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Mergers and Acquisitions Update

A roundtable with Heller Ehrman; Morrison & Foerster; and Skadden, Arps, Slate, Meagher & Flom.

     Executive Summary
      Mergers and acquisitions show no sign of slowing down this year. According to research firm Dealogic, merger volume totaled more than $420 billion in the U.S. in the first quarter of 2007. In this month's roundtable, our M&A experts discuss trends in private company sale process and deal protection, the reemergence of the two-step acquisition process, and whether the new disclosure compensation rules will affect the M&A market.
      The panelists are Timothy Hoxie of Heller Ehrman; Gavin Grover and Michael O'Bryan of Morrison & Foerster; and Rick Madden of Skadden, Arps, Slate, Meagher & Flom. The discussion was moderated by Custom Publishing Editor Chuleenan Svetvilas and reported by Krishanna DeRita for Barkley Court Reporters.
      MODERATOR: What are the current trends in private company sale process?
      GROVER: I'm going to speak in five-year trends as opposed to the last quarter. We've seen an increasing number of private M&As in lieu of IPOs and a corresponding amount of interest in how you adapt a typical venture-backed company to some of the public company M&A considerations that have come out of developments in public company law and the board's duties. For example, recent Delaware court decisions involving public companies address what a board can and can't do in locking up a target company in a particular transaction. These decisions are very influential in private M&A as well.
      Yet the reality in many of these private M&A deals is that the venture people and the stakeholders can essentially cut the economics of the deal and the buyer typically wants to lock up the resulting deal. To some degree that may seem to conflict with what Delaware law seems to say about what should happen, at least in a public company setting. It's interesting to note, though, how some private companies have navigated through those restrictions and still effectively get to a substantially locked-up deal, apparently without putting the board into a fiduciary bind. There are different techniques that can work for some private companies, for example, where the company will essentially have the votes ready to go, but not bound, and then after signing, go to a very rapid shareholder vote-and so technically comply with what Delaware law seems to say a director should or shouldn't do in locking up a deal.
      HOXIE: That's right. Of course, as a legal matter, there really isn't a difference between the board's duties in a public or private context. But we know that if you sat in a negotiating session and asked, say, for a fiduciary out in a private deal, you would be laughed out of the room. While there is a heightened sensitivity to fiduciary obligations in the private context, we still take advantage of the fact that most, if not all, constituencies are represented in the private boardroom to do things we wouldn't in the public context, such as arranging fully locked-down deals sequenced to comply with Omnicare by arranging for a quick shareholder vote immediately after signing the merger agreement.
      We just had our vote a couple of hours after the signing of the merger agreement. I question whether we would have the same degree of comfort if we were doing that in the public context. I'm not sure that it's unprecedented, but it's certainly rare.
      MADDEN: A lot of it comes out of the fact that you are starting to see the sales of many of the companies that had multiple rounds of venture and angel capital come in. Unlike a lot of the prior company sales?where maybe it's a family?you actually have disparate interests in your stockholder base that you have to pay attention to, and it is the same statute and you can't just say, "Well, it's a private deal."
      HOXIE: Fiduciary issues are more difficult for directors in situations where, for example, there may not be enough deal consideration to go around to all classes. There may be different appetites to do a deal depending on the way the liquidation preferences stack out. Some of the fiduciary issues that are arising in these contexts are really quite difficult, and aren't resolved by reference to slogans such as "fiduciary duties are owed to all shareholders."
      O'BRYAN: And those issues can be harder or easier in the private context. As a private company, sometimes it seems easier because you think you have a better understanding of who your shareholders are and what they want. The reality is, though, during a sale process you have to recheck who your shareholders are because if the company has grown or gone through financing, you may now have many different kinds of shareholders. Also, many companies have at least postured themselves as driving toward an IPO-presumably when most shareholders would be converted into common holders. But whether it's a negotiating posture or what they hope to do, until the IPO actually occurs, they still haven't converted everyone to common [stock] to give you a level playing field.
