Practising Law Institute. CORPORATE LAW AND PRACTICE Course Handbook Series Number B Pocket MBA

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1 CORPORATE LAW AND PRACTICE Course Handbook Series Number B-2124 Pocket MBA Fall 2014: Finance for Lawyers and Other Professionals Co-Chairs James J. Agar Philip J. Bach Ewa Knapik Dana G. McFerran Ziemowit T. Smulkowski To order this book, call (800) 260-4PLI or fax us at (800) Ask our Customer Service Department for PLI Order Number 51033, Dept. BAV5. Practising Law Institute 1177 Avenue of the Americas New York, New York 10036

2 25 Closing Business Transactions Substantive Outline Michael F. DeFranco Baker & McKenzie LLP Brooks T. Giles Katten Muchin Rosenman LLP This presentation has been prepared as of July If you find this article helpful, you can learn more about the subject by going to to view the on demand program or segment for which it was written 639

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4 I. INTRODUCTION The following is a substantive outline designed as an accompaniment to a presentation on the elements of Closing Business Transactions. The presentation and outline cover the basics of the negotiation process (including the roles of lawyers and investment bankers in that process and common dynamics that negotiators are likely to encounter as they work towards closing a transaction); common stumbling blocks to closing transactions (such as valuation disparities and working capital adjustments); and certain fringe deal issues, which may not occur in all transactions but which can require significant time, attention and effort when they arise. II. THE NEGOTIATION PROCESS AND TRANSACTION ROLES OF LAWYERS AND BANKERS A. Types of Transactions and Transaction Leverage Most M&A transactions are, at a basic level, either auctions or exclusive (or semi-exclusive ) negotiations between two parties. A successful negotiation requires an understanding of the relative positions of the parties. 1. Auctions Auction processes may take many forms depending on the particular circumstances involved, however common elements often are: The seller will provide information about the target (usually in the form of an offering memorandum) to multiple potential bidders. After receiving initial indications of interest from prospective bidders, the seller s counsel will distribute a seller-favorable Auction Draft of the purchase agreement for the transaction. Bidders are then asked to respond with both a revised indication of interest, including a purchase price and a mark-up. The process is designed to result in increased leverage for the seller, particularly in the early stages of the process. Investment bankers typically represent sellers in auctions and manage the procedural aspects of the auction

5 As the auction progresses, lawyers begin leading legal due diligence efforts and negotiation of the transaction agreements. 2. Exclusive Transactions Exclusive transactions come in a variety of forms, as two parties may negotiate exclusively at any time; however, some conventions are customary for exclusive transactions. Buyers are likely to request exclusivity (either for a defined time period or on a rolling basis depending on achieving procedural benchmarks) early in the transaction. Generally the buyer s counsel will draw up the initial draft of the purchase agreement and ancillary documentation. Investment Bankers typically participate where there is a need for a market check, fairness opinions or valuation assistance. Financial Buyers: Traditionally, financial buyers (e.g., private equity funds) can be classified as investors interested in the return they can achieve by buying a business; they therefore are often interested in cash flow and exit options. Financial buyers may act as their own investment bankers. Strategic Buyers: Strategic buyers are generally interested in a company s fit into their own long-term business plans, which may include vertical expansion (toward the customer or supplier) or horizontal expansion (into new markets or product lines) and often put a larger emphasis on cost savings and other synergies. 3. Transaction Timing Many transactions have the same basic timing components. Letter of Intent: Seller leverage is often greatest where price and other major features of the transaction are yet to be developed. Investment bankers often hold a leading role at this stage. Preliminary Negotiations / Contract Drafting: Buyer leverage may increase as more seller time and resources are committed. Here, lawyers must help their client understand key liabilities and lead the process of drafting transaction agreements

6 Final Senior Management Approval and Signing: This stage occurs once a purchase agreement is largely negotiated. Lawyers and investment bankers will follow the lead of their clients (the driving force behind the final stage). Post Signing: Lawyers typically lead (almost exclusively) the process of obtaining consents and closing a transaction. B. International and Cultural Issues in Negotiations Individual international dynamics are too numerous to describe, but cultural issues occur in nearly every cross-border transaction. Agreement Style / Governing Law: Sellers and buyers prefer the governing laws of their home jurisdiction and that agreements resemble those to which they are accustomed. Due Diligence and Coordination Challenges: In a cross-border transaction, the due diligence review process is a daunting task. Different legal systems, accounting standards, types of business organizations and the unique legal characteristics of each jurisdiction, in addition to language and cultural barriers, present obstacles to the diligence investigation which are wholly absent in the domestic context. C. Special Circumstances Special Committees: Special committees may be created when some or all of the Board of Directors are conflicted. Special committees may have their own counsel and investment bankers requiring an additional degree of coordination (i.e. between the target, the special committee and the buyer and each of their representatives). Control Parties: Majority shareholders are an example of a control party. Majority shareholders will often be represented by their own counsel and other advisors. To add to this complexity, the presence of a majority shareholder is a major cause for the need to engage a special committee

