How the Type of Buyer May Affect a Target’s Remedies

In exploring a potential public company sale, target boards rightly focus on the amount and type of consideration offered by potential buyers and the level of deal certainty. However, when considering offers (including at early stages in the process), target boards should also take into account the risk of a buyer breach, including in connection with a financing failure, and the remedies that will be available to the target as a result. Although, as a matter of principle, the consequences to the target of a failed deal should not be different depending on the type of buyer, as discussed below, the remedies offered by strategic buyers often dramatically differ from the remedies offered by financial buyers. [1]

In public M&A transactions, there are generally three potential remedies available to targets in the event of a buyer breach: (1) specific performance of the merger agreement (and the equity commitment letter, if any), (2) termination of the merger agreement with payment of a reverse termination fee [2] and (3) termination of the merger agreement with the right to recover monetary damages for pre-termination breach.

Specific performance may be unconditional (i.e., full), entitling the target to force the buyer to close regardless of whether its debt financing is available, and, thus, allocating all of the financing risk to the buyer. Alternatively, specific performance may be conditional, allocating all of the financing risk to the target, because the target can only force the buyer to close if the debt financing is available, all conditions to the buyer’s obligations to close are satisfied and the target has confirmed that it is ready, willing and able to close. Financial buyers rarely agree to anything more than conditional specific performance, whereas strategic buyers typically agree to unconditional specific performance, even if they are funding all or a large portion of the purchase price with debt. [3] This pattern makes sense given that strategic buyers are typically pursuing the transaction to advance strategic objectives and have access to a balance sheet (or balance sheet financing) to fund the purchase price, whereas financial buyers are typically special purpose entities with a business model dependent on leveraged financing (using the target’s balance sheet) to achieve acceptable returns on equity, with no other source of available funds to complete the closing if the debt financing fails.

Reverse termination fees serve as liquidated damages to partially compensate the target for the loss of the benefit of its bargain in the event of a buyer breach. Such fees are typically payable (1) upon either the buyer’s failure to close when required or upon a buyer breach that is material enough to cause the failure of a closing condition, (2) upon the buyer’s failure to close when its conditions to closing have been satisfied, whether or not due to a financing failure or a covenant breach, or (3) upon a financing failure. In 2018 and the first half of 2019, nearly 87% of transactions with a financial buyer provided for a reverse termination fee, whereas less than 30% of transactions with a strategic buyer provided for such a fee.

It is important to note that the fiduciary considerations present in setting the size of a target company termination fee (payable to the buyer in the event the target terminates the merger agreement to pursue a topping bid) are not relevant in setting the size of a reverse termination fee. In the case of a target company termination fee, there is a concern that a termination fee above a certain percentage of equity value will have a chilling effect on topping bids and, thus, could be viewed, when considered in the context of the entire deal protection package, to violate the board’s Revlon-type duties. The size of a reverse termination fee, on the other hand, is not subject to such judicially established limits and is merely a matter of negotiation between the target and buyer. In practice, reverse termination fees in transactions involving financial buyers have been higher than company termination fees. In 2018 and the first half of 2019, as a percentage of equity value, the mean and median company termination fees were 3.7% and 3.5%, respectively, whereas the mean and median reverse termination fees in transactions involving financial buyers were approximately 6.4% and 6.1%, respectively.

Transactions with strategic buyers also tend to differ from transactions with financial buyers with respect to whether, in the event of a willful buyer breach, the reverse termination fee serves as the target’s exclusive remedy or whether the target is entitled to bring an action for uncapped monetary damages (in addition to or in lieu of receiving any reverse termination fee). During 2018 and the first half of 2019, over 96% of transactions involving strategic buyers provided for uncapped damages for willful breach, and, in fact, over 70% of such transactions provided for uncapped damages for any breach. By contrast, during the same period, only 53% of the transactions involving financial buyers had uncapped damages for willful breach.

