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

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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Are earnouts in today’s M&A market still primarily serving to bridge the valuation gap between buyers and sellers? Or do we need a different explanation for the prevalence of earnouts in recent, large M&A deals? Buyers and sellers are negotiating in what is arguably the most uncertain economic climate of the past decade. Whereas in the past, the caricature of a cautious, risk averse buyer bargaining with an optimistic seller may have served as a useful – if crude – illustration of the buyer-seller valuation gap, it’s unlikely there are many Panglossian sellers out in today’s market. What is more, the idea that the valuation gap arises from a buyer’s superior knowledge about market and industry conditions doesn’t seem as plausible when applied to large deals between sophisticated players. 

Earnouts have been a common term in acquisition agreements for high-growth businesses and small companies. By making part of the purchase price contingent on a target’s ability to meet future earnings targets or reach designated milestones, a buyer can reduce its exposure to the risk that the target doesn’t fulfill the seller’s rosy predictions. At the same time, a buyer can promise to reward the seller if the target’s post-sale performance equals the seller's projections of its pre-sale prospects. An earnout, the theory goes, enables wary buyers and eager sellers to bridge the gap between their respective valuations of the target’s future profitability. 

What accounts for this disparity in valuations? Professor Brian Quinn quotes the abstract of a recent paper by Roberto Ragozzino and Jeffrey Reuer concluding that the use of earnouts “increases with information asymmetries surrounding mergers and acquisitions.” In their article, the authors argue that earnouts appear more often in acquisitions where the target is a new company or for other reasons doesn’t have access to the buyer’s superior market and industry knowledge. For acquisitions of small, private companies by buyout firms and strategic buyers like public corporations, Ragozzino’s and Reuer’s empirical findings make sense. But for this M&A season’s rash of earnouts, especially those appearing in large transactions, we may need to abandon our reliance on the explanatory power of a presumed valuation gap. 

The cost of capital for buyout firms and other acquirers has risen considerably. On top of that, buyers are operating with an informational deficit. Even if they feel they may have a strong grasp of a target’s industry and confidence in its business model, the outlook for the general economy over the next 12 to 18 months is foggy at best. More important, unlike the M&A boom period of a few years ago, buyers do not have to push past as many elbows to bring a potential seller to the bargaining table.   Buyers, that is, appear to have a negotiating advantage in today’s market. Earnouts help buyers negotiating with poor information under current economic conditions in two ways. First, it allows them to limit their financial exposure to new investments in the event the economy doesn’t revive in the short- to mid-term. Second, it allows them to defer a significant portion of the purchase price to a time when the cost of capital should be cheaper. 

It’s true that earnouts in private equity deals have always served as a risk management tool. Yet, in the past earnouts generally served to protect buyers from a target’s failure to compete successfully in its industry, not from a continued or worsening recession. Now, however, private equity firms and other buyers are not merely hedging against business and industry-specific variables. They’re signing up for a broader insurance policy against future market conditions. The prevalence of earnouts in today’s market cannot be entirely attributable to a valuation gap; it would be wise to take a close look at the negotiation gap as well.  

Related Posts:  

Valuation of a Private Company

Growing the Company through Strategic Acquisitions

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A billion dollar drug. A change of control. A collaboration agreement. And Johnson & Johnson. Sound familiar? No, we’re not talking about the Schering-Plough and J&J dispute over whether the Merck-Schering merger violates the Remicade distribution agreement. This time, Johnson & Johnson may have gone into the breach, rather than having alleged it. The case involves Massachusetts-based Biogen Idec, the Irish drug company Elan Pharma, the multiple sclerosis drug Tsyabri, and around a billion dollars in annual revenue. The question is whether Johnson & Johnson’s purchase of a minority interest in Elan violates Biogen’s and Elan’s agreement to jointly develop and market Tsyabri. 