7 III. COMMON STUMBLING BLOCKS TO SIGNING AND CLOSING BUSINESS TRANSACTIONS Many transactions fail for nearly unavoidable reasons; for example, as a result of unanticipated due diligence findings or unexpected events. However, some key deal terms regularly create friction during the negotiation process. A. Valuation Disparities Unsurprisingly, the most common reason for transaction failures is disagreement on price. Both buyer and seller should review and engage with each other s business forecast on a detailed basis to determine whether potential forecasts driving valuation disparities are reasonable and should ensure any underlying valuation metrics (such as EBITDA) contain the appropriate inclusions and exclusions from current financials. Many tools exist to help bridge valuation disparities which provide a mechanism by which the seller can receive additional value in the sale and by which buyers can obtain assurance that they will not overpay if seller expectations are not realized. Earn-Outs: Contingent payments made by buyers to sellers following closing (see also, Section IV.A). Milestone Payments: Payment amounts contingent on the achievement of a milestone such as commercialization of a new product or other event. Contingent Value Rights: A securitized post-closing right used almost exclusively in the context of public company acquisitions. Stock Consideration: Providing some percentage of the consideration in buyer s stock can allow the seller to participate in the success of the combined business. Variable Closing Purchase Price: Where there may be an extended period between signing and closing (or rapid fluctuation in market values), parties occasionally use cash purchase prices that are determined by reference to a formula. To assist with risk limitation in these circumstances, collars can be used to contain the range of possible fluctuation

8 B. The Working Capital Adjustment Buyers generally expect that the day they acquire a business, it will maintain an expected level of working capital. Working capital adjustments are the predominant method in the U.S. by which buyers and sellers address this expectation. General Form: A common purchase price adjustment is based on the net working capital of the target company or business as of the closing date. Targets: Determining an appropriate target value for normalized working capital determines the likelihood of adjustment in favor of buyer and seller. Other Variations: Other common purchase price adjustments are based on net worth (or net assets), the value of specific assets (i.e. inventory), cash and debt, specific liabilities or contingencies and capital expenditures. Calculation Methodologies: The parties must decide what accounting principles will be used when preparing the financial statements and calculating the adjustment. Examples include: generally accepted accounting principles (GAAP) in accordance with past practice; narrative modifications; and the line item method. Parties often agree to precise calculation methodologies in schedules to the purchase agreement. In cross-border transactions, the parties may also be required to reconcile differences between GAAP and IFRS (International Financial Reporting Standards). Working Capital Disputes: A working capital estimate will be prepared based on the pre-closing financial statements presented by the seller and the final working capital adjustment based on actual financial statements generated post-closing. As a result of different preparation parties, different accounting firms and different interests of the parties, disputes are not uncommon. Therefore most agreements contain a process by which disagreements can be impartially adjudicated by an independent accounting firm in a timely and efficient manner, without resorting to litigation. It can be critical to specifically limit the types of matters which may be disputed and the types of information that may be presented to the independent accounting firm to ensure a quick dispute resolution process

9 C. Indemnification for Representations and Warranties 1. Survival Periods Sellers often require the implementation of a survival period after which claims related to representations and warranties may not be brought by the buyer. Generally, survival periods are one to three years in length in U.S. transactions (with exceptions for certain basic representations such as ownership of shares or assets, authority and no-conflict with organizational documents, as well as particular issues such as tax or environmental issues). Claims for fraud are often exempted from a survival period entirely. Buyers often request at least 18 months, to allow for an audit of the business while under the buyer s control. 2. Deductibles, Caps and Baskets Sellers often argue for specific numerical limitations to their indemnity obligations, generally using the following formats: De minimis: A bar on minor claims designed to deter indemnification claims for minor amounts. Cap: A maximum dollar limitation on a party s indemnification liability. Often, fundamental representations and certain other specified representations are excluded from the cap or subject to a higher cap. Basket: Baskets are thresholds that indemnifiable losses must reach before the indemnifier becomes liable. Baskets come in two forms: tipping baskets (which provide that if claims reach the threshold, the buyer will be liable for indemnifiable claims from dollar one) and deductible baskets (which provide that only amounts in excess of the threshold will be indemnified). 3. Materiality Scrape Seller representations and warranties frequently include a number of materiality and material adverse effect (MAE) qualifiers. Without any additional provisions, these qualifiers will bar a buyer s indemnification claim if the claim does not exceed the materiality or MAE threshold in the representation. Many buyers will argue that materiality and MAE qualifiers should be read out of the representations and warranties for 8 646

