Don’t look now, but the Delaware Chancery Court just upheld another Caremark claim in the face of a motion to dismiss. In his 50-page opinion in In re Clovis Oncology Derivative Litigation, (Del. Ch.; 10/19), Vice Chancellor Slights held that the plaintiffs had adequately pled that the board breached its fiduciary duties by failing to oversee a clinical trial for the company’s experimental lung cancer drug and then allowing the company to mislead the market regarding the drug’s efficacy.
In declining to dismiss the case, the Vice Chancellor observed that Delaware courts are more likely to find liability under Caremark for oversight failures involving compliance obligations under regulatory mandates than for those involving oversight of ordinary business risks:
Caremark rests on the presumption that corporate fiduciaries are afforded “great discretion to design context- and industry-specific approaches tailored to their companies’ businesses and resources.” Indeed, “[b]usiness decision-makers must operate in the real world, with imperfect information, limited resources, and uncertain future. To impose liability on directors for making a ‘wrong’ business decision would cripple their ability to earn returns for investors by taking business risks.”
But, as fiduciaries, corporate managers must be informed of, and oversee compliance with, the regulatory environments in which their businesses operate. In this regard, as relates to Caremark liability, it is appropriate to distinguish the board’s oversight of the company’s management of business risk that is inherent in its business plan from the board’s oversight of the company’s compliance with positive law—including regulatory mandates.
As this Court recently noted, “[t]he legal academy has observed that Delaware courts are more inclined to find Caremark oversight liability at the board level when the company operates in the midst of obligations imposed upon it by positive law yet fails to implement compliance systems, or fails to monitor existing compliance systems, such that a violation of law, and resulting liability, occurs.”
VC Slights cited the Delaware Supreme Court’s recent decision in Marchand v. Barnhill, and noted that that case “underscores the importance of the board’s oversight function when the company is operating in the midst of ‘mission critical’ regulatory compliance risk.”
Caremark requires a plaintiff to establish that the board either “completely fail[ed] to implement any reporting or information system or controls” or failed to adequately monitor that system by ignoring “red flags” of non-compliance. While the board’s governance committee was responsible for overseeing compliance with regulatory requirements applicable to the clinical trial, the Vice Chancellor held that the plaintiff adequately pled that it knowingly ignored red flags indicating that the company was not complying with those requirements. Accordingly, he declined to dismiss the case.
Ann Lipton has some interesting perspectives on VC Slights’ distinction between business & legal compliance risks over on her Twitter feed. Check it out.
Caremark still may be, as former Chancellor Allen put it, “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.” But after decades of routinely dismissing Caremark claims at the pleading stage, this marks the second time this year that the Delaware courts have declined to do so – and it’s the third case in the last two years in which they’ve characterized a Caremark claim as “viable.”
Is Caremark becoming a more viable theory of liability, or is board’s conduct in these cases just more egregious than in prior cases? It’s hard to say based on the limited evidence we have. For now, maybe the ’60s band Buffalo Springfield put it best – “There’s something happening here. What it is ain’t exactly clear. . .”
Financial buyers used to insist on financing conditions in their acquisition agreements. They learned long ago that a financing condition usually ramped up their offer’s uncertainty beyond what public company boards were willing to stomach. In order to remain competitive with strategic buyers, they abandoned the financing condition and opted to instead offer up a reverse termination fee that would come into play if they couldn’t finance the deal. But the terms of those deals made it clear that, as far as the seller was concerned, that reverse termination fee was all they were going to get.
While that combination of reverse termination fee and exclusive remedy provisions has become almost universal for deals involving private equity buyers, that’s not the case when it comes to strategic sellers. As this Cooley blog points out, not only do they rarely get maximum liability caps, but their ability to assert that the termination fee is an exclusive remedy is usually contingent on their compliance with other deal terms.
In the wake of the Delaware Chancery Court’s recent decision in Genuine Parts v. Essendant, the blog suggests that strategic parties would be wise to push for the kind of “clean break” that private equity buyers have been able to negotiate. Here’s an excerpt:
The Genuine Parts decision highlights why strategic parties would be wise to take a page out of the financial buyer’s exclusive remedies playbook. For a board of directors of the target company, the certainty of a clean break from a prior transaction is crucial and can raise questions that could factor into a board’s decision-making when evaluating competing bids.