In July, a Johnson & Johnson subsidiary entered into a set of financing and cooperation agreements with Elan worth around $1.5 billion. The agreements (which are not publicly available) would give J&J a 14.8% stake in Elan along with the option to finance Elan’s purchase of Biogen’s 50% interest in the multiple sclerosis drug Tsyabri. Under the terms of a development and marketing collaboration agreement signed by Biogen and Elan in 2000, if one of the parties to the agreement is acquired by a third-party, then the other party has the option to purchase the acquired party’s rights to Tsyabri. So why has Elan offered Johnson & Johnson this option to finance a purchase that may not ever happen?   

Elan, it seems, has been keeping a watchful eye on Biogen’s shareholders. Back in June, Carl Icahn – who has a 5.6% stake in Biogen – succeeded in getting two of his four nominees on Biogen’s board of directors. Icahn’s victory came after a fierce proxy battle waged over the course of six months. Although Icahn’s broader platform, which included moving the company’s state of incorporation to North Dakota, did not receive support from the board, there are no signs that the activist shareholder plans on relenting any time soon. On the contrary, Icahn has indicated that he intends to promote a sale of the company. By cozying up to Johnson & Johnson, Elan can ensure it has quick access to capital should Biogen suffer a change of control.   

Biogen was clearly troubled by the prospect of a big pharma player getting too close to its Tsyabri partner. If Biogen were to lose its rights to Tsyabri under the collaboration agreement’s change of control provision, the company’s value would sink. In what can only be a signal that communication channels between Biogen and Elan have broken down, Biogen sent off a July 28 letter to Elan alleging that the Elan-J&J partnership would materially breach the collaboration agreement. Specifically, Biogen claims that Johnson & Johnson’s option to finance a change of control purchase by Elan violates the collaboration agreement’s prohibition that neither party may assign or delegate any of its rights or obligations under the agreement without the written consent of the other party. Under the agreement, a material breach would initiate a 60-day cure period, at the end of which Biogen could terminate the collaboration agreement and take over Elan’s rights to Tsyabri. 

On August 6, Elan responded by filing a complaint in a Manhattan federal court seeking a preliminary injunction staying the 60-day period and a ruling that Elan’s and Johnson & Johnson’s arrangement does not breach the Tsyabri collaboration agreement. A federal judge in Manhattan has set a hearing for August 31.   

Without being able to review the Elan-Johnson & Johnson agreements, it’s difficult to assess whether or not their terms violate the Tsyabri collaboration agreement. From Elan’s own description of the agreements, however, we can presume with reasonable confidence that the issue will boil down to whether Johnson & Johnson’s option to finance an Elan change of control purchase of Biogen’s Tsyabri stake is equivalent to an assignment or delegation of Elan’s rights under the collaboration agreement. After reviewing the Tsyabri collaboration agreement, it doesn’t seem that the Elan-J&J deal violates the no assignment provision. 

Of course, we’ll be able to hear the opinion of a federal judge on the matter shortly.      

Update: Elan Loses to Biogen in Court for Assigning Tysabri Obligations to Johnson & Johnson

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

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How much would you pay for a “fair chance” at offering employment to a competitor’s top salespeople? What if you had valued the goodwill associated with these key employees to be worth nearly $3 million dollars, but was told by a court that your failure to structure an asset purchase properly entitled you to only one dollar in damages? A recent case before Delaware’s Court of Chancery illustrates how disciplined deal management by a company’s executive officers and thoughtful planning by legal counsel are essential to securing a buyer’s rights to the intangible business asset of human capital.

When the CEO of Ivize LLC, strode into the former Milwaukee offices of one of his company’s chief rivals on July 27, 2007, he was stunned to find the office in disarray and the absence of the branch’s manager and two top sales associates. Just the previous day, he had closed an asset purchase deal in which his company bought the Kansas City and Milwaukee branches of Compex Litigation Services for $3.4 million. As an established, nationwide provider of litigation support services to law firms and other clients, Ivize placed little value in Compex’s proprietary software, business model, or trade secrets. Instead, its CEO was primarily interested in buying what he regarded as Compex’s most valuable asset: its customers.

