Mergers and Heightened Regulatory Risk

Steven Epstein is a partner and Co-Head of the Mergers & Acquisitions practice at Fried, Frank, Harris, Shriver & Jacobson LLP. This post is based on a Fried Frank publication by Mr. Epstein, Gail Weinstein, Philip Richter, and Bernard A. Nigro Jr.

As U.S. corporations face the later stages of a prolonged economic recovery, with the prospect of slow growth, a number of strategies have been considered to meet the challenge of producing meaningful profit improvement in a short timeframe—with corporations increasingly turning to tax inversion transactions (for the dramatic and immediate reduction of tax expense) and mergers (for the significant expected synergies). At the same time, the U.S. government has evidenced rising skepticism toward inversions and mega-mergers.

The U.S. Treasury Department issued regulations this month (accompanied by calls from President Obama for further action by Congress) to limit the tax benefits of inversion transactions, in an effort to curb (or eliminate) them. On the merger front, U.S. (and non-U.S.) antitrust regulators have more frequently been applying increased scrutiny to transactions, requiring more broad-based remedies as a condition of granting approvals, and more often commencing litigation to block transactions. In addition, the prevalence of review of mergers by CFIUS (the Committee on Foreign Investment in the U.S.) for national security-related concerns has increased, with CFIUS review of transactions involving industries not typically associated with security concerns. Among the more prominent recent targets of these trends have been:

  • Pfizer-Allergan—the 2016 planned $160 billion inversion transaction, which was terminated by the parties the day after the new inversion rules were announced, based on the parties’ agreeing that those rules represented a “material change” to the tax laws;
  • AbbVie-Shire—the $54 billion inversion transaction, which was terminated at the end of 2014, shortly after the first set of rules targeting inversions was announced;
  • Halliburton-Baker Hughes—the $34.6 billion announced merger, which the U.S. Department of Justice this month challenged in court based on antitrust concerns, after rejecting the divestiture package offered by the parties;
  • Comcast/Time Warner Cable—the $45 billion announced merger, which was terminated in 2015 based on regulator’s concerns that the transaction would be anticompetitive, notwithstanding divestitures proposed by the parties;
  • Canadian Pacific offer for Norfolk Southern—the $30 billion takeover offer, which Canadian Pacific had been pursuing for months and withdrew earlier this week, just one business day after the DOJ spoke out against the deal; and
  • Anbang-Waldorf Astoria—the 2015 $2 billion acquisition of a hotel by a Chinese insurance company, which (although ultimately approved) was reviewed by CFIUS for national security concerns, despite the companies’ not being in security-related industries.

The Antitrust Challenge

Often, the most appealing potential transactions involve the acquisition of a competitor (due to, among other things, familiarity with the business, potential synergies, and overlapping customers and development plans). However, those transactions inherently present the greatest risk of an antitrust challenge. A critical part of the initial decision whether to pursue a transaction is a determination as to the likelihood that antitrust approval can be obtained—and, importantly, whether it can be obtained in a timeframe and on terms acceptable to the acquirer. The “go/no-go” decision at the earliest stages of evaluating a potential transaction should include consideration of the following:

  • What is the likelihood of obtaining the required antitrust approvals?
  • How long will it take to obtain the required antitrust approvals—and what will be the effect on the target’s business of the ongoing distraction and the requirements (of the merger agreement and “gun jumping” rules) that the business be managed in the ordinary course consistent with past practice pending closing?
  • What are the expected costs of obtaining the required antitrust approvals—including divestitures or support agreements that will be required by the regulators as a condition to approval—and will the acquirer’s rationale for the transaction hold up in light of those costs?
  • Given the degree of the antitrust risk, the nature of the transaction, the specific facts and circumstances, and the negotiating leverage of the respective parties, what is likely to be the allocation of risk as between the acquirer and the target with respect to the possibility of antitrust approval not being obtained?

