Practising Law Institute
From PLI’s Course Handbook
Mergers & Acquisitions 2008: Trends and Developments
#13962
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1
negotiating the purchase
agreement
Richard A. Goldberg
Lisa E. Pell
Dechert LLP
Copyright©2007 Richard A. Goldberg, Lisa E. Pell
All rights reserved.
This outline is current through November 20, 2007. Mr. Goldberg is a partner of, and Ms. Pell is an associate of, the firm of Dechert LLP. Portions of this outline have been, or may be, used in other materials published by the authors or their colleagues.
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RICHARD A. GOLDBERG +1 212 649 8740
richard.goldberg@
Partner
Dechert LLP
Richard A. Goldberg is a partner in the corporate and securities group. He focuses his practice on mergers and acquisitions as well as corporate finance. He has advised private and public companies, as well as investment banking firms, and represents numerous public companies on an ongoing basis. He has regularly advised corporate boards and special committees regarding governance and fiduciary duties.
He has counseled on a wide range of transactions, including proxy contests, hostile and friendly tender offers, self-tenders, joint ventures, going private transactions, spin-offs, acquisitions of entities under Chapter 11 protection, and other forms of corporate restructurings.
Notable transactions that Mr. Goldberg has recently handled include:
--Representation of The Lightstone Group and Arbor Realty Trust in their $8 billion acquisition of Extended Stay Hotels from The Blackstone Group. –
--Representation of BAWAG P.S.K. Bank on US matters in connection with its $4.2 billion) sale to Cerberus Capital.
--Representation of Goody's Family Clothing (Nasdaq:GDYS) in its $300 million sale to Prentice Capital and GMM Capital Management.
--Representation of Cantor Fitzgerald and eSpeed, Inc (NASDAQ: ESPD) in connection with their formation of a joint venture with Williams Energy, Coral Energy, Dominion Energy, Axia Energy, TXU Energy and Dynegy.
--Representation of Angelo Gordon and Eureka Capital in their $75 million acquisition of National Home Health Care (NASDAQ: NHHC).
--Representation of principal shareholder in connection with the sale of ILC Industries, a leading defense industry manufacturer to Berman Capital.
Publications and Lectures
Mr. Goldberg is widely published and frequently lectures on topics involving mergers and acquisitions and federal securities laws.
Education
Vermont Law School, J.D., cum laude, 1978, editor of the Vermont Law Review and member of the National Moot Court Team
Queens College of the City University of New York, B.A., 1974
NEGOTIATING THE PURCHASE AGREEMENT
Richard A. Goldberg
Lisa E. Pell
Copyright©2007 Richard A. Goldberg,
Lisa E. Pell
All rights reserved.
This outline is current through November 20, 2007. Mr. Goldberg is a partner of, and Ms. Pell is an associate of, the firm of Dechert LLP. Portions of this outline have been, or may be, used in other materials published by the authors or their colleagues.
I. INTRODUCTION 1
A. Function of the acquisition agreement 1
B. Main components 1
1. Representations and warranties 1
2. Covenants 2
3. Conditions 2
4. Indemnification 2
C. Simultaneous versus delayed closing 3
1. Purposes of a delayed closing 3
a. Possible consequences of a delayed closing 3
2. Effects on the agreement 4
3. Disclosure 5
II. REPRESENTATIONS AND WARRANTIES 5
A. Seller’s representations 5
B. Buyer’s representations 6
C. Specific seller representations 6
1. Financial statements 6
2. Assets and liabilities 7
a. Accounts receivable 7
b. Inventory 8
c. Plant and equipment 8
d. Liabilities 9
e. Taxes 9
3. Leases, contracts and other commitments 10
4. Customers and suppliers 10
5. Employee matters 10
6. Patents, trademarks, copyrights, trade names, etc 11
7. Litigation and compliance with law 11
8. Absence of certain changes 11
9. Insurance 11
10. Environmental protection 12
11. Data Backup and Redundancy 13
12. Regulation FD 13
13. Sarbanes-Oxley 13
14. Catch-all representations 19
D. Schedules 20
E. Prompt filing requirements for acquisition agreements 20
F. Limitations on representations and warranties 20
1. Materiality qualification 20
2. Double materiality 21
3. Knowledge qualification 22
a. The meaning of knowledge 22
G. Incorporation of SEC filings into representations and warranties 23
III. COVENANTS 23
A. General 23
B. Covenants pending the closing 24
1. Best efforts qualification 24
2. Stringency of certain covenants 24
3. Examples of specific covenants 25
a. Affirmative: 25
b. Negative: 25
C. Covenants effective after the closing 26
1. Contingent pay outs; earn outs 26
D. Specific covenants; effects of termination: no shops, options and break-up fees 27
1. No shop provisions 28
2. Force the vote provisions 29
3. Matching/Topping Rights 30
4. Stock or asset options 30
a. Stock options 30
b. Asset options 31
5. Expense reimbursement or break-up fees 32
6. Shareholder Voting/Option Agreements 32
7. Legality 32
a. No shop provisions 33
b. Options 33
c. Break-up fees 33
8. Deal Poaching 35
9. Legal Effect of Deal Protection Devices 36
a. Deal Protection Spectrum 38
IV. CONDITIONS 39
A. General 39
B. Material Adverse Effect/Change 40
C. Standards of compliance with conditions 44
D. Effect of failure of certain conditions 44
E. Under certain circumstances (e.g 44
F. Examples of specific conditions 46
1. that the representations and warranties are true at the closing and all of the pre-closing agreements of the parties have been performed; 46
2. that all necessary approvals from regulatory authorities have been obtained; 46
3. receipt of tax rulings; 46
4. delivery of certain financial statements; and 46
5. delivery of legal opinions (discussed more fully below) 46
G. Legal opinions 46
1. Purpose 46
2. Who can rely on the opinion 46
3. Opinion giver 46
4. Contents of opinion 47
a. Incorporation and good standing 47
b. Qualification 47
c. Enforceable in accordance with its terms 48
d. Consents 48
5. Transaction specific matters 48
6. Factual matters 49
7. Multiple jurisdictions 49
8. No Litigation Opinions 50
V. INDEMNIFICATION 51
A. General 51
1. Who should be the indemnitors? 51
2. Scope of the indemnity 53
a. Substantive elements 53
b. Fees and expenses 53
c. Third party claims 54
3. Who may be indemnified? 54
4. The amount of indemnification 55
B. Limitations on indemnification 55
1. The “basket” 55
a. Threshold 55
b. Deductible 55
c. Specific concerns 56
2. Survival 56
3. Caps on amount of indemnification 57
4. Defense of actual knowledge of buyer before the closing 57
C. Arbitration clauses 58
exhibit index
|Exhibit |Description |
|A |Acquisition of a company owned by an individual by an investor group.|
|B |Merger Agreement by and among Goody’s Family Clothing, GF Foods and |
| |GF Acquisition Corp. – two steps consisting of a tender offer |
| |followed by a merger This was a second round merger agreement |
| |entered after a topping bid had been received. |
|C |Fair merger agreement; not heavily negotiated. |
|D |Stock for stock merger agreement by and among Hewlett-Packard |
| |Company, Heloise Merger Corporation and Compaq Computer Corporation. |
|E |Heavily negotiated stock purchase agreement by and among Harrah’s |
| |Entertainment, Inc. and Horseshoe Gaming Holding Corporation. |
|F |Cash merger agreement among AT & T Wireless and Cingular Wireless et.|
| |al. |
|G |Asset purchase agreement among CVS Pharmacy, Inc., J.C. Penny |
| |Company, Inc., et. al. |
|H |Amended and Restated Agreement and Plan of Merger by and among |
| |National Home Healthcare Corp., AG Home Health Acquisition Corp. and |
| |AG Home Health LLC – negotiated cash merger agreement in the |
| |healthcare industry. |
INTRODUCTION.
1 Function of the acquisition agreement. In addition to setting forth the principal financial terms of a transaction, the acquisition agreement also sets forth the legal rights and obligations of the parties with respect to the transaction. It provides the buyer with a detailed description of the business being acquired and affords the buyer remedies where the description proves to be materially inaccurate. The agreement indicates the actions which must be taken by the parties to properly consummate the transaction and requires the parties to take these actions. Finally, the acquisition agreement allocates the risks associated with the purchased business among the parties to the agreement. Special consideration may be applicable to the structuring of an acquisition and/or sale of divisions and subsidiaries. Certain legal issues are unique to these divestiture transactions, and may require particular attention, such as: fiduciary issues, financials; shared assets and liabilities; antitrust issues, taxes and employee matters.[i]
2 Main components. The objectives of the purchase agreement are accomplished through the operation of the representations and warranties, covenants, conditions and indemnification provisions.
1 Representations and warranties. The primary function of the representations and warranties is to provide the buyer with a “snapshot” of the acquired business at a particular point in time, typically on the date the agreement is signed and again on the date of the closing.
2 Covenants. The covenants govern the relationship of the parties over a certain time period. Certain covenants apply from the signing of the agreement until the closing date and provide assurance that the proper actions are taken to facilitate the closing of the transaction and preserve the business pending the closing. Other covenants survive the closing for a certain length of time, such as covenants requiring cooperation of the parties with respect to the post-closing transition of the business or sharing of facilities.