Ivize accordingly allocated approximately $2.9 million of the purchase price for Compex’s two branches to goodwill associated with the transferred businesses. With respect to Compex’s Milwaukee office, the goodwill in concrete terms meant the customer relationships developed by its two top salespeople, who respectively accounted for 65% and 35% of the branch’s sales. Where, he wondered as he gazed around in disbelief at Compex’s largely abandoned offices, were the top salepeople? 

Equally puzzling to the CEO was the disappearance of Compex’s Milwaukee branch manager. The CEO had been led to believe that the manager had accepted Ivize’s offer of temporary employment during a brief post-closing transition period coupled with a severance payment of one year’s salary. What the CEO didn’t know was that shortly after Ivize and Compex signed a letter of intent on March 5, 2007, Ivize’s Chief Operating Officer and Compex’s CEO told the manager that if the asset purchase transaction successfully closed the combined Milwaukee businesses would be run by his longtime professional rival.          

Not surprisingly, the manager bristled at the news that he would soon lose his job to a business competitor. While Ivize conducted due diligence on Compex’s Kansas City and Milwaukee businesses, the manager used his position as a branch manager to undermine the transaction. He immediately informed Compex’s Milwaukee employees of the prospective buyout and told them he intended to start up his own litigation support services company. Over the next several weeks, the manager successfully solicited the top salepeople to join his new venture, held meetings to discuss his business plans on Compex’s premises, redirected some of Compex’s business to his new company, pilfered customer records, and stole company equipment.  

Eventually, the CEO succeeded in winning back some of Compex’s former customers, but in spite of his efforts the Milwaukee office’s sales slumped by 45%. Ivize sued Compex in the Delaware Court of Chancery for breaching its representation in the asset purchase agreement that “since April 1, 2007 [Compex] has operated only in the usual and ordinary course.” After reviewing the agreement and the conduct of the parties, the court determined that Ivize had in fact bargained for the physical assets of Compex, such as its computer equipment and office leases, and for “a fair chance at retaining the employees of Compex (who were the “essence” of the business) – not a contractual right to sign the employees to employment and/or non-competition agreements.” 

The court explained that Ivize could have structured the transaction so that the execution of employment and non-competition agreements with Compex’s primary salespeople was a condition to closing, which would have strengthened Ivize’s contractual rights under the asset purchase agreement. More important, it would have allowed Ivize to walk away from the deal rather than sink several million dollars into a quickly evaporating pool of goodwill. If Compex’s employees had signed employment and non-competition agreements with Ivize prior to the transaction’s closing, Ivize could have pursued the top salespeople and other defecting employees under the terms of those agreements. 

Although the court held that Compex breached its “ordinary course” representation in the asset purchase agreement, it nevertheless declared that “Ivize should not be rewarded with the same damages it would have been entitled to had it structured the agreement properly.” Because Ivize was not able to establish compensatory damages to the court’s satisfaction, the court awarded $1 dollar in nominal damages as a token acknowledgement of a technical injury. 

In its opinion, the Court of Chancery focused on how an inadequate deal structure curtailed Ivize’s remedies under the asset purchase agreement. But Ivize’s executive officers could have averted the need for appropriate contractual remedies if they had managed the deal properly. Given that the asset purchase agreement was signed on the transaction’s closing date, the CEO should have ensured that Ivize had executed employment and non-competition agreements with Compex’s key employees in hand prior to signing the agreement.  The irony is that while Ivize’s executives recognized the importance of goodwill generated by human capital, they did not understand the nature of goodwill associated with customer relationships and consequently failed to take appropriate actions to protect the company from the inherent dangers in bargaining for such an intangible asset.

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In my last post, I said that indemnification is:

• a promise
• by one person
• to make good
• certain losses
• suffered by another person

I'd like to explore this here.

The "promise" of indemnification is contained in an agreement that is primarily concerned with something else. For example, in a contract to develop a website, the party that performs the development service will be asked to provide certain assurances and indemnifications to the customer.  The promise of indemnification is in addition to the assurances about the services that are contained in the contract.  For example, the website developer will promise to make good any losses suffered by the customer in case a third party claims that the website infringes a copyright, or in case the website does not meet specifications.

