Here is a look back at the top M&A developments that affected deal-making last year and a look forward to our expectations for 2016.
Happy New Year M&A!
2015 witnessed an all-time high in M&A deal value at over $5 trillion, according to Dealogic. The high volume was primarily attributable to strategic megadeals that used stock as full or partial consideration, with healthcare and technology as the two most targeted industries.
In 2016, we continue to expect to see heavy M&A volume in healthcare with similar drivers. Big pharma will likely continue to try to fill product pipelines as high-revenue drugs go off patent (they seem to favor orphan, specialty and cancer drugs for hard to cure indications or for patient populations that are refractory to first line therapy). Specialty pharma may continue to compete for approved drugs that are underperforming where commercial execution can be improved. And development-stage life science companies will continue to consider M&A among its strategic alternatives in light of the challenges involved with transitioning from a development-stage company to a commercial drug company. Inverted pharma companies are likely to continue to use tax rate differences to create synergies that drive acquisitions.
In tech, M&A deal volume remained consistent but largely under the radar in 2015. Larger private and public companies continued to acquire talent and valuable assets, on generally favorable deal terms (if not valuations), but often on a smaller scale than anticipated. Because the public and private capital markets remained open for a large part of last year, many successful private companies retained pricing leverage over buyers or continued to prioritize IPOs over M&A exits – which may have depressed transaction volume. This year, with the volatility in the capital markets (and the unicorn phenomenon becoming more uncertain), we expect these companies and their institutional backers to be more receptive to M&A in 2016. We also note that large cap tech companies still have substantial cash on their balance sheets that can be used for acquisitions if targets become more affordable.
Private equity buyers, which have been relatively quieter in the markets due to high valuations, will likely be more active in 2016, as they seek new opportunities to buy unwanted assets or businesses (including those needing to be divested) from strategics. We also expect PE-to-PE sales and incremental add-ons to continue, assuming no major upheaval in the debt markets – a big assumption in the current environment.
We also expect cross-border M&A activity to continue unabated at high levels of volume in 2016 as deal makers continue to take advantage of, among other things, tax optimization and efficiency, fluctuations in currency prices (particularly in China) and pricing arbitrage from one country to another.
Who’s afraid of the big bad wolf?
Activism continues to fuel M&A, with breakups, divestitures and sales constituting the fastest growing type of requests by activists over the past five years by far. Activists are waging campaigns for deals even where regulatory concerns would normally be seen as a gating factor (Starboard/Office Depot, Elliott/Dollar Tree). We witnessed activists willing to confront even the largest companies and to engage on even signed deals (Elliott/Atmel, Icahn/Pep Boys).
In contrast to the “wolf packs” of old, activists no longer comprise only hedge funds but also family offices and traditional institutional investors. Moreover, activists no longer feel the need to acquire large stockholdings in order to push for their agenda. As a result, even the threat of activism plays a large role in boards’ review of strategic alternatives (both buy- and sell-side) on a more regular basis than in years past.
In a shift, boards’ reactions appear to have diversified from being solely defensive to more inclusive, with campaigns tending to settle relatively quickly and with about 36% (up from 30%) of all activist campaigns launched in 2015 resulting in board seat(s), according to FactSet Research.
Most companies by now have investor outreach efforts and corporate response strategies in place. Going forward – and particularly if private ordering for proxy access continues to swell –boards will need to focus on how best to govern their companies with dissenting voices in the boardroom. This will require attention, among other things, on board confidentiality and fiduciary duty issues related to the presence of dual-fiduciaries on the board and, potentially, managing and disclosing compensatory arrangements between the activist and its board member(s).
Drawing the path to closing when antitrust concerns are high
As we recently discussed in this Cooley Alert, a number of prominent deals in 2015 were blocked by the DOJ, fueling already-deep concerns that tie-ups with competitors will be closely scrutinized. Even smaller deals – particularly in the technology sector – are drawing attention.