3 Conditions. Acquisition agreements contain conditions precedent that must be met in order for the party receiving the benefit of the condition to be legally obligated to consummate the transaction. If one party fails to satisfy a condition by the date of the closing, the other party has the right to terminate the agreement and walk away from the transaction.
4 Indemnification. The indemnification portion of the agreement requires the parties to pay damages in the event of a breach of their respective representations, warranties and covenants. Indemnification provisions also serve to allocate specific post-closing risks associated with the transferred business.
3 Simultaneous versus delayed closing.
1 Purposes of a delayed closing. In most instances, the parties would prefer to sign the agreement and close without any delay. However, it is often necessary to delay the closing to provide time to obtain third party and/or governmental consents which are required to consummate the transaction or to facilitate the financing of the transaction. For example, transactions exceeding a certain size require the approval of the Federal Trade Commission, and others necessitate filings with the Securities and Exchange Commission (“SEC”), e.g., where securities of the purchaser are issued as consideration for the transaction in a manner which constitutes a public offering. In addition, the seller and possibly the buyer may need to obtain shareholder consent to the transaction. In such an event, if the seller or the buyer, as the case may be, is a public reporting company, subject to the SEC’s proxy rules, an SEC filing would also be required. The two-part signing and closing allows the parties to reach an agreement as early as possible and attend to these matters after the agreement is signed.
1 Possible consequences of a delayed closing. The Delaware Supreme Court held, that in a two step merger, the value added to the business being acquired following a change in majority control and during the transition period “accrues to the benefit of all shareholders and must be included in the appraisal process on the date of the merger.”[ii] Accordingly, when a buyer is considering a two step acquisition, the buyer should consider the possibility that dissenting shareholders who do not sell their shares in the first step of an acquisition may be entitled to their pro rata share of the value added to the business being acquired by the buyer during the transition period, thereby forcing the buyer to pay a higher price to such shareholders at the second step of the acquisition than the original price paid.
2 Effects on the agreement. Acquisition agreements involving a simultaneous signing and closing are much simpler than those involving delayed closings. The reason for this is that the covenants which govern between the signing and the closing and the conditions to closing may be eliminated. For example, no shop provisions, options and break-up fees are only necessary in the event of a delayed closing (see section IIIC “Specific covenants; effects of termination: no shops, options and break-up fees” below). Other than the principal financial terms, only the representations and warranties, the related indemnification provisions and the post closing covenants need to be included in the Agreement.
3 Disclosure. During the period between the signing and the closing, the buyer is typically given full access to the seller’s books, records and other pertinent data. Prior to the signing, the buyer’s access will be less extensive because of the seller’s reluctance to provide certain information in the absence of a signed agreement.
REPRESENTATIONS AND WARRANTIES.
1 Seller’s representations. The seller’s representations and warranties serve various purposes from the buyer’s perspective. First, the buyer seeks assurance that the seller has the authority and power to enter into the transaction, and that once the buyer pays the consideration, it will own the business being acquired. Second, the representations serve as a means to acquire information from the seller regarding the nature and value of the business. Representations force the seller to carefully consider and disclose material that may not otherwise be discoverable by the buyer through due diligence. In addition, through the operation of the conditions to closing, the representations provide the buyer with the right to terminate the agreement in the event that any of the representations prove to be false at the time of the closing. The representations also provide the groundwork for indemnification after the closing.
2 Buyer’s representations. The seller will also want to obtain representations to the effect that the transaction is properly authorized and is binding on the buyer. Aside from these, the form of payment will govern the extent of any other representations and warranties that the seller will require from the buyer. If the consideration is in the form of cash, the seller will usually not seek many other representations and warranties, provided that it is satisfied with the buyer’s ability to pay. However, if the consideration includes securities of the buyer, the viability of the buyer’s business and associated risks become material to the seller. Accordingly, in these situations, the seller will seek the same type of business disclosure that it is providing to the buyer.
3 Specific seller representations. The following is a brief discussion regarding specific types of representations typically made by the seller.
1 Financial statements. The seller’s financial statements are a significant source of information regarding the seller’s business. A set of year end and stub period (if applicable) financial statements is usually attached as an exhibit to the acquisition agreement or otherwise delivered to the buyer. The seller represents that the financial statements are complete and correct, fairly represent the financial condition of the business (including the liabilities of the seller) for the periods indicated, and were prepared in accordance with generally accepted accounting principles (“GAAP”). Additional representations might also be sought that mirror Sarbanes-Oxley certification requirements. See section 13 below.
2 Assets and liabilities. The seller will frequently also be asked to make representations about specific assets and liabilities included in the financial statements. This gives the buyer greater protection than the financial statement representation alone because a representation that the financial statements have been prepared in accordance with GAAP may not be breached for a minor variation from the balance sheet with respect to the value of certain assets which are of particular importance to the buyer. The following are examples of these types of representations:
1 Accounts receivable. Negotiations frequently revolve around the seller’s reluctance to state that the accounts receivable are collectible, which is in effect a guarantee of collection. Although the seller typically refuses to give such a guarantee, it will usually agree to represent that the accounts receivable arose in the ordinary course of business and represent the actual obligations of its customers. The seller also typically agrees to represent that, except for amounts reserved in allowance for doubtful accounts, there are no known claims or offsets against the receivables. If the collectibility of the accounts receivable is an integral part of the value of the business being acquired, the parties sometimes agree that the buyer has the right to “put” or sell back to the seller the receivables that remain uncollected after a certain period of time. A buyer may be reluctant, however, to turn over the collection process to the seller who may not have the same customer sensitivities as the buyer.
2 Inventory. The objective of a representation regarding inventory is to flush out obsolete or unsaleable inventory that has not been written off and to make sure that the inventory has been accounted for on a consistent basis.
3 Plant and equipment. The seller typically represents that the plant and equipment is in good operating condition and that no fundamental structural problems exist. The seller may also be asked to represent that the plant and equipment is sufficient to run the business. The seller will not want to make this representation so stringent as to turn it into a warranty that the equipment will not break down.
4 Liabilities. A representation stating that the financial statements have been prepared in accordance with GAAP will not cover liabilities which are not required to be included on a balance sheet (e.g. certain contingent liabilities and lease liabilities which are not capitalized) or which occur after the date of the financial statements. As a result, it is important to obtain a representation that states that there are no undisclosed liabilities except as set forth in the financial statements or on an attached schedule and except those that have been incurred in the ordinary course of business subsequent to the date of the balance sheet. The schedule typically excludes liabilities below an agreed upon dollar threshold.
5 Taxes. A buyer will typically want a representation that all of the required tax returns have been properly prepared and filed and that all taxes shown to be due thereon have been paid, e.g., income taxes, excise taxes, customs taxes, sales taxes, etc. It is helpful for the representation to specify the years through which the seller’s income tax returns have been audited and to indicate whether the seller has waived the statute of limitations with respect to any tax years. Of course, a tax representation is less significant in a sale of assets than a sale of stock.
3 Leases, contracts and other commitments. The buyer needs to be familiar with all of the seller’s material agreements in order to be forewarned about the obligations that the buyer will be undertaking. In addition, the buyer will review these documents to be sure that they are assignable. The buyer typically seeks a schedule of material agreements and a representation that the seller is not in default under any material agreement. The definition of a “material” contract will depend upon the size of the business being acquired and the cost to the seller of compiling the agreements.
4 Customers and suppliers. Where material, the seller is asked to represent that customer and supplier relations are satisfactory. Frequently, a schedule of the principal customers and suppliers is provided.
5 Employee matters. This representation covers the seller’s potential liability under employee benefit plans such as health plans, pension plans, retirement plans, etc. and their respective compliance with ERISA. Typically, the representation also covers unions, if any, and labor relations, as well as a statement that there are no unfair labor practices or proceedings pending.
6 Patents, trademarks, copyrights, trade names, etc. Where material, all patents, trademarks and licenses are listed on a schedule to the purchase agreement. In addition, the seller may be asked to represent that to its knowledge, its intellectual property is not being infringed upon by any third party and that it is not infringing the intellectual property rights of a third party.
7 Litigation and compliance with law. This representation typically covers threatened as well as pending claims. Knowledge qualifications are usually permitted for threatened litigations but not for those that are pending.
8 Absence of certain changes. This representation assures the buyer that there have been no material adverse changes in the business subsequent to the date of the most recent financial statements. Frequently, the representation will also cover changes in the industry in which the seller operates.
9 Insurance. This representation typically provides that the seller maintains adequate insurance with reputable insurance companies. In addition, the buyer will often want to know whether the seller has been refused any insurance or has experienced any insurance cancellations, as these are often indications of operational problems or uninsurable risks. A schedule of all the types and amounts of insurance maintained by the seller is sometimes included as part of the representation. Care should be taken to identify insurance coverage that is maintained on a “claims made” basis e.g., product liability or directors and officers liability insurance. “Tail” coverage is often available for purchase by the buyer to avoid gaps in coverage which would otherwise arise under a “claims made” policy. It is also useful to ascertain whether there is “entity” coverage as part of any directors and officers liability insurance policy.
