Private Equity Law Review : New York Private Equity Lawyer & Attorney : Geoffrey Parnass : Corporate & Business Law

In debates over public policy, the first battle often involves a contest over narrative. If others adopt your story, you can gain an early advantage by having lawmakers solve the problems you define for them. In this month’s hearings on “Enhancing Oversight of Private Pools of Capital” before the House Financial Services Committee, Douglas Lowenstein, President of the Private Equity Council (PEC), told a familiar tale: Twin brothers, both productive and contributive to the common good, unjustly subjected to different standards. Why should Abel’s gifts be accepted, while Cain’s gifts are rejected? Mr. Lowenstein did not invoke our shared concept of justice, but instead turned to the pragmatist’s supreme value: practicability. In his criticism of Congressman Paul Kanjorski’s (D-PA) draft amendments to the Investment Advisers Act of 1940 (IAA), Mr. Lowenstein claimed the bill’s venture capital exemption may “prove impossible to implement” because private equity and venture capital funds “have virtually the same business model, skill set, and compensation structure.” But how accurate is this statement?         

Private Equity vs. Venture Capital

In his own testimony before the Committee, Terry McGuire of the National Association of Venture Capitalists drew a distinction between venture capital’s investments in young enterprises and private equity’s buyouts of mature companies:

Importantly, the capital supplied to a venture capital fund consists entirely of equity commitments provided as cash from investors in installments on an as-needed basis. Venture capital funds do not use debt to make investments in excess of the partner’s capital commitments or “lever up” the fund in a manner that would expose the fund to losses in excess of the committed capital or that would result in losses to counter parties requiring a rescue infusion from the government.

Venture capital’s “straightforward equity investment,” Mr. McGuire concluded, meant that venture capital “risk is contained and measured,” thereby distinguishing it from the systemic risk Rep. Kanjorski’s draft legislation seeks to monitor.

When describing private equity investments, however, Mr. Lowenstein spoke only of “adding managerial expertise, making capital and R&D expenditures, expanding into new markets and developing new products, and making strategic acquisitions to create the scale required to compete and become market leaders.” Nowhere did he discuss the centrality of restructuring the balance sheet, or leverage recapitalization, to PEC members’ strategy for increasing the rate of return on their investments. On the contrary, most of Mr. Lowenstein’s discussion of private equity practices focused on the limited partnerships at the fund level rather than delving into an explanation of how such funds finance their portfolio company acquisitions. When he touched upon borrowings by portfolio companies, he did so only to note that such loans constituted “a small portion of the overall credit market.” 

In spite of the striking similarity between the PEC’s remarks on October 7 with those delivered to the same Committee on July 17, the PEC tellingly dropped any reference to the 3:1 to 4:1 Debt/Equity ratio carried by private equity fund investments. Back in July, the PEC cited the ratio to compare it to the 32:1 Debt/Equity ratio of failed investment bank Lehman Brothers, a favorable foil, to be sure. Even then, the PEC stressed that Lehman’s parent company carried the debt, thus exposing “the entire bank to collateral calls.” Limited partners in private equity funds, on the other hand, have no such exposure because their organizational documents preclude follow-on equity infusions into existing investments. 

By concentrating on the risks to LPs of any single portfolio company capsizing, the PEC may have lost the forest for the trees. After all, the Obama administration, the Federal Reserve, and Congress have made it clear that the impetus behind regulatory reform is “to monitor and identify emerging risks to financial stability across the entire financial system.” In this context, any assessment of private equity funds must take into account all stakeholders in their portfolio company investments, including banks and bondholders.   

Leveraged Recapitalization (or Restructuring the Balance Sheet)

To begin with, “private equity” is somewhat of a misnomer; a more apt name would be “private levered equity,” a term that would at least acknowledge the critical role of leveraged buyouts (LBOs) in private equity’s investment strategy. Until the credit markets dried up over the last 12 months, equity investments by LBO funds have always been supplemented by a healthy dose of debt financing. Historically, private equity buyouts have been largely funded by acquisition debt, usually comprising senior term and revolving loan facilities paired with a post-acquisition high-yield bond offering, which was occasionally backstopped by mezzanine financing. (In addition to high interest rates, mezzanine loans usually require warrants attached, allowing lenders to roll over into a shareholder’s position upon the occurrence of certain adverse events.) 

What’s the advantage of using relatively small amounts of equity in an investment? Part of the answer may be found in the implications of what is known in modern portfolio theory as the Modigliani-Miller theorem. Nobel Laureates Franco Modigliani and Merton Miller showed that – at least in “perfect capital markets” – the composition of a firm’s securities does not change the total value of a firm’s assets. That is, a firm may divide its cash flows into dividends to shareholders and interest payments to creditors without decreasing the value of its underlying business operations. Without getting into the way in which real-world market imperfections affect the implementation of the Modigliani-Miller theorem, we’ll summarize its influence on the structure of LBOs.    

The expected rate of return on an investment increases in proportion to a company’s Debt/Equity ratio.  (The basic principle is the same as mortgaging the purchase of a house.) In practice, the portion of a portfolio company’s cash flows available for dividend payments to the LBO fund actually is decreased for several reasons. An increased Debt/Equity ratio results in a commensurate increase in the risk that a company will go bankrupt because it fails to make timely interest payments on its debt obligations. For deeply subordinated high-yield debt, for example, some of this risk is borne by bondholders, who accordingly demand higher interest rates, thus siphoning off some of the company’s cash flows that would otherwise go to shareholders. But the cost of servicing debt in turn is reduced by an important provision of the U.S. corporate tax code: interest payments by a company on its debt are tax-deductible (whereas dividend payments are not). So every dollar paid to the company’s senior lenders and bondholders in fact only costs the company a fraction of that amount; the benefits of this tax shield ultimately accrue to the LBO fund that owns the company. (It should be noted that the Wall Street Journal reported this week that a presidential tax-policy panel headed by Paul Volcker is currently examining whether to eliminate the “tax code’s bias toward raising money from tax-deductible debt issues rather than from stock sales.”)

Leveraged Buyouts & the 2006-2007 Credit Bubble

In arguing against the need to disclose information to the SEC, Mr. Lowenstein insisted that “third parties that privately negotiate with PE funds,” including creditors, “are all highly-sophisticated market participants with the leverage to bargain with the fund at the time that the counterparty or creditor relationship is first established.” Yet, the experience of the past four years has demonstrated that even sophisticated lenders are subject to market forces and may sacrifice their negotiating leverage in order to capture fees in a highly competitive environment. As Professors Colin Blaydon and Fred Wainwright of Dartmouth’s Tuck School of Business described the situation in a 2006 article, “The Balance Between Debt and Added Value,” before the credit bubble burst:

Banks and other lenders are aggressively competing with each other for deals to generate fees and interest income in the midst of a relatively low interest rate environment. The result has been a steady expansion of the amount of debt available for leveraged acquisitions and a relaxation of lenders’ terms and conditions. This expansion of debt availability has permitted investors to quickly recapitalize their acquired companies and make large dividend payments to themselves and other equity owners.

