DealLawyers.com Blog

From MergerMarkets, here is a 60-page survey of North American deals done in the first half of 2005. Morrison & Foerster, Merrill Corporation and Global M&A assisted in putting together this comprehensive survey.

The PCAOB recently adopted Auditing Standard No. 4, “Reporting on Whether a Previously Reported Material Weakness Continues to Exist.” The new standard is intended to provide a mechanism by which auditors could express an opinion on the status of a material weakness as of an interim date, rather than waiting for the next year-end audit report.

Although the auditor’s evaluation would be similar to the auditor’s annual evaluation of internal control over financial reporting under Auditing Standard No. 2, the engagement under AS No. 4 is designed to be significantly narrower in scope, as the auditor’s testing is limited to the controls specifically identified by management as addressing the material weakness.

Materiality, in the context of an engagement under AS No. 4, is assessed as of the date management asserts that the material weakness no longer exists. The result is that in certain cases, a material weakness may no longer exist due to a change in the size of the financial statement accounts, rather than as a result of changes in the design or operation of controls. For example, this could occur as a result of an acquisition. AS No. 4 states that in many of these cases, the company will have undergone significant changes, with associated changes in internal control over financial reporting, so that the auditor would need to perform a full audit of internal control over financial reporting in order to have a sufficient basis for assessing materiality, understanding the company’s overall internal control over financial reporting post-acquisition and rendering an opinion about whether a previously reported material weakness continues to exist.

Thus, if a company that has a material weakness engages in an acquisition of sufficient size to impact the materiality analysis, it is unlikely that the company will be able to avail itself of the interim auditor assurance available under AS No. 4 and, instead, would have to wait to for the year-end audit.

AS No.4 will be submitted to the SEC, which will publish the standard for public comment, and will be effective as of the date of SEC approval.

In our “Auctions” Practice Area, we have posted the Toys R Us Shareholder Litigation opinion and there are some interesting comments on management retention negotiations in the context of a deal. Pages 47-51 (particularly 50-51) deal favorably with the CEO/director’s involvement in the transaction and the refusal to negotiate with bidders regarding management agreements. There is also mention in a footnote
regarding accelerating vesting of director options to correspond with the acceleration of employee options. A large portion of the discussion in the case deals with termination fees and the auction process.

Join us on September 21st for a webcast – “Winning Strategies in Auctions” – featuring David Katz of Wachtell Lipton and Eileen Nugent of Skadden Arps as they discuss the auction process, such as steps to reduce the impact of the “Winner’s Curse,” including analysis of the Toys R Us opinion.

Today, we have posted the next installment of DealLawyers.com “M&A Boot Camp.” This segment is brought by Wilson Chu of The Deal Guys’ Blog fame, doing his bit on negotiating tactics, such as:

– Gentleman Dealmaking
– Win-Win Does Not Mean: I Win Twice
– Negotiating Reps and Warranties
– Schedules Really Matter
– LOIs as Upfront Ego Management
– Take a Seventh Inning Stretch
– Use of Undermining Words and Phrases
– The Longer You Sit on a Problem, the More You’ll Own it
– Limitations of Emails and Conference Calls
– Educating Your Client to Support Your Position
– Go Deep – Be Prepared for Multiple Levels of Arguments
– Driving the Deal
– Always, Always be Prepared

Last month, the FASB and IASB proposed a standard — one of the most ambitious under the FASB/IASB convergence agenda — that would replace the existing requirements of FASB Statement No. 141, Business Combinations, and IFRS 3. FASB and IASB made their proposals in separate exposure drafts (here is the FASB’s exposure draft); the comment period ends October 28.

The proposals retain the fundamental requirement of IFRS 3 and Statement 141 that all business combinations be accounted for using a single method in which one party is always identified as acquiring the other. The major changes include a proposal that the acquired company must be measured at fair value; that goodwill attributable to any noncontrolling interests (not just the portion attributable to the acquirer) must be recognized; and that there would be fewer exceptions to measuring at fair value

Back on July 11th, the New York Times ran a Dealbook column by Andrew Sorkin that the then upcoming shareholder vote on the acquisition of Gillette would test the validity of so-called “fairness opinions.” Given that P&G shareholders approved the merger with an overwhelming level of support – 96%, according to this article – I wonder where that leads us on fairness opinions?

To learn more on this topic, see this thoughtful memo from Wachtell Lipton regarding conflicts in fairness opinions – as well as the transcript from our recent webcast: “Conflicts of Interest and Dicey Engagements.”