Critical Points for Early Planning

In deals that present antitrust issues, the government’s approval of the transaction will depend on whether it is persuaded that the transaction would be pro-competitive or neutral as to competition in the relevant markets or would have anti-competitive effects. The parties’ success in meeting their objectives will depend in large part on the planning that occurs at the very earliest stages of consideration of a deal, as well as the parties’ choice of the numerous tools available to them to craft remedies to potential antitrust concerns (which, of course, must be balanced against the parties’ other objectives).

Involving antitrust counsel. Antitrust counsel should be engaged from the earliest stage of consideration of the transaction—to help make these determinations and, critically, to review management, board, and banker materials and presentations so that the deal can be presented to the regulators in the best possible light, without problematic documentation that will reduce the likelihood of or increase the conditions for approval being obtained. It should be kept in mind that all documents (including emails) relating to a proposed acquisition (that are not prepared for or by the company’s attorneys) are potentially subject to inspection in connection with the government’s review of a proposed transaction.

Enhancing deal certainty and allocating risk in the merger agreement. The parties will want to craft merger agreement provisions that clearly state the parties’ respective rights and obligations with respect to regulatory matters, while enhancing deal certainty and allocating the risk of failure to obtain antitrust approval. The parties will have to make decisions as to the necessary trade-offs among the relevant agreement provisions in order to arrive at the appropriate “package” of terms for the deal. The key provisions are:

  • Standard of efforts. The standard for the efforts that the parties (particularly the buyer) have to make to obtain antitrust approvals—such as reasonable efforts; best efforts; or “hell-or-high-water” (which requires that the parties take any and all efforts to obtain antitrust approvals);
  • Specific efforts. Whether and to what extent the efforts to obtain antitrust approval include an obligation to divest assets (and provide support agreements), to resist litigation brought by the government to block the transaction, or other specific efforts;
  • Divestitures cap. If there is an obligation to divest assets, what the maximum amount of required divestitures is (the “Divestitures Cap”), and whether there are specified assets that would have to be divested and/or specified assets that would not have to be divested;
  • Drop dead date. The drop dead date (i.e., the date beyond which the efforts to obtain antitrust approvals would no longer have to be made and the deal would terminate if the necessary approvals have not by then been obtained); and
  • Reverse termination fee. Whether a “reverse termination fee” will be payable by the buyer to the target company (or, in a private deal, to the seller) if antitrust approvals are not obtained and the deal is terminated, and the amount of the fee.

Obtaining antitrust approvals as quickly as possible. Although both parties will want to consummate a contemplated merger as quickly as possible, in deals that present antitrust concerns, the parties often select a drop dead date that is far into the future so that there is sufficient time for the process of seeking to obtain the antitrust approvals. That process is clearly taking longer than in the past. The drop dead date should be selected to provide sufficient time for the antitrust review process, and, if appropriate, for resisting litigation that may be brought by the government seeking to block the deal. We note a recent situation in which, at the 15-month drop dead date, the target company terminated the merger agreement to enter into a different transaction and the original acquirer paid a very large reverse termination fee, although the litigation with the antitrust regulators over the deal was in the final stage, with the court ready to rule.

Thus, the parties’ early planning and decisions relating to the approval process should take into account the imperative of obtaining the required approvals as quickly as possible. The longer the time period to closing, the greater the potential negative impact on the target company’s business, based on industry market reaction to the proposed merger and the typical merger agreement provision that the target be operated pending closing only in the ordinary course consistent with past practice. The acquirer, particularly in a stock deal, may also be subject to interim covenants relating to the conduct of its business pending closing. Further, the distraction and uncertainty for both parties during the period from signing to closing can significantly affect how they are managed. When crafting the divestiture package and other remedies to be proposed to the regulators (discussed below), the merger parties have to carefully balance the competing interests of minimizing the assets to be divested or other remedies and optimizing the timetable for obtaining approval.