In previous posts, we’ve covered the advent of so-called “covenant lite” senior loan agreements (which eliminated or reduced maintenance covenants requiring companies to meet certain financial ratios) and “payment-in-kind,” or PIK notes, to bondholders (which permit a company to issue additional notes to bondholders in lieu of cash interest payments). Declining interest rates over the course of 2006 and 2007 coupled with banks’ eagerness to generate underwriting fees from bond issues enabled private equity funds to generate immediate returns for their investors through financial engineering.

According to a New York Times story on the bankruptcy filing of the Simmons Bedding Company, the company’s private equity owners Thomas H. Lee Partners paid itself and its limited partners a $375 million dividend with the proceeds of post-acquisition debt issuances, allowing it to recover all of its initial equity investment. This sort of recapitalization through additional borrowing serves two purposes: it puts cash directly in the hands of an LBO fund’s LPs and GP and it decreases the fund’s exposure to the portfolio company’s risk profile. Even though portfolio companies generally were able to lock in their debt obligations at low interest rates, these highly leveraged companies were vulnerable to a general economic turndown. Ironically, many of the institutional investors who as limited partners in private equity funds benefited from leverage recapitalization also suffered as portfolio company bondholders when they were only able to recover cents on the dollar, if anything at all.

Private Equity Firms & the Banks

Although senior term and revolver loans for acquisitions are initially funded by a consortium of lead banks, the banks seek to syndicate interests in the loans to other counterparties in an attempt to decrease their risk exposure to any single portfolio company’s financial performance. Similarly, banks underwriting post-acquisition high-yield offerings privately place the bonds with a large number of institutional investors, many of whom later sell interests in these notes to other qualified institutional buyers in the secondary market. A single LBO investment, in other words, has many stakeholders other than the private equity fund itself. 

What happens when the market for LBO senior loan syndication or private placements of high-yield bonds suddenly dries up? Usually, the banks are left holding the debt. Foretelling things to come, Bloomberg reported in July 2007 that “banks have had to dig into their own pockets to finance parts of at least five leveraged buyouts over the past month because of the worst bear market in high-yield debt in more than two years.”   

In late 2006, when private equity funds eyed larger prey, both on their own and in concert with others in “club deals,” banks began to offer buyout firms “equity bridge loans” for the first time since the late 1980s. When banks issued equity bridge loans, they intended them to serve as temporary advances of credit to a private equity fund to facilitate the acquisition of a company. After the deal closed, the banks would then seek to find buyers for the equity stake they had taken in the portfolio company. Although such loans carried a high degree of risk, the competition among banks during the years 2006 and 2007 for the high fees they earned from LBOs provided them with sufficient incentive. After all, according to Dealogic, private equity firms generated 22% of investment banking fees during the period from mid-2006 through mid-2007. In August 2007, BusinessWeek reported that banks were “on the hook for billions of dollars,” although none of the banks would reveal their exposure.

Leveraged Buyouts & Systemic Risk Regulation

As far back as May 2007, Federal Reserve Chairman Ben Bernanke warned that the LBO model resulted in banks’ sharing a significant amount of risk in private equity investments:

There are some significant risks associated with the financing of private equity including bridge loans. ... We are looking at that….. I urge banks to closely evaluate the risk that they’re taking not only in the context of a highly liquid, benign financial environment, but in one that might conceivably be less liquid and benign.

As Chairman Bernanke recognized over two years ago, the institutional investors constituting private equity funds’ limited partners are not the only stakeholders in LBOs. 

None of this should be misconstrued as a call to arms for the regulation of all private equity funds. But unless Congress takes into account the nature of private equity’s leveraged buyouts – especially ones conducted by billion-dollar mega funds like those managed by the PEC’s members – regulatory reform will most likely fail.      

In closing, it’s worth reading the Wall Street Journal’s coverage of Terry McGuire’s interview with founder and chairman of global private equity firm Advent International, Peter Brooke: 

The people that over-leveraged their companies, the people that did these dividend recapitalizations and the things of that nature, have done no one any good…We have to face the fact that there is going to be some form of restrictive legislation on private equity managers…The bad guys deserve it, the good guys don’t deserve it, but I’ll tell you, they’re all tarred with the same brush.

 Related Post: House Hearing on Private Equity and Venture Capital Regulation - Part 1: The Private Equity Council

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Everybody likes a fight. So it came as no surprise that the media dredged up some hackneyed headlines to describe the House Financial Services Committee’s hearings on regulating hedge funds, venture capital, and private equity earlier this month. Whether they dodged bullets at a “Showdown at the VC Corral” or witnessed bloodlust as “PE lobbyists throw VCs under the bus,” journalists let us know that – surprise! – the private equity community trashed the venture capital exemption in Congressman Paul Kanjorski’s (D-PA) draft bill on amendments to the Investment Advisers Act of 1940 (IAA). Even so, it was somewhat disappointing that nobody offered any details about the testimony of Douglas Lowenstein of the Private Equity Council (PEC). True, details don’t always make for compelling news copy, but the PEC’s testimony seems to warrant a second look. Part 1 of this post first asks the questions: “On behalf of whom does the PEC speak?” and “What weight should Congress give to their opinions?” We then review some of the PEC’s specific complaints about Rep. Kanjorski’s draft bill. In Part 2, we’ll analyze the PEC’s arguments for eliminating the bill’s venture capital exemption, especially its facile equation of private equity acquisitions with venture capital financing.    

How Representative is the Private Equity Council?

What is the Private Equity Council? It’s a D.C.-based trade group formed in February 2007 to lobby public policy makers on behalf of some of the largest private equity firms in the U.S., including Blackstone, KKR, Carlyle, Bain, Apollo, Apax, and Madison Dearborn, each of which has over $10 billion in assets under management. By its own admission, the PEC represents only a dozen large private equity firms, even though it estimates that there are over 2,000 private equity firms based in the U.S. By comparison, the National Venture Capital Association (NVCA) has over 450 members, more than half of the approximately 740 U.S. venture capital companies, representing more than 90% of the venture capital industry’s assets under management. The PEC’s presence at the Committee’s hearing on “Enhancing Oversight of Private Pools of Capital” probably speaks more to its members’ influence on Wall Street and K Street than it does to its suitability as an advocate for the private equity industry as a whole. 

