Freshfields M&A Forum: Part 2 – Navigating to closing and how to prepare for the journey
The second segment of the Freshfields M&A forum focused on the challenges facing buyers between signing and closing, from navigating CFIUS to engaging with the US antitrust agencies. Here are the highlights – or you can watch the session below.
CFIUS/FDI and protectionism
Aimen Mir, CFIUS, Washington, DC
- Under the Trump administration, the authorities of the Committee on Foreign Investment in the United States (CFIUS) were expanded to cover non-controlling investments and to create a mandatory filing requirement, among other things. At the same time, CFIUS’s resources were strengthened, allowing it to scrutinize more deals.
- As a result, it is no longer a viable strategy to try to rely on CFIUS not detecting the transaction – indeed last year CFIUS called in more than 100 non-notified deals, a few of which involved European companies. CFIUS’s greater resources also mean it is more willing to impose conditions on companies.
Is CFIUS just an issue for Chinese investors?
- President Trump was very vocal about US/China tensions. That has continued under the Biden administration, which, if anything, is more focused and deliberate.
- Almost all direct Chinese investments are heavily scrutinized by CFIUS, creating a long and uncertain deal process with heightened risk of failure. However, the committee is on the lookout for any China nexus. The investor’s limited partners; its co-investors (and even any history of Chinese co-investments); and the extent of its China footprint (e.g., R&D facilities, JVs and even the commercial importance of China as a market) are all seen as potential red flags. A similar lens is applied to Russia.
- Historically, CFIUS has drawn a clear line between issues of national security and economic interest. However, in recent years economic considerations have become more readily accepted as national security considerations, in line with the view of China as a strategic competitor across all areas of the economy.
- In some areas, the key CFIUS risk factor is the sensitivity of the target rather than the identity of the buyer. But whereas in the past these calculations typically involved assets in defence, technology, and government supply chains, in a post-COVID world, more activities are deemed “critical” (healthcare being a prime example highlighted by the pandemic).
How should buyers respond?
- Navigating CFIUS requires a sophisticated understanding of how the government perceives risk. As an example, Chinese companies will often push for broad strategic agreements with their Western counterparties. While these may mean little on the ground, to a US government official they may look like a route to technology transfer. Articulating the commercial context around issues such as these, in government-friendly terms, is essential.
- Buyers need to know when and how to push back if the government identifies a potential risk and seeks mitigation. What are the concerns, and is there an acceptable alternative to address them that protects the commercial interests of the parties?
- The decision on whether to file requires expert judgement. Often the government may have access to information that even the parties do not have that could risk the deal. Likewise, filing in an abundance of caution may see conditions imposed on the transaction that would not have occurred had the parties chosen not to file.
- It is critical to front-load CFIUS analysis given the potential impact of the process on deal terms and timelines. Failing to give CFIUS considerations sufficient attention early in the deal process can result in inadequate diligence and preparation, which can lead to an unnecessarily long CFIUS review process.
- Sometimes the committee can do something unexpected, such as during a recent deal that had no apparent major risks but where the government was concerned that the merged business would become a target for Chinese interference. In scenarios such as these, the challenge is then to negotiate the protections the government requires without destroying the operational or commercial rationale for the transaction.
US and global antitrust trends
Meghan Rissmiller, Antitrust, Washington, DC
- The tone of the US antitrust agencies – the Federal Trade Commission and the Department of Justice – has changed in recent years, as it has among other competition authorities across the world. Previously the agencies were open to collaborating to find solutions to perceived competition concerns. Today, in the words of Jonathan Kanter, head of the DoJ’s antitrust division, they are “enforcers, not regulators”.
- Aside from tone, substantive assumptions have also changed. Historically, the agencies have not sought to intervene in vertical or non-horizontal mergers because such deals were often seen as pro-competitive and efficiency-enhancing. However, in the last year or so we have seen five challenges of vertical transactions.
- Likewise, it used to be the assumption that difficult deals could be resolved via remedies. Today, the agencies have stated a preference to litigate rather than accept “imperfect” or complex remedies. We are likely to see remedies going forward only when they are both: 1. simple and 2. structural, as well as continued US enforcer hostility to behavioral remedies, which contrasts with at least the EC’s position.
- Finally, the agencies are taking a more expansive view on theories of harm – previously their primary focus was on price and quality (i.e., the consumer welfare standard), now they are more open to considering the impact of transactions on innovation and labor markets, among other things.
How is this affecting deal timelines?
