Warning: CPSC Civil Penalties on the Rise

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FALL 2016

IN THIS EDITION

l Government and Regulatory Warning: CPSC Civil Penalties on the Rise l Corporate Not Just Earnouts: Creative Ways for Private Equity Sponsors

to Bridge Valuation Gaps l Energy and Regulatory Equity Investors Beware: FERC is Reconsidering

Whether to Permit Income Tax Allowance ("ITA") For Pipelines Owned by Partnerships, LLCs or other Tax PassThrough Entities l Government Investigations, Compliance and Enforcement Regulatory Considerations: Whistleblower Protection Rule Compliance Enforcement Forges Ahead

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FOR MORE INFORMATION Private Equity Troutman Sanders LLP

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Warning: CPSC Civil Penalties on the Rise

By Eric Unis

The United States is the world's largest market for consumer goods and many analysts thus see consumer goods manufacturers and distributors as an attractive sector for private equity investment. However, manufacturers and importers of consumer products sold in the United States must be aware that there is a reinvigorated and increasingly powerful safety regulator watching them. A busy 2016 for the United States Consumer Product Safety Commission (the ``CPSC'') shows that, more than ever, businesses must be ready to act when there are safety concerns with their products. The consequences of a failure to do so could include paying millions of dollars in civil penalties.

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Not Just Earnouts: Creative Ways for Private Equity Sponsors to Bridge Valuation Gaps

By John McDonald, Michael Weinsier and Paul Steffens

As the competition for quality acquisition targets continues to be fierce, private equity sponsors are increasingly confronting gaps between the valuations at which they are willing to acquire companies and sellers' valuation expectations. These valuation gaps are causing private equity sponsors to be uncompetitive in auction settings and are preventing them from being able to persuade owners to sell in proprietary dealflow situations. Sophisticated M&A market participants know that earnouts are often used by buyers and sellers to address valuation gaps. However, there are several other ways to address valuation gaps that may be less wellknown, but can be quite effective. This article discusses some common sources of valuation gaps and creative ways that private equity sponsors can bridge them and get their acquisitions closed.

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ABOUT THE PRIVATE EQUITY QUARTERLY This newsletter features content on developments in the private equity space, including industryspecific news. The Private Equity Quarterly is edited by Harris Winsberg and Kiran Mehta.

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Equity Investors Beware: FERC is Reconsidering Whether to Permit Income Tax Allowance ("ITA") For Pipelines Owned by Partnerships, LLCs or other Tax PassThrough Entities

By Kurt Jacobs

The D.C. Circuit has remanded to the Federal Energy Regulatory Commission ("FERC") for further consideration the issue of whether FERC should continue to allow partnerships, LLCs and other tax passthrough entities that own and operate FERCjurisdictional facilities such as interstate oil, petroleum product and natural gas pipelines to collect in their rates as an "expense" the federal income tax that is paid on the profits made by such entities by their partners or members. Presently, the tax passthrough entity may recover through its rates the amount of such tax attributed to and paid by a partner or other member. The D.C. Circuit has suggested that this existing practice "may" result in a double recovery of taxes by the entity or its members. Were FERC, on remand, to change its policy and no longer permit partnerships and other tax passthrough entities to include an income tax allowance in their rates, this would have a substantial downward impact on rates, and therefore on the cash flow, revenues, profits and distributions of this large and growing class of non corporation FERCregulated companies.

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Regulatory Considerations: Whistleblower Protection Rule Compliance Enforcement Forges Ahead

By Sharie Brown

Since receiving the election results of November 8, 2016, many experts, commentators and U.S. public officials have expressed the view that the U.S. Congress is likely to repeal or substantially amend the DoddFrank Wall Street Reform and Consumer Protection Act ("the DoddFrank Act"). However, such legislative or regulatory action may not come soon enough for registered investment advisers and registered brokerdealers who are being examined for compliance with Rule 21F17 of the Dodd Frank whistleblower regulations enforced by the U.S. Securities and Exchange Commission ("SEC" or "Commission").1 A recent Risk Alert from the SEC's Office of Compliance Inspections and Examinations ("OCIE"), dated October 24, 2016, entitled, "Examining Whistleblower Rule Compliance" ("Risk Alert"), warned that the SEC Staff will review compliance manuals, codes of ethics, employment agreements, and severance agreements to determine if they contain provisions that unlawfully restrict employees and individuals from communicating with the SEC about securities laws offenses.