To be sure, the PEC’s members will be among those most affected by any regulation of alternative investment vehicles and consequently deserve to have their voices heard by Congressional lawmakers. They are also most likely to be scrutinized by any governmental body charged with the duties of a “systemic risk regulator.” At the same time, the Committee should not take the opinions of Mr. Lowenstein on Rep. Kanjorski’s bill as representative of the some 1,900 other private equity firms, who apparently don’t merit a seat at the bargaining table. It should be borne in mind that some of the PEC’s members either already are, or soon will be, subject to SEC registration and reporting requirements. The Blackstone Group LP (BX) currently trades on the New York Stock Exchange (NYSE), while KKR’s recently completed reverse merger with its Euronext Amsterdam-listed affiliate KKR Private Equity Investors positions it for a planned NYSE listing in the spring of 2010. Meanwhile, the PEC’s other members tend to target acquisitions of relatively mature companies, many of whose securities are publicly traded. In the process of taking such companies private, private equity funds must comply with various SEC requirements, including the Securities Exchange Act’s Rule 13e-3 “going private” disclosures for affiliates of equity issuers, the Williams Act’s regulations governing tender offers, Regulation 13D filings on beneficial ownership, and Section 16’s insider trading rules.

In his prepared testimony, Mr. Lowenstein tacitly acknowledged that many of the investment and fundraising activities of the PEC’s members already fall within the purview of governmental authorities. He seemed resigned that more stringent regulation was inevitable when he gave his lukewarm endorsement: “we are generally supportive of requiring registration of advisers to private pools of capital.” As expected, Mr. Lowenstein’s criticisms of specific provisions in the Kanjorski bill relate the objections of the PEC’s members. It would be foolish to ignore the obvious fact that small- to midsized private equity firms have no trade association that the Committee could have summoned to the Hill. Aside from these firms’ limited resources, the “lone wolf” investment style of private equity firms discourages the formation of a nationwide trade association. After all, the PEC itself was formed only after its members began to club together in mega deals for large corporations. But it would be even more foolish for Congress to disregard how the Kanjorski bills regulatory reforms will impact the vast majority of private equity firms.         

Big Private Equity’s Need for a Competitive Advantage

A close reading of Mr. Lowenstein’s October 6 testimony before the Committee indicates that the PEC’s members are most concerned with the prospect that the draft legislation’s “broad disclosures to third parties” would put its constituents at a “serious competitive disadvantage.” By contrast, the testimony of Terry McGuire of the NVCA focused on how the onerous regulatory burdens of the IAA would interfere with venture capital firms’ ability to “start and grow new companies.” Mr. McGuire pointed out that even relatively large venture capital firms – such as his own Polaris Venture Partners – run on skeleton crews ill-equipped to shoulder heavy administrative burdens. Compliance with the requirements imposed on IAA registered advisers would not only hamper the investment activities of big VC firms, but venture capital firms of all types and sizes.   

Mr. Lowenstein took particular issue with Section 204(b)(7) of the discussion draft, which would grant the SEC broad rulemaking authority to require IAA registrants to provide reports, records, and other information to “investors, prospective investors, counterparties, and creditors” of private funds. For private equity firms to comply with these requirements, Mr. Lowenstein contended, “is potentially destructive of normal commercial relationships and could expose proprietary information and trade secrets to those with whom we compete.” The PEC’s members appear to fear a scenario in which they are compelled by the SEC to disclose certain information to one of their senior lenders, such as JPMorgan or Goldman Sachs, which could then pass on such information to the banks’ respective private equity affiliates, like JPMorgan Partners or Goldman Sachs Private Equity Group. Averring that keeping such information confidential is crucial to retaining a private equity fund’s competitive advantage, Mr. Lowenstein exhorted the Committee to eliminate the provision from any final legislation. Such concerns more likely represent those of the PEC’s membership than of the typical private equity fund, which is unlikely to be able to convince banking behemoths like JPMorgan or Goldman Sachs to provide debt financing on a $50-$150 million leveraged buyout of a midmarket company. 

Moreover, for reasons we’ll explore in more detail in Part 2, Mr. Lowenstein’s argument that creditors and investors that negotiate with private equity funds “are all highly-sophisticated market participants with the leverage to bargain with the fund at the time that the . . . relationship is first established” rings hollow. Does anyone who witnessed the lending frenzy of 2006 – 2007 honestly believe that banks in such a competitive landscape would “simply refuse to lend to the fund if the lender is not satisfied that it has received sufficient upfront information about that fund and its investments?”

Assets under Management Threshold

It’s true that elsewhere in his testimony Mr. Lowenstein championed the concept of “calibrated reporting requirements for different types of funds,” an argument that on its face promotes the interests of smaller private equity funds. A good argument could – and should – be made that the IAA’s $30 million threshold is too low for advisers to private funds, many of whose deals, whether structured as leveraged buyouts or pure equity buyouts, could not arguably pose a systemic risk to the financial system. But even here, where Mr. Lowenstein appears to stand up for most private equity firms, he subsequently undermines this position by demanding that “the language [of the bill] base calibration not just on the type and size of the fund, but on their potential to cause systemic risk.” The problem with this argument is that nowhere does Mr. Lowenstein propose another way for Congress to devise a metric for determining systemic risk.   

Once again, this proposition only serves the interests of the PEC’s members. As Part 2 will show, Mr. Lowenstein’s insistence that the size and type of fund bears no relation to whether or not its investment activities pose a systemic risk relies on his attempt to equate venture capital financing with private equity LBOs. According to the PEC, the two are merely different species of the same genus. But the history of large LBOs over the past three years tells another story. Remember, as recently as this past April French banks seriously considered quarantining their LBO debt in a “bad bank” lest their liabilities metastasize.   

Related Post: House Hearing on Private Equity and Venture Capital Regulation - Part 2: Leveraged Buyouts

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At the end of last week, the House Financial Services Committee focused on regulatory reform measures designed to mitigate systemic risk to the financial system and to regulate hedge funds and private equity. Federal Reserve Chairman Ben Bernanke offered his advice on what steps Congress should take to reform U.S. financial regulation. Congressman Paul Kanjorski introduced draft legislation that would require all private equity and hedge funds that manage assets in excess of $30 million to register with the Securities Exchange Commission, but would exempt venture capital funds from SEC registration. This week, the Committee expects to be just as busy. Tomorrow, October 6, the Financial Services Committee plans to hear testimony from representatives of the venture capital, hedge fund, and private equity industries. In today’s post, we’ll summarize Mr. Bernanke’s recommendations for managing systemic risk, dissect Rep. Kanjorski’s draft bill, and provide you a brief preview of tomorrow’s hearing.

