some of the highlights:
– Approximately 25% of the non-insured deals surveyed provided for an indemnity escrow (as compared to approximately 37.5% in 2018). The reduction in the number of deals providing for indemnity escrow is likely as a result of the increase in the number of “no survival” deals.
– Approximately 43% of the insured deals surveyed provided for an indemnity escrow (as compared to approximately 55% in 2018). The reduction in the number of deals providing for indemnity escrow is likely as a result of the increase in the number of “no survival” deals.
– The median escrow amount in 2019 for the non-insured deals surveyed was approximately 10% of the purchase price (consistent with 2018), with approximately 83% of the noninsured deals having an indemnity escrow amount of 10% or less but only approximately 25% of the non-insured deals having an indemnity escrow amount of 5% or less.
– The median escrow amount in 2019 for the insured deals surveyed was approximately 0.6% of the purchase price (as compared to approximately 0.9% in 2018). It is plain to see the dramatic impact that R&W insurance has on the indemnity escrow amount (0.6% versus 10% for non-insured deals). The vast majority of insured deals had an indemnity escrow amount of less than 5% and, of those deals, approximately 91% had an escrow amount of 1% or less.
– The median indemnity escrow period for non-insured deals was 13.5 months and the median for insured deals was 12 months.
The survey also covers other indemnity-related provisions, rep & warranty survival provisions & carve-outs from general survival provisions, fraud exceptions & definitions, and governing law provisions. One interesting observation is the number of “no survival” deals – approximately 29% of non-insured deals & 41% of insured deals provided that reps & warranties wouldn’t survive closing.
Of course, all of these deals pre-dated the Covid-19 crisis, and as I read the data, I can’t help wondering how different some of it may look in next year’s survey.
I’ve previously blogged about the possibility that buyers might try and invoke MAC clauses in order to terminate deals during the Covid-19 crisis, and I’ve also blogged about some of the challenges buyers attempting to claim a MAC under these circumstances might face. Now, this Troutman Sanders memo says that a handful of buyers have decided to see if they can wiggle out of their pre-Covid-19 deals in reliance on a MAC clause. This excerpt addresses the ongoing back & forth between Bed Bath & Beyond and 1-800-Flowers.Com:
Bed Bath & Beyond filed suit against 1-800-Flowers.Com Inc. seeking to hold it to a $252 million deal in which 1-800-Flowers.Com would buy Personalizationmall.com (Company) from Bed Bath & Beyond. The purchase agreement was executed on February 14, 2020. It included a typical MAE clause that limits the definition of MAE to an individualized event negatively affecting the Company or a broader event that has “a disproportionate effect” on the Company. The deal was scheduled to close on March 30, 2020.
A week before the anticipated closing, 1-800-Flowers informed Bed Bath & Beyond that it was unilaterally delaying closing until April 30, 2020 due to COVID-19. 1-800-Flowers represented that it still wanted to close the deal, but that COVID-19 was preventing it from integrating the business and satisfying certain conditions of the deal. While 1-800-Flowers stated it was not terminating the parties’ agreement or invoking the MAE provision, it represented that it needed additional time to “assess” whether an MAE had taken place.
In response, Bed Bath & Beyond filed suit in Delaware Chancery Court seeking to force 1-800Flowers to close the transaction. In the complaint, Bed Bath & Beyond alleges that there has been no MAE because COVID-19 has not had a “disproportionate effect” on the Company. It claims that 1-800-Flowers’ delay is a maneuver to allow it to “wait and see” the ultimate effect COVID-19 has on the Company’s business and to assess whether it can retroactively assert an MAE to terminate the agreement. According to Bed Bath & Beyond, “even a calamitous event such as COVID-19 does not permit a party to avoid its obligations.”
The memo speculates that more buyers are likely to follow a strategy of seeking to first delay a deal in the hope that business conditions before resorting to an MAC-based termination. The memo also discusses three other pending deals in which buyers’ have sought to call a MAC. Stay tuned, I’m sure there’s much more to come.
This Sidley memo notes that ISS’s recent guidance on short-term poison pills suggests that it may not think they’re such a bad idea during a time of significant market disruption. Here’s an excerpt:
In ordinary times, we typically advise companies to refrain from adopting a poison pill in the absence of a specific activist or takeover threat and instead keep it “on the shelf” (i.e., fully drafted and ready for adoption). That is because ISS, Glass Lewis and many institutional investors generally frown upon the adoption of poison pills in the absence of such a specific threat. What was unclear until ISS issued new guidance yesterday was whether the proxy advisory firms would consider market conditions due to the COVID-19 pandemic a type of threat that may justify the adoption of a poison pill.