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? TROUTMAN SANDERS LLP. ADVERTISING MATERIAL. These materials are to inform you of developments that may affect your business and are not to be considered legal advice, nor do they create a lawyerclient relationship. Information on previous case results does not guarantee a similar future result.

MANAGE SUBSCRIBER PREFERENCES HERE.

FALL 2016

GOVERNMENT AND REGULATORY

Warning: CPSC Civil Penalties on the Rise

By Eric Unis

The United States is the world's largest market for consumer goods and many analysts thus see consumer goods manufacturers and distributors as an attractive sector for private equity investment. However, manufacturers and importers of consumer products sold in the United States must be aware that there is a reinvigorated and increasingly powerful safety regulator watching them. A busy 2016 for the United States Consumer Product Safety Commission (the ``CPSC'') shows that, more than ever, businesses must be ready to act when there are safety concerns with their products. The consequences of a failure to do so could include paying millions of dollars in civil penalties.

ABOUT THE PRIVATE EQUITY QUARTERLY

This newsletter features content on developments in the private equity space, including industryspecific news.

The Private Equity Quarterly is edited by Harris Winsberg and Kiran Mehta.

FOR MORE INFORMATION

Private Equity

Troutman Sanders LLP

The CPSC

AUTHORS

The Consumer Product Safety Act established the CPSC in 1972. The CPSC is an independent federal agency with the stated mission to protect the public from unreasonable risks of injury associated with consumer products. The CPSC has jurisdiction over almost anything a consumer can buy ? everything from apparel, to appliances, to electronics, to sporting goods, to toys.1 Despite the CPSC's broad jurisdiction, for much of its history the CPSC has been characterized as understaffed, underfunded, and sometimes less than vigilant in its enforcement activity. Recent events, especially many multimillion dollar settlements, are proving that reputation to be a thing of the past.

One core function of the CPSC is its development and enforcement of safety

standards and rules for consumer products. For example, the CPSC enforces

a ban on lead in surface coatings on children's products, flammability

standards for garments, and very particularized standards for certain products such as bicycles and infant cribs. The CPSC's core functions also include seeing that businesses report potential safety hazards to the agency and administering product recalls. In large part, the CPSC relies on a system of

Eric Unis 212.704.64482 Email

obligatory selfreporting and all companies must be mindful of their reporting

obligations. If a business becomes aware that a product it manufactures,

imports, distributes, or sells does not comply with a CPSC product safety

standard or otherwise contains a defect which could create a substantial

product hazard or an unreasonable risk of serious injury or death, it

must immediately report that information to the CPSC. Therefore, it is essential

that all businesses have adequate systems in place to monitor reports of safety

incidents involving their products. There is no precise formula for determining

when the reporting obligation is triggered but various factors must be carefully

assessed on a casebycase basis, including the number of safety incidents

and the severity of any potential injuries. If a product recall is necessary, the

CPSC will typically work with businesses to administer the recall and ensure

that as many affected products as possible are returned or repaired. If a

company fails to meet its reporting obligation, the company will be subject to

civil penalties.

The CPSIA of 2008

The Consumer Product Safety Improvement Act of 2008 ("CPSIA") was a major turning point for the CPSC. Passed after a slew of recalls involving lead containing toys imported from China, the CPSIA led to many new regulations, including, most notably, a requirement that manufacturers and importers certify that children's products are in compliance with CPSC standards based on thirdparty testing. Other new features of the CPSIA included new regulations concerning limits on phthalates in infant products and product registration for durable infant or toddler products. But also, very significantly to all consumer

products companies, the CPSIA increased the maximum civil penalty available under the Consumer Product Safety Act, more than eightfold, from $1.825 million to $15.45 million.

The CPSC in 2016

There has been a dramatic increase in the number of businesses paying civil penalties for failing to report safety hazards. Civil penalties in the seven figures are now becoming commonplace when they were once a rarity. Below are some significant CPSC settlements from 2016.