Bernanke’s Testimony on the Oversight of Systemic Risk

The Chairman of the Federal Reserve, Ben Bernanke, journeyed to Capitol Hill last Thursday to offer the House Financial Services Committee his perspective on proposed financial regulatory reforms. Like Treasury Secretary Timothy Geithner, who appeared before the same Committee back in March, Mr. Bernanke emphasized the current regime’s deficiencies in managing systemic risks to U.S. financial markets. Single agencies may be well suited to oversee a single firm or financial sector, Mr. Bernanke pointed out, but have neither the resources nor the expertise to oversee divers types of market players, let alone to anticipate the ways in which their dealings with one another may threaten the financial system as a whole. 

As a remedy to this regulatory malady, Mr. Bernanke highlighted two areas for reform. First, he advised Congress to establish an “oversight council” empowered “to monitor and identify emerging risks to financial stability across the entire financial system, to identify regulatory gaps, and to coordinate the agencies’ response to potential systemic risks.” As conceived by Mr. Bernanke, the oversight council would comprise representatives from governmental agencies tasked with supervising the financial sector. In order to fulfill its mandate, the oversight council would need to have access to a wide range of information from various agencies regarding the institutions and markets they supervise as well as the authority to collect information on its own.

Second, Mr. Bernanke recommended the “reorientation of individual agency mandates to include . . . the responsibility to try to identify and respond to the risks” posed by the firms and markets within each agency’s purview. While Mr. Bernanke acknowledged that each agency individually could take on this challenge, he suggested that they would be aided or advised by the oversight council as well. Although individual agencies could adapt their responses to systemic threats arising in the areas over which they have authority, Mr. Bernanke considered it probable that many systemic risks would cross traditional regulatory boundaries. In such situations, the oversight council would be best positioned to intervene. 

Mr. Bernanke’s proposed “oversight council” fleshed out the bare bones of Mr. Geithner’s “systemic risk regulator.” The Board of the Federal Reserve, it appears, lined up behind President Obama’s prescriptions for regulatory reform. It therefore was not surprising when Congressman Paul Kanjorski (D-PA), Chairman of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises released draft legislation mirroring a model bill issued by the Obama administration in July. 

Private Fund Investment Advisers Registration Act of 2009

Late in the day on October 1, Rep. Kanjorski circulated a “discussion draft” of the Private Fund Investment Advisers Registration Act of 2009, which would eliminate the Investment Advisers Act of 1940's “private fund adviser” exemption. Under the draft bill, all hedge funds and private equity funds with assets under management in excess of $30 million would be required to register with the SEC. The text of the bill introduces a definition of the term “private fund” into the Advisers Act. In its proposed formulation, a private fund would mean an investment fund that would qualify as an investment company under the Investment Company Act of 1940 were it not for the exceptions provided by §3(c)(1) or §3(c)(7) of the Company Act and that either (i) is organized under the laws of the United States or (ii) has 10% or more of its outstanding securities by value owned by United States persons. Under the Company Act, Section 3(c)(1) excludes funds beneficially owned by 100 persons or less and Section 3(c)(7) excludes funds whose securities are owned by certain “qualified purchasers” from the definition of an investment fund.  

The proposed bill would also eliminate the “private fund adviser” exemption under §203(b) of the Advisers Act, which presently is available to any adviser that has fewer than 15 clients and does not generally hold itself out to the public as an investment adviser. As we explained in an earlier post, the SEC historically has interpreted the term “client” in §203(b)(3) to refer to the limited partnerships advised by hedge fund managers and private equity firms rather than to the investors constituting their limited partners. Rep. Kanjorski’s draft legislation vests the SEC with broad rulemaking authority, including the power to change the definition of the term “client” under the Advisers Act. This provision pointedly overturns the 2006 ruling by the D.C. Circuit Court of Appeals in Phillip Goldstein v. SEC that vacated the SEC’s “Hedge Fund Rule,” which allowed the agency to “look through” a limited partnership’s legal structure to count each limited partner as a client.  

The Private Fund Investment Advisers Registration Act would require all SEC-registered hedge fund managers and private equity firms to maintain records or file reports disclosing:

• the amount of assets under management;
• the use of leverage (including off-balance sheet leverage);
• counterparty credit risk exposures;
• trading and investment positions;
• trading practices; and
• such other information as the SEC (in consultation with the Federal Reserve) determines necessary or appropriate for the assessment of systemic risk.

The draft bill also empowers the SEC to share information about hedge funds and private equity firms with either the Federal Reserve or any other government agency tasked with monitoring systemic risk to the financial system. 

Rep. Kanjorski’s proposed legislation exempts advisers to venture capital funds from registering with the SEC. In its current draft, the bill vests the power to identify and define the term “venture capital fund” with the Commission. This exemption has been heralded by many as a victory for the venture capital community, which has contended that its investments do not pose any viable threat to the financial system. Prior to the release of Rep. Kanjorski’s draft legislation, Barney Frank (D-MA), Chairman of the House Financial Services Committee, explained: “We are supportive of the role of venture capital, we are working in consultation with venture capital, and I don’t think there will be anything in there for venture-capital firms.” 

Aside from the discussion draft’s close tracking of the Treasury Department’s own proposal for the regulation of hedge funds and private equity, the House Financial Services Committee’s alignment with the Obama Administration on this issue is perhaps best exemplified by Rep. Kanjorski’s adoption of one of Mr. Geithner’s favorite metaphors for hedge funds and private equity firms. In his press release accompanying the distribution of the bill, Rep. Kanjorski observed: “[W]e need to ensure that everyone who swims in our capital markets has an annual pool pass.”

Capital Markets Regulatory Reform Hearing

Last Wednesday, representatives of the hedge fund industry’s main lobbying group, the Managed Funds Association, met with Mr. Geithner, Mr. Bernanke, and Mary L. Schapiro, chairwoman of the SEC, to voice their opinions on President Obama’s plans for overhauling the financial regulatory system. We expect to hear more from representatives of the hedge fund and private equity community at tomorrow’s Financial Services Committee’s hearing on “Capital Markets Regulatory Reform.” The following individuals are scheduled to testify before the full committee:

• The Honorable Richard H. Baker, President, Managed Funds Association
• Mr. Douglas Lowenstein, President, Private Equity Council
• Mr. James S. Chanos, Chairman, Coalition of Private Investment Companies
• Mr. Terry McGuire, Co-Founder and General Partner, Polaris Venture Partners, and Chairman, National Venture Capital Association

You can watch a live webcast of the hearing on the House Financial Services Committee’s website.