Should the board discount the financial terms of a competing bid for the risk attendant to possible litigation above and beyond the payment of the termination fee? Will potential competing bidders be more reluctant to make competing offers if the potential cost is greater than the termination fee? Worst of all from the intervening buyer’s (and target company’s) perspective, when the payment and acceptance of the termination fee does not act as a bar to further claims, the intervening buyer essentially funds the aggrieved first buyer’s litigation case (which was never the intent of the termination fee).
The blog doesn’t suggest that a target’s failure to comply with a non-solicitation covenant should just be shrugged off – but it says that the better approach would be to require the jilted buyer to elect its remedies & either accept the termination fee or take its chances in court.
In situations where the buyer may not know whether the seller breached its obligations at the time it needs to make this decision, the blog says the appropriate alternative may be to sue the buyer for tortious interference. As I blogged over on “John Tales” a while back, there’s some very interesting case law on tortious interference with an acquisition agreement.
I’ve previously blogged about the rise of mootness fees as plaintiffs’ favorite post-Trulia method for extracting a quick buck in federal merger objection strike suits. Last summer, a Chicago federal court balked at signing off on a mootness fee, which the judge referred to as a “racket” promoting useless merger litigation.
It looks like that case may be the start of a trend. This Morris James blog highlights a Delaware federal court’s recent decision refusing to approve a mootness fee application on the basis that the additional disclosures provided conferred no benefit to shareholders. Here’s an excerpt from the blog:
The district court denied the plaintiffs’ fee applications because it found that the plaintiffs failed to carry their burden to show the supplemental disclosures provided a “substantial benefit” justifying a fee award. CitingWalgreens and Trulia, the court reasoned that the plaintiffs “must establish, as a factual predicate, that the supplemental information was material.”
First considering supplemental disclosures of unlevered free cash flow projections used in the target’s financial adviser’s discounted cash flow analysis, the court reasoned that past cases supporting that such information can be material in certain circumstances do not make it per se material. The court explained the plaintiffs did not “explain how the stockholders would have been misled” by the omission of this information in these circumstances, nor did they “cite evidence or expert opinion on the issue.”
The court held similarly with respect to supplemental disclosures about the adviser’s calculation of the discount rate, the terminal multiple and the perpetuity growth rate. Again, the plaintiffs cited no authority showing this information is per se material, only cases “where courts found, on better developed records, that certain omissions were material given the particular factual circumstances.” The court further explained “neither caselaw nor law review articles are evidence of materiality in this case.”
Finally, the court held similarly with respect to supplemental disclosures of the multiples for each comparable company or precedent transaction included in the adviser’s analyses, when prior disclosures had already provided the overall ranges of multiples used. Such disclosures were not per se required, and plaintiffs failed “to connect the supplemental information to the facts of this case such that I could conclude that the omissions were material to DST stockholders given the total mix of information available to them.”
The blog notes the Court’s references to Trulia and Walgreens, and suggests that one of the takeaways from the decision is that “requests for court approval of mootness fees may involve similar judicial scrutiny of the benefit achieved, even though mootness dismissals do not involve potentially problematic classwide releases.” Considering the fact that about 70% of merger objection lawsuits this year have been filed in the 3rd Circuit, this decision has the potential to put a real crimp in the mootness fee racket.
The IRS is taking heat in a recent report ssued by the Treasury’s inspector general for tax administration (TIGTA) over its lack of a strategy to assess compliance issues associated with mergers and acquisitions. Here’s an excerpt:
The IRS does not have an overall strategy to address potential tax noncompliance of merger and acquisition transactions.IRS Examination managers TIGTA spoke with asserted that issues related to mergers and acquisitions generally receive the same attention as any other issue. IRS data indicate that adjustments were proposed in 400 (8 percent) of the 4,965 instances in which mergers and acquisitions were potentially an issue in closed cases from Fiscal Years 2015 through 2018.
When LB&I Division examiners were able to propose an adjustment to merger and acquisition issues, the proposed adjustments were significant: an average of approximately $15.2 million per issue. The IRS collects information on mergers and acquisitions from taxpayers engaging in those transactions but does not use it to identify potential noncompliance.
Taxpayers that engage in a tax-free reorganization must notify the IRS with their next tax return by including a statement. When TIGTA asked the IRS to provide the number of these statements filed for Tax Years 2015 through 2017, the IRS explained that while these statements are part of the taxpayer’s return, it was unable to provide the information.
