United States: Recent Trends and Changes in Merger and Acquisition Activities

In 2002, the United States adopted the Sarbanes-Oxley Act in response to the thenrecent scandals involving Enron, Arthur Andersen, Global Crossing, Tyco, WorldCom, Adelphia, and others. The Sarbanes-Oxley Act is very broad, covering, among other things, corporate responsibility, financial disclosures, corporate fraud, a new public company accounting oversight board, and auditor independence. The Sarbanes- Oxley Act is not only the most comprehensive federal lawmaking in the field of securities regulation in over 50 years, but it is also the most comprehensive Congressional lawmaking ever in the field of corporate governance. Although the Sarbanes-Oxley Act does not apply directly to merger and acquisition activity, it has affected the way in which all public companies - and all private companies who plan to go public in the next several years - approach transactions.

First, the Sarbanes-Oxley Act and recent corporate scandals in the United States have led to a much more cautious approach to financial reporting and methods of doing business, including the manner in which companies approach potential merger and acquisition transactions. In addition to making companies generally more risk-averse, these scandals have increased skepticism regarding the accuracy of companies. public filings. As a result, when acquiring a public company - or assets or a division of a public company - acquirors are performing more due diligence than ever before. Not surprisingly, companies also have increased their accounting due diligence of acquisitions involving non-public companies. Due diligence of such acquisitions is also made more difficult because many private companies do not have audited financial statements. In addition, there is a perception that the difference in scrutiny between audits of public and private companies has widened since the adoption of the Sarbanes-Oxley Act. This perception also has led to more intense accounting-related due diligence of acquisitions involving private companies.

Second, this generally increased level of caution has been reinforced by the provisions of the Sarbanes-Oxley Act that require CEOs and CFOs to personally certify the accuracy of their companies' financial statements. These certifications must accompany even quarterly, non-audited financial statements and, as a result, often apply to the financial results of acquired businesses prior to their being audited by the company for the first time. As a result, companies generally have insisted on doing more due diligence earlier in the transaction process and integrating businesses as fully as possible immediately after closing. These changes have led to both a greater emphasis on accounting due diligence and delayed the closing of transactions.

This increased emphasis on accounting-related due diligence has been complicated by the limitations that the Sarbanes-Oxley Act places on public companies' independent accounting firms. These limitations were motivated by the belief that the independence of auditors could be compromised if the auditors receive significant non-auditing work from their audit clients. Such non-independence, it is feared, could lead to a relaxed auditing relationship that is inconsistent with the role of an independent auditor. The Sarbanes-Oxley Act specifically prohibits independent auditors from giving valuations and fairness opinions in connection with merger and acquisition transactions. In addition, U.S. Securities and Exchange Commission (SEC) rules adopted after the Sarbanes-Oxley Act was enacted require additional disclosure related to all auditing and non-auditing fees paid to independent auditors. Many shareholder activists have scrutinized these fees and criticized companies with significant non-auditing relationships with their independent auditors. As a result of both these prohibitions and this public perception, companies have relied increasingly on third parties who are not their auditors to perform their accounting due diligence. In many cases, this has slowed further the due diligence and acquisition process.

The Hart-Scott-Rodino Premerger Notification Act (HSR Act) requires parties to mergers, acquisitions, joint ventures, and other transactions above the HSR Act's filing thresholds to submit filings with the federal government prior to their consummation. The parties cannot close such an acquisition until more than 30 days after they make the HSR filing unless the period is shortened or extended by the government - which occurs well over 50 percent of the time. The purpose of these filings is to give the government - which has found it easier to stop potential transactions than to "unwind" them afterward - a chance to stop anticompetitive transactions before they close.

During the waiting period and through closing, the government views the companies involved in proposed transactions as competitors; companies are expected to continue treating each other as competitors. For example, the companies cannot enter into pre-transaction agreements to set prices or jointly announce price increases without violating federal antitrust laws. The government takes the position that - until the proposed transactions actually close . all such actions are prohibited as "gun-jumping" and expose the companies and their officers to criminal penalties, including jail terms.