This concern for deal certainty has resulted in increased attention to the sharing of potentially sensitive information during the due diligence process and has resulted in increased legal review of board materials at the earliest stages of the transaction. In addition, the concern for deal certainty has also resulted in increased negotiation of the various “efforts” covenants that are often contained in merger agreements. These covenants define the level of efforts or action that a purchaser will take (e.g., “any and all steps,” “reasonable best efforts,” “no action” or variations in between) to eliminate antitrust objections or obtain the required antitrust approvals. In addition, more and more sellers are requesting that buyers agree to a “reverse” break-up fee if the transaction fails to close because of antitrust concerns in order to motivate the buyer to address those concerns and help compensate the seller in the event the deal fails to close, and “ticking fees” that increase the longer it takes to address antitrust concerns, to speed up the process. Other covenants restrict the actions that a purchaser can take between the signing and the closing which could exacerbate antitrust problems, such as acquiring certain assets or businesses.
With the high level of antitrust scrutiny expected to continue, parties will likely continue to flesh out purchasers’ obligations in merger agreements. There has been some concern that including detailed efforts covenants in a merger agreement might itself provide a “roadmap” for regulators to identify problematic lines of businesses or assets that need to be divested. In some cases where antitrust concerns are obvious, their value may well outweigh that risk. In certain recent deals where antitrust scrutiny was expected, the DOJ rejected the parties’ pre-negotiated divestiture package as insufficient, suggesting that a provision that may be seen as providing certainty does not always do so.
Reverse break-up fees, which have been highlighted by recent and prominent payouts, will likely continue to be requested. As deal values have soared, the fee amounts have increased. The amount of these fees as a percentage of deal value, however, has not changed and has generally ranged from 2% – 20%, but may be higher.
The expected level of antitrust scrutiny may also play a factor in what deal structure to choose. In addition to the regulatory environment that at times may seem hostile to merger parties, there is also a significant level of hostile deal activity that has resulted in signed deals being jumped by bidders offering competing proposals. If a buyer expects a long regulatory-review period, it may be better to structure the deal as a statutory merger than as a tender offer because once the target’s stockholders have approved the deal the exposure to a hostile bid is eliminated, regardless of how long it takes to obtain regulatory approvals and eventually close.
Did you say bankers have conflicts?
The Delaware courts continue to focus on financial advisor conflicts and the need for boards to identify, vet and manage their advisors’ actual and potential conflicts in a sale process. The more recent decisions focus on the need to address current and historical conflicts prior to engagement – particularly if financial analyses are presented – and to address them in representations, warranties and covenants in engagement letters. In addition, boards should establish processes to remain informed of any current or developing conflicts throughout the transaction and to disclose them to stockholders. It will be interesting to see how this practice evolves in light of the understandable difficulty in identifying which of the bankers’ relationships and discussions (some of which may be necessary to facilitate the deal) need to be disclosed. What is clear is that boards need to be proactive and diligent with respect to their financial advisor conflicts but that an informed decision to proceed with an engagement in spite of a perceived conflict that honors best practices should not affect the legitimacy of the engagement. There is also continuing heightened focus on attention to financial projections and company metrics that underlie the advisor’s work or fairness opinion.
Big things can come in small packages: no gatekeeper liability for advisors
Late last year, the Delaware Supreme Court upheld rulings finding a financial advisor liable for approximately $76 million in damages for aiding and abetting breaches of fiduciary duties by former directors of Rural/Metro in connection with the company’s 2011 sale to a private equity fund. Despite finding that the financial advisor was liable for aiding and abetting based on its effective fraud on the board, the opinion also explained that the decision should be read narrowly and disavowed the notion that financial advisors, as experts, should serve as “gatekeepers” for the board. The Court explained that the role of a financial advisor is primarily contractual in nature and is typically set forth in the engagement letter. It then clarified that a financial advisor cannot be found liable for failing to prevent a board from breaching its fiduciary duties. Although this language was contained in a footnote to the opinion, it was a big development for financial advisors that is sure to be cited in conflicts cases to come.
