In this issue:
By Charles C. Comey
The past twenty-four months have seen a surge in the number of increasingly sophisticated merger and acquisition transactions involving U.S., Japanese and European multinationals and China-based companies (listed and unlisted, private and state-owned). Morrison & Foerster has advised on many such transactions, including representing Softbank in connection with Yahoo!’s US$1 billion investment in Softbank’s China affiliates, Alibaba.com and Tao Bao; UPS in its acquisition of its international express package delivery business from Sinotrans; and Joyo.com in its acquisition by Amazon.com. In this environment, it is critical to focus on the right issues in preparing for and executing a China M&A transaction. As advisors to some of China’s leading technology companies, multinational and private equity acquirers, we offer the following practical observations:
Every Transaction Requires Regulatory Approval
Acquisitions of domestic Chinese corporations often require multiple layers of regulatory approval, and it is important to identify and anticipate approval issues early on to avoid delays or other complications later. For example, an acquisition of a listed state-owned enterprise will likely require approvals from the Ministry of Commerce (MOFCOM), State-owned Assets Supervision and Administration Commission of the State Council (SASAC) as well as the Chinese Securities Regulatory Commission (CSRC). Further approvals may be required depending on the structure of the transaction and industry of the target. Previously unregulated transactions that now may require approvals include wholly offshore transactions that involve Chinese resident shareholders of the offshore target. This is a direct result of two circulars promulgated earlier this year by the State Administration on Foreign Exchange (SAFE). As further described below, antitrust issues will become increasingly important, particularly for multinational acquirers, and therefore must be well considered in connection with acquisitions of PRC businesses that occur onshore or offshore.
Larger, More Sophisticated Deals
Recently we have seen the advent of much larger, more complex deals. These include the hostile battle for Harbin Brewery, as well as the widely reported leveraged buy-out underway for Harbin Pharmaceutical. Typically, companies that command larger valuations and the potential returns that are attractive to private equity acquirers are state-owned. Regulatory hurdles as well as the structuring and other similar complications that come with leveraged transactions combine to make for a challenging execution environment requiring experienced counsel to navigate.
Achieve Consensus on Regulatory Approach Early
As experienced China deal-makers know, not only does every transaction require approval, but target companies may have different corporate forms that are governed by differing acquisition rules and regulations. For example, acquisitions of domestic businesses that are not state-owned will be governed by the Tentative Provisions on Acquisition of Domestic Enterprises by Foreign Investors (2003) (the "M&A Rules"), while the acquisition of a state-owned enterprise may be governed by the Provisional Regulations on Using Foreign Investment to Reorganize State-owned Enterprises (2002). In some cases, it may be unclear whether one or more regulations govern the acquisition. It is critical in all acquisitions of Chinese companies to achieve an understanding with the target and its advisors as to:
It is important not to exclusively rely on the transactional counterpart, and to identify and manage these critical areas using the advice of seasoned counsel.
Deal Process/Quality Due Diligence
As is readily apparent from the high-profile disclosure issues facing recent global securities offerings of Chinese banks, the disclosure environment, while improving, is vastly different than that of the US or Europe. In executing China M&A transactions, proactive diligence measures are necessary. For example, it is important to create a framework within which the target’s personnel understand clearly what information is being sought, and are comfortable that its business information is being understood. This typically means conducting meetings with relevant operational personnel present on both sides at which the diligence process is explained, operational teams are assigned and diligence requests and issues are reviewed. Another key factor in obtaining quality diligence information is building relationships between operational personnel of the acquirer and target. Finally, expecting and looking for the unexpected during the diligence process is crucial. For example, it is important to identify significant customers or vendors who may not be readily identifiable as affiliates of the target shareholders. These parties should be identified so that the acquirer can assess whether revenues or cost savings can be reasonably expected to continue after the acquisition has been consummated and the purchase price has been paid.
We believe PRC Antitrust issues will become extremely important in the coming years as the Chinese market matures and category consolidation continues to accelerate. The M&A Rules already provide a skeletal framework of regulation within which acquirers and targets must operate and make filings to MOFCOM in connection with domestic and offshore acquisitions. However, certain acquirers have taken the view that the fact that MOFCOM is not responding to antitrust filings is a signal that filings need not be made. We take the view that if the transaction triggers a filing requirement under the M&A Rules, best practices dictate that the proper filings are made. As preparation of the filings, gathering the necessary data, and consulting MOFCOM authorities may take time, acquirers are well advised to consult counsel early in the process so that antitrust issues do not result in any delays and can be factored into the convergence of regulatory views among the target and acquirer described above.
