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

In acquisitions of public companies, private equity sponsors often seek to retain members of the target’s management to run the day-to-day operations of the portfolio company after closing. Almost invariably, the sponsors will offer management shares in the surviving company in order to align the managers’ interests in improving the company’s profitability with those of the private equity fund. Sponsors may offer managers an equity interest in the surviving company in proportion to their existing equity interests in the target company (known as “roll over” equity). Alternatively, they may allow managers to invest their own funds to purchase equity in the surviving company alongside the private equity fund (a deal structure known as a “buy-in management buyout” or “bimbo”). When management is offered equity in the acquiring company without having to take out loan notes to finance their buy-in, their shares are known as “sweet equity.”  Such equity interests may be offered either in addition to or in lieu of equity options that vest over time or upon meeting certain financial milestones (referred to as “promote equity”). 

When private equity sponsors issue equity interests in the surviving company to a public target’s current management, the managers may be considered “affiliates” of the target company who are “engaged” in a transaction subject to the Securities Exchange Act’s Rule 13e-3 “going private” filing requirements. Although the Staff of the Division of Corporation Finance of the Securities Exchange Commission as a policy does not provide guidance on whether or not a particular party should be deemed an “affiliate” for purposes of this rule, Compliance and Disclosure Interpretations (C&DIs) released by the Staff on January 26, 2009 together with the Staff’s interpretive releases provide practitioners guidance on what types of deal structures may require Schedule 13E-3 filings. For an overview of Rule 13e-3’s definitions of a “going private” transaction and “affiliate,” please see Part 1 of this post.     

Management as “Affiliates” in Private Equity Buyouts

The SEC has maintained that the determination of a person’s status as an affiliate is a factual question that only may be determined by considering all the relevant circumstances of a given transaction. Nevertheless, the Staff’s C&DIs provide some insight into the factors considered by the Staff to be determinative of a person’s affiliate status. Judging whether or not officers or directors of a publicly traded target company are affiliates of the company under Rule 13e-3 generally turns on whether or not they have the power to direct or cause the direction of the management and policies of the target company. According to the Staff’s interpretive releases and C&DIs, the continuity of management or directors of the target before and after the transaction in question likely indicates that the deal requires compliance with Rule 13e-3.

In the interpretive release adopting Rule 13e-3 (Release No. 34-16075), the Staff suggested that even if an unaffiliated private equity sponsor engages in arm’s-length negotiations regarding the acquisition of a target, yet intends to keep the target’s management in place after the purchase is completed, the parties engaged in the transaction may be required to file Schedule 13E-3. Among the factors the Staff takes into consideration are:

• an increase in consideration received by management;
• any alterations in management’s executive agreements that are favorable to management;
• equity participation of management in the acquiring or surviving entity; and
• the representation of management on the board of directors of the acquiring or surviving entity. 

The Staff has consistently held that members of senior management of a public corporation that is “going private” are affiliates of the company. In deals where a transaction is accomplished by way of a merger, the Staff has concluded that senior managers are required to file Schedule 13E-3, even though: 

• management’s involvement in the target’s negotiations with the buyer was limited to the terms of each manager’s future employment with or equity participation in the acquiring or surviving company; and
• the target’s board of directors appointed a special committee of outside directors to negotiate all other terms of the transaction except management’s role in the acquiring or surviving entity. 

Measures taken by a public company’s board of directors to protect shareholders from the possibility that its officers or directors may collude with a buyer do not alone obviate the need for a Schedule 13E-3 filing.  Factors considered by the Staff include: whether management would hold a material amount of the surviving company’s outstanding equity securities, occupy seats on the company’s board of directors in addition to having senior management positions, or would otherwise be in a position to “control” the surviving company. 

Although the Staff has not defined what constitutes a “material” equity interest in a company, historically it has determined that a 10% ownership interest is sufficient to cross the materiality threshold. Nevertheless, this 10% figure should not be taken as a bright-line rule, as even a smaller equity interest in a public target may trigger Rule 13e-3 if other evidence of “control” is present.  

Private Equity Funds as “Affiliates” of the Target and its Management

In one of the January 2009 CD&Is, the Staff specifically addressed the situation where a financial buyer, previously unaffiliated with the target, intended to enter into separate agreements with members of the target’s senior management resulting in management’s ownership of 20% of the surviving entity after the deal closed. Although the managers neither negotiated the merger agreement with the private equity sponsors nor executed any documents regarding their future equity participation, the Staff held that “where there exists a general understanding that a target’s senior management will receive equity in a surviving equity, whether derived from unexecuted documents or otherwise, Rule 13e-3 may apply.” The Staff reasoned that because senior management understood they would be equity holders in the surviving entity, the financial buyer in effect straddled both sides of the transaction (i.e. as both acquirer and target). Owing to the substantial equity participation in the transaction by senior management, each of whom would remain in a position to influence the policies of the target, the financial buyer could be in “control” of the target before the deal closed.

As the previous CD&I demonstrates, where management of the target company is effectively “on both sides” of the transaction, the private equity funds (and any acquisition vehicles formed for the deal) may also be deemed to be affiliates of the target company engaged in the transaction and thus be required to file Schedule 13E-3. In Release No. 34-16075, the Staff stated that “affiliates of the seller often become affiliates of the purchaser through means other than equity ownership, and thereby are in control of the seller’s business both before and after the transaction. In such cases the sale, in substance and effect, is being made to an affiliate of the issuer.”

A recent example of this scenario may be found in the July acquisition of Bankrate, Inc. by funds advised by Apax Partners in which the Apax funds, the holding companies set up by Apax to complete the deal, members of senior management, and Bankrate jointly filed a Schedule 13E-3. 

Related Post: Going Private: Rule 13e-3 and the Acquisition of Public Companies – Part 1

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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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We recently discussed the FDIC's adoption of a final policy statement governing private equity investments in failed banks.  As we and other commentators have noted, the final policy continues to put private equity investors at a disadvantage when compared to strategic investors such as existing regulated bank institutions.  Most importantly, the policy imposes a substantially higher capital requirement for private equity firms (10% of Tier 1 capital vs. 5%) which must be maintained for at least 3 years.

The final policy statement reflects the FDIC's earnest desire not to turn over bank deposits -- that amazing funding source guaranteed by the full faith and credit of the United States -- to unschooled and possibly unscrupulous owners.  That mistake was made during the last banking crisis, and one thing that people in large bureaucracies learn well is not to repeat the mistakes of the recent past.  Accordingly, the FDIC must do what it can to ensure that the private capital which comes to the rescue of failed banks is provided this time by firms and management teams that respect the sanctity of bank deposits, and the FDIC's guarantee.

The policy statement is just that -- a statement of policy.  In many important areas, there are no detailed regulations, defined terms, or clear rules to guide deal making.  Sooner or later, any private equity firm looking at purchasing a troubled bank must contact the FDIC to get its opinion on the meaning of key provisions of the policy.  One may justly conclude that this is exactly what the FDIC wants to have happen.  By compelling firms to get critical interpretive clearance on key deal terms, the FDIC has the ability to screen firms and their management teams and sift the wheat from the chaff, so to speak.

The final policy statement is an important road map for well-regarded and experienced private equity firms to invest in troubled banks.  Other players, without deep experience and respected management teams to run the banks, may as well sit out this round.  Of course, things can change.  The crisis may escalate and the need for fresh capital may become acute.  Also, given the large number of troubled banks on the horizon, there may be opportunities to purchase the assets of institutions that must be liquidated because they fail to find buyers deemed worthy by the FDIC.