10 Environmental protection. Representations with respect to environmental protection are often one of the more significant representations in the acquisition agreement. If lenders are involved, they are particularly concerned with these representations in view of the potential lender liability associated with environmental noncompliance. Environmental representations typically encompass compliance with applicable environmental laws. However, this is often an area of negotiation because environmental laws are so comprehensive that sellers are typically unwilling to represent that they are in compliance will all such laws.
11 Data Backup and Redundancy. In an environment of heightened concern about data redundancy capabilities, a representation should be sought which provides assurances about protections against loss of critical data.
12 Regulation FD. Regulation FD adopted by the Securities and Exchange Commission (“SEC”), generally applies whenever a senior official of a U.S. public company or another employee or agent who regularly communicates with the investment community discloses material nonpublic information to a security market professional or to a security holder where it was reasonably foreseeable that the security holder would trade based on the information. When the disclosure obligations of Regulation FD are triggered, the issuer is required to either simultaneously, for intentional disclosures or promptly, for non-intentional disclosures, make public disclosure of the same information. Thus, the buyer might ask the seller to represent that no disclosure violating Regulation FD has been made.
13 Sarbanes-Oxley. The Sarbanes-Oxley Act of 2002 (“SOX”) was enacted on July 30, 2002, with the aim of increasing corporate responsibility.[iii] Among other things, SOX imposes two separate certification requirements on the chief executive officer (“CEO”) and chief financial officer (“CFO”) of a public company. Section 302 of SOX requires that the CEO/CFO make specific representations in their respective certifications to each annual report on Form 10K and each quarterly report on 10Q.[iv] Section 906 creates a new CEO/CFO certification requirement in connection with all periodic reports that contain financial statements.
In 2003, the SEC adopted requirements relating to executive management internal control over financial reporting as required under the SOX mandate. The rules adopted pursuant to Section 404 of SOX require that the CEO/CFO include in their annual reports a report of management on the company’s internal control over financial reporting.[v] A company that is an “accelerated filer,” as defined in Exchange Act Rule 12b-2, commencing with reports for its fiscal year ending on or after November 15, 2004, must comply with Rule 404 management report on internal control over financial reporting disclosure requirements in its annual report for that fiscal year. A company that is not an “accelerated filer,” must comply with Rule 404 disclosure requirements commencing with reports for its first fiscal year ending on or after July 15, 2007.[vi]
The CEO’s/CFO’s internal report must certify their responsibility for establishing and maintaining adequate control over financial reporting for the company; assess the effectiveness of the company’s internal control over financial reporting as of the end of the company’s most recent fiscal year; identify the framework used by management to evaluate the effectiveness of the company’s internal control over financial reporting; and certify that the public accounting firm that audited the Company’s financial statements included in the annual report has issued an attestation report on management’s assessment of the company’s internal control over financial reporting.[vii] Furthermore, the CEO/CFO must evaluate any change in the company’s internal control over financial reporting that occurred during a fiscal quarter that has materially affected or is reasonably likely to materially affect, the company’s internal control over financial reporting. In view of the requirements of SOX, the buyer might ask a public company seller to represent that it has complied with the requirements of SOX and to make further representations that mirror the contents of these certifications.
The effect of complying with Section 404 of SOX may add significant challenges to due diligence. With a looming deadline for certification of internal controls, there may be pressure to integrate an acquired division or subsidiary rapidly so that the certification can be made. Due diligence will be necessary to determine whether there are weaknesses in internal controls that will prevent certification in a timely manner. Poor internal controls of a target company were once less significant during the due diligence process because it was viewed that the poor internal controls would be fixed post-acquisition. Poor internal controls can now impact the acquiror to the extent that management and the auditor may conclude that the acquiror and the target, taken as a whole do not have effective internal control over financial reporting. In addition, some seemingly small acquisitions can affect the acquiror’s Section 404 compliance process if the operations of the new entity represent specific risks to the acquiror or cause a previously insignificant business location to become significant when combined with the acquired entity. Acquisitions of private companies may cause additional difficulties in this area because private companies are less likely to have devoted much time to documenting their controls. If an acquisition is closed before the end of a buyer’s fiscal year end, the SEC recognizes that it is not always possible to conduct an assessment of an acquired business’ internal control over financial reporting in the period between the consummation date and the date of management’s assessment. Management may exclude the acquired business from their assessment and explain why they have done so.[viii] This is, in effect, a one year grace period for compliance for acquisitions made late in the year. However, management may not make this exclusion for more than one year after the acquisition date or in more than one annual management report.[ix] Although the acquiror may have an extended period of time to prepare its report under Section 404 covering the acquired entity, the first Section 302 certification under SOX after acquisition must include the operations of the acquired entity, and that certification must be made as of the end of the quarter in which the acquisition closes.
It is also worth noting that the requirements of SOX may affect public companies acquiring private companies that were not subject to the same SEC oversight prior to the acquisition. Under the securities laws, if the acquisition is large enough, as defined by SEC regulations, a buyer that is a public company must disclose the historical audited financial statements of the seller on a Form 8-K and in some cases, in a proxy statement or registration statement related to the proposed acquisition. Depending upon the size and nature of the transaction, the buyer may have to include the target company’s audited financial statements from the previous year or up to three years prior to the transaction. These requirements make it incumbent upon the buyer to ensure that the audited financial statements are available or can be made available prior to the due date of the SEC filing. In addition, though SOX does not impose new obligations on the officers of the buyer to certify the target company’s historical financial reports, it does create new criminal penalties and increase already existing civil and criminal penalties under pre-existing securities laws.[x] For example, Sections 13(a) and 18 of the Securities Exchange Act of 1934 (the “Exchange Act”) impose personal liability (and criminal liability) on the CEO and CFO of a buyer for the contents of any Exchange Act filings and corporate officers signing such filings can be held liable for material misstatements or omissions under Section 10(b) of the Exchange Act. As SOX increases, considerably, the civil and criminal penalties for violations of these laws it is critical that the parties to a merger or purchase agreement conduct extensive due diligence throughout the process in order to carefully review the financial statements and information concerning the target.
14 Catch-all representations. The buyer will sometimes ask the seller to make the general representation that there are no material misstatements or omissions in the representations. This type of representation can be a shortcut in cases where the principals desire to consummate the transaction quickly, without extensive due diligence or time spent on preparing schedules to the agreement.
4 Schedules. Schedules are typically the most illuminating portions of an acquisition agreement because they disclose all of the exceptions to the representations and warranties. For example, a representation will often provide that there are no defaults in material agreements except as set forth in the attached schedule. In evaluating a potential acquisition candidate, a review of schedules to previous acquisition agreements by such candidate can provide a useful source for due diligence.
5 Prompt filing requirements for acquisition agreements. It should also be noted that under 8-K disclosure requirements, a merger or similar asset or stock purchase agreement must be disclosed on Form 8-K within four business days of execution.
6 Limitations on representations and warranties.
1 Materiality qualification. The manner in which a representation is drafted plays an important role in the allocation of risk between the parties. It will determine whether the existence of certain previously undisclosed facts will permit the buyer to terminate the transaction or, after the closing, seek indemnification. One way to shift risk to the buyer is to qualify some or all of the representations with materiality exceptions, e.g., “except for those which do not have a material adverse effect upon the Company, its financial condition or the transaction contemplated hereby.” Accordingly, the buyer bears the risk and costs with respect to any non-material items.
Different materiality standards may be used in the various sections of the acquisition agreement. For example, the seller may agree to disclose all litigation (without any materiality qualification) but limit the right to indemnification to situations in which exposure from the undisclosed litigation exceeds a certain dollar threshold. This option allows the buyer to flush out any potential problems with the seller’s business through detailed disclosure schedules, but without triggering indemnification obligations for immaterial matters. Another alternative would be to require disclosure and indemnification for all litigation, but permit the buyer to terminate the agreement only in the event that the undisclosed litigation has a material adverse effect on the acquired business. The parties typically arrive at compromises on these issues depending on the particular facts related to the transaction.
2 Double materiality. The buyer should bear in mind the pitfall of double materiality. This occurs when a representation is qualified by materiality and the corresponding indemnification provision is conditioned upon the breaches resulting in a certain threshold level of damages. The result is that the representation would not be breached, and any resulting loss would not be counted toward the minimum threshold level, unless there exists a material obligation or liability which is not disclosed. Due to the interplay of these provisions, the buyer may suffer substantial damages without triggering indemnification, leaving the buyer without adequate protection.
3 Knowledge qualification. The seller can also limit the scope of its representations by having them qualified by a phrase such as “to the best of Seller’s knowledge”. This qualification limits the duty to disclose to only such information as is within the seller’s knowledge. Often, the seller will argue that it can only make representations as to what it knows. However, the issue is not the veracity or trustworthiness of the seller. Instead, it is purely a question of who among the parties will bear the risk of unknown liabilities. By adding a knowledge qualifier, the risk is shifted from the seller to the buyer.