Gree Electric. In March, the CPSC announced that Gree Electric agreed to pay a record $15.45 million civil penalty, the first time that the CPSC obtained the maximum civil penalty authorized under the CPSIA. What caused Gree to earn this dubious honor? Gree manufactured, imported, and sold more than 2.5 million dehumidifiers under various brand names which were recalled in 2013 due to a defect that caused them to overheat and catch fire. The CPSC alleged that Gree did not make a timely report of the defect, but also that Gree sold dehumidifiers bearing the UL safety certification mark despite knowledge that the products did not meet UL flammability standards.

It is also noteworthy that the CPSC obtained this record shattering settlement in a case where Gree voluntarily reported the defect to the CPSC, albeit late, and without any reports of injury, only reports of property damage. Although the larger CPSC settlements previously tended to be in cases where injuries actually occurred, the potential for injury may trigger defect reporting obligations and the Gree case shows that a harsh penalty may be imposed even without a single injury. While this case was the first time the CPSC has obtained the $15.45 million maximum civil penalty, it almost certainly won't be the last. In fact, the CPSC has signaled that settlements at or near that amount could be announced in the near future.

Sunbeam. In June, the CPSC entered into a $4.5 million settlement with Sunbeam Products, Inc. Sunbeam imported and sold about 520,000 Mr. Coffee Single Cup Brewing systems in 2011 and 2012. The CPSC alleged that, during that time, Sunbeam received "numerous" reports of the products' chamber opening and expelling hot water and hot coffee grounds towards consumers, including at least 32 reports of consumers being burned, before Sunbeam belatedly reported.

Teavana. Also in June, the CPSC entered into a $3.75 million settlement with Teavana Corp. The CPSC alleged that Teavana received "numerous" reports of its tea tumblers exploding, shattering, or breaking between 2010 and 2013, including six reports of consumers being cut by broken glass or burned by hot liquid, before Teavana reported.

Goodman Co. In September, the CPSC entered into a $5.55 million settlement with Goodman Co., a manufacturer of air conditioners and heaters sold under various brand names. Goodman received numerous reports of its units catching fire, smoking, and overheating, including three reports of hotel fires. After several years, Goodman reported the issue to the CPSC, but allegedly minimized the true extent of the hazard in both its initial report and by failing to notify the CPSC of fires potentially caused by defective units that occurred after the initial report.

A common feature of the recent CPSC settlements is a requirement that the company implement a compliance program for reporting product safety issues to the CPSC. Compliance programs are, of course, a good idea for any company in the consumer products business that wants to avoid becoming the next cautionary tale.

1 The key exceptions are FDA jurisdiction over food, drugs, and cosmetics, and NHTSA jurisdiction over automobiles and automobile parts.

? TROUTMAN SANDERS LLP. ADVERTISING MATERIAL. These materials are to inform you of developments that may affect your business and are not to be considered legal advice, nor do they create a lawyerclient relationship. Information on previous case results does not guarantee a similar future result.

MANAGE SUBSCRIBER PREFERENCES HERE.

FALL 2016

CORPORATE

Not Just Earnouts: Creative Ways for Private Equity Sponsors to Bridge Valuation Gaps

By John McDonald, Michael Weinsier and Paul Steffens

As the competition for quality acquisition targets continues to be fierce, private equity sponsors are increasingly confronting gaps between the valuations at which they are willing to acquire companies and sellers' valuation expectations. These valuation gaps are causing private equity sponsors to be uncompetitive in auction settings and are preventing them from being able to persuade owners to sell in proprietary dealflow situations. Sophisticated M&A market participants know that earnouts are often used by buyers and sellers to address valuation gaps. However, there are several other ways to address valuation gaps that may be less wellknown, but can be quite effective. This article discusses some common sources of valuation gaps and creative ways that private equity sponsors can bridge them and get their acquisitions closed.

ABOUT THE PRIVATE EQUITY QUARTERLY

This newsletter features content on developments in the private equity space, including industryspecific news.

The Private Equity Quarterly is edited by Harris Winsberg and Kiran Mehta.