Hedge Fund and Private Equity Regulation Series

For other posts in our series on U.S. regulatory proposals for private equity and hedge funds, see:

Regulation of Private Funds: Senator Reed and the Congressional Hearings

• Senator Jack Reed's (D-RI) bill, the Private Fund Transparency Act of 2009 (S.1276), was referred to the Senate Committee on Banking, Housing, and Urban Affairs on June 16, 2009.

Geithner Calls for a Lifeguard to Monitor “Private Pools of Capital”

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When a private equity fund buys substantially all of a public company’s outstanding shares in a cash offering, the acquisition may be described colloquially as “taking the company private.” From the perspective of the Securities Exchange Commission, however, the term “going private” applies specifically to situations where either the issuer of an equity security or one of its affiliates purchases the shares. When this occurs, Rule 13e-3 under the Securities Exchange Act of 1934 requires the issuer and any of its affiliates participating in the transaction to file detailed disclosures on Schedule 13E-3. At first blush, it would appear that the buyout of a public company by an unaffiliated private equity firm wouldn’t implicate Rule 13e-3. Nevertheless, as we’ll explain in Part 2 of this post, the structure of leveraged buyouts by private equity firms often triggers the additional disclosure obligations mandated by the Rule.

More often than not, private equity buyers seek to retain a public company’s executive officers to manage the company’s business operations after the transaction has closed. Private equity firms typically offer these managers so-called “sweet equity,” or shares in the new holding company that will own the public company’s business operations post-closing, as an enticement for them to remain.  Owing to the way in which Rule 13e-3 defines the term “affiliate,” the issuance of equity interests to these executives frequently requires both them and the private equity fund to comply with Rule 13e-3. In today’s post, we’ll review the general requirements of Rule 13e-3. In Part 2, we’ll examine how the Rule applies to private equity buyouts where a public company’s existing managers stay on to run the business after closing.

“Going Private” Transactions 

The SEC adopted Rule 13e-3 over concerns that a “going private” transaction conducted by an issuer or its affiliates may be designed to favor its own interests rather than those of unaffiliated shareholders. When a public company launches a tender offer to purchase substantially all of its own outstanding equity securities, it plays a unique role. Unlike third-party buyers who must conduct arm’s-length negotiations over the terms and conditions of an acquisition, an issuer may abuse its insider position to dictate terms – including the proposed purchase price – unilaterally. 

Going private transactions tendered by an issuer or its affiliates present complex agency problems. Directors and managers of a company charged with representing the interests of a company’s shareholders may instead promote the interests of the entity acquiring the securities. The directors, for example, could choose to launch the tender offer during a period of depressed market prices, resulting in a loss to unaffiliated selling shareholders. In addition, directors and officers of the company could use coercive practices in order to secure shareholder votes approving the transaction. To protect shareholders from manipulative tactics, the SEC requires issuers and its affiliates to provide investors with extensive information about the transaction.      

In order for a transaction to be considered “going private,” Rule 13e-3 demands that it meet three criteria. Specifically, it must:  

1. be a transaction or series of transactions resulting in the purchase of a security by the issuer or one of its affiliates, that
2. has either a reasonable likelihood or the purpose of producing, either directly or indirectly,
3. the effect of causing a class of equity securities of an issuer subject to Section 12(g) or Section 15(d) of the Exchange Act (a) to be held by fewer than 300 persons or (b) to be delisted or no longer authorized to be quoted on an inter-dealer quotation system of a registered national securities association (such as NASDAQ).

Rule 13e-3’s Definition of “Affiliate” and “Control”

In the context of buyouts of public companies by private equity funds, the determination of whether or not Rule 13e-3 applies turns on whether an affiliate of the issuer (that is, the public company that is the target of the acquisition) is considered to be a buyer of the target’s equity securities. Rule 13e-3 defines an affiliate of an issuer as “a person that directly or indirectly through one or more intermediaries controls, is controlled by, or is under common control of such issuer.” Although Rule 13e-3 does not specify what constitutes “control,” Rule 12b-2 of the Exchange Act, which applies generally to rules under the Exchange Act, defines “control” as “the possession, direct or indirect, or power to direct or cause the direction of the management and policies of a person, whether through ownership of voting securities, by contract or otherwise.” 

This broad definition of control creates an unsettling degree of uncertainty as to who or what may be considered an “affiliate” of an issuer in a transaction involving the acquisition of a public company’s shares. In some situations, the SEC may decide that a person indeed exercises such control where he has the power to influence a company’s management and policies, even if the person holds a low percentage of the company’s voting securities.

Schedule 13E-3

Rule 13e-3’s filing and disclosure requirements apply to both the issuer and any of its affiliates engaged in the “going private” transaction. According to the SEC, the rule is designed to ensure that all holders of the class of securities subject to the transaction receive information regarding the issuer and each of its affiliates engaged in the transaction. To that end, Schedule 13E-3 requires a discussion of the purposes of the transaction, any alternatives that the company considered, and whether the transaction is fair to all shareholders. The Schedule also must inform investors whether and why any of its directors disagreed with the transaction or abstained from voting on the deal. Moreover, Schedule 13E-3 must indicate whether a majority of directors who are not company employees approved the transaction.

In Part 2 of this post, we’ll analyze the application of Rule 13e-3 in buyouts by private equity funds in which managers of the public company are offered “sweet equity” in the new holding company. 

Related Post: Going Private: Rule 13e-3 and Private Equity Buyouts - Part 2

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The DVD releases of future Disney films featuring Marvel superheroes undoubtedly will contain bonus items for the cinephile. If a single viewing of a movie doesn’t sate your appetite, you’ll probably be able to watch it again accompanied by the director’s audio commentary. The Walt Disney Company’s S-4 registration statement regarding its proposed merger with Marvel Entertainment, Inc. contains a director’s commentary of a different stripe. The SEC filing includes a six-page section titled the “Background to the Merger” that describes the terms of Disney’s first proposal to Marvel, subsequent negotiations among their legal counsel, and explanations for why Marvel eventually agreed to the deal. We’ll break down this behind-the-scenes look at the talks. Keeping in mind that Disney and Marvel are both Delaware corporations, it’s difficult not to read this section – with its emphasis on the transaction’s deal protection terms – as a preemptive apologia of the Marvel directors’ actions in light of their Revlon duties to maximize shareholder value in the sale.