      You can end up with all these extra complications?not only do you have the varying economic interests of different shareholders who have come in over time, but the shareholders can be different in their posture toward the company and the type of stock they hold. That could be very interesting as the company gets close to doing an IPO and the situation Rick [Madden] described.
      GROVER: There's been a good deal more litigation in the past five years, partly because of the downturn in the technology and venture communities as a result of the Internet bubble breaking. There has been more litigation over director fiduciary duty issues in connection with the various constituencies and classes of shareholders that exist within private companies, and separately there have been developments in fiduciary duties, typically in the public company realm, arising from the heightened scrutiny following Enron and WorldCom. With so much M&A, there's been a lot of litigation, and the courts seem to be more willing than they were previously to articulate what directors should and shouldn't do, at least in a public company sale process.
      HOXIE: One of the things that we can do to help directors understand their role is to ask, "If somebody were to question this deal someday, why will you say it is a fair deal? Have we, for example, done enough looking? Have we pushed as far as we could in negotiations?" Since we are not going to wind up with features like a fiduciary out, the board needs to ask, "Okay, how are we going to establish, if we were ever asked, that this is the best deal available to us? Does our management team have enough familiarity with the market that they've asked the right potential buyers? Should we hire a bank? Should we do an auction?" Those questions are very relevant in the private context and very appropriate for us to be discussing with our clients going in.
      MADDEN: And, without the public company fiduciary outs or an action, if you have a large number of option holders they may exercise, or a large number of employees with stock and a number of different classes of preferred, it's not too far off to think that there could be a lawsuit that says, "How did the board get to these decisions?"
      MODERATOR: Moving on, what are the trends in deal protection?
      MADDEN: A series of recent Delaware cases are challenging some of the beliefs of corporate attorneys about what types of protections are acceptable and what rules of thumb are applicable. There's been a shot across the bow to the concept that a 3 percent termination fee is inherently a valid and defensible position given the Netsmart case. There's also been some challenge put to the recent "go shop" provisions. Maybe these provisions are not as much protection as people had hoped they were in all cases. In general, the Delaware court has been holding the board's feet to the fire much more in terms of the transactions and the process than they have in the recent past.
      HOXIE: There is no magic formula. Courts look at the facts and much of the focus is on how good your process was. Courts ask the same questions that we were talking about earlier: What did your board do? A court is going to be very sensitive to that when it turns to look at deal protections. The better your front-end process, the more leeway you are going to get on deal protection and vice versa.
      At some point, even "go shops" aren't going to protect "no process" on the front end unless you have some real reasons why you did it. You could have situations where an engaged board thoughtfully decides that the nature of the business is such that you can't be auctioned. One of the messages in these recent cases is you better have reasons for having made those choices as opposed to, "Oh, we took the first deal and thought we'd check the price later."
      GROVER: And Chancellor Strine has been speaking out aggressively to the deal community about the same theme, which is that the judiciary will look past the form of what you are doing to see what's really going on. "We didn't just fall off the turnip truck" was one of his quotes that's been cited widely. One point seems to be that you can't mechanically rely upon something that may not provide much practical protection for the shareholders to assure that there's an opportunity for a better deal, if the board or management has established too much momentum with a private equity firm or other preferred bidder.
      The level of attention to all aspects of the process now seems to go beyond what used to be there. And it goes all the way back to the beginning of the process: how did you set it up, what did you do at this stage, was it really a level playing field, did you just let private equity people look at it and why, those kinds of issues.
      O'BRYAN: It sets up an interesting dynamic when you are talking to your client. The courts have told us in recent cases that if you want to get the attention of a chancellor in Delaware, you tell them that a board did something because it's "typical and customary." But when you go into the boardroom to talk to your client, questions from directors naturally include: "Are we doing everything that's typically done?" Maybe they are, but that doesn't always answer the question, or at least it needs to be answered in context. Directors want you to give them at least some lines that they can cross. But the bad news is, lawyers can't always tell them: "As long as you did that, then you are going to be fine."
      The good news is, the courts tell directors that they generally will protect the directors' judgments. But the courts also want to make sure directors recognize when they are making judgments, and that includes, for example, the decision at the beginning of the process about how they were not going to shop the company because they were worried about losing the company's salespeople. Recently the courts have taken issue with whether a company can be shopped and what the impact is of that on a particular company.