FOR MORE INFORMATION

Private Equity

Troutman Sanders LLP

AUTHORS

Sources of Valuation Gaps.

Valuations gaps have many sources, but some of the most often encountered include:

l Comparing NonComparable Companies. Sellers sometimes read media

accounts or hear from other business owners about high EBITDA or other

multiples achieved in deals involving other companies that they think are

comparable to their own companies and apply those multiples to their own

companies. However, although superficially similar, the sellers may not

appreciate that there may be meaningful differences between those other

companies and their own, which make those multiples unlikely to be

achieved in their sale transaction. The other company may be in a higher growth segment of the industry, resulting in a growth trajectory that justifies a higher multiple, or have a more diverse customer base, a more attractive mix of products, better margins or stronger defenses to competition. It may have

John McDonald 212.704.6234 Email

systems that will scale more easily upon expansion of the business, which

make it attractive to buyers looking for a platform to make future

acquisitions. It may be a substantially larger company (e.g., large cap vs.

middle market) and/or one whose stock is publiclytraded, but the seller may

not realize that larger publiclytraded companies often garner meaningfully

higher multiples than smaller, privatelyheld companies, even within the

same industry.

l Competition from Strategic Buyers. The dearth of quality middlemarket companies and strong competition from strategic buyers has driven up valuations for some companies beyond what some more disciplined private equity sponsors believe they can pay while still achieving their LP investors' return expectations upon exit. Those sponsors know that, particularly for moderate growth companies, it is extremely difficult to outgrow a substantial overpayment in purchase price. Due to the sustained economic expansion over the last five years, many strategic buyers are sitting on substantial amounts of cash and have limited options for organic growth, which is pushing them to buy rather than build. Strategic buyers may have

Michael Weinsier 212.704.6194 Email

opportunities to realize synergies upon integration of the acquired company with their own businesses that are unavailable to financial buyers. They may view certain acquisition targets as a way to address key gaps in their product, service or geographical market offerings, enable them to get into new complementary businesses or otherwise have strategic imperatives beyond mere financial growth potential. Sellers see the high valuations being paid by strategic buyers and push private equity sponsors to increase their purchase prices.

l Tightening Debt Markets. Many of the deals against which sellers are benchmarking their own transactions were done in late 2014 and 2015, at the peak availability of lowcost, readilyavailable debt financing. Regulatory and other changes in the debt markets since then have meaningfully reduced leverage levels for private equitybacked acquisitions, causing a corresponding reduction in the prices that private equity sponsors can pay for companies. The effect has been more pronounced for large cap transactions, but has also affected middlemarket deals.

Paul Steffens 704.998.4054 Email

Creative Ways to Address Valuation Gaps.

Knowing that valuation gaps are inevitable in today's M&A marketplace, creative private equity sponsors can use the following methods to bridge them:

l BoltOn and TuckIn, Rather than Direct. Private equity sponsors can address their inability to compete headon with strategic buyers on valuation by focusing their efforts on bolton or tuckin acquisitions effected through their existing portfolio companies, rather than on direct acquisitions (i.e., new platform companies) by their funds. That is the case because, like strategic buyers, those portfolio companies can pay higher multiples, while still preserving sufficient future upside, through operational synergies with the portfolio company's business, consolidating redundant overhead and other costcutting efforts.

l Increased RollOver. Increasing the amount of equity that the acquired company's existing equityholders are required to "rollover" into the post acquisition capitalization ? say, 3040% rather than the more typical 1520%, can meaningfully reduce the size of the private equity sponsor's equity check. Increasing the amount of equity that is rolled over above 20% can have tax structuring implications however, increased rollover enhances alignment of interests between the sponsor and the acquired company equityholders, essentially requiring them to take ownership of the higher valuation of the company that they're advocating in the sale process, while creating an additional means of wealth creation for them upon exit if their projections underlying the higher valuation are actually realized.