- FTC head Lina Khan has introduced meaningful process changes that are affecting deal timelines; as an example, engaging earlier at the Commission level in Staff investigations and requiring more from the Staff to defend closing an investigation.
- Early in the pandemic, measures were taken to suspend the early termination of the HSR process, which meant that the normal 30-day waiting period could be shortened to as little as 15 days for deals with no competitive impact. This was originally explained as being temporary to deal with a record number of filings but is still in place today, extending the timelines of even non-controversial deals.
- At the same time, the DoJ and FTC are taking longer to decide which one will review a particular transaction. Knowing when to submit the HSR notice is therefore a critical call – go too early and much of the 30-day window could be eaten up by this back-and-forth. (The implication being that the Staff will have less time to perform its initial investigation and could force parties to seek additional time even when there are no issues).
- The FTC has also rescinded its prior approval policy and started to include prior approval requirements in consent agreements. A prior approval requirement means that if a party enters into a consent, any future deals in the same relevant market (even those that are not HSR reportable) must be approved by the FTC in advance. This can have serious implications for companies that plan to do multiple acquisitions, especially where the conditions can extend for up to 20 years.
- Finally, both the FTC and DoJ have begun sending letters to parties at the end of the HSR period stating that they can close their deals, but that the relevant agency has not completed its investigation (so-called “close at your own risk” letters). Post-closing reviews of complex transactions have always been possible, but the letters are new and introduce further uncertainty into the process of getting to closing.
Important new trends in the allocation of antitrust and CFIUS/FDI risks
- Historically, buyers doing horizontal deals generally knew how to assess and navigate the antitrust landscape, how long it would likely take to get through the second request process and how to propose and implement remedies to alleviate regulatory concerns. Parties generally negotiated regulatory commitments in merger agreements within this framework and could usually assess which areas posed risk and whether remedies were practical. And where there was some daylight in the agreed remedy standard and potential risk areas, protections such as reverse break fees could be discussed.
- However, given the current environment, relying on traditional analysis, negotiating tactics and merger agreement tools may not be sufficient.
- Today, vertical mergers are now being challenged more regularly. Unlike horizontal overlaps, vertical deals may not offer any feasible structural (divestiture) remedies, and behavioral remedies are largely off the table because the FTC and DoJ don’t like them relative to structural solutions. This is a great example of how parties and their advisers are having to think about how to make deal documents work in these grayer areas. From where we sit, we see M&A agreements evolving in a few ways.
- First, we’re seeing longer outside dates, even for transactions where the parties agree there should not be any substantive antitrust risk. We had a recent deal where the outside date was something like 15 months just to budget for the remote possibility of a challenge, despite the parties and their advisers agreeing the substantive risk was low. Longer outside dates, in turn, put pressure on interim operating covenants, which govern how the business is run between signing and closing.
- Second, more parties are committing to litigate in deal agreements because the FTC and DoJ are showing their propensity to challenge transactions in court (the route by which the agencies block deals under the US antitrust laws).
- Third, we are seeing reverse breakup fees agreed to more and more, even in contracts with a ‘hell or high water’ clause (where theoretically there should be no scenario where this sum would be payable). But with parties having to evaluate the possibility of the US government simply challenging deals it views as anti-competitive (including under non-traditional antitrust theories), litigation has to be part of the strategic toolkit.
- Fourth, we are seeing an increase in “fix-it-first” strategies, where companies are completing divestitures before going to the antitrust authorities to eliminate their concerns.
- Finally, in complex, cross-border deals, having a global antitrust strategy is critical. Buyers need to think about where they need to file, and when, to mitigate the risk of a regulator stepping in to block a deal after their counterparts in other countries have approved it (antitrust authorities are increasingly coordinating across borders). Careful thought – even if it takes time – can produce a swifter result than proceeding with all deliberate speed from the get-go.
Navigating the latest execution risks relating to employees and shareholder approvals in the US
- The sums involved in terminating employees during change-of-control transactions can be a shock for European acquirors – US public company CEOs and management teams are often entitled to significant severance packages through their employment contracts.
- CEOs and other senior individuals may even be able to resign voluntarily and receive this enhanced severance; some contracts contain a ‘good reason’ provision, which allows the individual to quit and still receive a pay-out under certain conditions. Egregious conduct (such as cutting pay) would qualify, but so might less obvious issues such as the fact the CEO is now in charge of a subsidiary rather than the main business.
- If the buyer wants key individuals to remain, they may choose to convert their severance packages into retention payments that extend over a period of years. Here, the complexities of the US tax code, such as Section 409A and section 280G, need to be carefully thought through.