Often pricing is based on a multiple of EBITDA or similar formulae based on pre-tax profits of the target from prior periods. The combination of the unpredictability of certain industries, opaque regulatory environment and the disclosure climate underscore the critical importance of post-closing purchase price adjustments wherever possible. At a minimum, targets should be required to stand behind projections for future financial periods in the form of representations and warranties. To mitigate such risks, the acquirer should seek phased purchase price payments with adequate holdback rights and escrow reserves in the event adjustments are necessary. Other special accounting/pricing issues that can come up in the China M&A context include the following:
Each transaction is unique, and the foregoing observations are provided to illustrate the issues that foreign acquirors often face in a China acquisition. Sophisticated buyers are well advised to consult experienced counsel early to reduce the risk of regulatory or other roadblocks later and help to ensure timely execution and closing.
By Michael G. O’Bryan
Signing a merger agreement does not always end the bidding for a target company. The announcement of a merger agreement focuses outside attention on the target company and the transaction. Other parties, in the U.S. and abroad, may be attracted to the target or may be concerned about the competitive impact of the acquisition of the target by the original acquiror, and accordingly may make their own offers to acquire the target (often referred to as "topping" or "jumping" the original acquiror’s deal). Recently, for example, CNOOC made an offer for Unocal after Unocal announced a merger agreement with Chevron, and Haier America, together with two U.S. private equity firms, made an offer for Maytag after Maytag announced a merger agreement with another U.S. private equity firm. Neither of those offers was accepted, although Maytag ultimately terminated its original merger agreement to accept an offer from yet another bidder, Whirlpool.
The time between signing an agreement and actually closing the acquisition of a U.S. company, particularly a U.S. public company, usually is at least 4 to 6 weeks and more typically runs 2 to 4 months or more. Disclosure materials for the target’s shareholders must be prepared and, for public targets, submitted for review by the Securities and Exchange Commission, and then distributed to shareholders. Regulatory processes may be required, including most prominently Hart-Scott-Rodino antitrust review and in some cases national security review by the Committee on Foreign Investment in the U.S. Other factors also may affect timing, such as whether the acquiror is using any stock in its bid. During this period – after signing and announcement but before the actual closing – other parties can scrutinize the transaction and any public disclosure materials and decide if they want to make their own offers.
A buyer that has signed a merger agreement, of course, would prefer to prohibit the target company from entertaining alternative offers. The target’s board of directors, however, has a continuing obligation to its shareholders under fiduciary duty principles to seek the best course of action for its shareholders. These fiduciary duties limit the contractual restrictions that a target can accept. The contractual restrictions on a target’s ability to seek or accept alternative offers are called "deal protection measures" or "lock-up provisions." If a target board accepts too many restrictions, a court may find that the board violated its duties and may refuse to enforce the restrictions on behalf of the acquiror.
This article reviews some of the relevant fiduciary duties imposed on boards and some of the most common deal protection measures. The principal deal protection measures from the April 2005 merger agreement between Unocal and Chevron are noted for purposes of illustration.
Board Fiduciary Duties
Target company directors must comply with the fiduciary duties imposed by state corporate law. (This article focuses on Delaware state law because of the high percentage of public companies incorporated under that state’s law and hence subject to its corporate governance requirements.) The general duties of a director are to act with due care and loyalty to the company and its shareholders. Recent court cases in Delaware also have emphasized the duty of directors to act in good faith.
The duty of care is particularly important when considering deal protection measures. This duty requires that directors act on an informed basis after due consideration of relevant materials and information. While it is not always clear exactly when the duty terminates, it is clear that it does not terminate when the company signs an acquisition agreement. Directors must continue to act on an informed basis with respect to actions such as recommending the transaction to the company’s shareholders. Deal protection measures that are overly restrictive, such as those that prevent directors from even considering or reviewing a potential competing bid, may be seen as interfering with the board’s obligation to make informed decisions and thereby giving rise to a breach of the duty of care.
Revlon Auction Duty
When selling control of the company, directors also have a duty to obtain the best price reasonably available for the shareholders. This duty was articulated by the Delaware Supreme Court in the 1986 case of Revlonv.MacAndrews & Forbes Holdings, and is often referred to as the "Revlon duty" or "auction duty" of directors. The Revlon duty in theory does not apply to stock-for-stock transactions, to the extent that control of the successor entity remains broadly dispersed in public hands. The Revlon duty thus applies most directly to transactions where the consideration is all or largely cash.
When the Revlon duty applies, directors must have some basis for determining that a particular deal represents the best price reasonably available. This can be done through a public auction of the company. However, courts have recognized that a public auction preceded by an announcement that a company is for sale may be severely disruptive for the company, and have allowed boards to proceed without auctions so long as the board has developed some body of reliable evidence with which to judge the transaction. Courts also may look to whether the contractual restrictions in the acquisition agreement preclude or unduly restrict another buyer from offering the target a better price and other terms. Holding the company open to such other offers is referred to as a "post-agreement market check."