l Seller Paper. Similarly, requiring sellers to effectively finance part of the purchase price through receipt of "seller paper" ? promissory notes from the acquired company to the sellers often having mezzanine debtlike terms such as a higher interest rate, subordination to the senior debt and sometimes warrants or other equity kickers ? reduces the size of the sponsor's equity investment and can help mitigate the impact of a higher valuation paid in the acquisition. In an investment world where the riskfree rate of return is effectively zero, seller paper can provide sellers with comparatively attractive interest rates, as compared to other investments, while giving them the ability to extend credit to a business that they know very well (albeit one that they will no longer control). Seller paper can also provide meaningful tax benefits to sellers by enabling them to push taxable income into future tax years, after the tax year in which the closing occurs, in which they may be in a lower tax bracket.

l Escrow For Specific ValuationImpacting Issues. In M&A transactions in which there are discrete issues that could meaningfully impact the valuation of the acquired company (e.g., a pending litigation or regulatory investigation), but the parties cannot agree on the magnitude of that impact, a portion of the purchase consideration can be put into a third party escrow fund until the issue is resolved and the issue's ultimate impact is determined.

l FlipTax/AntiEmbarrassment Provisions. Private equity sponsors can address seller concerns about "selling too cheaply" or otherwise "leaving money on the table" from a lower valuation through socalled "fliptax" or "antiembarrassment" provisions. In these provisions, the sponsor agrees to share with the sellers the upside realized by the sponsor, in excess of its cost basis in the acquired company, upon a subsequent sale of the acquired company within a relatively short period of time ? typically 12 years ? after

the original closing.

l Rep and Warranty Insurance and Other Escrow Reduction Methods. Sophisticated sellers know that it's not what you get, but what you get to keep that is most important in M&A transactions. Accordingly, sellers may be willing to accept a transaction at a lower valuation, but with a smaller percentage of the purchase consideration put into escrow to secure their postclosing indemnification obligations, because it can result in greater sale proceeds for them than one at a higher valuation, but with a substantial escrow. That is the case because sellers ? correctly or not ? may heavily discount the likelihood of ever actually receiving purchase consideration put into escrow. As a result, private equity sponsors that substantially reduce or eliminate their escrow amounts, either through "rep and warranty" insurance or by performing comprehensive due diligence upfront and assuming some additional risk, can sometimes win in competitive situations, despite assigning lower valuations to the acquired company than their competitors.

l NonFinancial Aspects. Although the valuation placed on the acquired company and the resulting amount of sale proceeds are, of course, very important to sellers, nonfinancial aspects of the transaction can be meaningful as well. Some sellers favor strategic buyers over private equity sponsors because of a perception that sponsors will dismantle their businesses, terminate their employees or otherwise damage their "legacies," despite the reality that it is strategics, rather than sponsors, that are more likely to take those types of actions in order to realize "synergies" in connection with the transaction. As a result, particularly for sellers that are longstanding pillars of their communities, commitments from the buyer to maintain the acquired company's facilities and operations in their present locations, to retain its key employees and to continue to use its corporate name for at least a specified period of time after closing can provide some additional consideration for sellers (particularly founders) to accept a lower valuation.

l Earnouts. Last but not least, valuation gaps can be addressed by conditioning the sellers' receipt of a portion of the purchase price upon the acquired company achieving specified financial targets (typically EBITDA, cashflow, net revenue or net income) or milestone events over a specified time period after the closing (typically 13 years). As a Delaware Chancery Court judge remarked, an earnout "often converts today's disagreement over price into tomorrow's litigation over outcome."1 As a result, great care needs to be used in defining the events that will result in earnout payments, including the accounting methodology used in calculating the financial metrics. Attaching an example earnout payment calculation as an exhibit to the purchase agreement can help minimize later disputes. Parties sometimes provide for dispute resolution mechanisms for earnout payment calculations involving independent accounting firms, similar to those used for postclosing net working capital adjustment disputes. Some key issues in earnout transactions include the buyer's obligation to support the acquired company during the earnout period, decisionmaking authority regarding operation of the business during the earnout period, whether operations must be conducted in the same manner as prior to closing, whether earnout payments accelerate upon a subsequent sale of the acquired company, and whether earnout payments are tied to key management team members staying with the acquired company during the earnout period (which can have adverse tax consequences for sellers). In addition to addressing valuation gaps, earnouts also act as a form of seller financing, in which the buyer effectively pays the purchase price to the sellers out of the profits of the acquired company. While they have their issues, earnouts can provide the most accurate calibration between the value of the acquired company and the price paid by the buyer and so can be an effective way for parties to bridge valuation gaps.