Dissenters need not dissent: appraisal arbitrage continues
Last year, the Delaware legislature amended the appraisal statute to try to discourage appraisal arbitrage as an investment strategy but failed to adopt a share tracing requirement, which continues to allow investment funds to seek dissenters rights for shares bought after a deal’s announcement that were not actually voted against the merger due to the fact that most shares are held in fungible bulk through DTC. These investment funds buy shares after the announcement of a deal and file an appraisal claim with the hope of a court judgment at a higher price than the merger price. In addition, arbitrageurs also hope to benefit from the provision in the appraisal statute that guarantees an interest payment (5% plus the Federal Reserve discount rate compounded monthly) on the appraised amount from the time of the merger until the judgment is paid, regardless of whether the appraised value is higher than the merger price.
In 2015, a number of appraisal decisions found that a fully-negotiated merger price (and not an independent valuation by the court) is the best indicator of fair value in cases where there was a fair and robust sale process at arms-length, and held that the merger price was the fair value of the appraised stock (Ancestry.com, Ramtron, BMC Software). With these recent decisions as precedent and the rise of interest rates (which makes the interest rate strategy less attractive), arbitrageurs may eventually decide to move on. However, because appraisals continue to have settlement value, they will likely continue as an investment strategy for these funds in the near term.
Minding the gap
Earn-outs as a form of consideration appear in a minority of deals. In many industries such as in life sciences where the viability and profitability of a significant asset is uncertain, some form of contingent consideration is standard to bridge the valuation gap and allocation of risk between a buyer and a seller. In particular, acquisitions of private life science companies often have a substantial component of the overall deal value in contingent milestones. In some cases, disputes may develop over whether buyers have proceeded with the development of a product in the manner or on the timetable that a party anticipated when the milestones were negotiated. This may lead to post-closing disputes over whether a buyer used the appropriate level of effort to attain the given milestone or whether milestones have been satisfied, which often result in some form of renegotiation with the seller representative.
Last year, the Delaware Supreme Court in Qinetiq confirmed that unless an agreement expressly requires a higher level of effort, a buyer has no independent obligation or implied covenant of good faith to try to maximize value or trigger an earn-out and that a buyer’s obligations will be interpreted based on the plain language in the contract. The Court held that because the contract merely prohibited the buyer from acting “with the intent of reducing or limiting [the earn-out payment],” the buyer did not breach the contract when it failed to meet revenue targets for the given product because it did not intend to reduce or limit the earn-out, even though the buyer may have known that its actions would have resulted in the failure to achieve the milestone. The decision adds to an earlier 2015 Chancery Court ruling that similarly held that the earn-out language meant what it said and that the implied covenant of good faith will not be applied to fill in gaps where they do not exist.
These developments underscore the need for sellers to ensure that the agreement expressly defines what scope of effort and actions a buyer should take to achieve a given milestone, which will depend on the specific facts and circumstances involved but may include a promise to act based on qualitative operational covenants or to take specific, enumerated actions. We are already seeing affected parties heed these warnings.
Private merger structure – binding stockholders
Recent developments affecting private mergers as they relate to minority stockholders have required parties to rethink their choice of structure or develop contractual workarounds.
In the recent Cigna decision, the court held that certain common provisions in the merger agreement were not enforceable against the stockholders that did not sign the agreement. These provisions included the indemnification obligations, a release of claims by sellers against the buyer and the appointment of a sellers’ representative. Also last February, in Halpin v. Riverstone, the court found that a drag-along provision in a stockholders’ agreement did not prevent minority stockholders from exercising their appraisal rights because the company technically failed to comply with the advance notice requirement in the provision. Interestingly, the court also questioned the general enforceability of a waiver of appraisal rights by common stockholders, a provision that is commonly included in the stockholders’ agreements of many VC- and PE-backed companies. The court noted that unlike the holders of preferred stock, whose rights are grounded in contract, the rights of common stockholders vis a vis the corporation and its directors are grounded in statute and common law and, therefore, the question of whether common stockholders can contractually waive their statutory appraisal rights in a squeeze-out merger before the fact, is uncertain.