10 indemnification purposes. Note that this alone does not affect the text of the representations and warranties in their capacity as a closing condition. These materiality scrape provisions are heavily negotiated, with the sellers perspective usually being that such scrapes should not be included and the buyer arguing for inclusion. A common compromise is that materiality and MAE qualifiers will remain in the representation to determine whether a breach of the representation or warranty exists but will be read out for the purposes of determining the buyer s damages for the breach. 4. Anti-Sandbagging/Benefit of the Bargain Seller s request anti-sandbagging provisions as to obtain protection from immediate post-closing indemnity claims where a buyer discovered the existence of an indemnifiable matter prior to closing. Buyer s often resist such provisions due to the ambiguities and proof requirements of determining knowledge and because they believe they should have the benefit of the representations negotiated. A common compromise is silence (which can have varying effects based on applicable governing law). 5. Escrow Arrangements Buyers may request that a portion of the purchase price be placed in escrow to guarantee that funds are available for potential indemnification claims post-closing (where the buyer has concerns about its ability to secure payment for indemnification claims from the seller). D. Antitrust Efforts Covenants Antitrust efforts covenants detail the level of effort the buyer must exert in seeking antitrust approvals. Common approaches taken include: reasonable best efforts or commercially reasonable efforts, but no obligation to make any divestitures; no divestiture in excess of [$ impact/lost revenue]; take any and all action necessary unless it would result in MAE; hell or high water covenant: take any and all action necessary even if it would result in MAE; or 9 647

11 reverse break fee paid by buyer to seller if deal fails due to unsatisfied antitrust conditions if other conditions are satisfied. E. Approvals Some approvals must be obtained before a transaction can close. Examples of such approvals are: Stockholder Approvals: such as shareholder approvals for sales of substantially all assets or mergers. Government/Regulatory Approvals: such as Anti-Trust, foreign investment approvals and others. Contract Approvals: Some contracts cannot simply be assigned; in those situations, the buyer may require contract consents for assignment as a closing condition to ensure that it is purchasing a business with the benefit of the contracts in question. Payoff Liens and Lien Releases: If the target company has outstanding debt, buyer or the terms of the applicable debt documentation may require that such debt be paid down in connection with the closing. F. Termination Rights 1. Termination upon MAE If the agreement contains a MAE closing condition, the buyer is not required to close if the target has suffered an MAE between signing and closing. Proving the occurrence of an MAE can be extremely difficult in U.S. courts. That being said, buyers typically view the MAE termination right as an important exit right for its potential ability to avoid a disastrous acquisition or provide bargaining leverage to negotiate in the event the target suffers an adverse event. The actual definition of MAE is heavily negotiated. Customary Exclusions: Exclusions from the MAE definition help the seller narrow the items that may be considered an MAE and are focused on events or circumstances that are beyond the seller s control. Common exclusions include: Change in the economy or business in general; Changes in the industry in which the target operates; Changes in laws and regulations;

12 Acts of war, acts of God, and terrorism; The effects of the announcement of the transaction; Failure of the target to meet internal projections; Changes in GAAP; and Changes caused by an action required of sellers under the transaction agreement. 2. Other Common Termination Rights Below is a short list of other common termination rights: Inability of the other party to satisfy its closing conditions following an agreed-upon opportunity to cure. If the parties fail to obtain shareholder or regulatory approval. Drop Dead Date : if the closing conditions have not been satisfied by the agreed upon date, then a party may terminate the agreement. If any law makes the consummation of the transaction illegal. 3. Fiduciary Outs Fiduciary outs are generally found in transactions involving public targets. Fiduciary out provisions aim to reconcile the tension between a board s continuing fiduciary duties and the binding commitment to close a transaction upon signing. No-Shop Covenants: Restrict the target s ability to negotiate with an alternative bidder; sometimes no-shop covenants follow a go-shop period where negotiation with alternative bidders is expressly contemplated. Change in Recommendation Provisions: Typically, a target board is only permitted to change its recommendation in favor of a transaction where required by its fiduciary duties. Many transactions specify that such a change of recommendation may only occur where a target receives a superior proposal for an acquisition. Target boards are sometimes permitted to change a recommendation upon occurrence of intervening events that are exogenous to the target