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The FDIC made some compromises, but will continue to hold private investors in failed banks to a higher standard than strategic buyers. The FDIC’s board approved a final policy on private equity investment in troubled financial institutions by a 4-1 vote; Director John Bowman stood alone in opposition to the measure. Even so, the FDIC expressed a commitment to review the policy in six months. The chair of the FDIC Board, Sheila Bair, said that the 61 private comment letters “gave us a lot to think about.” In today’s post, we’ll summarize public comments and the final rules for the policy’s capitalization, source of strength, and cross guarantee requirements.

Capitalization.   The majority of comments opposed the FDIC’s proposed rule that private equity investors maintain a 15% Tier 1 leverage ratio in failed banks. Some pointed out – as we did over a month ago – that the suggested ratio was three times that currently imposed on healthy banks. The heightened capitalization requirements, many argued, would place private equity investors at a competitive disadvantage to strategic buyers. Others predicted that private equity firms would be less likely to invest in failed banks and more likely to offer less competitive bids to the FDIC.       

Final Rule. Banks owned by private equity investors are required to maintain a 10% Tier 1 leverage ratio for the first three years. The FDIC reserves the right, however, to impose a higher leverage ratio on a particular investor if it determines that the situation warrants special treatment. After three years, private equity-owned banks must remain “well capitalized” (or maintain certain financial ratios specified in FDIC regulations). The FDIC justified the increased capital requirements as a necessary protection against the “higher risk profile” of private investments in troubled financial institutions.

Source of Strength. The controversial source of strength requirement would have required private equity funds to infuse ailing banks with additional capital. Comment letters overwhelmingly objected to this rule, claiming it could create unlimited liability for private investors. Even more to the point, a number of commentators observed that the rule would bar private equity firms from investing in failed banks altogether. By the terms of their organizational documents, private equity funds are prohibited from providing capital support to or making subsequent investments in their portfolio companies. 

Final Rule. It’s gone. The FDIC deleted the source of strength provision, noting that it would not be possible for private equity firms “as a practical matter.” (It’s not clear why the FDIC did not take practical matters into account when drafting its initial proposal.)    

Cross Guarantee. Commentators complained that the cross-guarantee requirement would place the other investments of private equity investors at risk. They emphasized that different funds – even those managed by the same private equity firm – have different investors and accordingly should be treated separately. Several commentators claimed the rule would impede a private equity manager from investing in two different banks through two different funds with two distinct groups of investors. As we wrote earlier, the rule would also inhibit club deals in failed banks.   

Final Rule. The FDIC raised the threshold for the cross guarantee rule to apply. Under the revised rule, if investors own 80% or more of two or more banks, the stock of the banks commonly owned by those investors must be pledged to the FDIC. If one of the banks fails, the FDIC may exercise its pledge to the extent necessary to recoup any losses it incurs. 

It looks like the FDIC will have a lot of inventory on hand in the coming months. Every week we witness more and more bank failures. The forecast doesn’t bode well either. According to the Financial Times, Dick Bove of Rochdale Securities predicts that another 150-200 banks will likely fail in the next several months. So far, the FDIC has not been able to get rid of all of the failed banks already on its books.  The New York Times reported that of the 77 banks that have failed this year, the FDIC has found buyers for only 69 of them.

We suspect the FDIC hasn’t gone far enough to make investments in failed banks attractive to private equity firms. If banks continue to fail, the FDIC will most likely have no choice but to open the market to as many potential buyers as possible. In six months’ time, it wouldn’t be surprising if we see the FDIC Board revisiting these issues once again.

Related Posts: 

Revised FDIC Policy Clears Way for Experienced PE Firms

Flawed FDIC Guidelines May Block Funding for Failed Banks

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When shopping for law firms, private equity firms may head straight to Tesco. Tesco, one of Britain’s grocery retail giants, has become synonymous with one-stop shopping. Known for its bargains, the ubiquity of its stores, and its relentless advertising campaigns, Tesco seems to have little in common with private equity or law firms. Now, thanks to the British tabloids’ obsession with catchy headlines, “Tesco Law” stands for a set of new regulations that will allow law firms to issue shares to non-lawyer investors, merge with companies, and list shares on the London Stock Exchange.   Though these new rules don’t become effective until 2011, Bloomberg reports that several private equity firms have already scouted the market by holding quiet talks with law firms.   

Reform of the Legal Profession

The Legal Services Act of 2007 sets the stage for the legal profession in England and Wales to become arguably the most liberal in the world. According to the Ministry of Justice, the government designed the reforms to “encourage more effective competition and [to allow firms] to provide a range of legal services to consumers, increasing access to justice.” The government began rolling out the reforms this past March. By forming “legal disciplinary practices” under the Legal Services Act, law firms can be owned by different types of lawyers and can sell up to a 25% stake to non-lawyers. The only requirement is that the firm continue to limit its business to providing legal services. In the next stage, expected to be implemented in 2011, firms will be allowed to reorganize as alternative business structures, providing them even greater flexibility in raising capital. Once reorganized, law firms will be able to offer shares in their firms to non-lawyers, merge their firms with companies that offer other services, and list their shares on the London Stock Exchange.   

So far, according to The Law Society’s Gazette, the legal disciplinary practice option has not attracted many keen investors. But private equity firms don’t seem to have cold feet merely because others have been afraid to dip their toes in the water. Bloomberg reports that small and mid-sized private equity funds may be willing to invest millions of pounds in law firms. Fleming Family & Partners Ltd., Phoenix Equity Partners Ltd. and Lyceum Capital Partners LLP are all said to be considering investments. In interviews with Bloomberg, representatives from private equity firms indicated that they are also evaluating investments in other legal service providers.        

Non-lawyer Investors and the Future of the Legal Profession

From initial news reports, it appears that the Legal Services Act will have the greatest influence on mid-sized firms. Law firms that historically have been limited by liquidity constraints will be able to raise capital through equity offerings. With more money on hand to expand their services, entrepreneurial mid-sized firms may acquire greater market shares. As of now, the UK’s prestigious “Magic Circle” firms scoffed at the idea of allowing non-lawyers into the fold, but they may have to reassess their stance once a radically new legal regime has altered the competitive landscape.  

It’s tempting to see the changes in England and Wales in the light of whispers about possible changes to the legal profession in India. Currently, foreign lawyers cannot practice in India and foreign law firms cannot open offices there either. Undeterred by resistance, British law firms have been pressing the Indian government for changes to India’s protectionist policies. If India were to loosen restrictions on the practice of law by foreigners, we could witness a Copernican turn in the management of law firms. Companies already outsource routine legal tasks, such as prior art searches in patent applications, to captive or third-party legal process outsourcing companies. Non-lawyer investors in British law firms would be less likely to heed traditional conceptions about the legal profession. It may take a non-lawyer to recognize and take advantage of the cost benefits achievable through vertical integration in the legal industry by consolidating traditional law firms with other legal services providers, including outsourcing companies.     

What about the chances of a successful law firm IPO? Unfortunately, the May 2007 initial public offering of Australian class action law firm Slater & Gordon is the only case study we have of a law firm’s stock listing. Slater & Gordon’s stock has declined by around 33% from its high price in September 2007. Yet, Deloitte & Touche notes that Slater & Gordon’s stock price has tracked the overall market and concludes the correlation suggests that the market values law firms just as any other business.