Recent Harder Line Approach by Antitrust Regulators

U.S. antitrust regulators have been taking a harder line approach with respect to the approval of divestiture packages proposed by merger parties. There has been increased emphasis on the divestiture of whole businesses rather than targeted overlapping assets. An example is the 2013 $20.1 billion merger between Anheuser Busch InBev and Grupo Modelo, where the DOJ insisted that not just identified overlapping assets, but the entire U.S. business of Grupo Modelo had to be divested. Also, the DOJ has been quoted as saying about the Halliburton-Baker Hughes deal that the proposed divestiture package is problematic because Halliburton is not offering to sell full business units, with the result that a buyer of the divested assets would be at a competitive disadvantage because of the facilities, employees, contracts, intellectual property and R&D resources that would remain in the hands of Halliburton-Baker Hughes.

The agencies’ skepticism that proposed divestitures—even of whole businesses—will have the pro-competitive effects predicted by the merger parties has intensified as a number of approved divestitures have failed, with the regulators being forced to approve sales of assets back to the companies that had divested them. For example, in 2014, one year after the divestiture of Hertz’s Advantage Rent a Car as the basis for antitrust approval of the Hertz-Dollar Thrifty merger, the acquirer of Advantage (despite its being an experienced car rental company and having had the benefit of support agreements from Hertz) declared bankruptcy. Many of the Advantage locations were sold to other car rental companies already serving the same markets and several were sold back to Hertz. In a similar situation, in 2015, the FTC approved the Albertsons-Safeway merger, based on the divestiture of a large number of stores to a smaller grocery chain. Within months, the acquiring chain filed for bankruptcy due to pressures from the rapid expansion, and the FTC ended up permitting Albertsons to buy back many of the divested stores.

Further, the antitrust regulators have recently focused not only on merger parties’ combined market shares in existing product markets, but on potential harm to future industry innovation—particularly in industries where a small number of competitors with large R&D budgets are viewed as driving innovation. For example, last year, Applied Materials, a semiconductor manufacturing equipment supplier, 18 months after announcing plans to acquire Japanese rival Tokyo Electron, in a $9.8 billion all-stock deal, abandoned the transaction amid concerns by the DOJ (and foreign antitrust regulators) regarding the deal’s potential impact on innovation in that industry. Such concerns can be difficult to address through targeted divestitures. (For further discussion of the Applied Materials situation, please see the Fried Frank Antitrust & Competition Law Alert, Future Competition Poses Present Risk to Deals, dated May 5, 2015.)

Thus, while the Halliburton-Baker Hughes merger—which, as noted, this month was challenged by the DOJ in court—likely would have always attracted a high level of antitrust scrutiny (given that the parties are, respectively, the second-largest and third-largest oil field services companies in the world), it is clear that it has become increasingly difficult to obtain antitrust approval of large mergers. In a recent speech, U.S. Attorney General Loretta E. Lynch stated that, when the DOJ is skeptical that divestiture or other remedies will safeguard competition, the government “will prosecute [its] suits to the very end” and will not “settle for the sake of settling.” She also indicated that the more complex the deal, and the more markets it “potentially endangers,” the greater reluctance the government will have to approving the deal based on proposed divestitures.

Creative Use of Available Tools to Meet the Antitrust Challenge

A variety of tools are available to craft remedies to antitrust concerns arising from a proposed transaction and to allocate the risk between the parties as to the possibility of approval not being obtained. Parties are advantaged by being strategic in their selection among these tools and in creatively tailoring them in novel ways to meet the challenges of the specific deal at issue.

Crafting Divestiture Packages

Integrated package approach. Regulators will be less likely to approve a divestiture package that is comprised of a diverse assortment of assets than a package that is presented as a stand-alone business or as part of an integrated plan that will enable the assets to be pro-competitive after divestiture. Thus, in transactions that present significant antitrust concerns, it should be taken into consideration early in the parties’ planning that, for the proposed divestiture package to be viewed by the regulators as likely to be pro-competitive, it may become necessary to include assets that the acquirer would prefer to retain. Whether these assets should be included in the initial proposed package or only if necessary later in the process will depend in large part on an analysis of how likely it is that they will ultimately have to be included and the merger parties’ view of the importance of obtaining approval sooner rather than later.