- Section 409A applies to deferred compensation, very broadly defined, which can cover severance. It imposes a penalty tax on employees if compensation is not structured carefully to comply with its payment timing rules, and converting severance into retention is tricky. Section 280G imposes an excise tax on the individual, and a lost deduction on the company, if payments in connection with a change in control exceed 3x the individual’s average compensation over the past five years.
- Some executives may also have tax gross-up clauses in their contracts, whereby their employer pays any additional income taxes they incur. Given the fact that in some deals the severance packages together can run into tens of millions of dollars, these will also be closely scrutinized by the buyer’s shareholders. There are ways to “mitigate” the Section 280G consequences in a public deal, and lots of time is often spent on this.
How do European buyers deal with US employee equity?
- Whether it is stock options or restricted shares, the basic choices for a buyer have historically been to cash them out or roll them over. Today, we are increasingly seeing target employees’ equity roll over into cash that pays out over the vesting schedule of the awards.
- In a stock deal this is generally straightforward to do, but in a cash deal the buyer has to determine what ratio to use for the conversion, and there are strict rules under Section 409A of the US tax code about not increasing an employee’s spread value as a result of a deal.
Alice Greenwell, People & Reward, London
- In some situations, employees who used to receive target stock will now receive acquirer stock. In other cases, the target stock will be canceled, and new stock granted under the acquirers’ plan.
- This needs careful thought however, not least because the route chosen may require shareholder approvals. This needs to be wrapped into the overall deal approvals, otherwise the buyer may find it has significant awards to satisfy and no means to satisfy them.
- Additionally, there may be securities laws considerations. Even if the buyer is not US-listed, it will still need to comply with the securities law exceptions that cover employees. Rule 701 of the Securities Act is typically relevant at the federal level, and the buyer has to meet the technical requirements of the laws in every state where the target’s employees live.
- If the buyer wants to do a cash-out, they must assess the employees’ equity plan to make sure this is allowed (although US plans are typically flexible).
- Most US benefit plans are contractual rather than statutory, so parties must negotiate post-closing benefits and compensation comparability covenants. Often the buyer commits to maintain compensation and benefits for a period after closing, which may require HR input at an earlier stage in negotiations to ensure the buyer can meet its commitments.
- It is also important to consider whether equity can be included in any go-forward promises, because many European companies have tighter controls than in the US around how far down the organization equity awards can go. Sometimes buyers will say they will provide cash to match equity, but some choose not to because it leads to a very large packages.
- It is important to remember that none of these considerations restricts the buyer’s ability to sever in the US.
- The merger agreement will be expressly clear that the individual employees do not have privity with the company to enforce; it is a moral obligation that buyers tend to comply with, but not something that can be litigated by those affected. With that said, buyers do comply with these commitments as they go to broader reputational and employee relations considerations that can be very important for dealmakers, especially repeat buyers.
How deal protections in the US have evolved, and what this means for European acquirors
- Deal protections in the US have remained unchanged in recent years. Most US deals have no-shop covenants but will allow the target to negotiate with a topping bidder with a “superior proposal” prior to the shareholder vote on the deal. The original bidder will generally have last-look matching rights and the right to a break fee should the target choose to proceed with the interloper.
- Delaware case law states that break fees can go as high as approximately 4 percent of the target’s equity value at the sale price, although in bigger deals, break fees tend to be between 2 and 3 percent (given the law of large numbers). Outside the US, break fees are typically limited to 1 percent, so in situations where there are deal protections on both sides, one party may assert the need for equality where it plays to their advantage. Where the deal agreement includes fiduciary concepts on both sides, this will often push the parties towards the lowest common denominator.
- In the US, what constitutes a “superior offer” is at the discretion of the board using agreed criteria (price, likelihood of completion, etc), whereas in other jurisdictions there may be a set price increment or percentage above the incumbent transaction that has to be met.
- In stock deals, we sometimes see acquirers try to negotiate so that the target cannot terminate to take a superior proposal and simply change its board recommendation (a so-called “force-the-vote” provision). Doing so is permissible under Delaware law as a fiduciary matter, but even in stock deals is not the norm. However, the target’s shareholders still have the final say and are able to vote down the transaction.
- Another issue worth noting is that private equity transactions, the agreements will often include a ‘go shop’ clause where the target has the right to solicit for a period of time after signing and pay a lower break-up fee for a bidder that emerges during this window. This is not a legal requirement but is included due to the perception that there could be conflicts in PE deals where management teams are rolling over.