1 The meaning of knowledge. Frequently, the parties negotiate over what the appropriate meaning of “knowledge” should be. The seller will sometimes argue that it cannot be held responsible for the knowledge of all of its employees while the buyer will claim that, as between the seller and buyer, the seller should bear the risk of information known by its low level employees. A frequent compromise is to define the individual(s) whose knowledge is subsumed within the meaning of the term. Often, these individuals will be limited to the seller’s officers (or just its executive officers) and its directors. The definition of knowledge may also clarify whether it includes constructive knowledge.
7 Incorporation of SEC filings into representations and warranties. In situations where the party providing the representations and warranties is a public company, it may be sufficient to simply have a representation regarding the accuracy of the company’s SEC filings coupled with limited additional representations concerning transaction specific matters, such as the authorization and execution of the agreement. However, the buyer is likely to want more specific representations about specialized areas of concern such as environmental and ERISA compliance and customer relations.
COVENANTS.
1 General. Many of the covenants contained in the acquisition agreement require the parties to obtain the necessary approvals and consents from various governmental agencies and third parties, which are required for the consummation of the transaction. The delayed closing provides the parties with sufficient time to perform these covenants. Other covenants ensure that the seller’s status quo is preserved during the hiatus between the signing and the closing.[xi] Where the parties have a simultaneous signing and closing, the covenants will be limited to post-closing items such as payment of relevant taxes, filing of tax forms and the general covenant to take any further actions which may become necessary to consummate the transaction.
2 Covenants pending the closing.
1 Best efforts qualification. When a third party consent is necessary to consummate the transaction, the buyer may seek an affirmative covenant that the seller will use its “best efforts” to obtain such consent. “Best efforts” is an ambiguous phrase which parties are sometimes reluctant to use. For example, a party may be concerned that such a covenant may require it to commence litigation, if necessary, in order to obtain such consent. A compromise sometimes entails the phrase “reasonable efforts” instead of “best efforts”.
2 Stringency of certain covenants. The buyer will typically desire strict covenants aimed at preserving the seller’s status quo by requiring the seller to seek the buyer’s consent prior to taking certain actions. However, the covenants should not be drafted so strictly as to materially interfere with the business of the seller pending the closing.
3 Examples of specific covenants.
1 Affirmative:
1 to obtain all necessary consents;
2 to carry on the business only in the ordinary course;
3 to maintain plant, property and equipment;
4 to comply with all applicable laws;
5 to pay all taxes when due and avoid liens; and
6 to maintain qualifications to do business in appropriate jurisdictions.
2 Negative:
1 not to introduce any method of accounting inconsistent with that used in prior periods;
2 not to enter into any transaction other than in the ordinary course of business, e.g., sales or purchases of a material amount of assets, bank borrowings;
3 not to amend the seller’s charter and by-laws or principal agreements, except in the ordinary course;
4 not to grant any increase in the salary or other compensation of any employee, except in the ordinary course of business (absent previously anticipated increases or scheduled bonuses);
5 not to enter into any long-term contracts or commitments (specific dollar thresholds can be employed); and
6 not to release any claims or waive any rights against third parties.
3 Covenants effective after the closing.
1 Contingent pay outs; earn outs. Earn outs provide flexibility in determining a purchase price of the acquired business. Earn outs allow the buyer to pay most of the agreed upon purchase price at the closing, and then make subsequent additional payments which are contingent upon how the business performs after the acquisition. When using earn out provisions, it is important to clearly define the performance criteria that trigger the additional payments. Performance criteria may include attaining specified revenue or earnings levels, EBITDA or other defined targets such as completing the development of a new product line or receipt of awards relating to the acquired business’ performance or products. Clear definition of the accounting terms to be used in earn out provisions is also critical (reference to generally accepted accounting rules is helpful). In that regard, it would be advisable to have an accountant review the earn out provisions to lessen the potential for ambiguity in interpretation, e.g. review by one or more certified public accounting firms. Further, the period of time over which the contingent payments may be earned, and the timing of computation and payment of the subsequent payments (whether annually or incrementally) must be clearly stated in the earn out provision. Since disputes with respect to earn out provisions are common, a clause providing for an alternate dispute resolution method may be useful.
4 Specific covenants; effects of termination: no shops, options and break-up fees. In the event that the agreement has a delayed closing and the seller is publicly held, the seller’s board of directors could be faced with an unsolicited offer between signing and closing which it could not ignore without violating its fiduciary duties. To protect against this possibility, the buyer often requests certain covenants which minimize the actions the seller can take in respect of a third party, discourage third party offers and compensate the buyer if a transaction is consummated with a third party. These protections generally prohibit the seller’s board from soliciting or negotiating with alternate purchasers (subject to the seller board’s fiduciary duties, as discussed below). The provisions may also grant the buyer certain rights in the event that the contemplated transaction is never consummated, such as reimbursement of the potential purchaser’s expenses, a specified termination fee or an option to purchase certain assets or stock of the seller. These provisions are discussed below.
1 No shop provisions. The agreement will generally contain a no shop provision prohibiting the seller from soliciting other offers. However, the seller will generally insist upon an exception which enables the seller to entertain unsolicited third party offers if the failure to do so would violate the fiduciary duties of the seller’s board to its shareholders. This exemption is typically referred to as a “fiduciary out.” The “fiduciary out” generally plays a more important role when the seller is a publicly held, as opposed to a closely held, company for two reasons. First, in a closely held company, it is likely that the shareholders have agreed to the transaction with the initial purchaser and may indeed all be parties to the acquisition agreement. Second, since there is no public market for the shares, it is less likely that a competing bid would emerge without cooperation of the shareholders.
2 Go shop provisions. It has become common for agreements to contain a brief opportunity for the seller to conduct a brief “go shop” period, during which the seller can verify that there is no better offer available. The go shop provision is common in transactions where there has not been a full auction and in going-private transactions, where a related party is the acquiror. The acquirors will protect themselves against a higher offer through the payment of break-up fees. The Delaware Chancery court recently addressed the duty of a Board to get the highest price for the sale of a company in the context of a limited auction. In Netsmart[xii], the plaintiff shareholders claimed that (i) the Special Committee appointed by the Board to find an acquirer for the company failed to find the highest bidder from within the limited universe of private equity firms that were being courted and (ii) the Board, in not seriously considering all of the possible strategic acquirers and only courting private equity firms, acted unreasonably. The court determined that the actions of the Board did not constitute an adequate market check thereby suggesting that the exclusion of a search for strategic acquirors made the process flawed. As such the court granted the plaintiff shareholders a preliminary injunction. A brief go-shop provision might have avoided this result.
3 Force the vote provisions. The Delaware General Corporation Law provides that the terms of a merger agreement may require that the agreement be presented to the shareholders for approval even under circumstances where the Board has concluded that the agreement is no longer advisable and recommends that the stockholders reject it, i.e., under circumstances which compel the board to exercise its “fiduciary out.”[xiii] This provision could affect negotiations with respect to the “fiduciary out.” Even if a Board withdraws its recommendation of a transaction, an agreement requiring the matter to be submitted to shareholders has been held to be enforceable unless coupled with a lock-up of the vote of a majority of the shares.[xiv] From a seller’s perspective, it may be undesirable to include this type of provision, as it removes control in a bidding process from the seller’s board. While the Board may withdraw its recommendation in favor of a transaction, it must nonetheless submit the matter to a vote of its shareholders if the provision is included. This provision may chill a competitive bid by complicating and lengthening the termination process. A potential bidder, who knows that the merger agreement must be submitted to shareholders for approval even if a subsequent offer is clearly superior, may be reluctant to endure the delays inherent in a shareholder vote. From the buyer’s perspective, this “chilling” of a competitive bidding process would be particularly desirable.
4 Matching/Topping Rights. The acquiror may seek the right to match or top a superior proposal. Generally, the provisions offer a two to three day period to the buyer to match or top the competing bid. This right affords the buyer a strategic advantage in bidding, giving it the last opportunity to bid.
5 Stock or asset options. As a result of the “fiduciary out” typically included in the no shop provision, the potential buyer is at risk of the transaction not being consummated due to a competing bid. Accordingly, a purchaser will sometimes ask for an option to purchase stock or assets of the seller upon the occurrence of a triggering event in order to deter, and give itself an advantage over, other potential purchasers. The triggering event is typically the termination of the acquisition agreement or the acquisition by another potential purchaser of a certain percentage of the seller’s stock.
1 Stock options. A stock option grants the initial purchaser the right to purchase authorized but unissued stock of the seller upon the occurrence of a triggering event. Such an option is advantageous to the initial purchaser in three respects. First, in the event the seller is considering a competing offer from another potential buyer, the initial purchaser can exercise its options and vote the shares in favor of its transaction with the seller and against the competing offer. Second, by increasing the number of shares outstanding, the issuance of the option would make the purchase by a competing bidder more costly. Finally, in the event a competing offer is commenced and the initial purchaser is outbid, the initial purchaser can realize a profit by exercising its options and tendering its shares for the higher bid.