Suitable buyer—consider types of support for divested assets. A suitable buyer will typically be one with the experience, infrastructure, and financial wherewithal to be a strong competitor in the relevant market. If, as is often the case, the only potential buyers of the assets to be divested are not likely to be “suitable buyers” who will be able to support and develop the assets, short-term support agreements may be required by the regulators as an additional condition to approval. The government’s emphasis in recent years has been on support that will permit the buyer of the divested assets to become a completely independent strong competitor as quickly as possible. Thus, for example, in the Anheuser Busch InBev-Grupo Modelo situation, where the buyer of the divested assets did not have sufficient brewery capacity to brew and package the Modelo brand it was acquiring, the DOJ rejected the parties’ proposal that AB/In-Bev provide a 10-year supply of the beer to the buyer. Instead, the government insisted on a commitment by the buyer that it would expand its brewery capacity and a support agreement from AB/InBev that it would provide supply and transition services for the period required for the buyer to become a wholly independent competitor that would replace Modelo as a competitor in the U.S. market in perpetuity.

Support agreements can be creatively tailored to the specific circumstances. For example, in a situation in which our client placed a very high priority on a proposed merger and it was clear that there were very few potential buyers for the assets that might be deemed to be “suitable,” we crafted a support arrangement where, over a period of time, a development fund with a fixed dollar amount, established by our client and administered by the regulator, was available for expansion purposes upon the request of the divestiture buyer. While financing of a divestiture buyer is disfavored by the regulators, under the specific circumstances applicable in that case, the escrow of the funds—with no strings attached, the money placed in a fund administered by the regulator, and the buyer able to access the money at any time and without restrictions (other than that it had to be used for a specific type of expansion in a specific area)—was viewed by the regulators as ensuring that the buyer would be an effective competitor.

Consider spin-off of divested assets. A merger party could also consider whether, in lieu of divesting assets to a buyer, the assets could be divested in a spin-off. A spin-off could offer the advantages that a suitable buyer would not have to be found and that the arrangements are self-executing (i.e., the company determines the arrangements without having to negotiate with a third party). It should be easier to provide to a spinco, rather than to a third-party buyer of assets, the agreements and other support that would ensure that the spinco would be a strong competitor. Perhaps most importantly, all of the value delivered to the spinco would be captured by the merger party’s stockholders (rather than by a third party, in what is often the equivalent of a “fire sale” due to the pressure to divest to obtain the approvals).

We note that spin-offs have rarely been used for required antitrust divestitures. First, as a business matter, depending on the circumstances of the specific situation, creating a strong competitor through a spinoff may not be the preferred option when there are other acceptable alternatives. We note that the spin-off in this context would not involve the typical arrangements that favor the company and disfavor the spinco; rather, the arrangements would have to ensure that the spinco would be a viable stand-alone entity and a strong competitor. Thus, a spinco would have to have sufficient assets transferred to it, adequate capitalization, a strong management team, and so on. Second, the regulatory agencies would have to be satisfied as to the viability and independence of the spinco, as well as issues relating to completion risk and timing of the spin-off (including any required stockholder or third party approvals and SEC review). (We note that the spinoff alternative is unlikely to be acceptable to the regulators where there is concentrated ownership of the divesting company, due to issues relating to overlapping ownership with the spinco.)

However, in our view, under appropriate circumstances, a spin-off may be an effective option for meeting business objectives (indeed, the availability of a viable spin-off alternative should increase the company’s negotiating leverage with potential third party buyers of the assets to be divested); and, if properly crafted and presented, may be acceptable to the regulatory agencies.

With respect to spinoffs and the other approaches described above, we note that, in the current enforcement environment, pursuing creative remedies will take strong advocacy and a convincing showing that the proposed solution will effectively preserve competition in the relevant markets.