      MODERATOR: What are the implications of the reemergence of the two-step acquisition?
      HOXIE: In the public sphere with the SEC's recent best-price-rule clarifications, we are seeing the two-step acquisition come back in terms of people being more willing to do it. A healthy percentage of the deals in the last few months have been tender offers. Those transactions present a set of issues that people may not be completely aware of, including dealing with issues that arise between the time of a possible change of control and the final closing. For example, who's going to be the board, what kind of insurance are they going to have?things that your typical acquisition agreement clauses don't necessarily handle cleanly without work. You also need to think about who can tender and who cannot for section 16 purposes; making sure that you hold your officers and directors out of the tender if you want to get board approval of their sales in the back-end merger for 16b-3 purposes.
      MADDEN: The interesting challenge is highly leveraged transactions and what they do to the relative capabilities of private equity firms versus strategic buyers. For a strategic buyer, a tender is very easy. If they are using leverage, it's not leverage that necessarily needs to be tied to the stock of the asset that they are buying, whereas such is not the case for private equity buyers. Each deal has to stand on its own, and the margin rules prevent leverage of greater than 50 percent; since nobody is going to let you have the 90 percent tender threshold, you have to at least be ready for the possibility that you are above 50 percent but less than 90 percent. Fortunately, and with the current easy credit terms, it hasn't really been too much of an issue so far to structure around this limitation.
      O'BRYAN: Probably the biggest difference for the tender offer, beyond all the mechanics that the lawyers look at, is speed to closing. And that can be a good thing and a bad thing. It can be a bad thing because you might not always want to close in the quickest possible way. Fifteen or so years ago when companies were talking about post-agreement market checks, some targets added on to the time between signing and when you could close the transaction, just to make sure that there was enough time for information to be disseminated and other potential buyers to react. Even if you could get the closing done right away, you might start the tender a little later so it wouldn't close as quickly. If it were a merger, it might be okay because those naturally take a little longer. So speed isn't always the best thing, though sellers, of course, remain concerned about material adverse changes and other potential developments.
      You also may find yourself in situations from the buyer's perspective where you don't necessarily get the speed that you want, or in the situation Tim [Hoxie] described where you quickly get to control but can't close the back-end merger so you have these other potential problems. Also, when talking about a seller's outs in a deal, in a merger or tender offer they tend to last until the shareholders speak, saying "we're selling now", or when they vote. When you have a merger that's subject to regulatory issues and it's going to take a long time to finish, it can go on for a long time past a shareholder vote, but you find that your fiduciary out was turned off at the time of the shareholder vote. In a tender offer, though, the tender offer tends to get extended and extended. So you end up not having the seller's fiduciary out turned off until farther out, which can be more problematic for buyers.
      MADDEN: Although in heavily regulated industries the tender offer is less attractive because of the delay, in most other transactions where you just have a normal SEC threshold, the tender creates a compelling strategic advantage to the buyer. It's hard not to tender if the price is decent because the merger agreement may or may not close, but if it's the day before the tender is going to close, you have to make a very hard decision.
      HOXIE: It does tend to incentivize people to, in effect, vote yes, because you do have a moment where you say, "I want my money now, and I don't know if I don't tender, if I'm going to wait several months for my money in a back-end merger." So I think it does create a little incentive to tender. And of course, if you tendered, you don't have dissenter's rights.
      MODERATOR: Will the new compensation disclosure rules affect the M&A market?
      MADDEN: I think they will. For all of the discussion that people had about whether SOX was going to push public companies into the private realm, different people have different opinions as to how much of the going-private trend has been due to SOX or not. Embarrassing articles about a CEO's compensation certainly have the same potential to make a private company more interesting. It is also starting to have the effect of simplifying executive compensation packages.
      Many of the more interesting "prerequisites" are being eliminated, which makes their compensation reasonable compensation that a private equity buyer would offer. Private equity buyers tend not to offer as many perks and tend to offer salary and option or equity. As compensation starts to look more alike and with more public scrutiny to the various details of the executive's compensation, the new rules (probably at least as much as the SOX rules), have created a motivating factor for companies to go private.