2 Asset options. An asset option provides a buyer with the option to purchase a particular asset of the seller at an advantageous price upon the occurrence of a triggering event. Since the particular asset underlying the option is often a significant division or subsidiary of the seller (sometimes referred to as a “crown jewel”), the asset option can be successful in deterring potential purchasers who are mainly interested in, or unwilling to consummate the transaction if the seller were to lose, that asset.
6 Expense reimbursement or break-up fees. Typically, the acquisition agreement will contain a provision whereby the seller will be required to reimburse the initial purchaser for expenses incurred in connection with the transaction and/or pay a termination fee in the event that the acquisition agreement is terminated because of a specified reason, including the consummation, or recommendation to the seller’s shareholders, of an alternative offer. These payments deter competing offers by making them more expensive and reimburse an unsuccessful potential purchaser for expenses incurred in connection with the failed acquisition. These may be aggregated with termination fees for purposes of testing the reasonableness of the termination fee.
7 Shareholder Voting/Option Agreements. Where there are meaningful blocks of voting stock held by management or significant shareholders of the target, the acquiror may seek a commitment from these holders to vote in favor of the transaction, an option to purchase their shares or the right to share in their profits made from a superior proposal.
8 Legality. In the event of a change of control, the primary objective of the seller’s board of directors must be “to secure the transaction offering the best value reasonably available for [its] stockholders.”[xv] No shop provisions, options and termination fees are generally material features of a transaction to be considered by the board of directors in the exercise of their fiduciary duties to further that end.
1 No shop provisions. While no shop provisions are not per se illegal, they must not limit the fiduciary duties of the seller’s board of directors or they will be unenforceable.[xvi]
2 Options. Asset and stock options have generally been upheld in Delaware courts if the granting of the option is necessary, and is used, to encourage either the initial offer or other competing offers on terms more favorable to the seller’s shareholders.[xvii] However, these options generally have been enjoined where they have been used to favor one buyer over another in the bidding process, and to exclude or limit competing offers, to the detriment of the seller’s shareholders.[xviii]
3 Break-up fees. Break-up fees are generally upheld if they are reasonable in relation to the size of the whole transaction.[xix] In each case, the test would be whether the defensive measure used enhanced the bidding process in order to maximize the value to the seller’s shareholders.[xx] In addition, Courts will take into account the overall effect that all of the protective measures have collectively on competing bids.[xxi] Break-up fees average generally between 1% and 3.5% of the overall deal value, with smaller deals at the higher end of the range. In 2005, the last year for which there is a formal study, break up fees, as a percent of transaction value, ranged from a high of 10.0% to a low of 0.1%, with a mean of 3.1% and a median of 3.2%.[xxii] Breakup fees since 2005 have generally been trending downward slightly, to levels between 2% and 3%, in view of judicial scrutiny. One significant break up fee paid to a spurned buyer was $200 million, paid to First Bank System of Minneapolis;[xxiii] although seemingly large, this amount represented less than 2% of the overall deal.[xxiv] The Delaware Court of Chancery indicated that although the break up fee was significantly large in the aggregate, it was not inappropriate with respect to the total value of the transaction.[xxv]
In a 1998 decision, the Delaware Supreme Court ruled that a $550 million break-up fee (which represented 2% of the deal value) characterized in the agreement as “liquidated damages” was valid.[xxvi] The court analyzed the fee under traditional contract law principles rather than fiduciary principles. The liquidated damages analysis asks two questions: 1) Are the potential damages uncertain? and 2) Is the amount reasonable? If the answer to both questions is yes, then the fee is valid. This analysis departed from the usual business judgment rule presumption in favor of the directors of the seller, where the fee is valid unless the directors acted in a disloyal or grossly negligent manner. The lesson of this case may be that designating a break-up fee as “liquidated damages” may increase the scrutiny of the reasonableness of the fee by a reviewing court.
9 Deal Poaching. Although break-up fees and options are designed to diminish the possibility of interference in an acquisition agreement by an outside party, they are not always effective. Some sellers have run auctions and signed deals with the highest bidder only to have the deal upset by a later offer with a higher price. The later offers were submitted by buyers because the break-up fees and options were not enough of a financial detriment to deter them from interfering with the signed deal. Large financial penalties could ensure that the prospective buyers put their best offer on the table at an early stage. No court has yet addressed this policy argument in favor of large break-up fees and options.
10 Legal Effect of Deal Protection Devices. The combination of deal protection devices including no shop provisions, voting agreements, and force-the-vote provisions adopted by a board that are designed to coerce the consummation of a merger and preclude the consideration of any superior transaction can be held invalid and unenforceable under certain circumstances. In a 2003 decision, the Delaware Supreme Court ruled that a target’s board decision to combine two otherwise valid defensive devices, a majority stockholder voting agreement and a “force-the-vote” provision permitted by Section 251(c) of the Delaware General Corporation Law, caused them to operate in concert as an absolute lock up, in the absence of an effective fiduciary out clause in the merger agreement.[xxvii] The Delaware Supreme Court explained, a “board’s decision to protect its decision to enter into a merger agreement with defensive devices against uninvited competing transactions that may emerge is analogous to a board’s decision to protect against dangers to corporate policy and effectiveness when it adopts defensive measures in a hostile takeover contest.[xxviii] The Delaware Supreme Court confirmed, however, that defensive devices adopted by a board to protect the original merger transaction must withstand enhanced judicial scrutiny, even when that merger transaction does not result in a change of control.[xxix]
The Delaware Supreme Court analyzed the defensive measures under enhanced judicial scrutiny rather than the business judgment rule. The enhanced judicial scrutiny test requires two threshold determinations: 1) a determination that the defensive measure is not coercive or preclusive and 2) a second determination that the defensive measure falls within a range of reasonableness.[xxx] Therefore, a board must demonstrate that its defensive devices are not draconian (preclusive or coercive) and that it has reasonable grounds for believing that a danger to the corporation and its stockholders exist if the merger transaction is not consummated. The latitude a board will have in either maintaining or using the defensive devices it has adopted to protect the merger it approved will vary according to the degree of benefit or detriment to the stockholders’ interests that is presented by the value or terms of the subsequent competing transaction.[xxxi] This case illustrates that the combination of defensive devices including the omission of an effective fiduciary-out clause in a merger agreement may increase the scrutiny of the reasonableness of the devices by a reviewing court.
1 Deal Protection Spectrum. In determining an acceptable level of deal protections, Delaware decisions have considered a spectrum of cases between deals that were not shopped before the protection was put in place and fully shopped deals. Delaware courts have generally ruled that the more a deal is shopped, the greater the deal protection that will be permitted. In other words, when there is a sound pre-deal process, higher breakup fees and other deal protections will be upheld. The Delaware Chancery Court recently provided additional guidance on the level of deal protections that are acceptable in a situation where there had been something in between a fully shopped deal and no shopping at all. Toys "R" Us had engaged in a lengthy auction to sell its largest division, at the end of which, a determination to sell the whole company was made. A few bidders then participated in a bidding process for the whole company. Vice Chancellor Strine found that the Toys "R" Us board acted reasonably in providing a 3.75% termination fee and matching rights to the highest bidder.[xxxii] In concluding that the Toys "R" Us board had a reasonable basis to accede to the winning bidder's demands, Vice Chancellor Strine indicated a reluctance to second guess the board's actions. The decision signals that the Boards will be granted latitude to address the facts of a particular sale process, as long as there is no self-dealing, some shopping has first taken place and there is ample opportunity for a post-signing market check.
CONDITIONS.
1 General. The parties’ obligation to close the transaction is subject to certain conditions precedent which, absent a waiver, must be fulfilled before the party to whom the condition runs is obligated to close. Certain conditions are reciprocal, such as the requirement to obtain the necessary governmental or third party consents to the transaction. Other conditions encompass circumstances beyond the parties’ control, such as the absence of an injunction against the transaction. In addition, there may be conditions that are specific to the seller, such as the absence of a material adverse change in the seller’s business.
2 Material Adverse Effect/Change. The Delaware Court of Chancery, in a 2001 decision in the Tyson case, highlighted the importance of the careful drafting of a “material adverse effect” (“MAE”) or “material adverse change” (“MAC”) clause.[xxxiii] Basing its decision on New York law (because the merger agreement was governed by New York law),[xxxiv] the Court determined that the seller had not suffered a MAE and ordered the buyer’s specific performance of the merger agreement.[xxxv] In its analysis of the MAE clause, the Court looked at the information available to the parties during and after closing. The Court paid particular attention to the buyer’s access to information during its due diligence review and to any additional material disclosed in the schedules to the merger agreement.[xxxvi] Despite a significant drop-off in earnings during the seller’s first quarter, the Court found that, when examined in connection with the cyclical nature of the seller’s business and its consistently fluctuating economic performance over time, the drop-off did not indicate a material change in the financial situation of the seller over a long period. In addition, rather than judging the buyer’s dealings under the standard of a reasonable purchaser, the Court subdivided the reasonableness standard into that of an acquiror looking at the long-term prospects of the business and a short-term speculator. The Court reasoned that a short-term speculator may well consider a first-quarter drop-off in earnings as “material” while a long-term acquiror would need to look at the seller’s earnings over a long period of time: “a MAC embraces a development that is consequential to a company’s earning power over a commercially reasonable period, measured in years rather than months.”[xxxvii] The Court’s analysis leaves the interpretation of a MAC clause dependent on the nature of the buyer. For example, the MAC clause in a highly leveraged transaction (which is dependent on financing) is more likely to be judged on a short-term basis.