Disney-Marvel Negotiations: The Director’s Cut

Negotiations between Disney and Marvel focused on two transaction documents: the merger agreement and a voting agreement with Marvel’s CEO Isaac Perlmutter, who owns about 37% of Marvel’s shares through various affiliates. On August 11, Disney’s lawyers emailed their initial drafts of the merger agreement and voting agreement to Marvel’s legal counsel. According to the S-4, Marvel objected to several deal protection mechanisms contained in Disney’s proposal:

• a “force the vote” provision requiring Marvel to put the Disney deal before Marvel’s shareholders, even if Marvel’s board of directors received a superior bid for Marvel by a third party;
• a break-up fee equal to 4% of the transaction value if Marvel ended the deal;
• a  soft lock-up provision that would proscribe Marvel’s board from dropping its recommendation of Disney’s offer unless a third party made a superior offer to Marvel; and
• a demand that Mr. Perlmutter agree (i) to vote his Marvel common shares in favor of the Disney transaction and (ii) to veto any other transaction with another prospective buyer for a period of 18 months after the termination of the merger agreement.  

After two weeks of intense negotiations, a number of substantive terms remained outstanding. Disney continued to insist on a “force the vote” provision in the merger agreement and refused to concede on any of the deal protection measures contained in its first draft of the Perlmutter voting agreement. On August 27, Marvel’s special transaction committee informed the company’s financial and legal advisers that it would not recommend a transaction to Marvel’s board that included a “force the vote” provision or an 18-month tail on Mr. Perlmutter’s voting agreement because they considered these terms to be improper restrictions on the Marvel board’s ability to consider or enter into transactions with other potential buyers prior to the consummation of the Disney deal.   

During the ensuing days, Marvel told Disney that it would be willing to agree to a break-up fee equal to 2.9% of the transaction value in return for concessions by Disney on the other requested deal protection measures. 

In response to Marvel’s counteroffer, Disney agreed:

• to remove the “force the vote” provision;
• to let Marvel terminate the merger agreement in favor of a superior proposal if the board decided that “failing to do so might reasonably be expected to be a breach of its fiduciary duties;”
• to reduce the break-up fee from 4% to 3.5% of the transaction value;
• to allow Marvel’s board to change its recommendation of the Disney transaction to Marvel’s shareholders if it concluded that it had a fiduciary duty to do so; and
• to eliminate the 18-month tale on Mr. Perlmutter’s voting agreement (so that a termination of the merger agreement would constitute a termination of the voting agreement as well). 

Marvel’s Board of Directors Meeting

Marvel’s board of directors convened a meeting on August 30 to consider Disney’s revised proposal with its financial and legal advisers. During the course of the meeting, Marvel’s outside legal counsel advised the board on the agreements’ deal protection measures and the board’s fiduciary duties under Delaware’s general corporation law in the event that it received a possible superior proposal from a third party after the signing of the Disney merger agreement. Marvel’s lawyers also analyzed the procedure for considering alternative bids for the company under the merger agreement, the situations in which the board could terminate the merger, and the conditions under which the break-up fee would be payable to Disney. In the end, Marvel’s attorneys concluded that Disney’s deal protection measures “provided the Marvel board of directors with sufficient flexibility to entertain bona fide alternative proposals, were consistent with the Marvel board of directors’ fiduciary duties and were not coercive to Marvel stockholders.”

The following day Disney and Marvel signed the merger agreement and Mr. Perlmutter and Marvel entered into the voting agreement with Disney.

Critic’s Corner

Of course, the “Background to the Merger” section only summarizes discussions between Disney and Marvel. The disclosure contained in Disney’s S-4 stresses the companies’ haggling over the deal protection terms, but negotiations over the purchase price and the proportion of cash and stock that made up the purchase price were probably not mere subplots to the main action. Nevertheless, the narration of Disney’s and Marvel’s back-and-forth over the deal protection terms at times resembles Kabuki theater more than the Hollywood blockbusters the marriage of the two companies is likely to spawn. While it’s well known that a board’s fiduciary duties under Delaware law to maximize the sale price of a company does not impose any “legally prescribed steps that directors must follow to satisfy their Revlon duties,” Delaware courts have done a fairly decent job of coloring in the outlines of directors’ obligations to shareholders in the sale of a company since the 1986 landmark ruling. The story told by Disney’s S-4 raises questions about what purpose the inclusion of terms likely proscribed by Revlon in the first draft of a merger agreement serves. For example, how useful are such terms as bargaining chips when making an initial offer to a potential seller’s board of directors? When a buyer agrees to eliminate these types of deal protection measures in subsequent negotiations, has it really conceded anything of value? 

The Sequel

Nowadays, it seems that almost every profitable movie has a sequel in the works before it has even finished its run in the cinemas. We see no good reason why this blog post shouldn’t follow suit:

Much of the discussion in the S-4 regarding merger negotiations between Disney and Marvel addresses what actions the Marvel board would be permitted to take if it were to receive a “superior proposal” from a third party. But without an explanation of what constitutes a superior proposal under the merger agreement, any discussion of the proposed merger signifies very little. When we revisit the Disney-Marvel merger in a later post, we’ll take a closer look at the merger agreement’s definition of a Superior Proposal.

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As we previously noted, the ILPA (International Limited Partners Association) recently published a wide-ranging set of “best practices” that it hopes will shape the practices of the private equity sponsor community. In this piece, we’d like to focus on ILPA’s recommended changes to the fiduciary duty provisions of investment partnership agreements. First, we’ll summarize ILPA’s wish list in the area of fiduciary duties. Then, we’ll examine the investor documents of a well-known sponsor (KKR) to see how far apart current practice is from ILPA's wish list.

First, a little background. A fiduciary duty is a relationship of confidence or trust between two parties. A fiduciary must be loyal to the person to whom he owes the duty. He must not put his personal interests before that duty, and must not profit from his position as a fiduciary, unless the principal consents. Under common law rules, the general partner of an investment partnership owes a fiduciary duty to the limited partners. 

In Delaware, where most investment partnerships are formed, the fiduciary duty include an obligation to act in good faith and with due care and loyalty. The duty of care requires a general partner to act for the partnership in the same manner as a prudent person would act on his own behalf.  The duty of loyalty prohibits a general partner from taking any action or engaging in any transaction that is not in the best interests of the partnership where a conflict of interest is present. However, Delaware law also says say that these duties can be “restricted or eliminated” in the partnership agreement. Most sponsors take advantage of the opportunity to both restrict and eliminate fiduciary duties.

ILPA hopes to push back against the erosion of fiduciary duties and “reinforce” the fiduciary duties of the sponsor community. Specifically, it wants to delete:

• Provisions that reduce fiduciary duties “to the fullest extent allowed by law”.
• Provisions that allow general partner to use its sole discretion and weigh its own self-interest against the interest of the fund.
• Provisions where limited partners waive broad categories of conflicts or affiliated transactions.
• Provisions that allow general partner and its affiliates to be exculpated or indemnified for conduct constituting a material breach of the partnership agreement, breach of fiduciary duties, or other “for cause” events.