Permissible Deal Protection Measures
A target board may agree to some measures to protect an acquisition transaction against a potential competing transaction. Generally this is done at the insistence of the acquiror, who refuses to proceed with a transaction the target board deems favorable unless the target gives it some assurance that the target is not using its transaction as a stalking horse to find a better deal. However, the protective measures typically must pass a two-part test: (i) the target board must have reasonable grounds to believe that a third-party bid would pose a threat to the company, and (ii) the measures adopted must be reasonable in relation to the threat. In a change of control transaction courts also will review the measures to confirm they are consistent with the board’s Revlon duty.
Determining the relative reasonableness of the deal protection measures involves a highly fact-specific review. Courts will investigate the process by which a target board determined to agree to a particular transaction and the deal protection measures, as well as the process by which a competing bidder would be able to approach the company. For example, a board that is relying on a post-agreement market check will not be able to adopt deal protection measures as strict as those that could be adopted by a board that conducted a full auction of the company before executing the acquisition agreement.
The 2003 Delaware case of Omnicarev.NCS Healthcare provides an example of the limits on permissible deal protection measures. In Omnicare, the Delaware Supreme Court found that the directors of a target company had violated their fiduciary duties when they approved a stock-for-stock merger agreement under circumstances that guaranteed stockholder approval of the agreement. Stockholders holding a majority of shares had agreed with the buyer to vote to approve the agreement, and in the merger agreement the company agreed to hold a stockholders’ meeting even if the company board later withdrew support for the transaction. The Court concluded that the measures made it "mathematically impossible" for any other offer to succeed, even if more favorable to the stockholders, and that the measures thus were not a reasonable response to the threat of losing the initial transaction. The Court found the provisions to be in violation of the board’s duties and refused to enforce them on behalf of the original buyer. The Omnicare decision has been criticized, but it still stands for the proposition that the shareholder vote for a transaction cannot be entirely locked up.
Common Deal Protection Measures
There are many different types of deal protection measures. A company hoping to displace an acquiror that has signed an acquisition agreement with a target must review the acquisition agreement and related documents carefully to see what measures have been adopted and the most effective way of approaching the company and its shareholders.
Some of the most common deal protection measures are discussed below.
Almost all acquisition agreements prohibit the target from actively seeking other bids. These provisions, known as "no-shop clauses," prohibit the target from soliciting, providing information to, or otherwise encouraging other potential acquirors. They typically apply as well to sales of assets by the company, and so would apply even to a proposed acquisition of less than the entire company.
The Chevron/Unocal transaction provides one example of a no-shop clause.
To accommodate the fiduciary obligations described above, however, a no-shop clause typically includes a "fiduciary out" that allows the target board to furnish information to or negotiate with a third party that makes an unsolicited proposal. Most such clauses require the target board first to make an affirmative finding that the unsolicited proposal is superior to the original transaction (or is reasonably likely to result in a superior proposal).
The target board typically also must conclude that the unsolicited transaction is reasonably likely to be consummated, which requires the target board to review a number of factors, such as the ability of the alternative bidder to finance its proposal, if applicable, and any potential regulatory hurdles. Most such clauses also require the board to determine that its fiduciary duties require it to take such actions. The Unocal agreement, for example, requires the board to determine that a competing proposal is, among other things, "reasonably likely to be consummated on the terms ... proposed, taking into account all legal, financial, regulatory and other aspects of such proposal" before it can exercise its rights under the fiduciary-out provision.
The target board typically also must give the original acquiror notice of the inquiries the board receives from other potential acquirors as well as the steps it is taking with respect to such inquiries.
A no-shop provision binds the target company, and as such does not prevent another company from appealing directly to the target company’s shareholders, such as by launching a tender offer or proxy campaign. However, a no-shop provision may make it difficult to get the target company’s assistance in closing the tender offer.
One of the most common deal protection measures is the termination fee (also called a break-up fee). Under this measure, the target agrees to pay the original acquiror a substantial sum of money under certain circumstances if the transaction is terminated and not closed. A typical clause may require the fee to be paid if:
The termination fee can be quite large in absolute terms. In the Chevron/Unocal transaction the termination fee could be as much as US$500 million; to accept the subsequent bid from Whirlpool, Maytag had to pay US$40 million to the original acquiror. However, courts will assess the reasonableness of the fees under the fiduciary principles noted above. While there is no bright line, fees often are in the range of 2-4% of the transaction’s equity value. The validity of the termination fee depends on a number of factors, including the size of the transaction, the restrictiveness of other deal protection measures, and the degree to which the target company was shopped prior to signing the original acquisition agreement.
"Force the Vote" Clause
A target board must recommend an acquisition agreement before it is submitted to the shareholders for approval. However, once the board has recommended the acquisition, the board can submit the acquisition agreement to the shareholders even if the board subsequently withdraws or changes its recommendation, such as where another bid has surfaced or other circumstances have changed. Some agreements thus require the board to submit the acquisition agreement to the shareholders, even if the board has changed its recommendation. Unocal agreed to such a provision in the Chevron/Unocal transaction.