The report also noted that the IRS proposed audit adjustments for underreported taxes on deals of approximately $296 million in 2018 – compared to approximately $1.05 billion in 2015. The report said that the percentage of deals with proposed adjustments also declined from 9.1% to 5.3% over the same period.
The IRS disputes the report’s conclusion that it lacks a strategy to address noncompliance in M&A transactions, but the report is getting some media attention, so don’t be surprised if the IRS takes a harder look when it audits your deals than it has in recent years.
It’s pretty common for a buyer to seek some sort of non-competition protection from a seller in connection with an acquisition. But this Goodwin memo points out that non-competes are attracting increased scrutiny from antitrust regulators. The memo highlights a recent deal in which the FTC required the parties to terminate a non-compete provision in order to obtain antitrust clearance. Here’s the intro:
The Federal Trade Commission and the Antitrust Division of the Department of Justice are making clear that noncompete agreements embedded in any kind of transaction under their review will be closely scrutinized. Close examination of proposed noncompetes is now yet another item to consider in the negotiation of any deal. Specifically, the FTC recently agreed to clear a deal for Nexus Gas Transmission to buy a pipeline in Ohio from North Coast Gas Transmission. But the FTC only did so after the parties themselves agreed to nix a noncompete provision in the agreement that prohibited the seller from competing with the buyer.
Specifically, the agreement provided that Nexus would buy one of two regional pipelines owned by North Coast, and that North Coast would then be barred from competing with Nexus to provide natural gas pipeline transportation services in the area for three years after the acquisition closed. According to the FTC, the noncompete at issue was impermissible because it would result in a lessening of competition, and the noncompete was not reasonably limited in scope to protect a legitimate business interest, such as intellectual property, goodwill or customer relationships, that would protect the buyer’s investment.
Non-competes are not per se unlawful under the antitrust laws. Instead, the memo notes that these provisions “are reviewed for their reasonableness, which includes scrutinizing their product and geographic scope, duration, and whether they are reasonably related to a legitimate business purpose.” The memo also provides some advice on key points to keep in mind when negotiating these provisions in order to reduce antitrust risks.
Despite the rise of protectionism & other pressures on globalization, cross-border transactions continue to grow, and companies are looking beyond the developed world and considering deals with targets in more challenging jurisdictions. This recent interview with Akin Gump’s Christian Davis & Melissa Schwartz provides some insights on how to manage the risks associated with doing a deal in Africa, Central Asia & other “frontier” markets. This sidebar to the interview identifies some “red flags” that companies thinking of doing a deal in a challenging jurisdiction should keep an eye out for:
– Parties or controlling entities, or entities in the supply or distribution chain, are sanctioned parties or located in a geographic area subject to comprehensive sanctions.
– Parties involved have been subject to recent enforcement actions by or made voluntary self-disclosures to OFAC, Department of Justice or other agencies relating to sanctions, corruption or money laundering
– Products or technology involved in business are subject to export controls applicable to the jurisdiction
– Business sectors involved are subject to heightened regulatory requirements and/or enforcement
– Business includes extensive use of “middlemen” or third-party intermediaries, consultants, increasing the corruption risks
– Involvement of governmental entities as transaction parties or major customers
– Absence of foreign investment protections, whether through treaty and/or local law
– Lack of bilateral investment and/or tax treaties with the jurisdiction
Section 382 of the Internal Revenue Code significantly limits a buyer’s ability to use a target’s pre-acquisition net operating losses to offset future income. However, if a target has appreciated assets, Section 338 of the Code allows a buyer to use those NOLs more quickly to the extent that it opts to recognize the target’s “built-in” gains on those assets within five years after the ownership change.
On the off chance that the first paragraph persuaded at least a few of you that I know what I’m talking about here, I’m going to quit while I’m ahead and just point you in the direction of this recent Jones Day memo, which says that proposed IRS regulations would reverse this favorable treatment under Section 338:
Very generally, if a corporation experiences a more than 50% change in ownership over a rolling three-year period, section 382 of the Internal Revenue Code imposes an annual limit on the corporation’s ability to offset future income with existing NOLs. This limit is tied to equity value and interest rates and therefore may be extremely low, particularly for a distressed company whose NOLs are often among its most valuable assets. Significantly, to the extent a corporation recognizes “built-in” gain within five years after an ownership change (realized gain), the corporation increases its annual limit up to its overall net unrealized gain on the ownership change date.