As we hoped, it appears that at least ISS understands why the adoption of poison pills may be warranted in these unprecedented times. In its April 8 guidance, ISS reiterated that it would consider situations on a case-by-case basis, and it noted:
“A severe stock price decline as a result of the COVID-19 pandemic is likely to be considered valid justification in most cases for adopting a pill of less than one year in duration; however, boards should provide detailed disclosure regarding their choice of duration, or on any decisions to delay or avoid putting plans to a shareholder vote beyond that period. The triggers for such plans will continue to be closely assessed within the context of the rationale provided and the length of the plan adopted, among other factors.”
The authors don’t expect ISS to penalize boards that adopt pills with a duration of less than a year in response to a sharp drop in their company’s stock price, assuming that the other terms – particularly the trigger threshold – are justified. In that regard, the memo notes that ISS’s stated position is consistent with its April 3 recommendation to vote “against” the Chairman of The Williams Companies due to the board’s adoption of a poison pill with a 5% trigger in a situation where the poison pill was not adopted to protect the company’s NOLs.
Along the same lines, the memo makes it clear that ISS’s guidance isn’t going to provide companies with a free pass to implement short-term pills, and that a board adopting a pill “needs to communicate clearly the rationale for adoption, and the rationale for any terms that are outside the norm, to all constituencies, including ISS, other proxy advisory firms and institutional investors.”
The memo also suggests that ISS’s guidance indicates that it will take a more skeptical view of activist claims made in proxy contests in the current environment – with ISS noting that activists that move forward with contests this spring will be labeled by management as “opportunistic or unreasonable,” and stating further that, in some cases, “that will not be an unfair characterization.”
This Gibson Dunn memo reviews how the Covid-19 crisis is affecting the market for R&W insurance, and considers how the crisis may influence the market over the longer term. The memo says that insurers are insisting upon robust Covid-19 related due diligence, and are likely to focus increasing attention on the reps & warranties and pre-closing covenants and conditions potentially implicated by the crisis:
Additionally, we expect that insurers will be particularly focused on certain representations in acquisition agreements (and the related disclosure schedules) that are more likely to be impacted by the pandemic—such as representations regarding customer and supplier relationships, accounts receivable, absence of changes to the target’s business, undisclosed liabilities, financial statements adequately presenting the target’s financial condition, employees, compliance with laws and adequacy of insurance—and insurers will expect to see that buyers have tailored their diligence to confirm the accuracy of those representations.
Insurers have also focused on how the parties have allocated COVID-19 related risks in the acquisition agreement (either explicitly or implicitly) between signing and closing and the related closing conditions. Prior to the pandemic, buyers had largely accepted very narrow closing conditions under which they could only terminate in the event of a “Material Adverse Effect” (which itself was narrowly defined). Insurers are particularly sensitive to efforts of the parties to shift this deal risk to the insurers and generally prefer to see the issue explicitly addressed.
The memo says that insurers are also proposing exclusions for coverage for some COVID-19 related risks even in the absence of specific COVID-19 due diligence issues – and that the breadth of these exclusions is changing on a daily basis.
The memo speculates that the likely increase in distressed transactions will keep demand for R&W insurance high during the short-term, but outside of those transactions, changing marketplace dynamics – such as an increase in buyer leverage – may result in greater reliance on seller indemnities backed by substantial escrows.
Aon recently released a study analyzing the approximately 340 claims made on more than 2,450 rep & warranty insurance policies that it placed in North America between 2013 and 2019. Here are some of the highlights:
– More than $350 million above the policy retention has been paid by representations and warranties insurance to Aon clients in North America. More than $525 million in total loss has been recognized (when factoring in erosion of policy retentions).
– 30% of claims have been resolved, 4% have been denied, 54% are active and 12% are inactive to date (ones in which no correspondence has been provided in over a year).
– Claims were made on 22% of all policies placed between 2013 and 2017; however, the percentage of policies notified of a claim between 2014-2016 gradually increased from 18.6% on policies issued in 2014 to 25.3% on policies issued in 2016.