A well-drafted MAE clause should provide exceptions to a MAE to account for unavoidable circumstances such as changes to general industry conditions or natural disasters. The parties in the case discussed above had not included such exceptions and though the Court determined that in that specific case it was not necessary, subsequent Delaware decisions have since held that if the parties desire that such exceptions apply they must be written into the agreement and will not be assumed by the court.[xxxviii] The tense of the MAE is also important. The clause should be both immediate and prospective in nature. For example, a clause that outlines events that “have” a MAE would be more narrowly construed and include only those consequences that occur simultaneously with the happening of the MAE and have an immediate effect on the seller’s business, such as the destruction of the seller’s primary manufacturing plant. In contrast, a clause outlining events that are “reasonably likely to have” or “could” have a MAE involves a more sweeping definition and might include an event that is more difficult to measure, such as the loss of a major supplier or employee.[xxxix]
There is no definitive test for determining whether a MAE has occurred. The “materiality” of an event is normally a question of fact. Case law provides no definitive standard for evaluating the concept of materiality.[xl] The Tyson case, though very specific in its application, emphasizes the importance of the parties paying greater attention to the drafting of the MAE clause. Proper language and the tailoring of the MAE clause to the nature of the business involved are critical.
Delaware courts are unlikely to read a contract creatively to save a party from unfavorable wording.[xli] In a lawsuit filed by Monolithic System Technology Inc. against Synopsys, Inc., Monolithic sought to enforce the companies’ merger agreement that detailed the desire of Synopsys to acquire Monolithic for $432 million in cash and stock, or $13.50 a share. At issue in the lawsuit was an MAE clause that was drafted very favorably to Synopsys. The clause defined an MAE as one “that is or that reasonably could be expected to be or to become materially adverse” to Monolithic. If Synopsys determined that Monolithic had suffered an MAE, it could abandon the deal by paying a $10 million fee. Another condition relevant in the litigation required that there be no pending litigation that “if adversely determined, could reasonably be expected to have a company material adverse affect and that could materially and adversely affect the right of Synopsys or Monolithic to own the assets or operate the business of Monolithic.” This condition, which provided another path to Synopsys to abandon the deal on the basis of an MAE, gave Synopsys leverage in determining the potential severity of a lawsuit against Monolithic. As a result of such broad and favorable language to Synopsys, Synopsys was able to terminate the merger agreement due to a patent infringement suit brought against Monolithic by UniRAM Technology Inc. Three days into the trial challenging Synopsys termination of the merger agreement, Monolithic settled its suit against Synopsys and retained the $10 million termination fee previously paid by Synopsys. Monolithic’s decision to dismiss the litigation was viewed as its realization that Delaware courts are not inclined to read beyond the language of a contract.
The parties should realize, however, that deals are not generally easily terminated for technicalities or trivial reasons. A buyer should be aware that in transactions in which the buyer walks away from a deal on MAE grounds, the target company may seek legal remedies against the buyer on the grounds that a MAE did not occur. Though courts are generally reluctant to find a MAE, if drafted carefully a MAE clause can serve as a “backstop” protecting both parties from the occurrence of events that substantially threaten the success of a deal.
An issue not yet tested by the courts is whether the inability of a public seller to file requisite SOX financial certifications between the signing of an agreement and closing would be a legitimate reason for a buyer to withdraw from a transaction on MAE grounds. Some merger agreements now make such certifications a condition to closing.
Other conditions that are specific to the seller may relate to the performance of covenants which are aimed at preserving the status quo of its business between the signing and closing of the agreement. Often, the parties confirm these conditions by providing the other party with a closing certificate signed by one or more principal executive officers, certifying compliance.
3 Standards of compliance with conditions. Covenants may also include materiality qualifiers, requiring only that the condition be satisfied in all material respects. However, this will usually be inappropriate with respect to regulatory approvals.
4 Effect of failure of certain conditions. The failure to satisfy a condition will generally provide the non-breaching party with the option to terminate. However, the agreement may also permit the non-breaching party to seek damages for breach of the covenant not performed.
5 Under certain circumstances (e.g. where a buyer ends a deal on MAC grounds) the non-terminating party may seek legal remedies against the terminating party for terminating the deal. Another potential consequence that a buyer terminating a deal must consider is that the target company’s shareholders may commence an action against the buyer. Shareholders may seek to enforce the acquisition agreement, to recover damages based upon a theory of diminution in value of the target company’s stock, or may make securities fraud claims alleging that the buyer failed to disclose that it was aware of material adverse information about the target at some point prior to its termination of the agreement or that buyer misrepresented its intention to close the transaction to the detriment of the target’s shareholders.[xlii] A review of case law in this area indicates that, absent exceptional circumstances, the Courts will generally deny shareholders claims based on a lack of standing to sue or in the case of securities fraud claims, on the grounds that the buyer does not owe a duty to disclose information about the target to the target’s shareholders.[xliii] The Courts, generally stress the importance of drafting a merger or acquisition agreement with precise language to make clear the intent of the parties. Most merger agreements contain explicit language providing that neither the agreement nor the transaction itself is intended to confer any rights or remedies on anyone who is not a “party” to the agreement. Current case law suggests that a court will deny shareholders the ability to sue the buyer directly where the agreement includes such language and, if other documents accompany the agreement, the agreement includes an integration clause, and nothing in the agreement suggests an intent to grant such rights to a third party.[xliv] Despite the failure of the majority of such claims, their increasing frequency suggests that the buyer should be aware from the inception of a deal through post-closing of the risk of shareholder lawsuits not only in the drafting of the purchase agreement but in its internal statements and public disclosures, including e-mails, concerning the transaction.
6 Examples of specific conditions. Examples of specific conditions include the following:
1 that the representations and warranties are true at the closing and all of the pre-closing agreements of the parties have been performed;
2 that all necessary approvals from regulatory authorities have been obtained;
3 receipt of tax rulings;
4 delivery of certain financial statements; and
5 delivery of legal opinions (discussed more fully below).
7 Legal opinions. The scope of legal opinions are typically the subject of much negotiation.
1 Purpose. The main purpose of a legal opinion is to force opposing counsel to perform the due diligence required to ensure that the transaction is handled properly. It is not a vehicle for making the opinion giver a guarantor of his client’s representations.
2 Who can rely on the opinion. The opinion giver will explicitly specify who is entitled to rely on the opinion. Typically, the opinion giver limits such reliance to only the opposing party. However, in certain instances the buyer’s financing sources will also be entitled to rely on the opinion.
3 Opinion giver. The opinion can be given by either inside or outside counsel. In most instances, the recipient of the opinion will prefer to receive an opinion from outside counsel as an independent party and a deeper pocket.
4 Contents of opinion. The contents of a legal opinion are usually negotiated as part of the operative document. In most cases, the opinion will be limited to providing the opposing party with comfort that the objectives of the transaction have been accomplished. Typical portions of the opinion include the following:
1 Incorporation and good standing. A basic component of most legal opinions is an opinion as to the due incorporation and valid existence of the opinion giver’s corporate client. As a safeguard, the opinion giver should obtain and explicitly rely upon one or more certificates from state authorities attesting that the corporation is an existing corporation, in good standing and that all franchise tax returns have been filed to date.
2 Qualification. Opinion givers may be reluctant to opine that their corporate client and all of its subsidiaries are qualified to do business in every state in which such qualification is necessary, because businesses are often not in full compliance with these provisions. A frequent compromise is a simple recitation of the states in which qualification has been effected.
3 Enforceable in accordance with its terms. Unless the only obligation under the agreement is a cash payment, many opinion givers are unwilling to give an unqualified opinion that such agreement is “enforceable in accordance with its terms” because of the uncertainty surrounding the meaning of the phrase. However, as a compromise, the opinion giver will make this opinion subject to creditors’ rights and equitable principles. Care should be taken that the governing law clause of each of the operative agreements provides for the law of a state in which the opinion giver is qualified to opine.
4 Consents. The opinion giver will also be asked to give the opinion that no consents are required in order to consummate the transaction or that the required consents have been obtained.
5 Transaction specific matters. It is typical for the opinion giver to opine that the transaction contemplated by the acquisition agreement will not result in any violation of law known to be applicable to their client or breach the certificate of incorporation or by-laws or any material agreement to which their client is a party.
6 Factual matters. The party receiving the opinion will often ask the opinion giver to opine as to factual matters such as the existence of any breach of current agreements or the existence of any pending litigations. Most firms resist giving opinions involving such factual matters. For example, in order to opine as to the absence of breaches of existing agreements, the opinion giver would have to rely almost entirely on his client’s representation that no breaches exist. Some firms will agree to provide such opinion to the best of their knowledge. In such cases, they will typically limit the scope of their opinion to specified agreements and will exclude compliance with financial covenants. An opinion as to the absence of pending legal claims should specify, if true, that no search of court dockets was made. Otherwise, even if such opinion is qualified as being given to the best of the opinion giver’s knowledge, an assumption can be drawn that a docket search was made.