Conclusion.

In conclusion, as discussed above, there are many tools available to creative private equity sponsors to use to bridge valuation gaps and get their transactions closed. Please do not hesitate to contact the authors with any questions concerning the matters discussed in this article.

1 Airborne Health, Inc. v. Squid Soap, LP, 984 A.2d 126 (Del. Ch. 2009).

? TROUTMAN SANDERS LLP. ADVERTISING MATERIAL. These materials are to inform you of developments that may affect your business and are not to be considered legal advice, nor do they create a lawyerclient relationship. Information on previous case results does not guarantee a similar future result.

FALL 2016 ENERGY & REGULATORY

ABOUT THE PRIVATE EQUITY QUARTERLY

Equity Investors Beware: FERC is Reconsidering Whether to Permit Income Tax Allowance ("ITA") For Pipelines Owned by Partnerships, LLCs or other Tax PassThrough

This newsletter features content on developments in the private equity space, including industryspecific news.

The Private Equity Quarterly is edited by Harris Winsberg and Kiran Mehta.

Entities

FOR MORE INFORMATION

By Kurt Jacobs

Private Equity

The D.C. Circuit has remanded to the Federal Energy Regulatory Commission ("FERC") for further consideration the issue of whether FERC should continue to allow partnerships, LLCs and other tax passthrough entities that own and operate FERCjurisdictional facilities such as interstate oil, petroleum product and natural gas pipelines to collect in their rates as an "expense" the federal income tax that is paid on the profits made by such entities by their partners or members. Presently, the tax passthrough entity may recover through its rates the amount of such tax attributed to and paid by a partner or other member. The D.C. Circuit has suggested that this existing practice "may" result in a double recovery of taxes by the entity or its members. Were FERC, on remand, to change its policy and no longer permit partnerships and other tax passthrough entities to include an income tax allowance in their rates, this would have a substantial downward impact on rates, and therefore on the cash flow, revenues, profits and distributions of this large and growing class of non corporation FERCregulated companies.

Troutman Sanders LLP AUTHOR

On July 1, 2016, the D.C. Circuit in United Airlines, Inc. v. FERC, 827 F.3d 122 (2016), held that FERC had not "adequately justified" its current policy of granting to pipelines owned by partnerships ("partnership pipelines") an income tax allowance ("ITA") ? that is, granting partnership pipelines the authority to recover from their ratepayers/transportation customers as a "cost" the income taxes paid by partnerinvestors on their distributive shares of partnership income. Although the D.C. Circuit had considered and upheld in 2007 FERC's policy of permitting such recovery, the Court held in United Airlines that the discounted cash flow methodology that FERC uses to establish a pipeline's return on equity "determines the pretax investor return required to attract investment, irrespective of whether the regulated entity is a partnership or corporate pipeline." Slip op. at 22. The Court held that with an income tax allowance, "a partner in a partnership pipeline will receive a higher aftertax return than a shareholder in a corporate pipeline, at least in the short term before adjustment can occur in the investment market." Id. The Court found that the facts before it "support the conclusion that granting a tax allowance to partnership pipelines results in inequitable returns for partners in those pipelines as compared to shareholders in corporate pipelines." The Court stated that "[e]ven if FERC elects to impute [investor] partner taxes to the partnership pipeline entity, it must still ensure parity between equity owners in partnership and corporate pipelines" and had failed to do so. The Court rejected FERC's argument that it was the Internal Revenue Code, and not FERC's policy, that resulted in a lack of parity between corporate shareholders and partner investors, and the Court suggested that under Supreme Court energy precedents, there should be aftertax parity with respect to corporate shareholders and partner investors in regulated pipelines.

Kurt Jacobs 202.274.2871 Email

The Court remanded to FERC the issue of providing income tax allowances to partnership pipelines, without indicating any required or preferred remedy. The Court noted that FERC had indicated at oral argument that it might be possible to "remove any duplicative tax recovery for partnership pipelines directly from the

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