13 Matching Rights: In the event a target receives a superior proposal, a buyer will want the opportunity to revise the terms of its existing deal with the target. Force the Vote Provision: Regardless of whether the target has a superior proposal or an intervening event has occurred, the buyer can require the target s stockholders to vote on the original transaction. Break-Up Fees: Buyers typically require targets to pay a break-up fee if the merger agreement is terminated (i) by the buyer in connection with a breach of the no-shop covenants, (ii) by the target if the target terminates the merger agreement in connection with a superior proposal or (iii) by the buyer if the buyer terminates the merger agreement in connection with a change in recommendation. G. Financing Covenants 1. Standard Provisions Most financing covenants include some standard provisions, such as obligations to negotiate definitive agreements based on a debt-commitment letter, to maintain the debt-commitment letter in effect, to pursue alternative financing (if necessary) and to satisfy the conditions to funding. Some of these provisions are also paired with reverse break fees that require the buyer to pay the fee upon a financing failure. There are a number of common formulations to the text of financing covenants included in transaction agreements. Reasonable best efforts or commercially reasonable efforts with obligation to cause the lenders to fund and explicit obligation to litigate against the lenders. Reasonable best efforts or commercially reasonable efforts with obligation to cause lenders to fund, but no explicit obligation to litigate against the lenders. Reasonable best efforts or commercially reasonable efforts with no obligation to cause the lenders to fund, and no explicit obligation to litigate. No covenant, just a representation

14 2. Reverse Termination Fees Reverse termination fees force the prospective buyer to pay a fee if an acquisition does not close. Sometimes a reverse termination fee in these circumstances will be bifurcated depending on the reason for the termination (e.g., fee plus expense reimbursement in some scenarios, and only expense reimbursement in others). Forms the reverse termination fee can take include: The pure option : the transaction will include no specific performance remedy for seller, but the buyer must pay a reverse termination fee upon failure to close. The financing failure : the seller retains specific performance rights, however if financing is unavailable the buyer pays reverse termination fee upon failure to close. IV. FRINGE DEAL ISSUES A. Earn-outs 1. Calculation Earn-outs will typically be measured in terms of the company s earnings post-closing and how actual earnings compare to those projected by the parties prior to the closing, but can also be based on: EBITDA, net sales; individual product performance; revenue growth; gross profit; or other metrics. 2. Dispute Resolution Earn-outs typically last for 1-3 years post-closing, although shorter and longer earn-outs are not uncommon occurrences. Typically, earn-outs are based off of annual audited financials to take advantage of the third party verification of financial statements. Earn-outs can also be based of quarterly financials, sometimes with a year-end true up to audited financials. Sellers will want to negotiate an efforts covenant to ensure that the buyer promotes the products of the sold business vigorously to achieve the earn-out requirements. One problem with earn-outs from a seller perspective is that the receipt of the earn-out funds is never as certain as additional purchase price paid at the closing. The seller will undoubtedly negotiate hard for covenants protecting it against the buyer s ability to take actions which will affect

15 earnings (such as over-accruing consolidated overhead to the sold business) without the seller s consent. In any event, sellers bear some risk of future adverse events inhibiting earn-out payments. Typically a buyer will prepare a computation of the earn-out for the earn-out period. The seller will have time to accept or raise objections. If the seller raises objections, the parties then typically have a finite period of time to resolve the dispute. In the event that the parties cannot resolve any dispute, they frequently designate an independent accounting firm to serve as the ultimate arbiter. B. Sale of Divisions A sale of a business division can create particularized issues for a seller and buyer for several reasons. 1. Information Asymmetries Between Division Employees and Parent Company Sellers of business divisions are motivated to keep the group of persons aware of the potential sale to a minimum to avoid disruption of production for the relevant business unit. This knowledge group is often comprised of C-suite employees and key accounting and legal managers. In a typical transaction for the sale of a business as a whole, that group would have considerable knowledge regarding the company - but where the transaction involves the sale of a division, that group may not have detailed information regarding the division. Absent inclusion of a number of members of the division in the knowledge group related to the transaction, sales of business divisions consequently involve a number of information asymmetry problems, such as the following: The team leading the seller group may not have sufficient details to identify all the assets, liabilities and services of the division potentially being sold (including likely transition services the division would require post-closing). Further, sellers may not have an easy way to access this information without expanding the knowledge group. Buyers on the other hand are particularly insistent on identification of assets and liabilities where such assets and liabilities are intermingled with other divisions