Reverse Termination Fees

The risk of not ultimately obtaining antitrust approval is sometimes (often, in antitrust-sensitive deals) dealt with through a “reverse termination fee”—i.e., a fee paid by the acquirer to the target company (or, in a private deal, the sellers) if antitrust approvals are not obtained by the drop dead date. The premise of an RTF is that it (i) provides a financial incentive to the buyer to take the necessary steps with respect to divestitures or other solutions to satisfy the concerns of the antitrust regulators so that the deal can proceed and (ii) provides the seller with compensation if the regulators’ antitrust concerns cannot be satisfied and the deal cannot proceed. RTFs tend to be negotiated based on the specific facts and circumstances of individual deals—with RTFs used most frequently, and tending to be larger amounts, in those deals in which the antitrust risk is perceived to be greatest and where the target company (or seller) has reasonable negotiating leverage. A higher RTF might also be used as part of inducing a target company to agree to more restrictive interim covenants on the target’s operations pending closing or to a more distant drop dead date. RTFs are also used in transactions that face other types of regulatory issues—including, in inversion transactions, changes in the expected tax treatment.

RTFs are not subject to the same type of fiduciary duty issues as deal protection breakup fees and a successful fiduciary challenge to an RTF would be unlikely. The size of RTFs has not been limited to the typical 3-4% range of deal protection fees. A Practical Law study released this month indicates that, of 112 public and private deals (with respect to the public deals, announced from November 2012 through 2015, with a deal value over $100 million; and, with respect to private deals, announced from June 2012 through 2015, with a target company equity value over $25 million), 49 of them contained an antitrust-related RTF, with the fees ranging from less than 3% (8 deals), between 3% and 4% (10 deals), between 4% and 6% (21 deals), and over 7% (10 deals).

The trend has been toward more frequent use of, and higher amounts for, RTFs. Most recently, the merger agreement for the Intel-Altera transaction (a $16.7 billion deal) included a $500 million RTF; Charter Communications-Time Warner Cable (a $55 billion deal) included a $2 billion RTF; Monsanto-Syngenta (a $46 billion deal) included a $2 billion RTF; and the Halliburton-Baker Hughes transaction (a $34.6 billion deal) includes a $3.5 billion RTF. The $54 billion AbbVie-Shire inversion merger included a $1.6 billion RTF. We note that, counter to the trend, the $45 billion Comcast-TWC deal did not contain any RTFs. Interestingly, the stockholders of TWC brought, unsuccessfully, breach of fiduciary duty claims against the board for not obtaining an RTF; and, in the AbbVie-Shire inversion transaction, the stockholders of AbbVie brought, unsuccessfully, breach of fiduciary duty claims against the AbbVie board for agreeing to such a large RTF when there was a known risk that there could be a change in tax treatment for inversions.

In the most common formulation, an RTF is a specified amount that is paid if antitrust approval cannot be obtained by the drop dead date or can only be obtained by divesting assets that exceed the Divestitures Cap. Parties may wish to consider alternative structures in order to craft the provision to better meet the parties’ concerns and objectives in the given situation. For example, an RTF could escalate gradually over time (a so-called “ticking fee”); could increase if antitrust approval has not been obtained after a specified period of time (but before the drop dead date); or (although consideration would have to be given to the increased leverage provided to the regulators) could increase if antitrust approvals would have been obtainable had the acquirer agreed to specified divestitures or divestitures at a specified amount above the Divestitures Cap.

“Optionality” Based on Antitrust Developments

When negotiating a merger agreement for a deal that presents antitrust concerns, the parties may wish to consider providing in the agreement for a degree of flexibility or “optionality” for one or both of the parties with respect to the transaction, as more information becomes available at various times as to the likelihood and cost of ultimately obtaining antitrust approvals. This approach may be especially useful in deals in which, with respect to the likelihood or costs of ultimately obtaining antitrust approval, there is a high degree of uncertainty, the merger parties have a fundamentally different view, and/or the merger parties have a significantly different level of tolerance for the risk.