So, how far back do LPs have to push on fiduciary duties? To answer that, we looked at the prospectus filed by KKR & Co. LP last year when it tried to go public. The prospectus summarizes the lengths to which KKR has gone to restrict or eliminate any fiduciary duty to investors. In short, KKR has fully eliminated the core fiduciary obligation to put the interests of investors ahead of its own interests, and to act solely in the best interests of investors where a conflict is present. In making any discretionary decision, the KKR general partner is allowed to take into account whatever factors it wishes, including its own interests, and does not have any duty or obligation to consider any factors affecting investors.

Moreover, the KKR general partner cannot be liable to investors for any act unless there has been a final and non-appealable judgment by a court determining that it has acted in bad faith or engaged in fraud or willful misconduct. That's a pretty high hurdle.

As the prospectus itself informs us, in language only a lawyer could love: “These modifications are detrimental to our unitholders because they restrict the remedies available to our unitholders for actions that without those limitations might constitute breaches of duty, including a fiduciary duty, and they permit our Managing Partner to take into account the interests of third parties in addition to our interests when resolving conflicts of interest.”

It looks like ILPA and its members have a ways to go.

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A July ruling by the Court of Chancery holds important lessons for how Delaware courts interpret advancement and indemnification provisions in limited partnership agreements. In J. Michael Stepp v. Heartland Industrial Partners, L.P., two former officers and directors of the defunct Collins & Aikman Corporation sought advancement of legal fees and indemnification from the company’s majority investor, Heartland Industrial Partners, L.P. After C&A disclosed historical accounting irregularities, J. Michael Stepp and David A. Stockman incurred hefty expenses resulting from civil and criminal proceedings brought against them in connection with their roles at the portfolio company. Heartland rebuffed the directors’ request, insisting that (i) the general partner of the private equity fund had the discretion to refuse their advancement application and (ii) the directors failed to satisfy the requirements of the partnership agreement’s indemnification clause. The Court of Chancery disagreed and chastised Heartland for relying on ambiguous contractual language to shirk its obligations.   

Contractual Ambiguity Resolved Against General Partner

In his opinion, Vice Chancellor Strine drew on general principles of Delaware contract law. Confronted with a partnership agreement marred by slipshod drafting, Strine emphasized the public policy considerations behind Delaware courts’ approach to interpreting the foundational documents of business entities. 

Delaware courts resolve ambiguities in governing instruments in order to provide uniform, predictable interpretations of the documents that officers, investors, and other constituencies who provide benefits to the entity rely on in making their decisions about whether to participate in the entity’s activities. This principle of interpretation protects the participants’ reasonable expectations, which in turn benefits the entity by encouraging participants to provide their capital, be it human or financial, at a lower cost than they would if they faced greater uncertainty.

Directors, officers, and employees of limited partnerships, Strine observed, generally do not take part in the negotiation of the partnership’s organizational documents. Consequently, when deciding whether to work for a limited partnership, they must rely on the plain meaning of the terms of the partnership agreement in order to understand their rights and obligations. To protect the reasonable expectations of people who join a partnership after its formation, Strine reasoned, Delaware courts construe ambiguous terms against the drafter of the governing instrument.     

Advancement of Legal Fees & Expenses

The court granted the directors’ motion for summary judgment that they had a mandatory right to the advancement of legal fees and expenses under the limited partnership agreement.   After finding themselves defendants in half a dozen civil actions, Stepp and Stockman first applied for advancement of legal fees and expenses to C&A’s and Heartland’s insurance carriers. Once they exhausted the insurance policies, the directors turned to Heartland itself. Heartland’s general partner refused to authorize their petition.  

The relevant section of the partnership agreement read: “[e]xpenses reasonably incurred by an Indemnitee shall be advanced by the Partnership,” but “[n]o advances shall be made by the Partnership. . . without the prior written approval of the General Partner.” Heartland claimed that the prior written approval requirement granted the general partner sole discretion to decide whether to accept or deny an application for advancement. The court rebuked Heartland for its strained interpretation of the written approval requirement because it eviscerated the mandatory advancement language. Strine instead construed the requirement as performing the ministerial function of ensuring the directors’ request for an advancement of expenses was reasonable. According to the court, the general partner did not have the power to withhold its written approval merely to block the directors’ contractual rights to mandatory advancement.

Indemnification of Legal Fees & Expenses

Stepp and Stockman sought indemnification for expenses related to their defense against criminal charges, all of which were dismissed without prejudice by a federal court. The partnership agreement contained expansive indemnification rights by promising the directors restitution for “any and all claims. . .of any nature whatsoever.” But the partnership agreement subjected this broad indemnity to certain qualifications. In its motion to dismiss, Heartland maintained that the partnership agreement required the directors to demonstrate good faith, lawfulness, and the absence of any willful or knowing misconduct. 

The partnership agreement was silent with respect to the rights of indemnitees who were successful in proceedings brought against them. As a result, the court held that the terms of the agreement did not clearly require an indemnitee to prove good faith, lawfulness, or lack of willful misconduct where, as occurred in the case of Stepp and Stockman, the indemnitee emerged victorious in the underlying proceeding. In support of its construction, the court cited recent Delaware case law mandating an award of indemnification after the dismissal of a case without prejudice. 

Indemnification decisions, the court explained, should be made on a case-by-case basis. Otherwise, directors who are defendants in lawsuits would have to wait until all proceedings against them have been dropped or resolved. To apply Heartland’s interpretation of the agreement would contravene Delaware’s “strong public policy interest in promoting indemnification. . . to encourage capable people to serve as directors.” Given the agreement’s mandatory indemnification provision and the directors’ successful defense against the criminal charges brought against them, the court observed that Heartland bore the burden of proof that Stepp and Stockman did not satisfy the indemnification requirements. The court accordingly rejected Heartland’s motion to dismiss the directors’ claims for reimbursement.

Freedom of Contract & Delaware’s Limited Partnership Act

Vice Chancellor Strine noted that Section 17-108 of Delaware’s Limited Partnership Act affords limited partnerships greater freedom to draft their own indemnification plans than is available to corporations under Section 145 of Delaware’s General Corporation Law. In the case of Heartland, the court remarked that “drafters of the Partnership Agreement used their contractual freedom to craft an approach to indemnification that employs language drawn from § 145, but in a selective way that creates some room for confusion.” 