This pattern carries some logic because allowing the target to pursue an action for uncapped monetary damages raises the prospect that the target will seek and be awarded “benefit of the bargain” damages and, thus, prompts the same concerns for financial buyers as unconditional specific performance. However, so long as a financing failure is not considered a willful breach, whether a buyer breaches is within the buyer’s control. Moreover, providing that the reverse termination fee is the target’s sole and exclusive remedy for a willful breach essentially gives the buyer an option not to close, with an exercise price equal to the reverse termination fee, and the financing and other buyer covenants lose some of their potency. An arguable compromise—a two-tiered reverse termination fee, with a lower amount payable in the event of a financing failure or non-willful breach and a higher amount payable in the event of a willful breach (including a failure to close when financing is available)—limits the target’s damages in the event of a financing failure (or other unintentional breach), while holding the buyer accountable for any willful failure to comply with the financing or other covenants in the agreement. However, only four transactions in 2018 and the first half of 2019 provided for such a two-tiered reverse termination fee.

While the patterns associated with target remedy packages (and the reasons therefor) are relatively clear, it is also true that each transaction brings a different mix of circumstances that may warrant departing from the norm. Among the things a target board can do in attempting to construct a remedy package that best preserves the benefit of its negotiated bargain are:

• When evaluating potential bidders at the outset of a transaction, be aware of the different dynamics between financial and strategic buyers in terms of target deal protection and consider what remedies the buyer (or its parent fund) has agreed to in the past.
• Consider the practical risks (and consequences) of a buyer breach, taking into account that many financial buyers (and, in particular, private equity firms) are frequent transactional parties and face significant reputational harm if they are unable to close due to a financing failure or if they willfully breach a merger agreement.
• Consider whether the consideration being offered by financial buyers is sufficiently greater than the consideration being offered by strategic buyers to compensate the target for the smaller potential recovery in the event of a failed transaction due to a buyer breach.
• If, in the board’s business judgment, it is in the best interests of the target to engage with one or more financial buyers, aim to negotiate a reverse termination fee that is high enough to provide sufficient incentive for the buyer to close and make sure that payment of the fee is guaranteed by an entity with sufficient assets to cover the payment. The size of the buyer’s fund and the buyer’s access to capital, along with the relative negotiating leverage of the parties, rather than fiduciary duty concerns, will dictate the upper limit of the fee.
• Consider a two-tiered reverse termination fee, with a lower amount payable in the event of a financing failure or non-willful breach and a higher amount payable in the event of a willful breach (including a failure to close when financing is available).

At the end of the day, the remedy package is only one of many factors for target boards to consider in negotiating a public company sale, and the outcome largely depends on overall deal dynamics, including, in particular, whether both strategic and financial buyers are serious bidders. In considering the totality of the circumstances, target boards may get comfortable accepting typical financial buyer remedy packages. Nevertheless, purely from a remedy perspective, targets are much more likely to obtain the best terms from strategic buyers.

Endnotes

1For simplicity, we do not separately address hybrid buyers (i.e., financial buyers that already have a portfolio company in the target’s industry). However, we note that if the buyer is a portfolio company of a financial buyer, the target may be able to argue successfully that the buyer is more like a strategic buyer than a financial buyer and should, thus, offer a more expansive remedy package.(go back)

2While reverse termination fees can be payable in other circumstances (e.g., for failure to obtain antitrust or other regulatory approval), the focus of this article is on triggers relating to the buyer’s breach, financing failure or other failure of the buyer to close when its closing conditions have been satisfied.(go back)

3Statistics in this article are based on all-cash public M&A transactions involving U.S. targets and that were announced from January 1, 2018 to June 30, 2019 and not withdrawn as of September 1, 2019, as reported by DealPointData. In the 130 such transactions, the target was entitled to unconditional specific performance in nearly 90% of the transactions involving a strategic buyer, and the target was entitled to conditional, limited or no specific performance in over 75% of the transactions involving a financial buyer.(go back)