      GROVER: It's still a little early to try to predict some of this, because the new executive compensation rules just rolled in for this proxy season. But to Rick [Madden]'s point, if you look at the disclosure the SEC now appears to require regarding a company's parachute agreement and other agreements, it will be very different to read in a company's annual proxy?outside the context of a proposed transaction?about the millions of dollars that the CEO may get in a change of control, than when that same information is in disclosed merger documents as shareholders are asked to consider a specific transaction. That's where there may be pressure if shareholders say, "Gee, this is outrageous, how can this CEO be looking at that kind of a windfall when the stock is languishing and the company is not performing?" And that's what some people expect may happen. We'll see. At the same time though, the compensation committee wants to attract top-flight talent and the top managers can still command mega grants and very, very rich compensation packages.
      HOXIE: It is one more burden of being public. It is probably reasonable to assume that it could have the effect of just being one more push towards staying away from the public markets. That could result in more M&A activity, obviously, when you weigh the merits of an IPO versus M&A as an exit. But whether this is going to have any impact on a public company being acquired by another company, my sense is, it's probably not. It's an additional disclosure that must happen, but in that context, once you are already public, I suspect in most cases it will be just some more disclosure that needs to be addressed.
      O'BRYAN: The courts and, to some extent, the plaintiffs already have been pushing for a balanced and sometimes fuller disclosure. For example, if you are going to put out relative compensation information, then you have to be accurate when you say how you look compared to others. At this point, these are things that you would probably get a compensation consultant to come in and tell your committees anyway. So the new rules are probably not going to make a huge change in the M&A market. It will have an influence on the people we are talking to when we are advising on deals, though, because it typically affects them most directly.
      Timothy Hoxie is a shareholder at Heller Ehrman. His mergers and acquisition experience includes stock and asset acquisitions, tender offers (both issuer and third party), acquisitive mergers, spin-offs, reorganizations, exchange offers, and "going private" transactions. He has represented public and private parties in acquisition transactions and overseas buyers and sellers as well as investment funds and other private investors acquiring substantial or controlling interests in businesses. He is the former Co-Chair of the Corporate Practice Group and former Chair of the California Business Law Section.
      Gavin Grover is a co-chair of Morrison & Foerster's firmwide Mergers & Acquisitions Group and has previously headed the Public Companies Group and the global Corporate Group for nine years during which time he presided over its rapid expansion from 65 lawyers to more than 200 lawyers today. Mr. Grover has been involved in over 250 merger and acquisition, financing, and strategic alliance matters including representing Verio, Inc., in the acquisition of approximately 40 Internet companies and $6 billion dollar sale to NTT.
      Michael O'Bryan is a co-chair of Morrison & Foerster's firmwide Mergers & Acquisitions Group. He has advised on more than 300 M&A matters, and his practice focuses on U.S. and international mergers, acquisitions, divestitures, joint ventures, and other strategic transactions, including the representation of boards and special committees in "going private" and related party transactions. He also regularly advises a number of investment banks in their M&A activities. Before moving to San Francisco he worked in Morrison & Foerster's Tokyo office for four years.
      Rick C. Madden is a partner at Skadden where he advises clients in connection with corporate and securities laws, with a focus on leveraged buyouts, mergers and acquisitions, and securities offerings. Mr. Madden represents private equity firms and companies in connection with acquisitions and divestitures, and he represents a number of REITs in connection with structuring and acquisition issues. He also represents initial purchasers, underwriters, and issuers in connection with sales of securities in private and public offerings and in out-of-court debt restructuring transactions.
      Barkley Court Reporters is affiliated with over 100 Realtime Certified Shorthand Reporters and has eight locations throughout California, offering worldwide scheduling 24 hours a day/7days a week. The company takes pride in being the first deposition agency to use and offer state-of-the-art technology and in setting the standards of professionalism, quality, and outstanding service for the industry. Large multistate case management is its specialty.

Megan Kinneyn

Daily Journal Staff Writer

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