You just knew I couldn’t resist jumping into the fray caused by CNOOC’s bid for Unocal. First, it’s IBM, then Maytag, now Unocal. If all this has you wondering if China’s going to be the 21st Century’s version of Japan, Inc’s buying spree of US companies, I think the answer if yes .. and then some.

So what else might China, Inc be eyeing? You’ll be interested to know that last year, the Chinese government actually telegraphed its intent by publishing a list of preferred industries that China wants its companies to pursue. The list is called the “External Investment in Various Countries Indistrial Guidance Catalogue.” With the compliments of Jean-Marc Deschandol, Managing Partner of the Bejing office of Norton Rose, this so-called “Outbound Catalogue” is attached for your reading pleasure. I can hear the scintillating conversation you’ll be having on your July 4th BBQ.

If you look at the US targeted industries, you won’t find energy. Maybe China left it out on purpose because energy’s so politically sensitive. Or it’s just a reminder that the Catalogue merely a non-exclusive list.

Now you’re one step closer to getting on board the China, Inc. Love Train…

Looks like more and more companies these days are being sold through an auction process. With strategic buyers coming back with a vengeance, and buyout shops – who despite already sitting on mountains of “dry powder” – trumping each other with new world record funds (for example, Goldman’s recent $8.5B fund closing in April which topped Carlyle’s $7.85 fund closed in March), and with hedge funds “converging” into the buyout space, it’s safe to say that we’re in a seller’s market.

On one hand, strategic as well as financial buyers generally don’t like being a competing buyer in an auction. (Ah yes, the dreaded “Winner’s Curse”). On the other hand, whether it’s a Fortune 500 divesting a business unit or even a financial sponsor seeking an exit for a portfolio company, an auction seems to be the best environment to stir up competitive bidding to take advantage of a seller’s market.

With auctions being a fact of life in today’s deal environment, I thought it’ll be interesting (at least to me) to think about some recent developments in auctions:

1. Virtual Data Rooms. No, I’m not talking about eBay. I’m talking about online versions of those paper filled document rooms typically guarded by our trusty and fearsome first year associates. These VDRs (or sometimes, called EDRs for Electronic Virtual Data Rooms) seem to be popping up more and more in auctions in the US and abroad. There are third party providers like:

http://www.bowne.com/DealRoomExpress/default.asp

http://www.intralinks.com/yb/ma.asp

www.data-room.org/about_virtual_data_rooms.htm

There are even proprietary systems housed on law firm extranets.

Some of the advantages of VDRs:

· 24/7, anywhere-in-the-world access via the internet
· VDRs are password protected, with some more sensitive documents further fire walled for even more limited set of eyes, even view-only access
· can easily accommodate multiple bidders simultaneously
· search features
· ability to monitor usage on a per-document basis

On the other hand, some disadvantages include:

· 24/7, anywhere-in-the-world access via the internet – for hackers, i.e., is anything truly hack proof?
· Cost, with it making sense for bigger deals, especially with multiple bidders
· If you’re a bidder, do you really want seller knowing what you looked at (and otherwise, figure out what’s important to you?)

For more on VDRs, check out www.deallawyers.com/Member/Columnists/Interviews/2005_02_08_Bifulk.htm

2. Staple Financing. This is the wonderful development brought to us by your friendly “Conflict? What conflict” investment bankers, who, in addition to representing seller in an auction, benevolently offer to provide the financing to buyer. This pre-arranged financing package is commonly called “staple financing.” (Do you think bankers are subliminally sending a message by using “staple”, as in “What’s the staple of an investment banker’s bonus? Fees and more fees…). The popularity of staple financing is surging in today’s auction-packed market.

Bankers pitch staple financing as an efficient way to get the target sold because the financing’s in the bag (i.e,, no more financing contingencies or delays in buyer scurrying around to find money). Even if buyer doesn’t bite, the fact that a financing package is already in place show potential buyers that the deal’s finance-able (i.e., the target’s really worth seller’s rich asking price).

Conflicts? Did I mention conflicts? If the same banker’s collecting fees to sell the company as well as provide money to buyer, how comfortable can seller really be that its banker is truly looking out for seller’s best interest. (Hmm, let’s see: I make money on a success fee if I get target sold and I make money lending to buyer? Can you spell N-E-W-T-E-S-T-A-R-0-S-A??). If prospects for seller’s repeat business is low (i.e, the banker’s losing a client in the sale), what’s the likelihood that the banker’s licking his chops at the prospects of a new relationship as lender to buyer?