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The proposed guidelines published by the Federal Deposit Insurance Corporation for private equity investments in failed banks were in line with what was expected, though they did not fail to displease private equity firms. The guidelines require that investors maintain a 15% Tier 1 leverage ratio in the failed bank for three years. This compares with the 5% Tier 1 leverage ratio required for healthy banks.  The obligation to “maintain” this capital ratio means the private equity firm would have to ante up more capital if the numbers slip. And the fuse would be running – the guidelines say the sponsor must “immediately facilitate restoring” the capital.

The private equity sponsor must also act as a “source of strength” to the bank, suggesting they would have to inject additional capital if trouble arises. At a minimum this would require a commitment to raise new capital if necessary.

Also, there is a significant expansion in the cross guarantee requirement. Under the proposed guidelines, a sponsor would have to pledge its investment in each institution in which it “individually or collectively” has a majority interest to cover the FDIC against potential losses. The guidelines would sweep up each participant in a club deal, whether or not it owns a majority stake. For example, a firm that had a 10% club investments in 2 failed banks would somehow have to pledge its investment in both deals to the FDIC. That requirement alone will likely rule out club deals for failed banks. The requirement raises big practical concerns, as each participant in the club would have to cross pledge its interest in different banks to other club-owned banks, all to make the FDIC more secure.  

And there are other problems, such as the 3 year holding requirement. All in all, the guidelines are not friendly toward private equity sponsors, and will go a long way toward dissuading them from investing in failed banks. This may come under political fire, as the FDIC will sooner or later be pressed to support new capital for failed banks, if faced with the prospect of nationalization.

The FDIC’s approach is similar to the one adopted by federal regulators in Blackstone’s failed acquisition of Alliance Data System. That deal broke up when the Office of the Comptroller of the Currency insisted that Blackstone backstop the credit card unit of ADS, which Blackstone was not contractually obligated to do. The banking regulators do not seem to have learned their lesson from that – private equity may walk away again.

Related Posts:

Revised FDIC Policy Clears Way for Experienced PE Firms

FDIC Adopts Strict Rules for Private Equity Investment in Failed Banks

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Does Merck-Schering’s reverse merger structure avoid triggering the change of control provision in Schering’s distribution agreement with Centocor? Only time will tell. But The Wall Street Journal reports that William Weldon, CEO of Centocor’s parent company Johnson & Johnson, admitted his company was “analyzing the situation” and “was not sitting back and doing nothing.” In our previous post, we summarized the Merck-Schering reverse merger deal structure. Today, we’ll review the Schering-Centocor distribution agreement’s change of control definition and inquire whether imprecise contract drafting may benefit Johnson & Johnson.

Ambiguity of “Change of Control” in the Schering-Centocor Distribution Agreement

The Schering-Centocor distribution agreement appears to offer two competing definitions of what would constitute a change of control. Section 8.2(c) of the agreement provides that either party may terminate the agreement if the other party suffers a “change of control.” The section begins by stating that if Schering or Centocor is “acquired by a third party or otherwise comes under Control of a third party,” then the “party not subject to such change of control” has the right to terminate the distribution agreement. The first two clauses of Section 8.2(c) indicate that Schering would suffer “such a change of control” if: (i) a third party were to acquire it or (ii) a third-party, directly or indirectly, were to own more than 50% of its voting rights, have the right to receive more than 50% of its profits, or otherwise control its management decisions. But at this point Section 8.2(c) continues in an unexpected way: it offers another competing definition of change of control.        

Without any reference to the first two clauses of Section 8.2(c), the remainder of the section purports to define the elements that constitute a “Change of Control.” According to this definition, a change of control under Section 8.2(c) would occur upon (i) a merger or other reorganization in which Schering was not the surviving corporation, (ii) any non-affiliate of Schering’s becoming a beneficial owner of more than 50% of Schering’s outstanding common stock or the combined voting power of Schering’s outstanding securities, (iii) certain extraordinary changes to Schering’s board of directors, or (iv) Schering’s liquidation or dissolution. What are we to make of this second definition?   

A court would most likely determine that the meaning of a “change of control” under the distribution agreement is ambiguous because the two definitions offered are susceptible to different reasonable interpretations and may have two separate meanings.  Unless a court determined that both the first definition and the second definition were coextensive, it would likely rule that the two change of control definitions are irreconcilable. In that case, the court may have to resort to extrinsic evidence of the parties’ intent at the time of contract to resolve the ambiguity. 

Effect of Contractual Ambiguity on Reverse Merger Structure

Given the distribution agreement’s ambiguity, what effect does this have on the ostensible protections afforded by the Merck-Schering deal structure?

First, as Robert Willens at CFO.com points out, although legally Schering will become the parent corporation of Merck, from a financial accounting perspective Schering will be the acquired entity. Generally, in a business combination involving the exchange of equity interests, the acquiring company is usually the one that issues the securities. But the Financial Accounting Standard Board’s SFAS No. 141, which provides accounting guidance for business combinations, notes that in reverse acquisitions, the company issuing equity securities is often the target. SFAS No. 141 states that the acquiring company in a merger will usually be:

• the merging entity whose owners as a group receive the largest portion of the voting rights of the combined entity,
• the merging entity whose owners have the ability to elect, appoint, or remove a majority of the members of the combined entity’s board of directors,
• the company whose former managers dominate management of the combined entity, and
• the entity that pays a premium over the pre-merger fair value of the equity interests of the combined entity. 

Merck, as Willens points out, seems to fit these criteria perfectly. If the dispute over which definition controls comes down to the intent of Schering and Centocor at the time they entered into the agreement, then Johnson & Johnson could argue that the broad “acquired by” language in the first definition was meant to cover transactions like the Merck-Schering merger. Although Merck will be a wholly owned subsidiary of Schering after the merger, Merck will have effectively acquired control over Schering’s operations. 

Second, as we discussed in our previous post, before Merck merges with Schering’s subsidiary, Schering must cause its board of directors to resign and appoint Merck’s directors to Schering’s board. Interestingly, the second change of control definition in the distribution agreement precludes certain extraordinary changes in Schering’s board of directors. While the definition allows changes in Schering’s board of directors that occur as a result of ordinary course shareholder and board actions, such as the periodic nomination and election of directors, it explicitly excludes directors whose initial assumption of office results from (i) an election contest or (ii) “other actual or threatened solicitation proxies or consents by or on behalf of a person other than the [board of directors]” (emphasis added). 

The drafters of this clause probably intended it to prohibit extraordinary changes to Schering’s board of directors resulting from tender offers or other hostile takeover techniques. Nevertheless, we do not know the content of pre-merger negotiations between Merck and Schering. It’s possible that the record would show that Merck’s conduct towards Schering arguably violated this provision by seeking to place its directors on Schering’s board. Remember, Schering has agreed to put Merck’s board of directors in control of the surviving Schering corporation before Merck becomes Schering’s subsidiary in the second and final step of the merger. 

The inevitable negotiations between Schering’s and Johnson & Johnson’s lawyers about the distribution agreement will depend on which side thinks the contract’s ambiguity gives it an upper hand.