7 Multiple jurisdictions. In certain instances, opinions will be required as to matters which involve the laws of a number of different jurisdictions. Often, the principal counsel for the parties will not be an expert in the laws of each of these jurisdictions. This issue can be dealt with in various ways. The opinion giver can assume that the laws of each jurisdiction, other than the jurisdiction in which he is an expert, are identical to the laws of such counsel’s jurisdiction or limit the scope of the opinion to the text of a particular statute, such as the corporate law of such state. In the alternative, the parties may retain local counsel in each jurisdiction for the purpose of giving an opinion. When making this decision, the parties weigh the sensitivity or importance of the issue requiring local counsel and the cost of retaining such counsel. Local counsel’s opinion may be rendered directly to the opposing party or to the principal opinion giver, who in turn relies on such opinion in rendering its own opinion to the opposing party. Choosing the latter alternative ensures that the principal opinion giver is confident with the choice of local counsel.
8 No Litigation Opinions. The current climate requires that opinions be considered more than just a closing document. Opinions giving comfort regarding litigation typically disclaim that any independent inquiry has been conducted. When a lawyer discovers potentially adverse information, however, he or she is faced with the decision as to whether to rely on the source of that information or conduct an independent inquiry into the facts. A recent decision found that in providing a no-litigation opinion, the transactional lawyer has a duty to perform customary diligence and conduct a further inquiry into the facts, rather than simply rely on conclusions of others. The conclusion was reached in spite of the inclusion in the opinion of a disclaimer regarding any independent investigation having been conducted.[xlv]
INDEMNIFICATION
1 General. The indemnification provisions are the principal mechanism in the purchase agreement for monetary risk shifting among the parties. The most common effect of the indemnification provisions is to provide the buyer with a remedy for any losses or expenses suffered in the event that the seller breaches the agreement or any of the representations or warranties. The indemnification may come in the form of a direct claim by the buyer against the seller for damages, or as a demand by the buyer to be indemnified from a third party claim regarding a matter for which the seller has assumed the risk.
1 Who should be the indemnitors? One of the most hotly debated issues in an acquisition agreement, regardless of the form of the transaction, is whether the shareholders of the acquired company will be required to stand behind the seller’s indemnification provisions. In the case of a sale of stock, if the shareholders do not agree to provide indemnification, there is no party available to provide the indemnity. If the seller is publicly held, its shareholders can provide indemnity in the form of a hold back from the consideration paid by the buyer or some form of deferred or contingent consideration. Alternatively, if there are one or more principal shareholders of a publicly held company who are intimately familiar with the seller’s business, they may be willing to provide indemnity, at least to a limited extent. The seller’s shareholders often argue that the buyer has ample opportunity to perform a complete investigation of the seller’s business through due diligence prior to the signing of the agreement. They also argue that they no longer wish to be subject to any potential liability relating to the business after the closing. That, in essence, is why they are selling the business. (The second argument is especially relevant to shareholders who are individuals). The buyer typically argues that the due diligence process never uncovers all liabilities and that they are unwilling to assume all of the risks in the transaction. If the seller is an individual and the buyer is relatively comfortable with the potential risks, the buyer may compromise by not seeking the shareholders’ indemnity in return for a reduction in the purchase price. However, if the seller has a parent company, the buyer will typically insist on indemnification by the parent entity.
2 Scope of the indemnity.
1 Substantive elements. The general indemnification provision will ensure that the buyer is made whole for breaches of the seller’s representations and warranties or covenants. Typical examples include misrepresentations as to the value of inventory, and the absence of undisclosed liabilities of the seller. The parties may also agree that the seller will continue to be liable with respect to certain specific liabilities, which will be stated separately from the general indemnification provision. For example, the seller may agree to remain liable for liability under specified on-going litigation.
2 Fees and expenses. The indemnified party will be entitled to indemnification for fees and expenses incurred in the process of enforcing its indemnification claims. Such fees and expenses include attorneys fees, accountants fees and fees of experts. Expenses that are not recoverable by the buyer include consequential damages (unless the indemnification provision explicitly allows such recovery).
3 Third party claims. The indemnification provisions will also cover post-closing claims by third parties against the buyer. Examples of these include products liability litigation based on products sold by the seller prior to the closing, claims for unpaid taxes and environmental liabilities. The agreement will typically enable the indemnifying party to control the defense of the claim and require the indemnified party to cooperate in the defense of the claim (with appropriate reimbursement). In addition, the indemnifying party will be prohibited from settling a claim without the indemnified party’s consent, unless the latter is released in full.
3 Who may be indemnified? The indemnification provision typically covers the buyer, the seller and their respective directors, officers, employees, shareholders, affiliates and funding sources or other assignees.
4 The amount of indemnification. The amount of indemnification is usually left for negotiation at the time the breach is discovered or ultimately to the courts. However, the parties are also free to agree in advance on liquidated damages in order to define the amount of indemnification. This is useful where the determination of damages is ambiguous. However, if the amount agreed upon is too high and is in effect a penalty, courts may not enforce such a provision.
2 Limitations on indemnification.
1 The “basket”. The seller will want to include a provision setting a minimum loss requirement beneath which the buyer will not be entitled to indemnification. Minimum loss provisions may take the form of a threshold or a deductible.
1 Threshold. If a threshold is built into the indemnity, the buyer will be entitled to indemnification only if the damages exceed a specified amount, e.g., if the damages exceed 5% of the purchase price. Once the damages exceed this amount, the buyer recovers from the first dollar of the loss.
2 Deductible. If a deductible is built into the indemnity, the buyer will only be indemnified for losses that exceed the agreed specified minimum amount. The buyer therefore bears the loss up to that minimum amount.
3 Specific concerns.
1 If the representations and warranties include materiality exceptions, the inclusion of a basket in the indemnity section can result in having an overprotected seller (see Section IIE2 “Double materiality” above).
2 Buyers may seek to side-step the basket by suing directly under the representations and warranties. To avoid this, seller should include a provision which provides that the sole remedy for breach of representations is through a claim for indemnification.
2 Survival. Sellers generally impose time limitations on the survival period of representations and warranties, and indemnification rights. This refers to the period during which a claim for indemnification must be asserted. The survival period should be long enough to allow discovery of inherent problems in the acquired business. A typical survival period is about two years, however, certain representations are typically held open for longer. At a minimum, the buyer should seek survival until the first audited financial statements following the closing are available. Representations concerning taxes, ERISA and environmental compliance often extend until the expiration of the applicable statute of limitations. Representations on issues which go to the essence of the transaction such as capitalization, corporate organization and authority to enter into the transaction are often perpetual. If the agreement simply provides for the survival of representations and warranties, and indemnification rights, without any time limitation, the survival will be equal to the appropriate statute of limitations within which to bring any actions under the acquisition agreement.
3 Caps on amount of indemnification. Sellers may try to limit their liability by including a specified amount beyond which the buyer will not be entitled to indemnification. This may apply only with respect to the seller’s shareholders and may be agreed to in the context of negotiating whether the selling shareholder will stand behind the indemnity.
4 Defense of actual knowledge of buyer before the closing. Seller may seek to include a provision prohibiting the buyer from recovering for the breach of a representation if the buyer had actual knowledge of such breach on or before the closing of the misrepresentation. This provision can make it more difficult for the buyer to obtain indemnification by imposing a burden on it to prove that it was not aware of such breach prior to the closing. Often the buyer will insist that the agreement affirmatively state that the indemnification provision will apply regardless of any investigations conducted on behalf of the buyer.
3 Arbitration clauses. A clause requiring arbitration can facilitate a speedy and inexpensive resolution of indemnification claims. Such clause should specify the method of selecting the arbitrator or arbitrators and the rules and jurisdiction for arbitrating. However, arbitration does have certain disadvantages. Often, the arbitrators are not lawyers and may have difficulty resolving complex legal issues. In addition, the discovery process in arbitration is limited. For the party who is likely to have to provide indemnification rather than receive it, litigation provides greater opportunities for delay which in turn benefits the payor. Another typical complaint about arbitration is that arbitrators tend to push the parties to compromise and settle on a middle ground. A party wishing to be completely exonerated or to be awarded the entire amount sought may be disappointed with the result.
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[i] Franci J. Blassberg, Special Problems in Acquisitions of Divisions and Subsidiaries, Bank and Corporate Governance Law Reporter, Volume 27, Number 2, October 2001.
[ii] Cede & Co. v. Technicolor, Inc., 684 A.2d 289, 298-99 (Del. 1996) (in appraising the value of Technicolor shares, the buyer’s new business plans and strategies that had been developed, adopted and implemented between the date of the merger agreement and the date of the merger are to be included in the valuation calculus). Followed by M.G. Bancorporation, Inc. v. Le Beau, 737 A.2d. 513, 525 (Del. 1999) (“the corporation must be valued as a going concern based upon the ‘operative reality’ of the company as of the time of the merger”).
[iii] Pub. L. No. 107-204, 116 Stat. 745 (2002).