In some respects, a promise of indemnification is redundant.  If the website developer represents in the contract that her work will not infringe a copyright, and it does, then the customer has a right to sue for breach of contract.  A separate promise to indemnify the customer against a claim of infringement is not really necessary, at least as to a claim brought by one contract party against another.  For this reason, some indemnification claims cover only claims by “third parties,” that is, people who are not parties to the contract. In general, it is accepted practice to ask and receive broad indemnification language, even though redundant.   

The "person" who makes the promise to indemnify is someone who has, in consideration of some payment or benefit, undertaken some kind of action, such as building a website.  The action, however, is one that has some risk or uncertainty associated with it.  For example, the finished website may infringe the copyright of someone else or may not meet specifications. The possibility of infringement may not be immediately apparent from an inspection of the website at the time it is delivered.  The possibility may only becomes apparent over time, hence the risk.

The promise to make good backs up some kind of assurance that the person made. The assurance is usually about something specific, such as “this website does not infringe any copyright” or “this website will meet specifications.” The “make good” includes the promise to “indemnify, defend and hold harmless”.  It is a promise to put the injured person back in her original condition, before the covered injury took place. In our example, that might include fixing the website to eliminate the infringing material, meeting the required specifications, refunding the payment if infringement cannot be cured or “defending” any legal costs, for example if the copyright holder sues for infringement.

The promise to make good covers only certain losses, namely, those losses arising out of a breach of the assurance. If an assurance is given that the website will not infringe a copyright, then the losses covered are only those that arise out of the infringement. Thus, before there can be a claim for indemnification, there has to be a loss; and for there to be a loss, there has to be a breach of some specific assurance. Often, where the loss is based on a third party claim, the loss has been established before the claim for indemnification is made. Where the loss is based on the character of the service itself, such as the specifications, then the loss will have to be established at the same time as the claim for indemnification.

The losses covered by indemnification include the costs and expenses of defending or pursuing a claim in court.  the biggest cost here is attorney fees.  In the American legal system, each party has to pay its own legal expenses.  Including attorneys fees in "losses" shifts this burden to the party who is providing the indemnification. 

Indemnification only covers losses "suffered by" the person to whom the assurances were made.  The suffering person is often expanded to include, in the case of a corporation, its officers, directors, shareholders and affiliates.  The losses cannot be speculative and must actually be incurred or suffered.

Related Posts:  What is Indemnification? -- Part 1

                         Indemnification Provisions of a Purchase Agreement

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When the topic of "indemnification" is reached during contract negotiations, the principals often grow silent and wait for their lawyers to speak.  The topic seems taboo, mysterious, off grounds to any but the intrepid legal specialist. 

But this is wrong, for indemnification is simply a promise by one person to make good certain losses that may be suffered by another person.  It is akin to a policy of insurance.  It is given where one person wants to back up or support an assurance made to another person. The word itself -- indemnification -- has the ring of insurance.  In fact, real insurance companies, like The National Indemnity Company, use a form of the word in their names.  I will discuss here the section of a business contract (usually near the end) in which one party, or both, agree to provide indemnification.

To illustrate this discussion, assume that a website developer has been hired to create a new website. The customer wants and receives written assurances that the website will not infringe any copyright, and that the website will function according to specifications.  The contract contains these assurances, along with the following simple, mutual indemnification clause:

“Each party shall indemnify, defend and hold harmless the other party (including such other party’s affiliates, partners, officers, directors, employees, agents, and representatives) against any claims and/or liabilities of any nature, including reasonable attorneys’ fees, arising out of or relating to any breach of the warranties made by such party in this Agreement.”

As I mentioned above, indemnification is simply a promise by one person to make good certain losses that may be suffered by another person.  To those like me who love bullet points, indemnification is:

• a promise
• by one person
• to make good
• certain losses
• suffered by another person

In my next post, I will discuss each of these elements in detail.

Related Posts:  What is Indemnification? -- Part 2

                          Indemnification Provisions of Purchase Agreements

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