A recent example illustrates the seriousness of inappropriate conduct prior to closing the transaction. According to allegations made by the United States Department of Justice, Gemstar and TV Guide, while negotiating a possible merger or joint venture, agreed to restrict their competitive activities. Specifically, the companies entered into an agreement pursuant to which they agreed to stop competing for certain customers. By the time the parties agreed to merge, most competition between the parties allegedly had stopped. In early 2003, after a merger closed, the United States Department of Justice announced that Gemstar-TV Guide International, Inc. agreed to pay $5.7 million in civil penalties and agreed to other restrictions to settle allegations of illegal coordination of their pre-closing business activities.

Effective in 2001, the HSR Act was amended in several important respects that have impacted merger and acquisition activities over the past several years. First, the "size-of-the-transaction" threshold used to determine whether HRS Act filings were required was increased from $15 million to $50 million, meaning that most transactions valued at or below $50 million do not require HSR Act filings. This increase significantly decreased the number of HSR Act filings. Second, the "size-of the parties" test - which exempts certain transactions based on the relatively small size of the companies involved - was eliminated for transactions valued at more than $200 million. As a result, all transactions exceeding this threshold will be reportable without regard to the annual net sales or total assets of any of the parties to the transaction. Finally, the previous flat filing fee of $45,000 was replaced by a new filing fee structure ranging from $45,000 to $280,000, depending on the size of the transaction.

Among the key areas of focus in any sale of a public company are the purchase agreement provisions governing the circumstances under which the agreement can be terminated by one of the parties. Buyers of all companies, whether public or private, negotiate a wide variety of representation, warranties, and covenants which, if materially breached, allow them to terminate the agreement. These highly negotiated and fact-specific provisions often are supplemented with a provision that allows the buyer to terminate the agreement if, prior to closing, the seller's business suffers a "material adverse change" (MAC).

In 2001, in IBP Inc. v. Tyson Foods Inc., the Delaware Chancery Court (Chancery Court) issued a very detailed judicial interpretation of these so-called MAC clauses. The agreement between Tyson and IBP defined a MAC as "any event, occurrence or development of a state of circumstances or facts which has had or reasonably could be expected to have a material adverse effect . . . on the condition (financial or otherwise), business, assets, liabilities or results of operations of [seller] and [its] subsidiaries taken as a whole." After Tyson entered into an agreement to acquire IBP, IBP announced that its earnings in 2001 would fall short of its 2000 earnings. Citing the MAC clause and other factors, Tyson terminated its agreement to acquire IBP. IBP sued Tyson for wrongful termination of the agreement and sought, among other remedies, an order requiring Tyson to proceed with the transaction.

While examining whether the MAC clause was invoked properly by Tyson, the Chancery Court noted that merger and acquisition agreements are heavily negotiated, explicitly and specifically covering a wide variety of risks. As a result, the Chancery Court determined that a party seeking to invoke a MAC clause as a result of facts and circumstances that did not violate any of the other, more specific provisions of the agreement must make a .strong showing. that a MAC occurred. In doing so, the Chancery Court found that a party seeking to enforce a MAC clause bears the burden of making a "strong showing" that a MAC occurred to overcome a strong public policy in favor of closing the transactions contemplated by a highly negotiated merger or acquisition agreement. As a result, the Chancery Court cautioned, any party wishing to terminate a deal on the basis of the broad language of a MAC clause must be able to demonstrate that the "adverse change" is of such a quality and magnitude to overcome a strong presumption in favor of closing the transaction.