– Claim size trended upwards in 2019, with an average claim payment of $10.7 million and 26% of all claims paid this year exceeding $10 million, largely due to the larger deal sizes (and proportionately larger insurance policies) that Aon worked on in 2017 and 2018.
– Deals valued over $1 billion have yielded a slightly higher claim frequency than smaller valuation bands, although only 9% of total claims made on these deals have resulted in a payment. This is lower than the average for smaller transactions.
Interestingly, the study found no discernible difference in the frequency of claims for transactions that included a seller indemnity (for breaches of any representations and warranties) compared to ones that didn’t.
Overall, Aon’s study found that claims under RWI policies increased by more than 400% between 2014 and 2018. That increase is largely attributable to the rapid growth of RWI policies over this period, but as noted above, the claims percentage rose from 18.6% on 2014 policies to 25.3% on 2016 policies. Due to the lag between closing & discovery of a breach, Aon says it is too early to determine whether the rise in claim frequency will continue for subsequent policy years.
The Covid-19 pandemic has seen previously sky-high M&A valuations plummet, at least for now. As a result, buyers looking to press on and do deals in this environment need to find creative ways to bridge gaps between the value at which deals can get done & what sellers believe their businesses are worth under normal conditions. This Dechert memo discusses strategies that buyers can employ in order to accomplish that objective.
Perhaps the memo’s most interesting suggestion is to look to Asia for insights as to how dealmakers there have approached valuation issues in the current environment. Asian financial markets have dealt with the effect of COVID-19 longer than U.S. or European markets, and have also had experience dealing with SARS and similar market disruptions. As a result, it may be helpful to consider recent valuation trends in those markets. These include:
– The use by sponsors of downside protections typically incorporated in venture capital transactions, given the similarities between the current environment of valuation uncertainty and the valuation uncertainties inherent in venture capital investments. These measures include negotiating for most favored nation clauses, down-round protections and enhanced liquidity and dividend preferences.
– Investors increasingly structuring their investment as a hybrid debt/equity instrument to ensure there is down-side protection, with the prospect of equity upside in the future.
– Investors providing convertible bridge loans with an agreed-upon conversion discount triggered by a subsequent equity investment, which provides initial capital to the target business and also provides the investor with more time to conduct diligence and determine the appropriate equity valuation.
The memo also addresses the possible use of earnouts, noting that while they are often complex and frequently end up in litigation, the can be a useful tool in an economic downturn. In addition, it discusses the possible use of toe-hold and other minority investments, which – if properly structured – can allow a company to obtain needed capital without a full exit at a depressed valuation, and also provide a path to control for the investor.
European regulators are becoming increasingly concerned about attempts by non-EU buyers to obtain control over suppliers of essential products – and healthcare products in particular. This Cleary Gottlieb memo says that the European Commission is urging member states to use existing foreign direct investment rules & introduce robust screening mechanisms where they don’t currently exist, in order to protect “critical health infrastructure, supply of critical inputs, and other critical sectors.” This excerpt summarizes the EC’s message:
The EC’s communication notes that the COVID-19 pandemic could give rise to “an increased risk of attempts to acquire healthcare capacities (for example for the productions of medical or protective equipment) or related industries such as research establishments (for instance developing vaccines) via foreign direct investment.” It further states that “vigilance is required to ensure that any such FDI does not have a harmful impact on the EU’s capacity to cover the health needs of its citizens.”
Because “acquisitions of healthcare-related assets would have an impact on the European Union as a whole,” the communication urges Member States that do not have screening mechanisms, and have not yet implemented the FDI Screening Regulation, “to set up a full-fledged screening system and in the meantime to use all other available options to address cases where the acquisition or control of a particular business, infrastructure or technology would create a risk to security or public order in the EU, including a risk to critical health infrastructures and supply of critical inputs.”
The memo also provides some details on the EU’s new FDI Screening Regulation, which will go into effect in October 2020. The EC’s communication to member states particular emphasis to the possibility of post-closing enforcement actions under a mechanism introduced by the FDI Screening Regulation.
In an effort to maintain my sanity by providing some non-pandemic content, I stumbled across the Chancery Court’s recent decision in Walsh & Devlin v. White House Post Productions, LLC, (Del. Ch.; 3/20), which involved claims arising out of an LLC’s attempt to back out of a contractual buyout process that it had started.