Once the board has changed its recommendation, the shareholders are more likely to vote against the transaction at the shareholder meeting. If the transaction accordingly is not approved, the primary effect of a "force the vote" provision will be on timing—the target could take 2 to 4 months to hold its shareholder meeting, and the target will not be able to take significant steps towards other transactions during that time. The target also will have to pay costs associated with the shareholder meeting. Such delays and costs could have a significant impact on the attractiveness of the target to competing bidders.
Shareholder Voting Agreements
Shareholders generally have the right to sell or vote their shares as they please. However, company boards must be aware of steps that shareholders have agreed to take on behalf of potential acquirors, and the effect that such steps may have on other potential bidders. Acquirors often seek to have significant shareholders of a target agree at the time an acquisition agreement is signed to vote their shares in favor of the acquisition. Such agreements of course are most effective in companies with relatively concentrated shareholdings, since such shareholdings make it easier for the acquiror to get closer to the vote required to approve the acquisition (generally 50% of the target’s outstanding shares, although in companies with more than one class of stock outstanding there also may also be a required class vote). U.S. federal securities rules may limit the types of shareholders a buyer can approach prior to the formal shareholder solicitation. The Chevron/Unocal transaction does not involve any disclosed shareholder voting agreements, presumably since no one shareholder holds a very significant portion of Chevron’s shares.
The specific provisions of a voting agreement can vary, although as noted above under the Omnicare decision voting agreements cannot be used to completely lock up a transaction. Many voting agreements terminate upon the termination of the acquisition agreement. Some more powerful agreements, however, prohibit the shareholder from voting to approve any competing bid for a specified period of time after the acquisition agreement is terminated. The so-called "profit sterilization" provision also is becoming more popular. This provision requires the shareholder to give to the initial buyer some or all of the additional profit realized by the shareholder if the company ultimately is sold to a competing buyer.
Quick Shareholder Vote
The target board’s fiduciary duty to consider or to be able to accept competing bids typically is seen as lasting only through the shareholder vote. Accordingly, the sooner the target shareholders vote, the quicker the original acquiror permissibly can cut off the target board’s ability to consider other transactions, even if closing of the transaction may be delayed for regulatory or other reasons. Conversely, where a company has not been the subject of a vigorous auction process prior to signing the original acquisition agreement and directors are relying on a post-agreement market check, it may be necessary to allow more time than the statutory minimum before obtaining shareholder approval and closing the transaction.
This measure applies more typically to private companies than to public companies. As noted above with respect to voting agreements, it may be difficult to approach the holders of sufficient shares of a public company, and further many public companies have eliminated or restricted the ability of shareholders to act without holding a formal meeting. However, if the target company has a few large shareholders that could provide the necessary vote, it may be possible for those shareholders to act by written consent soon after the acquisition agreement is signed.
Stockholder Rights Plan
If a target company has a stockholder rights plan (commonly known as a poison pill), the buyer may require the target to agree not to redeem it on behalf of any other potential acquiror. If the target company does not have a stockholder rights plan, the buyer may require that it adopt one. The stockholder rights plan effectively prevents any other party from acquiring more than a specified percentage of the target’s outstanding securities without getting the target board to redeem the plan, and so prevents other bidders from launching (or at least from closing) tender offers made directly to shareholders. The target board must make its decision regarding redemption of the plan based on its fiduciary duties and may be required ultimately to redeem the plan in favor of a competing bidder. Nonetheless, the plan can discourage competing buyers and ensure that they approach the board before acquiring a significant stake in the target company.
A target company that has announced a merger agreement may become an appealing target for other potential acquirors. Those potential acquirors, however, need to review the announced transaction and applicable law carefully to determine the most appropriate method for approaching the target, as well as the potential costs and risks involved. Target companies also have incentives to keep looking for better offers, but they must do so within the procedures prescribed in their original merger agreements to avoid risking the original transaction. Potential acquirors seeking to contact companies that have announced merger agreements with third parties should work carefully with their advisors to maximize the potential for a successful transaction.
1 For a public company target, or for a private company being acquired by a public acquiror where the acquisition is material to the acquiror, the acquisition agreement must be filed with the SEC on a Form 8-K within four business days of the date of signing. If there is a shareholder voting agreement, it is likely to be filed as well by the target company or by the acquiror on its own filing with the SEC. The target also will file a proxy statement (for a merger) or a recommendation statement (for a tender offer) with the SEC that describes, among other things, its rationale for entering into the agreement and the process by which the agreement was negotiated. Documents filed with the SEC can be easily obtained via the Internet at the SEC’s EDGAR webpage, http://www.sec.gov/edgar.