Related Posts: Merck-Schering's Reverse Merger: Change of Control Provisions in Material Contracts

           A Duty to be Forthright: Negotiators Beware!

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

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Merck & Co. structured its acquisition of Schering-Plough Corp. as a reverse merger to avoid tripping a change of control provision in an important distribution agreement. This has received a lot of attention, not surprisingly. The distribution agreement (for the rheumatoid arthritis drug Remicade^®) brought in $518 million for Schering in the first quarter of 2009, constituting 18% of the company’s sales. In today’s post on the deal’s structure, we’ll summarize some of the terms of the Merck-Schering merger agreement and consider the importance to the M&A process of getting consents to change of control provisions in a target company’s material contracts.

Change of Control Provisions in Material Contracts

Generally, receiving consents or waivers to change of control provisions in material contracts is set out as a closing condition to an acquisition or merger. Indeed, determining which of a target’s contracts contain change of control provisions constitutes an important part of the pre-acquisition legal due diligence process. For some transactions, failure to obtain the appropriate consents may materially affect the value of the target company or may interrupt the target’s business operations if the deal were to go through. 

Take the case of a company whose sole assets comprise a group of television broadcasting stations. These stations rely on programming contracts they have with national network and cable television producers in order to provide most of their viewing content to their audiences. If the acquisition of the company by another corporation were to allow the television producers to terminate the programming agreements, the company’s broadcast stations may go off the air once the transaction is completed.     

Many counterparties insist on change of control provisions in important contracts on the grounds that they are reaching an agreement with a specific company and do not think it reasonable that they should later be bound to an unknown third party by the same terms. That’s the most likely rationale behind the change of control provision in Schering’s distribution agreement with Centocor, a subsidiary of Johnson & Johnson. As the creator and developer of the lucrative Remicade^® and other arthritis medications, Centocor agreed to share profits from international sales of some of its drugs with Schering in exchange for Schering’s distribution of the drugs outside of the United States. But if Schering suffers a change of control, the distribution agreement allows Centocor to terminate the agreement, causing all rights to profits from worldwide sales of the drugs to revert to Centocor. 

Last year, Remicade^® alone generated over $2.1 billion in sales for Schering. A great deal of money is at stake here. Merck, the potential acquirer of Schering, is a major pharmaceutical rival of Johnson & Johnson. The normal M&A process of procuring waivers to change of control provisions in material contracts does not seem to have worked. Instead, Merck and Schering decided to use the business reorganization technique known as a reverse merger for an unusual purpose: to avoid a change of control.          

The Reverse Merger Deal Structure

The Merck-Schering merger agreement contemplates a two-step transaction involving Merck, Schering, and Schering’s two special purpose, subsidiary holding companies, Blue, Inc. and Purple, Inc. In step one of the merger, Blue will merge into Schering and each share of Schering will be converted into the right to receive (i) 0.5767 shares of the surviving Schering corporation and (ii) $10.50 in cash. In step two of the merger, Purple will merge into Merck and each share of Merck will be converted into 1 share of the surviving Schering corporation. 

After the completion of these two steps, the surviving Merck corporation will be a wholly owned subsidiary of the surviving Schering corporation. Yet, the shareholders of pre-merger Merck will own approximately 68% of the surviving Schering corporation and shareholders of pre-merger Schering will own around 32% of the surviving Schering corporation. Although Merck will become a subsidiary of Schering, Merck’s pre-merger shareholders will together possess a supermajority of the voting and economic rights (or beneficial ownership) of Merck’s new parent company, Schering. 

One peculiarity of the Merck-Schering reverse merger transaction structure is that between steps one and two Merck finds itself in a slightly precarious situation. After the completion of step one, Schering’s pre-merger shareholders will have received shares of the surviving Schering corporation and a cash payout, but Merck’s pre-merger shareholders will not yet have seized control over the management of the surviving Schering corporation.  

The merger agreement has come up with a way to protect Merck’s shareholders during this governance gap. Simultaneously with the completion of step one of the merger, Schering has agreed that its board will cause all of its directors (other than 3 specified exceptions) to resign and to elect the members of pre-merger Merck’s board of directors as the directors of the surviving Schering corporation. Even before pre-merger Merck’s shareholders acquire their supermajority share of the beneficial ownership of the surviving Schering corporation after step two, they indirectly will have already taken the helm of the surviving Schering corporation through the election of their own directors to the new parent company’s board.        

In our next post on the deal, we’ll analyze the change of control provision in the Schering-Centocor distribution agreement and assess whether Johnson & Johnson has any colorable arguments that Schering will indeed undergo a change of control if the Merck-Schering reverse merger closes.

Related Post:  Can Merck-Shering's Deal Structure Avert a Change of Control?

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

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The gospel according to the Delaware Chancery Court is that a board of directors owes a duty to obtain the highest price for shareholders once a decision to sell the company has been made.  So it was a surprise to learn that Leo Strine, an outspoken member of the Delaware Chancery Court, said at a recent M&A conference that the duty to squeeze out every last penny in every takeover was “not productive for society.”

Sounds like blasphemy.  For years the Delaware courts have been advocates for the view that once a decision to sell has been made, the role of the directors is to pursue the best price with singular intensity.  The consequences of this orthodoxy are on display today.  During the LBO heyday, this approach led to acquisitions, such as the purchase of cyclical technology manufacturer Freescale by a Blackstone-led private equity consortium, with borrowed funds totaling 8.5 times the company’s EBITDA.  Clearly, the need to service this massive amount of debt from the cash flow of a cyclical company with high cap ex requirements will likely crowd out other uses of cash, such as hiring more engineers, investing in research and development, or just weathering a cyclical downturn in the economy.  

Despite these dire consequences, on display everywhere today, the view that the good of society is best served by paying shareholders the very last dollar in an acquisition still prevails.  I guess it’s fair to ask where that last dollar went.  If it went back into the market, then today it is very likely much less than it was a year ago.  Vice Chancellor Strine may therefore be right in asking whether the benefits of the singular focus on shareholder returns is the most productive result for society.

We are of course going through a severe deleveraging phase in the history of finance capitalism, and the prevailing mood is to question the wisdom of the past.  In all likelihood, this too will pass.  As the poet Elvis Costello has said:

“History repeats the old conceits,
The glib replies the same defeats,
Keep your finger on important issues
With crocodile tears and a pocketful of tissues.”   

 

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Practitioners of the art of leveraged buyouts are still waiting for seller's expectations to fall in line with current realities.  You still run across sellers who believe that the multiples of the 2006-2007 period represent an eternal, fixed emblem of value. Perhaps they can't be blamed, as the multiples were around for so long.   According to Michael Berk of TA Associates, "sellers are still expecting a multiple of 10 times plus". 

My perception is that sellers are starting to read the newspapers and are beginning to get the message that the decline is valuation may be here for awhile.  But right now, to the extent deals are getting done at all, it's where middle ground on price is reached through earn outs and other forms of contingent consideration.  It's simply not possible for a seller to walk away from a closing with the same amount of cash as in the recent past.   

Before middle ground is reached, buyers too need to make peace with the current environment.  They need to believe that the fundamentals of the target business are not deteriorating further, and that credit is available at a cost that supports equity returns.  It's hard to commit equity capital in an environment where a portfolio of fairly well-rated, publicly-traded bonds can get a 20% current cash return.