Fairness opinions get even trickier. Smart banks tell people to get a second (from another bank) fairness opinion when they’re sitting on both sides of the deal. Even smarter banks simply decline giving fairness opinions altogether.

It’s a question of allegiance. I’m sure no respectable banker would cross that line, but Eve’s apple is always out there.

3. Vendor Due Diligence Reports. From across The Pond comes this practice of seller engaging an independent (usually) accounting firm to provide a financial due diligence report on target. The reports are then offered to potential bidders as part of the information package in the data room. This practice is getting picked up by law firm on both sides of the Atlantic. See www.debevoise.com/db30/cgi-bin/pubs/Copy%20of%20PE%20Report%20Winter%202005.pdf for a good overview of the legal issues.

On the buy side, I’m not sure I’d tell a client that since there’s a VDD, there’s no need for further due diligence. On the other hand, it sounds like a great idea to streamline the sale process – and for law firms who provide the VDDs to get their piece of the auction.

If anyone has any other new developments in auction strategies, please feel free to share.

Everyone knows that even the most elegantly drafted earnout provisions can generate some unintended consequences in their actual implementation. A common earnout scenario involves the requirement that (i) at least one of the target’s officers (the “TO”) be an officer of the buyer (usually in charge of running the post acquisition target) and (ii) an audit be conducted by the buyer’s independent public accounting firm (the “BIPA”) regarding some or all of the earnout period. What many TOs don’t contemplate is that, as an officer in charge of the target’s post acquisition operations, the BIPA is, in all likelihood, going to require the TO is sign the BIPA’s management representation letter (“MRL”) as a prerequisite to the BIPA releasing the audit. The problem here is that the buyer may take positions regarding certain accounting issues regarding the earnout that the target would like to dispute, but with the TO signing the MRL, the target has at least tacitly concurred with the BIPA’s and buyer’s accounting treatment, thereby leaving the target to argue “I know I signed the MRL saying that I concurred with everything in the MRL and that everything in the MRL was accurate but now that we’re having this earnout discussion I disagree with some of the items I previously said I agreed with in the MRL…” Of course, the parties can agree that the MRL isn’t going “to be used against the target in any dispute” but the optics are difficult and you have to deal with the issue of inherent bias created with the mere presence of the TO’s signature to the MRL. The real solution is to have the parties agree when the deal is signed up that the TO will not have to sign a MRL. Because the BIPA can be the real stumbling block here (i.e., refusing to release the audit without a fully executed MRL) it’s a good idea to get them onboard at the same time.

Today, May 10, 2005, R. Hewitt Pate, Assistant Attorney General of the U.S. Department of Justice (AAG), and the chief enforcer of the country’s antitrust laws, resigned after completing a nearly two-year stint as AAG. http://www.usdoj.gov/atr/public/press_releases/2005/208940.htm. Pate will leave his position at the end of June.

Under Pate’s stewardship, the DOJ primarily focused on prosecuting bid rigging and other cartel arrangements under the antitrust laws, and was quite successful in that area. In the area of merger enforcement, though, the record of the DOJ under Pate is decidedly more mixed. Although the DOJ successfully negotiated merger remedies in several high-profile transactions–including First Data / Concord, Nestle/Dreyers, and Connors/BumbleBee–the Division also lost a high-profile merger challenge under Pate’s watch (U.S. v. Oracle Corporation), and suffered another high-profile loss in its challenge to the consolidation of school milk producers in Kentucky and Tennessee (U.S. v. Dairy Farmers of America).

Pate also emphasized the importance of intellectual property. His strong belief in the importance of protecting IP rights (even when directly in conflict with the antitrust laws) was evidenced in several significant amicus appellate briefs (most notably in Trinko v. Verizon) and speeches that he gave during his tenure as AAG. It will be interesting to see whether his successor places such a high premium on IP rights.

Will antitrust enforcement change fundamentally after Pate leaves? Doubtful. During the period before a permanent successor is announced, any interim antitrust chief will likely not take a radically different approach to antitrust enforcement. Any successor likely will come either from the ranks of the current DOJ leadership (the WSJ mentions Makam Delrahim, current one of Pate’s deputies) or someone hand-picked by the President’s circle of advisors. Until the next election, we’re likely to see more of the same from the DOJ.