Although the definition of a MAC in the agreement appeared to be a simple one, the Chancery Court found that the definition required a complex examination of the other provisions of the agreement to determine the intent of this provision. For example, the Chancery Court determined that Tyson was a buyer that was primarily interested in IBP's long-term, not short-term, financial condition and prospects. It then examined whether IBP's business downturn was indicative of a significant, long-term problem, which the Chancery Court believed the MAC clause was intended to address, or a temporary or cyclical problem, which the Chancery Court did not believe the parties intended to address with the MAC clause. In large part because the Chancery Court determined that IBP's business downturn did not represent a significant, long-term problem, it found that Tyson's true reason for terminating its agreement with IBP was "buyers' remorse" and issued an order requiring Tyson to acquire IBP.

Another set of such termination rights typically included in a merger or acquisition agreement where the target is a public company allows the target to terminate the agreement if the fiduciary obligations of its board of directors requires doing so, usually because a third party has offered to purchase the company for a higher price. Understandably, potential bidders typically will not devote the time and resources necessary to investigate a company and negotiate a transaction that, once publicly announced, can be terminated freely if topped by another bidder. Instead, potential bidders require the inclusion of protective provisions, including so-called "no shop" provisions that limit the seller's rights to solicit higher bids.

Although a practical necessity, these protective provisions are scrutinized strictly by courts to ensure that they grant companies the ability to, under appropriate circumstances, terminate purchase agreements to exercise their fiduciary obligations to shareholders. In Omnicare, Inc. v. NCS Healthcare, Inc., the Delaware Supreme Court (Court) held that such provisions are allowed only if both parts of the so-called Unocal test are met. Under the Unocal test, the directors of the selling company must first demonstrate that there were reasonable grounds to believe a danger to corporate policy and effectiveness existed. Typically, this test is satisfied when a change of control transaction, such as a sale of a company is contemplated. The second part of the Unocal test requires that the directors show that their defensive response was "reasonable in relation to the threat posed." This, in turn, involves a two-step analysis:

• The deal protection devices cannot be "coercive" (aimed at forcing upon the stockholders a management-sponsored alternative to a hostile offer) or "preclusive" (depriving the stockholders of all tender offers or precluding a bidder from seeking control by fundamentally restricting proxy contests or otherwise).

• The board's response must be within a range of responses reasonable in relation to the perceived threat.

In Omnicare, the Court invalidated no-shop provisions with the following measures:

(1) a requirement that the proposed merger be put to a vote of shareholders, even if the board of directors withdrew its recommendation; (2) shareholder lock-up agreements that guaranteed shareholder approval of the transaction; and (3) the absence of a "fiduciary out" clause in the merger agreement, which would have allowed the directors to terminate the merger agreement if a superior proposal were made. Although the Court appeared to believe that the first Unocal test was satisfied, it found that the deal protection devices were both coercive and preclusive because the combination of the required shareholder vote, the voting agreements, and the absence of a fiduciary out made it impossible for any other transaction to succeed. The Court stated that any vote of the stockholders would have been "robbed of effectiveness" due to the "impermissible coercion that predetermined the outcome" of the proposed merger without regard to the merits of that merger at the time that the shareholder vote actually was taken. Because the protective devices were designed to coerce the consummation of the proposed merger and preclude consideration of any other transaction, the Court held that they were unenforceable.

The Court also stated that the deal protection devices "completely prevented the board from discharging its fiduciary responsibilities to the minority stockholders" when presented with a superior proposal. Because there existed a group of stockholders with majority voting power who were committed irrevocably to the proposed transaction, the Court stated that the seller's board had an affirmative responsibility to protect the minority shareholders. The Court held that directors of a Delaware corporation "have a continuing obligation to discharge their fiduciary responsibilities, as future circumstances develop, after a merger agreement is announced." Accordingly, the board "was required to contract for an effective fiduciary out clause to exercise its continuing fiduciary responsibility to the minority stockholders." The Court stated that, while stockholder voting agreements and requiring a vote of stockholders even if the board withdraws its recommendation of the merger are valid deal protection devices, they cannot be combined to create "an absolute lock-up, in the absence of an effective fiduciary out clause" in a merger agreement.

These important decisions reinforce the importance of carefully drafting - and carefully determining the legal limitations upon - the termination provisions in a merger and acquisition agreement.