Probably sooner than later, perceptions of buyers and sellers will begin to align again.  Sellers will stop thinking about the past and realize that those valuations are not coming around again any time soon.  Buyers will start to get comfortable that business conditions are stabilizing.  When that happens, a new age of Aquarius will be born.

No one likes kissing frogs, but until this middle ground is reached, PE firms will be doing a lot of that.

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The recent decision of the Delaware Court of Chancery in the case brought by United Rental against the acquisition vehicles formed by Cerberus Capital imposes an affirmative duty to be forthright, or not devious, in the process of contract negotiations. The ruling seems to undo decades, if not centuries, of negotiating wisdom and practice. 

The United Rental court was unable to dispose of the case on summary judgment, as the contract interpretations offered by both sides were plausible. Because no decision as a matter of law could be reached, the court had to delve into the real intention of the parties on the issue whether they intended to provide a specific performance remedy.

To do this, the court heard testimony from 7 witnesses over a 2 day period. United Rental had the burden of proof to show that the parties intended to allow the remedy of specific performance, rather than the $100 million termination payment offered by Cerberus.

After all this testimony, the court remained unable to determine the shared objective intent of the parties. It therefore proceeded to adopt the breathtaking “forthright negotiator” principle:

“in cases where an examination of the extrinsic evidence does not lead to an obvious, objectively reasonable conclusion, the Court may apply the forthright negotiator principle.  Under this principle, the Court considers the evidence of what one party subjectively “believed the obligation to be, coupled with evidence that the other party knew or should have known of such belief.” In other words, the forthright negotiator principle provides that, in cases where the extrinsic evidence does not lead to a single, commonly held understanding of a contract’s meaning, a court may consider the subjective understanding of one party that has been objectively manifested and is known or should be known by the other party.”

Calling the negotiations “deeply flawed”, because both sides “failed to clearly and consistently communicate their client’s positions”, the Court found that United Rental’s attorney “categorically failed to communicate that United Rental believed it preserved a right to specific performance”. The Cerberus attorney, on the other hand, did clearly communicate his understanding that the agreement precluded specific performance. Because the United Rental lawyer did not continue to repeat his view that the agreement provide for specific performance, and relied instead on the fact that the agreement contained inconsistent provisions, he failed to satisfy the “forthright negotiator” principle.

It may come as a shock to corporate attorneys that deviousness has been barred from contract negotiations. Yet that is law of Delaware:  “United Rental knew or should have known what Cerberus’s understanding of the Merger Agreement was, and if it disagreed with that understanding, it had an affirmative duty to clarify its position in the face of an ambiguous contract with glaringly conflicting provisions."

A duty indeed!

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Deep within Blackstone's recent 10Q, in the MD&A section, the company discusses the negative impact that the "considerable turbulence" in the housing and sub-prime mortgage markets has had on other fixed income markets. 

"Deteriorating conditions in fixed income markets prevented lenders from syndicating senior loans and high yield debt."

Translation:  when the music stopped the the banks got stuck holding our last deals.

"[T]he backlog resulting from pending private equity-led transactions reached record levels."

Translation:  the banks can't get rid of the paper.

"This backlog resulted in lenders becoming less willing to fund new, large-sized acquisitions and as a consequence, the volume of new private equity acquisitions declined significantly in the quarter."

Translation:  until the pipeline gets opened we can't get the big dogs closed.

"Recently announced private equity-led acquisitions have mostly been smaller in size, with less leverage and less favorable terms for the debt provided, including more onerous loan covenants."

Translation:  looks like it's back to Plan A.

"The duration of current conditions in the credit markets is unknown."

No translation needed.

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Judge Christopher A. Boyko's order dismissing a number of foreclosure actions brought by a CDO trustee throws a hard light on a common practice in real estate loan syndication.  Due to the cost of  properly assigning the notes and mortgages that get tossed into the CDO trust, the assignments are not actually completed.  Instead, documents are signed expressing an "intent" to assign.  A spokesman for Deutsche Bank, the CDO trustee, said that skipping the assignment process :

"[Is] typically done as a matter of cost efficiency, since for some extremely high percentage of mortgages there will never be any foreclosure activity, there's no legal need for the assignments to be recorded until they need to be used." 

Because the assignments were not completed at the time the foreclosure actions were filed, Judge Boyko ruled that the CDO trustee lacked standing to bring the action.  A dismissal on these grounds is not based on the merits, and the trustee is free to refile the action once it completes the assignment paperwork.

Assuming, of course, that paperwork exists and can be found.  The paperwork underlying a large CDO is massive.  The notes and mortgages on which the CDO is based are originated in broker's and lawyer's offices around the country, and a book entry is made somewhere reflecting the loan.  That book entry is what is placed in the CDO trust, not the note and mortgage itself. 

Deutsche Bank tried the compelling argument that “‘Judge, you just don’t understand how things work.’”  That didn't go down well with Judge Boyko, who wrote that this attitude “reveals a condescending mindset and quasi-monopolistic system where financial institutions have traditionally controlled, and still control, the foreclosure process.”

The balance of power in the foreclosure process may tip toward plaintiff's attorneys if other courts begin demanding proper documentation of syndicated loans.

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In the investment world, there is no shortage of firms where everyone drinks the koolaid, believing the firm is a truly unique organization with values and a culture shared by no one else. Most times, the koolaid drinking is done in private, at partners’ meetings or golf retreats where the steady gaze of outsiders does not interfere with the collective daydream. It is therefore jarring to see the drinking done in public, especially in so formal a setting as a prospectus for an initial public offering.

The Summary section of the IPO prospectus of Blackstone Group contains the following announcement:

We Intend to be a Different Kind of Public Company

While we believe that becoming a publicly traded company will provide us with many benefits, it is our intention to preserve the elements of our culture that have contributed to our success as a privately-owned firm. In particular, as described below, we intend to continue to manage our business with a long-term perspective, to focus at all times on seeking to optimize returns to the limited partner investors in our investment funds and to retain our partnership management structure and culture of employee ownership of our business. 

Because our businesses can vary in significant and unpredictable ways from quarter to quarter and year to year, we do not plan to provide guidance regarding our expected quarterly and annual operating results to investors or analysts after we become a public company.

The logic here appears to be that one fosters a long-term perspective on business by refusing to provide guidance to investors about quarterly and annual operating results. But then, it is not really evident how these things are connected.  Is it really true that by not disclosing its quarterly and annual profit expectations, which Blackstone surely prepares internally, the firm will better manage its business for the long term?

It seems one thing to believe in the long-term perspective, after having drunk deeply from the bowl.  It is another thing to prominently feature the belief in an IPO prospectus.  But then, it was only a statement of intent. 

And what of the belief itself? Do private equity firms really manage their investments with a “long-term perspective”? Happily, Christina Padgett of Moody's Investor Service has recently written on this subject. In a recent report, Ms. Padgett wrote:

While Moody's would agree that leverage is likely to impose discipline and provide higher equity returns, the current environment does not suggest that private-equity firms are investing over a longer-term horizon than do public companies, despite not being driven by the pressure to publicly report quarterly earnings"

The report goes on to note that Celanese US Holdings, a chemical business owned by Blackstone Group, borrowed money within a year of the acquisition to pay a dividend to the private-equity firm, removing more than 95% of the cash equity originally invested in the deal. 

Blackstone's investors at least can breath a sign of relief, knowing that the firm has a sharp eye for the short term as well as the long. 