Basic framework for “optionality.” One possible framework for the concept would be to permit the target company to have the right to terminate the agreement early (before the ultimate drop dead date), at one or more points in time when additional information has become available, based on the likelihood of antitrust approvals ultimately being obtained having become significantly lower, or (in a stock deal) the costs of obtaining the approval having become materially higher, than the target had originally believed would be the case. For example, one formulation could be that, after a specified period of months from signing the merger agreement, the target would have the right to terminate, unless the buyer then increases its commitment to the transaction (through a heightened standard of efforts or additional specific required divestitures); and/or the buyer increases the compensation to the target in the event approval is not obtained (through a higher RTF); and/or the buyer increases the merger consideration (in the latter two cases, the increase could either be a one-time increase or be done on a “ticking fee” basis, with additional increases over time). Another possible formulation would be to provide the buyer and/or the target company with the right to extend the drop dead date under certain circumstances, such as if the buyer is then litigating with the government, with the buyer’s right, possibly, being subject to the buyer’s increasing the RTF, and the target company’s right, possibly, being subject to a decrease in the RTF.

Other possible formulations. It should be noted that there is a wide variety of ways in which the concept could be utilized, effecting trade-offs between and among various merger agreement provisions, depending on various developments occurring or information acquired after signing. Other examples of possible formulations include:

  • Downward adjustment in merger price based on divestitures. The merger consideration could be adjusted downward if the divestitures required for antitrust approval exceed a specified value or must include specified types of divestitures. For example, the merger agreement for the recently announced Sherwin Williams-Valspar transaction (an $11.3 billion all-cash deal), which provides for a Divestitures Cap of $1.5 billion (but no RTF), also provides that the $113 cash per share merger price will decrease to $105 per share if the required divestitures exceed $650 million. We note that a graduated scale tied to the amount of required divestitures—rather than the $650 million “cliff” provided for in Sherwin Williams-Valspar—might be a preferable structure in most deals. One disadvantage of a “cliff”-based price adjustment is that, if the divestiture package were close to the specified “cliff” threshold, the buyer would have the incentive to expand the package and cross the threshold to obtain the benefit of the price reduction. This problem could be addressed by having a linear price reduction above the threshold or attempting to contractually limit the buyer’s manipulation of the package under those circumstances.

The amount of the merger consideration also (or alternatively) could be adjusted downward based on the type of divestitures required for antitrust approval. For example, an adjustment could be triggered by a need to divest specified assets, or specified brands or types of assets or more than a specified amount of those types of assets.

  • Change in merger consideration from cash to stock. In an all- or part-cash deal, the parties could consider agreeing that, if divestitures exceeding the Divestitures Cap are required, the target company would have the right that, instead of a termination of the deal and payment of the RTF, the merger consideration would be restructured (wholly or partly) from cash to stock—in which case both parties, rather than only the buyer, would share in the “cost” of the divestitures. (Of course, a change in the form of consideration would involve meaningful mechanical and other difficulties that would have to be addressed, including the potential that a stockholder vote would be required.)
  • No break-up fee payable by target if other transaction is pursued. To provide a target company with increased leverage in ensuring a satisfactory outcome in the face of significant antitrust uncertainty for the deal with the agreed buyer, the target could be given a right, after a specified period of time or upon certain early developments in the antitrust process, to effect a transaction with a different acquirer, without paying a breakup fee and with it receiving the RTF from the buyer, unless the buyer increases the RTF and/or extends the drop dead date.

Other Tactical Issues

Effect of provisions on the regulators. One tactical issue to be kept in mind is to what extent the combination of merger agreement provisions that relate to antitrust approval will affect the leverage that the regulators will have in trying to extract remedies or block the transaction. For example, a “hell or high water” provision can increase the regulators’ leverage, particularly if the drop dead date does not provide sufficient time for the parties to litigate in the event the regulators seek to block the deal in court. Similarly, a list of assets (or types of assets), or a specified Divestitures Cap, can provide a “roadmap” and increase the leverage of the regulators, at least with respect to the specified assets (or assets up to the amount of the Cap). The dynamics of each deal will dictate how the parties’ balance the benefits of these types of provisions with the negative inferences that could be drawn from them by the regulators.

Political ramifications. Another tactical issue relates to the timing of a transaction based on political considerations. A transaction commenced currently would be subject to the relatively aggressive approach of the regulators described above; whereas a transaction commenced a few months from now would be in the queue for regulatory review under a potentially different regime. The preferred timing would depend on one’s view of the outcome of the upcoming election.

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