When drafting indemnification provisions in limited partnership agreements, general partners should focus on clarity and not rely on boilerplate or statutory language adapted from other sources of law. Freedom of contract does not come without substantial responsibilities. Bespoke partnership agreements need to be tailored to the specific circumstances of the contracting parties and any potential third-party beneficiaries. Populating a limited partnership agreement with a farrago of provisos and exceptions does not give a general partner the right to break its explicit contractual promises.

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Waterfall Structure

• The LP’s capital contribution plus preferred return should be paid first, before any distributions are made to the GP’s carried interest
• Establish GP carry escrow accounts with reserves of 30% or more to cover potential claw back liabilities
• Carry on recapitalizations should be paid only when the full amount of LP capital is returned on the recapitalized investment

Calculation of Carried Interest

• Carried interest should be calculated on net profits, not gross profits
• Carry should not be paid on current income
• Carried interest should be calculated only on an after-tax basis

Claw back

•  Claw back liabilities should be determined and reported periodically
•  Claw back liabilities should be paid within 2 years and should be gross of taxes paid
•  Effective joint and several claw backs should be implemented to make sure that full claw back liabilities are met

Management Fee Structure

• Management fees should be based on reasonable operating expenses and reasonable salaries, so that fees are not excessive.
• Management fees should reduce upon formation of follow-on fund and at the end of the investment period
• The management fee should be used to pay all normal operating costs of the GP, including interactions with the LPs. The LPs should have the power to review the partnership expenses annually
• Placement agent fees should be paid by the GP
• All transaction, monitoring, directory, advisory and exit fees should accrue 100% to the benefit of the fund.     

The Principles also include detailed suggested changes to the fiduciary duty requirements of the GP. For example, provisions of fund documents that disclaim or reduce fiduciary duties should be eliminated.  We will discuss these recommendations in more detail in a later post.

The Association is currently gathering formal endorsement of the Principles from its members and promises to publish a list of the endorsing institutions on its website.

How will the Principles be received by the sponsor community? That awaits to be seen. Institutional investors would love to establish a set of best practices across the sponsor community in order to make their investments in the asset class more uniform, and more favorable. They would like to reign in the variations in how sponsors define and enforce rules governing distributions, claw backs, and fees.  The sponsors will certainly resist any uniform treatment, and look for advantages at the margins, whether in the area of distributions or discretion in the application of fees.  Assuming a large number of institutional investors formally endorse the Principles, it may become difficult, if not impossible, for the GP community to ignore the recommendations.  The LP community has taken to heart the motto: United We Stand, Divided We Fall.         

Related Post:  Increased Capital Calls and Diminished Distributions for Private Equity LPs

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Attorneys for Biogen Idec Inc. and Elan Corporation finally faced off in a Manhattan federal court earlier this month. The two companies had adopted increasingly antagonistic postures towards one another as elements of Elan’s cooperation and financing agreements with a Johnson & Johnson subsidiary became public. Shane Cooke, Elan’s CFO, told the Wall Street Journal in July that its arrangements with J&J contemplated the possibility of the two companies working together to buy Biogen’s Tysabri stake if Biogen is acquired by a third party. Biogen protested that Elan’s proposed deal ran afoul of the companies’ collaboration agreement for the multiple sclerosis drug Tysabri. A defiant Elan filed a complaint in federal court requesting a declaratory judgment that it had not violated the collaboration agreement and a permanent injunction prohibiting Biogen from terminating their partnership. After five hours of oral argument, U.S. District Court Judge Deborah Batts ruled that the Elan-J&J partnership infringed the Tysabri agreement. 

As we explained last month, the Tysabri collaboration agreement provides that if either Biogen or Elan is acquired by a third party, then the non-acquired party has the option to purchase its stake in Tysabri. The agreement also contains a customary provision prohibiting the assignment of any rights or obligations to an unaffiliated third party without the other party’s written consent. At the hearing, Biogen’s attorneys cited a confidential clause in one of the Elan-J&J agreements giving Johnson & Johnson the option to finance an Elan change of control purchase of Biogen’s share in Tysabri. The clause requires Elan to take instructions from Johnson & Johnson if it ever enters into negotiations to purchase Biogen’s stake. By granting this option to J&J, Biogen argued, Elan effectively transferred its rights under the agreement to Johnson & Johnson.   As Biogen’s attorney Michael Gruenglas put it, Elan "is no longer in the driver's seat, Johnson & Johnson is driving the car."     

Although Judge Batts concluded that “it would seem there has been a breach of the Biogen-Elan collaboration agreement,” she saw the legal issues differently. Contrary to Biogen’s characterization of the Elan-J&J pact, Judge Batts declared that Elan had not assigned any of its rights to Johnson & Johnson. Instead, Batts explained: "It appears to the court that Elan has designated an obligation it has to Johnson & Johnson by taking direction from Johnson & Johnson on the purchase price negotiations.”

Judge Batts appears to have based the rationale for her decision on redacted portions of the Tysabri agreement’s “change of control” provision. The version of the collaboration agreement filed with the SEC details Biogen’s and Tysabri’s acquisition rights upon a change of control in the other party. But the publicly available version of the contract omits important clauses relating to the conduct of negotiations once the non-acquired party exercises its acquisition rights.   This version of the contract reads: “[i]n the event the Non-Acquired Party exercises its election [sic] to purchase the interest of the Acquired Party under this Agreement, the Parties shall…”, but then expunges the next 36 lines of the change of control provision. Significantly, the excised portions address how the companies are to proceed in the event that the non-acquired party decides to acquire the other party’s Tysabri stake. From Judge Batt’s justification for her ruling, it appears that these omitted clauses specify how pricing and other negotiations should be conducted.   

By putting the power of the purse strings in J&J’s hands, Judge Batts determined that Elan had effectively delegated its negotiating power to Johnson & Johnson.   Under the Tysabri agreement, Elan has a right to exercise its change of control purchase option, but it also has a corresponding obligation to negotiate with Biogen on such matters as the valuation of Biogen’s stake in the drug. According to Judge Batts, when Elan agreed to let J&J dictate the terms of those negotiations, it violated the “no assignment” provision of the collaboration agreement by transferring this obligation to Johnson & Johnson.       

As part of her ruling, Judge Batts remarked that Biogen was within its rights under the Tysabri agreement to give Elan a chance to rectify its breach and noted that Elan had 23 days left in the agreement’s 60-day cure period. The Wall Street Journal reports that Johnson & Johnson and Elan have been discussing ways to amend their cooperation agreement so as to avoid violating the Elan-Biogen Tysabri partnership.   Proposals by Johnson & Johnson include reducing their investment in Elan by as much as $100 million.   

Related Post: Pharma Contractual Dispute: Biogen and Elan to See Each Other in Court

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