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The recent tax proposal submitted by the two top lawmakers on the Senate Finance Committee "closes a loophole" in the treatment of publicly traded partnerships. 

Years ago, 1987 to be exact, Congress passed legislation treating publicly traded partnerships as corporations.  It excluded however partnerships that derived at least 90% of their income from interest, dividends, and gains from the disposition of a capital asset.  Blackstone and other private equity firms that are flocking to go public have relied on this exemption since most of their income qualifies for the exclusion.  The exemption is huge -- corporations pay up to 35% of their income to Uncle Sam.

The new bill provides that the exception from corporate treatment for a publicly traded partnership, 90 percent or more of whose gross income is qualifying income, does not apply in the case of a partnership that derives income from investment adviser services or related asset management services.  Such a partnership is treated as a corporation for Federal tax purposes and is subject to the corporate income tax.

This strikes at the heart of the private equity firm, which receives fees and carried interests from investment adviser services.  As such, the legislation is pointed directly at firms such as Blackstone that hoped to be publicly traded partnerships without paying a corporate tax.

Reflecting, however, the strong connections that Blackstone must have in Washington, the new bill contains a 5-year exception for any private equity firm that is already public or that has an IPO registration statement already on file with the SEC.  As my tax colleague Stephen Foley notes, Blackstone may have successfully lobbied for the ability to be one of the few private equity firms that can ever go public.

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Going-private transactions sponsored by private equity firms are facing increased resistance from public shareholders.  The resistance takes many forms, all designed to improve the price.  Like any seller these days, the opportunities to leverage competing bids typically bear fruit. 

A sponsor that faces stiff public stockholder resistance, and that wants to keep pricing within reason, has a few strategic alternatives:

Stub Equity

“Stub equity” has been included as a feature in several recent transactions, including Harman, Clear Channel and Aeroflex in the United States. Stub equity gives public stockholders the option to choose either cash or stock in the company post-leveraged buyout. Stub equity is intended to deflect concerns that the going concern value of the target is worth more than the sponsor takeout price by offering the public stockholders the ability to choose, at least in part, to roll its investment going forward (possibly on a tax deferred basis). The amount of stock that may be issued to public stockholders is typically capped by the sponsors. Generally, caps have been in the 20% to 30% range of the company’s equity post-leveraged buyout, although in at least one transaction, Countryside, the cap was set at 55%. Stub equity has a number of disadvantages to sponsors, such as the requirement to register with the Securities and Exchange Commission the shares to be issued to the public stockholders and the requirement that the target remain a public company and file Securities and Exchange Commission reports for some period of time after the closing. This structure also has certain drawbacks for public stock-holders, particularly retail investors, as the sponsors may not be required to maintain a NYSE or NASDAQ listing for the stub equity so there may be very limited liquidity. 

Contingent Value Rights

Similar to earn-out rights in a private company transaction, contingent value rights provide a mechanism to bridge a perceived value gap, and thereby help mitigate public stockholder opposition. Contingent value rights give public stockholders additional value if future hurdles are met and, as an example, can be tied to future financial targets or the sales price in the event of a divestiture of a division or key assets. However, unlike stub equity, contingent value rights customarily give public stock-holders limited upside potential and don’t carry any downside risk. A variation of contingent value rights was recently part of a stockholder derivative settlement in the Sabre Holdings going private transaction. The sponsors agreed to pay the public stockholders a percentage of any profits above a certain benchmark price if the sponsors flipped the company or divested certain crown jewel assets within a six month period following closing. This type of supplemental payment for public stockholders may become more common in merger agreements.

Time will tell how the great push back by public stockholders affects the going private trend.

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It's hard to ignore the growth of covenant-lite lending in private equity deals, when even famous investment gurus like  Anthony Bolton remark on it, and at his farewell dinner no less.  Here is what Mr. Bolton had to say on the topic:

“I think the phrase is ‘covenant-lite’, but in many cases it appears to mean no covenant at all,” Mr Bolton said. He added: “Covenant-lite borrowing ... will come back at some stage to haunt the banks,” he said.

Quotes about covenant-lite lending are usually paired with a dire prediction, such as the premonition of another financial bubble.  But will covenant-lite lending really come back to haunt the banks?   

In a typical covenant-lite deal, the lenders give up what are called "maintenance" covenants.  As the name suggests, these are requirements that the borrower maintain certain financial standards at regular intervals.  For example, a borrower might be required to certify that at the end of each quarter, it has maintained a certain ratio of EBITDA to total debt.  These covenants are designed to be an early warning system that the borrower's earnings are deteriorating, and it might become unable to meet debt service requirements at some time in the future.  With these maintenance covenants gone, the lenders rely solely on what are called "incurrence" covenants.  These require that a borrower meet defined financial standards not on a regular basis, but only when there is a specific event, such as an acquisition.  For example, if the borrower wants to make an acquisition, it must certify that it will meet a specific EDITDA coverage test after the acquisition is taken into account.   

Finally, in covenant-lite deals, the other covenants are less restrictive, for example allowing for more extensive dividend payments or larger capital expenditures.

How bad are covenant-lite loans?  Despite the publicity these deals receive, they appear to be limited to large private equity deals involving companies with earnings cycles that are relatively well known or at least fairly predictable.  With companies like these, perhaps the function of maintenance covenants -- to provide an early warning system -- isn't necessary.  What good is a warning when the funds have already been loaned?  Perhaps maintenance covenants aren't really needed, and their elimination is simply a matter of efficiency.

Perhaps the traditional way of lending, where a borrower is required to certify periodically that it remains healthy enough to maintain its debt, is out of date.  Then again, if it is merely out of fashion, we may see it come round again.  Time will tell.

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Freescale Semiconductor  was acquired by Blackstone Group, Carlyle Group, Permira Advisers LLC, and TPG Capital LLC in late 2006.  A recent article by Henny Sender in the Wall Street Journal discussed how this consortium convinced its banks and other lenders to accept an especially lenient package of covenants and interest payment options.  A review of Freescale's public filings since the deal closed reveals just how lenient the package is.

Believe it or not, due to the way the deal is structured, the trade creditors in 72% of Freescale's business are functionally senior to all of the $9.5 billion that was borrowed to finance the acquisition.  The $9.5 billion is "structurally subordinated" to these trade creditors, because the borrower of these funds is the parent company and the trade creditors deal with subsidiaries that did not guarantee the parent's debt.  Pretty neat trick.

Here is one of the Risk Factors in Freescale's Form S-4, filed on March 8, 2007 in connection with a bond exchange offer:

Claims of holders of the Exchange Notes will be structurally subordinated to the claims of creditors of our subsidiaries that do not guarantee the Exchange Notes, including trade creditors. All obligations of these subsidiaries will have to be satisfied before any of the assets of such subsidiaries would be available for distribution, upon a liquidation or otherwise, to us or creditors of us, including the holders of the Exchange Notes.

In a separate section of the S-4 we learn who these lucky trade creditors are and the magnitude of the structural subordination:

Our non-guarantor subsidiaries accounted for approximately $4,594 million, or 72% of our net sales, and approximately $635 million of our EBITDA for the year ended December 31, 2006.

There's more.  Not only is the unsecured high-yield debt in this boat, but the secured debt is too!  Information about the secured debt is a little hard to find in the filing, which is an exchange offer for the unsecured notes.  But here it is:

As of the issue date, none of our subsidiaries will guarantee the Exchange Notes or the new senior secured credit facilities.