IRS Notice 2003-65 helpfully permits a corporation to determine realized gain by comparing (i) the deemed depreciation/amortization that would result from a hypothetical sale of the corporation’s assets to (ii) the corporation’s actual (and often lower) depreciation/amortization. The difference between the above amounts represents realized gain even though no assets are sold.
The proposed regulations would significantly change the determination of overall net unrealized gain and realized gain. They would eliminate taxpayers’ ability to increase realized gain without actual dispositions of assets. The required calculations would significantly limit consideration of many liabilities in measuring asset value, reducing the amount (or existence) of overall net unrealized gain, a particularly meaningful change for distressed companies. Finally, the proposed regulations would make various technical (and generally taxpayer unfavorable) changes, including as to the treatment of contingent liabilities and debt cancellation income for these purposes.
The memo points out that start-up companies that experience a change in ownership as a result of a venture capital investment would be disproportionately impacted by the rule proposal.
The latest edition of Cornerstone Research’s M&A Shareholder Litigation Study says that federal courts remained the preferred venue for M&A objection litigation in 2018, but that state courts have gained some ground. Here are some highlights:
– Lawsuits were filed in 82% of deals valued at more than $100 million in 2018. That’s the same level as 2017 and up from the 71% of deals that were litigated in 2016 (the year of the Trulia decision).
– The percentage of deals that resulted in lawsuits during 2018 was lower than the 90% averaged between 2009 and 2015
– The number of lawsuits filed per deal remained relatively constant at approximately 3. That remains lower than the pre-Trulia average of approximately 5 lawsuits per deal.
– Approximately 91% of 2018 M&A lawsuits were filed in federal court, compared to 97% in 2017. The pre-Trulia average was 26%.
– Approximately 34% of 2018 lawsuits were filed in state courts, compared to 18% in 2017. The pre-Trulia average was 97%.
The study says that the 3rd Circuit was by far the most popular venue for federal filings, and that the Delaware Chancery Court handled almost twice as many cases (13 cases) in 2018 than during 2017 (7 cases) – but that’s still way below the 37 cases that were filed in Delaware during 2016.
Earlier this week, the Treasury Department issued proposed regulations that would implement the Foreign Investment Risk Review Modernization Act that President Trump signed into law last August. The proposed regulations address transactions that weren’t covered by the FIRRMA pilot program regulations that were put in place last October, and this Ropes & Gray memo says that they are a very big deal:
The draft regulations set forth in the Proposed Rules, if implemented in their current form, would mark a significant expansion of CFIUS’s jurisdiction to review foreign investments in the United States. Among other changes, the Proposed Rules would provide the Committee with the ability to review non-controlling investments by foreign persons in certain categories of U.S. businesses, including those dealing in critical infrastructure and sensitive data, and make certain filings by foreign government-affiliated investors mandatory for the first time.
The Proposed Rules also would alleviate existing CFIUS-related considerations for certain foreign investors, including by codifying exceptions to CFIUS’s jurisdiction, adjusting the procedures used to notify CFIUS of covered transactions, and potentially creating exclusions from the Committee’s jurisdiction for investors associated with certain countries.
The memo reviews the proposed regulations in detail. It notes that the comment period ends on October 17th, and that CFIUS has until February 13, 2020 to issue final rules.
This Proskauer memo walks through the various methods used by dealmakers to address antitrust risks in M&A documentation. Here’s an excerpt:
A number of tools are commonplace for addressing antitrust risk, including efforts clauses, end dates, break or termination fees, material adverse event clauses, and control of investigation strategy. These provisions govern the parties’ obligations in the period prior to closing, and set out parties’ obligations if the transaction is not completed.
Transactions can be terminated mutually, and often are. But when that does not happen, the parties’ actions leading up to termination will be scrutinized for compliance with the various agreement provisions. When uncovering a breach could make the difference in who takes on the cost of the failed deal, understanding and strictly complying with the provisions of the agreement becomes critically important.
The memo reviews common contractual provisions used to address antitrust concerns, provisions, addresses how to ensure compliance with them, and provides examples of how they’ve played out in real world situations.