[iv] See Rules 13a-14 and 15d-14 adopted by the SEC on August 29, 2002 under the Securities Exchange Act of 1934.
[v] See Exchange Act Release Nos. 33-8238, 34-47986, 68 Fed. Reg. 36636-01 (June 18, 2003) (the Adopting Release). See Exchange Act Release Nos. 33-8392, 34-49313, 69 Fed. Reg. 9722-01 (March 1, 2004). See sec. 404 of Pub. L. No. 107-204, 116 Stat. 745 (2002).
[vi] The SEC published a final rule extending the deadline for non-accelerated filers in compliance with Rule 404 disclosure requirements commencing with reports for its fiscal year ending on or after December 15, 2007. See Exchange Act Release No. 33-8760 (December 15, 2006).
[vii] Id.
[viii] See U.S. Securities and Exchange Commission, Management’s Report on Internal Control Over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports Frequently Asked Questions (revised October 6, 2004), available at .
[ix] Id.
[x] 18 U.S.C. § 1348 (2003), which was added by SOX, provides that any officer who makes the Section 906 certification knowing that the periodic report accompanying the statement does not meet the requirements of Section 906 is subject to a fine of up to $1,000,000 and up to 10 years imprisonment. If an officer’s false certification is “willful” the officer is subject to a fine of up to $5,000,000 and up to 20 years imprisonment. See also Todd M. Roberts, Sarbanes-Oxley and Target Financials: How Will New Requirements Affect Public Companies’ Acquisition of Private Entities?, 228 N.Y.L. J. 9 Nov. 12, 2002.
[xi] It should be noted that certain items, such as the seller’s balance sheet, will change during the interim period to reflect the continued operation of the business. These kinds of changes may be accounted for by a post-closing adjustment to the purchase price.
[xii] In re Netsmart Technologies, Inc. Shareholders Litigation, 924 A.2d 171 (Del. Ch. 2007).
[xiii] Del. General Corp. L. § 146(c).
[xiv] See Note 29.
[xv] Paramount Communications v. QVC Network, Inc., 637 A.2d 34, 43 (Del. 1994) (citations omitted); Matador Capital Management Corp. v. BRC Holdings, Inc., 729 A.2d 280 (Del. Ch. 1998); Kalnit v. Eichler, 99 F.Supp.2d 327 (S.D.N.Y. March 24, 2000).
[xvi] QVC, 637 A.2d at 49.
[xvii] Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173, 183 (Del. 1986). See generally, Arnold v. Soc’y. For Sav. Bancorp. Inc., 650 A.2d 1270 (Del. 1994); Cirrus Holding Co. Ltd. v. Cruise Industries, Inc., 794 A.2d 1191 (Del. Ch. 2001); McGowan v. Ferro, 859 A.2d 1012 (Del. Ch. 2004); In re MONY Group Inc. S’holder Litig., 853 A.2d 661 (Del.Ch. 2004).
[xviii] Id.
[xix] Cottle v. Storer Communication, Inc., 849 F.2d 570, 578 (11th Cir. 1988); Samjens Partners I v. Burlington Indus., Inc., 663 F. Supp. 614 (S.D.N.Y. 1987) (break up fee calculated as 2% of value of company not so onerous to exclude other bidders); Tsg Water Res., Inc. v. D’Alba & Donovan Certified Public Accountants, P.C., 366 F. Supp. 2d 1212 (11th Cir. 2004); In re Toys “R” Us, Inc. Shareholder Litigation, 877 A.2d 975 (Del. Ch. 2005).
[xx] Id.
[xxi] See Revlon, 506 A.2d at 184; QVC, 637 A.2d at 49.
[xxii] Richard S. Klein, Richard De Rose and Marc Asbra, Houlihan Lokey Howard & Zukin 2005 Transaction Termination Fee Study, Houlihan Lokey Howard & Zukin, Oct. 2005, at 4. The 2006 study has not yet been published by Houlihan Lokey. The comparable figures for 2004 for termination fees as a percentage of the transaction value were as follows: High (6.6%); Low (0.7%); Mean (3.2%), Median (3.3%). See Richard S. Klein, Joseph W. Cleverdon, Michael J. Huddleston and Steven B. Nielsen, Houlihan Lokey Howard & Zukin 2004 Transaction Termination Fee Study, Houlihan Lokey Howard & Zukin, Oct. 2004, at 2.
[xxiii] Saul Hansell, Wells Fargo Wins Battle for First Interstate, N. Y. Times, Jan. 25, 1996, at D1.
[xxiv] Cleary, Gottlieb On Options and Breakup Fees, Corporate Control Alert, Jan./Feb. 1996, at 11-12.
[xxv] Wells Fargo & Co. v. First Interstate Bancorp, No. 14623, 1996 Del. Ch. LEXIS 3, at *18-19 (Del. Ch. Jan. 18, 1996); Wells Fargo Lassos First Interstate, Corporate Control Alert, Jan./Feb. 1996, at 7.
[xxvi] Brazen v. Bell Atlantic Corp., 695 A.2d 43 (Del. 1997); Jonathan T. Wachtel, Breaking up is Hard to Do: A Look at Brazen v. Bell Atlantic and the Controversy over Termination Fees in Mergers and Acquisitions, 65 Brook. L. Rev. 585 (1999).
[xxvii] Omnicare, Inc. v. NCS Healthcare Inc., 818 A.2d 914, 939 (Del. 2003).
[xxviii] Id. at 932.
[xxix] Id. at 931.
[xxx] Id.
[xxxi] Id. at 934.
[xxxii] In re Toys “R” Us, Inc. Shareholder Litigation, 877 A.2d 975 (Del. Ch. 2005); see David Marcus, Toying with Auctions in Wilmington, Corporate Control Alert, July, 2005 at 12; see Orman v. Cullman, 2004 Del. Ch. LEXIS 150 (Del. Ch. Oct. 20, 2004).
[xxxiii] IBP, Inc. v. Tyson Foods, Inc., 789 A.2d 14 (Del. Ch. 2001).
[xxxiv] The Court suggested, in dicta, that its conclusion would not have been different under Delaware law. See Tyson, 789 A.2d 14.
[xxxv] Tyson, 789 A.2d at 21.
[xxxvi] In drafting schedules the purchaser should specifically indicate that the schedules qualify all representations and warranties.
[xxxvii] See Tyson, 789 A.2d at 67.
[xxxviii] See Great Lakes Chem Corp. v. Pharmacia Corp., 788 A.2d 544, 557 (Del. Ch. 2001). Followed by H-M Wexford LLC v. Encorp, Inc., 832 A.2d 129, 142 (Del. Ch. 2003) (“sophisticated parties to negotiated commercial contracts may not reasonably rely on information that they contractually agreed did not form a part of the basis for their decision to contract”).
[xxxix] See Arthur Fleischer, Jr., Contract Interpretation in Acquisition Agreements: The Content of Material Adverse Change, Insights, September 2001, at 4.
[xl] See generally Pan Am Corp. v. Delta Airlines, Inc., 175 B.R.438, 493 (S.D.N.Y. 1994); Rudman v. Cowles Communications, Inc., 35 A.D.2d 213, 217, 315 N.Y.S.2d 409, 413 (1970), modified, 30 N.Y.2d 1, 330 N.Y.S.2d 33 (1972); and Allegheny Energy v. DQE, Inc., 74 F. Supp. 2d 482, 518 (W.D. Pa. 1999), aff’d, 216 F.3d 1075 (3d Cir. 2000).
[xli] Synopsys Wins in a Walkover, Corporate Control Alert, Aug./Sept. 2004, at 14-16.
[xlii] See generally Gulf Oil/Cities Serv. Tender Offer Litig., 725 F. Supp. 712 (S.D.N.Y. 1989) (denying the shareholders claims based on a lack of standing to sue as a third-party beneficiary); Gordon v. Diagnostek, Inc., 812 F. Supp. 57 (E.D. Pa. 1993) (dismissing target shareholders’ securities fraud claims against the buyer and holding that the buyer did not owe the shareholders a duty to disclose information about the target, noting that under Rule 10b-5, “silence, absent a duty to disclose is not misleading”).
[xliii] In contrast Courts have been more receptive to shareholders’ claims that allege misrepresentations concerning the buyer itself or the buyer’s intentions toward a merger or acquisition. See e.g., Semerenko v. Cendant Corp., 223 F.3d 165 (3d Cir. 2000), In re MCI Worldcom, Inc. Secs. Litig., 93 F. Supp. 2d 276 (E.D.N.Y. 2000).
[xliv] See Gulf Oil/Cities, 725 F. Supp. at 733 (in denying the shareholders standing to sue, the court noted that the merger agreement, to which the shareholders were not parties, provided that “[t]his agreement (including the Annex, documents and instruments referred to herein) (i) constitutes the entire agreement . . . among the parties . . . [and] (ii) is not intended to confer upon any other person any rights or remedies”).
[xlv] Dean Foods v. Pappathanasi, 18 Mass. L. Rep. 598 (Mass. Super. 2004); see Donald W. Glazer & Arthur Norman Field, No-Litigation Opinions Can Be Risky Business, Bus. Law Today, July/Aug. 2005, at 37.
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