The U.S. government imposes a variety of controls on the import and export of goods and services. By their terms, these regulations apply to "persons subject to the jurisdiction of the United States," including foreign persons located in the United States; U.S. citizens and permanent residents located outside the United States; any corporation organized under U.S. law, and any entity owned or controlled by any U.S. person. In other words, these provisions sometimes apply to goods and services that never entered the United States. Accordingly, U.S. persons can be found to have violated these regulations if they in any way assist or become involved in a transaction between unaffiliated foreign firms and entities from the applicable countries.

Because of the broad reach of these provisions, they apply in some instances in which it is not altogether intuitive. For example, a Chinese joint venture involving a U.S. entity can be subject to the United States' North Korean embargo rules. Similarly, some U.S. companies, for tax reasons, establish a U.S. corporation to conduct business in foreign jurisdictions. Even if the subsidiary is located and doing business solely abroad, it is subject to the full scope of the sanctions because it was organized under U.S. laws. In addition, these regulations can place foreign affiliates of U.S. corporations in a dilemma as some jurisdictions specifically prohibit corporations organized under their laws from complying with, for example, the United States' embargo against Cuba. Accordingly, affiliates in these jurisdictions are left to choose which law to violate. As a result of the broad reach and sometimes non-intuitive implications of these rules and regulations, all international activities should be closely scrutinized during due diligence as potentially problematic.

In addition, the FCPA criminalizes illicit payments to foreign public officials by U.S. businesses and individuals. The FCPA has two basic parts. First, it prohibits any domestic or foreign company or any U.S. citizen or alien from bribing foreign government officials. Second, it imposes certain accounting and record-keeping requirements upon companies whose securities are listed on U.S. exchanges, including the New York Stock Exchange, Inc. or NASDAQ. The FCPA has not changed in the past several years; however, it has gained new prominence in the due diligence process in the post-September 11 world.

One of the few provisions of the Sarbanes-Oxley Act that applies to both public and private companies is the criminal "whistleblower" protection provisions. These provisions impose criminal sanctions against employers retaliating against employees who provide truthful information relating to the commission or possible commission of any federal offense. Those found to have violated these provisions are subject to a fine of up to $250,000 and/or imprisonment of up to 10 years for individuals and a fine of up to $500,000 for companies. Because the Sarbanes-Oxley Act includes a broad grant of jurisdiction over criminal offenses, activities outside the United States may be subject to criminal prosecution in the United States In addition, these provisions are specifically cited in the definition of "racketeering activity" in the Racketeer Influenced and Corrupt Organization Act (RICO). As a result, violations of these provisions likely will subject violators to liability under RICO. Although we have not yet seen RICO claims related to these provisions, we expect that such cases will be brought in the coming years.

In addition to these criminal provisions, the Sarbanes-Oxley Act includes civil whistleblower provisions. Unlike the similar criminal provisions, these provisions apply only to public company whistleblowers who provide information or assist in an investigation of a potential violation of federal security regulations or federal laws that prohibit shareholder fraud. An employee who prevails in any action under these provisions is entitled to "all relief necessary to make the employee whole," including (a) reinstatement with full seniority, (b) back pay with interest, and (c) special damages, such as litigation costs, expert witness fees, and reasonable attorney fees.

Although these whistleblower provisions generally are similar to other pre-existing civil and criminal sanctions, the Sarbanes-Oxley Act expanded many of these protections in a variety of ways. Perhaps equally important, the Sarbanes-Oxley Act and the recent publicity given to whistleblowers at several large public companies have drawn attention to whistleblower matters. As a result, according to the federal agency that administers the new regulations, over 300 whistleblower complaints were received in the first two years approximately after the Sarbanes-Oxley Act was enacted. Due to the potential adverse public reaction to these types of complaints and any allegations of retaliation, recent due diligence efforts have included a renewed focus on potential violations of the new whistleblower provisions contained in the Sarbanes-Oxley Act.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.