In other words, all $9.5 billion of the debt, secured and unsecured, sits at the parent company with 28% of the revenues.  The other 72% of the revenues run through various subsidiaries, none of which has guaranteed even the senior debt.  On top of that, the filing discloses that Freescale is allowed to incur an additional $1 billion of new debt, draw on a $750 million revolved and pay some of the bonds in PIK notes.  With the bulk of its trade creditors protected and plenty of excess capital, it's hard to imaging how this boat could ever go down.

Apologies to Polonius, but what a great time it is a borrower to be.

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The most recent issue of the excellent Deal Lawyers newsletter has a piece by Geoffrey Levin at Kirkland about club deals. 

It discusses the clubbing phenomenon from the standpoint of large public company sellers, noting that clubbing can be a great tool to coax out the best offer from a field of bidders and satisfy Revlon fiduciary duties.  Clubbing has been written about extensively as a way for private equity firms to make bids they otherwise might be loathe to consider.  Levin points out that sellers have to watch out that clubbing doesn't dry up the pool of bidders.  He goes through a number of useful provisions to insert in the seller's confidentiality agreement to strike the right balance between fostering club land and not getting crushed in the process.

Club deals get a lot of press, though they are far more prevalent at the top end of the private equity market than elsewhere.  Most deal makers naturally would prefer not to share the fruits of a successful bid with other firms.  Also, clubbing gets its popularity from the fact that target companies currently outstrip the ability of existing firms to swallow deals whole.  As fund sizes get larger, that may not be such a problem in the future.  Finally, a lot of syndication of risk in large deals can go on behind the scenes, as firms sell off chucks of equity exposure in private transactions.

One thing that may come of clubbing in the not so distant future is the merger of large private equity firms.  By working together through the purchase, management and sale of deals, PE firms will get to know one another and see the benefits of even closer affiliations.  If you think about the large PE firms as the premier capital aggregators of the 21st Century, you might conclude that they will become the Goldmans of the future.

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Contract parties very often want to pre-select the court in which any lawsuit arising under the contract must be brought. Issues of convenience and perceived fairness typically underlie the desire for these clauses. To be enforceable, forum selection clauses must be clear and unambiguous. 

A recent case from the Delaware Court of Chancery illustrates what happens when a forum selection clause is badly drafted. 

A manufacturer of microbial degradation and mold control products sued the investment banker it hired to assist with acquisitions. The manufacturer believed that the investment banker misused confidential information in the course of their relationship. The engagement letter tried to select the Southern District of New York as the sole forum in which litigation could be brought. The manufacturer sued in Delaware and the investment banker moved to dismiss the action.

Here is the defective forum selection clause:

“Any lawsuits with respect to, in connection with or arising out of this agreement shall be brought in a court for the Southern District of New York and the parties hereto consent to the jurisdiction and venue of such court for the Southern District as the sole and exclusive forum, unless such court is unavailable, for the resolution of claims by the parties arising under or relating to this agreement.” (emphasis added).

Because both the manufacturer and the investment banker were Delaware corporations, and no federal question existed, there was no basis for subject matter jurisdiction in the Southern District. That court was “unavailable”.

The investment banker argued that the parties “intended” to select any court located within the territory of the Southern District, not just the federal court called the Southern District of New York. But that’s not what the contract provision actually said, so the Delaware Court of Chancery ruled against the banker. For a forum selection clause to work, the parties must use “express language clearly indicating that the forum selection clause excludes all other courts before which those parties could otherwise properly bring an action.”  If the contractual language is not crystal clear, “a court will not interpret a forum selection clause to indicate the parties intended to make jurisdiction exclusive.”

The lesson? Use a proper forum selection clause, like this one:

Each party agrees to personal jurisdiction in any action brought in any court, Federal or State, within the County of New York, State of New York having subject matter jurisdiction over the matters arising under this Agreement. Any suit, action or proceeding arising out of or relating to this Agreement shall only be instituted in the County of New York, State of New York. Each party waives any objection which it may have now or hereafter to the laying of the venue of such action or proceeding and irrevocably submits to the jurisdiction of any such court in any such suit, action or proceeding.

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The Third Circuit Court of Appeals in Philadelphia recently decided an important case concerning whether a leverage spin-off can be attacked under fraudulent conveyance rules in bankruptcy.

In 1998 Campbell Soup Co. dropped the assets of its Vlasic pickle and Swanson dinner businesses into a newly formed subsidiary, and paid itself a $500 million cash dividend with funds borrowed against the assets. Campbell then spun out the new company to its stockholders, and Vlasic became a free-standing public company. Unfortunately, the pickle and frozen dinner businesses suffered and within 3 years of the spin off, Vlasic was in bankruptcy.

The trade creditors of Vlasic argued that the payment of the dividend to Campbell at the time of the spin off was a "constructively fraudulent transfer".

In orchestrating the spin-off, Campbell “negotiated” with the people who were to manage the business, but it would not take less than a $500 million cash payout. There was lots of evidence that Campbell massaged the businesses before the spin out to achieve the biggest cash payout possible. Vlasic had to restructure its debt shortly after the spin off, but went on for a year or so to operate relatively well.   In fact, the public markets valued the equity of Vlasic at $1 billion, even with the $500 million debt.

As the court said, the company did not collapse, but rather slowly declined. The game ended a little more than 2 years after the spin off.  At trial, the issue was whether the assets of Vlasic were “reasonably equivalent value” for the $500 million payment made to Campbell. Based on the fact that Vlasic traded at a $1 billion market value after the spin off, the trial court answered “yes”. 

The bankruptcy creditors tried to argue that Campbell’s prior manipulations had a lingering effect on the market value of the company after the spin off.  The Court of Appeals didn’t buy the argument, referring repeatedly to the fact that public investors valued the company at $1 billion after the spin off.

Soup's on!

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Several recent deals illustrate the extent to which financial covenants have all but disappeared from senior loan agreements in private equity transactions. The following transactions were chosen at random.

• In the October 2005 acquisition of Neiman Marcus by Texas Pacific Group and Warburg Pincus, the $2 billion senior loan facility provided by Credit Suisse and Deutsche Bank Securities had no financial covenants. The agreement did have the usual negative covenants, but even these were significantly weakened. For example, the restriction on incurring other indebtedness had 23 exceptions.

• In the November 2005 acquisition of the Vitamin Shoppe by Bear Stearns Merchant Banking, the senior revolving loan facility provided by Wachovia Bank had one financial covenant. It said that if the availability on the revolver was nearly tapped out (less than 10% remaining) then during the four preceding quarters the Fixed Charge Coverage Ratio had to be at least 1.1 to 1.0, or barely enough to cover the charges.

• Finally, in the January 2006 acquisition of AMC Entertainment by J.P. Morgan Partners and Apollo Management from Bain Capital Partners, the $850 million senior credit facility provided by Citicorp had one financial covenant. This covenant provided that as long as the revolver remained outstanding, the company had to maintain a ratio of Senior Debt to EBITDA, on a pro forma basis (!), of at least 3.25 to 1.0.

These random selections from the credit agreements of large and mid-market deals illustrates the extent to which lenders have turned over the risk of defaults to the ultimate purchasers of the debt, namely, the CLO pools.