Deal parties have responded to these rulings by considering a variety of contractual workarounds. These include closing conditions that require a high percentage of stockholders (90%) to sign joinders to certain sections of the merger agreement, which also helps to address the appraisal issue. Others have proposed (i) provisions that shift the risk of non-signing stockholders to the consenting stockholders on a pro rata basis through the use of escrows or otherwise or (ii) increasing the size of the escrow to account for the risk of failing to recover from non-signing stockholders. Naturally, sellers often resist these shifting provisions, which have sometimes had the beneficial effect of getting signatories to recruit non-signatories to sign joinders. In stockholders’ agreements, companies may continue to request drag-along rights (but with short advance-notice requirements or retrospective provisions) or obtain voting agreements in favor of the company, which could have the same effect as an appraisal waiver. We have seen various other fixes as well but so far no particular fix appears to have emerged as the dominant market practice.
While these workarounds may have disadvantages of their own, due to the difficulty of obtaining 100% participation for many private companies, we expect that parties will continue to prefer structuring their acquisitions as private mergers rather than as a stock purchase.
M&A litigation in private deals generally
We have seen an increasing focus in Delaware courts on private deals generally. After the Trados decisions, deal parties have been careful to ensure that any M&A deal involving a company with preferred stock or a management incentive carve-out has to be structured with the board’s fiduciary duties to the holders of common stock in mind. The affirmance of Nine Systems last month also underscores the need to have a fair process as well as a fair price in interested transactions, not just in an M&A deal but even well before during any recapitalization or corporate financing.
Since the Delaware Supreme Court has upheld the use of cleansing devices in Kahn v. M&F Worldwide Corp. and then again in the context of a private merger in Swomley, deal parties that have a controlling stockholder who participates on both sides or gets a benefit that others do not may find it beneficial to structure their “interested” transactions using the informed special committee and majority of the minority devices that were blessed in those cases. If properly used, the deferential business judgment review will apply and any litigation may well be dismissed at the pleading stage. However, any structuring considerations would need to consider the business realities affecting the company, which may ultimately make the use of these devices impractical.
M&A litigation then and now – what better time to review director indemnification
The Delaware courts appear to be trying to address the fact that over the past few years the vast majority of public M&A deals involved some type of stockholder litigation against directors.
In recent months, some notable decisions have served to discourage nuisance litigation by rejecting one popular method of extinguishing a fiduciary duty claim – disclosure-only settlements. In these settlements, target boards agree to amend their proxy statement/tender offer disclosures with additional disclosures in exchange for a broad, global release of claims. Meanwhile, plaintiffs’ firms walk away with attorneys’ fees for minimal effort. The WSJ reports that in the last quarter of 2015, the number of M&A suits decreased by half on account of these actions.
At the court and legislature’s urging, Delaware exclusive forum selection bylaws, which require fiduciary duty claims to be heard in Delaware, are also having an effect in reducing unmeritorious multi-forum litigation. It appears that the bylaws are being adopted on a regular basis with the blessing of at least a few non-Delaware courts and in-play adoptions are occurring with relative frequency as M&A deals are signed.
While the statistics show that M&A litigation has decreased, our experience shows that plaintiffs firms are instead focusing on stronger (or more creative) claims that can be litigated after closing that allege process and disclosure deficiencies in an effort to seek damages. Plaintiffs firms also appear to be filing breach of fiduciary duty claims in other contexts as well such as in compensation and corporate governance. For example, after the recent decision in VAALCO, which held that a “solely for cause” director removal provision was invalid because the company no longer had a classified board, several claims were filed against companies with annually-elected boards with charters or bylaws that contained this provision.
Many of these post-closing claims allege duty of loyalty breaches that can result in directors being personally responsible for the damages. Therefore, now is the time to review director indemnification provisions, including any provisions that provide for advancement to directors for expenses incurred in defending against a claim. Most companies address indemnification in their charter and bylaws but some companies also have standalone agreements with directors that typically do not give the director additional indemnification but may spell out some of the procedural issues that can get sticky in a dispute. Knowing your companies’ indemnification obligations will avoid complications down the road and provide assurances to nominees and continuing directors that they are covered.