The LLC agreement’s buyout provision was one that is pretty common in a variety of settings involving companies with management investors alongside PE firms or other sponsors. It gave the LLC the right to buy out management investors upon termination of employment, and established a “triple appraisal” pricing process. The LLC notified the plaintiffs that it intended to exercise that right, and duly produced the first appraisal. When the plaintiffs sought information in order to obtain a second appraisal, the LLC informed them that it had changed its mind and was no longer interested in buying their membership interests.
The plaintiffs went ahead and sought an second appraisal anyway, and when that appraisal produced a valuation that was 10% higher than the one produced buy the LLC, they sought to have a third appraisal completed. At this point, the LLC went silent. The plaintiffs responded by filing a lawsuit that essentially asked the Chancery Court to order the LLC to finish what it started.
The defendants moved to dismiss the breach of contract claim against the LLC. They argued that delivery of the buyout notice was simply an offer, which the LLC had the right to rescind at any time prior to acceptance. The plaintiffs countered that the exercise of the buyout right created a binding “call option.” After reviewing in detail the terms of the buyout clause, the Vice Chancellor held that the plaintiffs stated a claim:
The Buyout Provision is a call option. It contains both elements of an option contract: an offer to enter into an underlying agreement for the sale of property and a promise to keep that offer open. The underlying agreement is the Company’s “right to purchase” a member’s units “[i]n the event [that] [m]ember ceases to be employed by the Company.” The collateral agreement is Plaintiffs’ promise to keep that offer open: “such [m]ember shall be obligated to sell” his units to the Company. In sum, when executing the LLC Agreement, the parties agreed that all of pre-negotiated buyout terms would bind the parties in the event the Company exercised its option. This is, in all practical effect, the way a call option operates.
Because she concluded that the buyout provision was a call option, VC McCormick said that the Company could not withdraw from the price-fixing process after exercising that option – and she found that it was reasonably conceivable that the notice initiating the buyout process “constituted an exercise of the Company’s power of acceptance” under the buyout provision.
This kind of language is probably in thousands of buy-sell agreements, and I bet the drafters never thought for a minute that adding the language “. . .and the seller shall be obligated to sell” did anything more than add suspenders to the contractual belt. My guess is that language may get a closer look in the future.
By the way, I originally was going to title this blog “Delaware Chancery Says ‘No Backsies'” – but I concluded that was undignified, even applying the increasingly lax standards of a man who has spent the last two weeks in sweatpants staring vacantly into a seemingly endless stream of Zoom meetings.
Unfortunately, there’s likely to be an avalanche of debt restructurings over the coming months, and this Ropes & Gray memo says that some of them may trigger CFIUS review. Although loans are generally exempt from the CFIUS review process, adding a slice of equity or convertible debt to a foreign lender’s interest as part of a restructuring may alter the analysis:
In general, lending transactions are not within the scope of CFIUS’s jurisdiction, provided that they do not grant the foreign person economic or governance rights more characteristic of an equity investment. If a financing or lending transaction, for example, grants a foreign party (1) an interest in profits of a U.S. business; (2) the right to appoint members of the board of directors of the U.S. business; or (3) other comparable financial or governance rights characteristic of an equity investment, CFIUS could have jurisdiction over the transaction. Where a non-U.S. lender acquires a convertible debt instrument that will confer equity-like rights upon conversion, the CFIUS jurisdictional analysis becomes fact-specific.
Convertible instruments raise potential concerns because under the CFIUS regs, they are regarded as “contingent equity interests” and have the potential to trigger CFIUS jurisdiction either at the time of their acquisition or upon their conversion, depending on the circumstances.
The memo also notes that CFIUS jurisdiction can also be triggered by a default under a loan agreement, if there is a significant possibility that a foreign lender may acquire control of a U.S. business or qualifying access or rights over a technology, infrastructure or data (TID) U.S. business.
This March-April Issue of the Deal Lawyers print newsletter was just posted – & also sent to the printer – and includes articles on:
– Pre-Closing Covenants: Operating in the Ordinary Course of Business
– CFIUS 2020: Five Things to Know about Filings and CFIUS Risk
– FTC Targets M&A Agreements in Continued Campaign Against Noncompete and No-Poach Clauses
– Delaware Supreme Court Examines Director Liability for Acquisitions
– FTC and DOJ Announce New Draft Vertical Merger Guidelines
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