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The ratio of total debt to EBITDA in mid-market private equity transactions is now as high as it was in 1997 – 4.7 times for companies with less than $50 million in EBITDA and 5.4 times for companies with more than $50 million of EBITDA (Source: Standard and Poors). The ratio of EBITDA less CapEx to Cash Interest in highly leveraged loans is also falling – in the 4^th quarter of 2006 the ratio fell to 2.2 times (Source: Standard and Poors).

At the same time, the covenants being written for leveraged loans are becoming more “lite”: several years ago, loan covenants were written at a 15% discount to model; now they are being written at a 25% discount.

“Covenant-lite” transactions come in many forms. In their most direct form, the covenants that require the borrower to “maintain” certain financial ratios are eliminated altogether, and the lenders are left to rely only on covenants that restrict a company from “incurring” or actively engaging in certain action. For example, a covenant that requires a company to maintain a ratio of debt to EBITDA can be breached if the financial condition of the company deteriorates, as the covenant is measured periodically, usually quarterly. But a covenant that only restricts a company from incurring new debt cannot be violated simply by a deteriorating financial condition, the company has to take affirmative action to breach it. 

Less direct forms of “covenant-lite” include carve-outs in traditional maintenance covenants that forgive in advance a certain measure of deviation from the standard. It is sometime more palatable to embed these carve-outs in a traditional loan covenant than discard the covenant altogether.

In addition to covenant-lite structures, private-equity sponsored deals have started to include a greater number of “equity cure” provisions. These enable a borrower to cure a covenant deficiency by adding more equity into a deal to count as EBITDA, thereby curing the breach. The additional equity does not have to be used to pay down debt and can be used for different purposes such as capital expenditures. In effect, the private equity sponsor is pre-negotiating an equity infusion without having to get lender approval.

This trend is of course a function of the amazing amounts of liquidity available in the credit markets to fund acquisitions.  The impact of these covenant-lite transactions will be to retard the speed with which lenders will be able to take control over troubled deals.  That may not be such a bad thing.  Lenders are not equipped to own a business and typically sell too quickly when forced to take over a company.  The next downturn may provide less opportunity for distressed debt investors than previous business investment cycles, as fewer private equity sponsors may be handing over the keys to their lenders.  

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In a recent case from Delaware’s chancery court, the clear language in a merger agreement, controlling dispute resolution matters, was enforced by the court even where the method specified wasn’t the best way to resolve the dispute. The case underscores the importance of thinking carefully about the implications of arbitration clauses, and especially how two or more arbitration schemes relate to each other.

Matria Healthcare entered into an agreement to acquire CorSolutions Medical for $445 million. Both companies were engaged in the disease management business. Nearly 5% of the purchase price ($20.3 million) was set aside in an escrow account to satisfy claims that the closing net working capital of CorSolutions fell short of a minimum target. The escrow account was also available to satisfy claims under the indemnification provisions, including breaches of representations and warranties.

Whether a claim fell under the working capital adjustment or the indemnification claim was critically important, as indemnification claims were subject to a threshold of $4.45 million, while claims for a working capital adjustment were not subject to any threshold. There was an important procedural difference as well. Claims concerning the closing net working capital were to be resolved solely by a specific accounting firm. Indemnification claims were to be resolved in accordance with the Commercial Arbitration Rules of the American Arbitration Association, which give the parties the ability to challenge and investigate claims.  

The parties saw ahead of time that disputes involving, for example, misrepresentations could fit within both arbitration schemes. They decided that any matter relating to the closing working capital had to be resolved by the accounting firm mechanism, even though the matter could also be raised as a misrepresentation under the AAA procedure.

Shortly after the closing, a messy dispute arose involving a customer of CorSolutions. The customer instituted an audit of a CorSolutions disease management program. Matria dealt with the matter after the closing by negotiating a resolution with the client that involved, among other things, a cash payment of $1.5 million and amendments to the customer contract. Matria applied the $1.5 million payment as a debit to the closing working capital and asserted a claim against the escrow account.

The dispute could have been raised as both a working capital adjustment and a claim for indemnification. CorSolutions thought the working capital arbitration was too narrow a context to allow a full airing of the issues, and it asserted that the AAA was the only proper place to hear the dispute. It also, of course, wanted the claim to be subject to the $4.45 million threshold for indemnification claims.

The court agreed in substance with CorSolutions, but ruled in favor of Matria, on the strength of the clear hierarchy of arbitration contained in the merger agreement. Even though the dispute was one that typically would be subject to an indemnification threshold, the clear hierarchy of arbitration procedures forced the claim into the working capital adjustment, for which there was no threshold. Clever drafting by Matria’s attorneys.

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Fortress Investment Group LLC, one of the first private equity funds to go public, manages private equity funds with more than $17.5 billion in committed capital. The stock was priced at $18.50 on February 8, 2007 but quickly began trading at $31 per share on the first trading day. It has since tracked a steady decline and currently trades at $25 and change.

One of the private equity funds that Fortress manages provides debt and equity funding to other sponsors of private equity transactions. This fund finances small to mid-market transactions, deals with $5 million and more of EBITDA. Fortress provides “one stop financing” for these deals, lending all of the debt needed to finance the transaction and even part of the equity when necessary and attractive. The company likes to see a capital structure consisting of at least 40% of equity before it will finance the other 60%.

At a recent private equity conference, a representative of Fortress admitted that it was getting to be a struggle to find quality deals in the mid-market arena. One-stop financing has become the norm, and the field is seeing a good deal of competition on the lending side from hedge funds, mezzanine lenders and others. Sponsors are looking for and getting friendlier covenant and deal terms in order to maintain control of the company if a downturn in the economy should occur. The absence of good quality deals gives sponsors the ability to drive down interest rates and covenant protections.  At the same time, the amount of debt financing provided to sponsors is at peak multiples.

The pressure to continue putting funds to work is sure to lead to poor credit decisions by lenders.  Whether the gurus at Fortress will also fall to these temptations remains to be seen.

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Credit continues to be readily available for buyouts of all sizes at attractive terms.  One notable features of leveraged acquisition financing in the past few years has been the growth of “second lien” debt financing in place of traditional “high yield” debt financing.

As the name suggests, the providers of second-lien financing get a security interest in the underlying collateral, but it is ranked second to the senior debt. Specifically, the second-lien lender agrees to subordinate its security interest to the rights of the senior lender. Over time, as the senor term debt is repaid, the second-lien financing achieves a higher position in the capital structure, as it remains senior to trade and other unsecured debt. Under the Bankruptcy Code, holders of second-lien debt will have priority over unsecured creditors, the right to adequate protection, the right to post-petition interest, and the right to object to sales of collateral unless they are paid in full from the proceeds of sale.

The growth and popularity of second-lien financing has nearly eclipsed traditional high yield financing, especially in large transactions. But even in the mid-tier arena, second-lien financing is making rapid inroads on traditional high yield financing. The difference in pricing between second-lien and high yield financing can be 200 to 300 basis points. Whether the second-lien position is adequate compensation for this reduced interest will be discovered when the next round of defaults and workouts hits the private equity markets.  

In many ways, second lien financing is a product of the collateralized loan obligation market. CLOs are pools of capital that invest in collateralized loan obligations. The vast amount of cash that has poured into CLOs in recent years has increased the availability of financing structured as second-lien debt.

 

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