16 Sellers may not know which representations are feasible to make with respect to the business division. Where representations and warranties are negotiated despite these information difficulties, assembly of disclosure schedules may be challenging. This is particularly the case in cross-border transactions if no member of the knowledge group is present in the local jurisdiction. 2. Employment Issues There are unique challenges for the individual members of the business division even after members of the business division being sold are informed about the transaction. For buyers, the employees of a business division often represent the only source of know-how to operate the business division in the near term and are often critical for transactional matters. Sellers of a business division may not want to let high performing employees leave with the business division, particularly executives with rotational experience in other divisions. Buyers on the other hand, will not wish to let sellers cherry pick the best employees and leave the sold division with low performing employees. Buyers may also not wish to hire all of the employees of the division in question. 3. Conflicts of Interest for Division Employees Consider, for example, the experience of managers and executives of a business division to be potentially sold. Up until the closing of the transaction, the management group s employment agreements are with the seller and the seller determines the management group s day to day duties; however, the management group may be simultaneously negotiating future employment arrangements with the buyer which are dependent upon the future performance of the division. Moreover, the management group transitioning to the buyer will want the best employees to continue working with the division and will want to ensure the division has the appropriate resources, assets and freedom from liabilities to operate successfully in the future. All of the latter concerns align well with the needs of the buyer and create a conflict of interest for

17 senior employees in sales of divisions. In the most egregious cases, if employees of a division expect to receive equity as part of their new compensation package with the new owner, they may have an incentive to lower the buyer s expectations so that they can outperform for their new employer, but inadvertently cause the buyer to lower its price target. C. Works Council Approvals In a domestic transaction, the pre-closing consents and actions required to close are often limited to anti-trust filings and third party consents. However, there are a variety of additional actions and clearances which may be required depending on the jurisdiction at issue. For example, European works councils have substantial power that is protected by law and the courts. Among other powers which are generally relevant to the operation and management of acquired businesses, European works councils may benefit from consultation rights in M&A transactions, wherein parties to a transaction must consult with the works council before they can legally finalize the transaction. The scope and character of the consultation rights and the relative power of the works council vary from country to country. D. CFIUS Filings The 1988 Omnibus Trade and Competitiveness Act contained the Exon-Florio amendment to the Defense Production Act of 1950 (DPA). It established the authority for the U.S. government to review and block, on national security grounds, any covered transaction, i.e., any transaction which could result in control, by a foreign person, of business activities in U.S. interstate commerce. Exon-Florio is administered by the U.S. Committee on Foreign Investment in the United States (CFIUS), a committee composed of independent departments and agencies of the U.S. government, such as the Departments of Defense, Treasury, Homeland Security, and Justice. Reviews are done primarily pursuant to a voluntary system of notification of proposed or completed transactions. Failure to voluntarily notify an appropriate transaction runs the risk that CFIUS itself institutes a review at a later time that could potentially result in the transaction having to be unwound in whole or part after it is done

18 E. Foreign Corrupt Practices Act ( FCPA ) Diligence and Violations The U.S. Foreign Corrupt Practices Act of 1977, or FCPA for short, generally prohibits bribery of foreign government officials, whether directly or indirectly through employees, agents or other third parties. Under this law, the term foreign officials includes not just officials themselves, but also officers and employees of government-owned or controlled commercial enterprises (e.g., hospitals, universities and public transportation facilities) and public international organizations. Bribery of political parties, political party officials and candidates for political office also are covered by the FCPA. In appropriate circumstances, the FCPA can apply to U.S. and non-u.s. companies with securities listed on U.S. exchanges or registered with the U.S. Securities and Exchange Commission or SEC, as well as their officers directors, employees agents and shareholders. The FCPA also applies to private U.S. companies, their officers, directors, employees, agents and shareholders and U.S. individuals. In certain circumstances, the FCPA may also extend to non-us private companies their officers directors, employees agents and shareholders, and non-us persons, provided that these companies or persons take an act in furtherance of an improper payment while in the United States. Consequences of Violation: The FCPA is enforced by the Department of Justice or DOJ and the SEC. Penalties for violations include disgorgement of ill-gotten gains, debarment from contracting with the federal government, loss of export privileges, and damage to the entity s business reputation. Severe civil and criminal fines may also be levied on offending parties, as well as potential imprisonment for individuals. In many cross-border transactions, potential targets will not be subject to the FCPA prior to an acquisition, but may be subject to local anti-bribery laws or laws enacted pursuant to the OECD Convention on Anti-Bribery. Due Diligence and Compliance: The DOJ and SEC encourage companies to conduct pre-acquisition due diligence and improve compliance programs and internal controls. Comprehensive due diligence demonstrates commitment to uncovering and preventing FCPA violations, and in some instances the DOJ and SEC have declined to take action against companies that voluntarily disclosed and remediated conduct and cooperated with the DOJ and SEC in the merger and acquisition context

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