Mergers & Acquisitions for Business Leaders€¦ · Mergers and Acquisitions for Business Leaders of Public Corporations in the U.S. 2 M&A is increasingly a tool of choice. Leaders

March2017TerrenceJ.L.Reeves

Mergers&AcquisitionsforBusinessLeadersofPublicCorporationsintheU.S.AbriefreviewofdealstructuresandtrendingissuesinM&AunderDelawareLaw

EXECUTIVE SUMMARY

Business Leaders are under added pressure to innovate and gain market share to increase shareholder returns in response to global competition. Unfortunately, competitive advantages and extra-ordinary economic returns do not just fall out of the sky. As such, Business Leaders pursue Mergers & Acquisitions (M&A) opportunities as a way to acquire potential increased returns.

There are three primary types of M&A transactions. An “asset deal” involves the

purchase of all or some of the assets of one corporation by another. A purchaser may also acquire a company by buying its outstanding shares through a “stock deal.” The third, a merger, is the legal combination of two companies to form a single entity under state law. Mergers are schemes of arrangement. The primary schemes used in the U.S. are direct (target folds into the purchaser directly), forward triangular (target is absorbed by subsidiary of purchaser) and reverse triangular (target absorbs subsidiary of purchaser). Of note, triangular mergers involve three companies.

Each M&A type has risks and benefits. Unsurprisingly, a benefit to one party may result

in a loss to another. Consequently, Business Leaders face important choices about deal structure and the resulting tax obligations for the company and its shareholders. Generally, shareholders and targets prefer stock deals, while purchasers prefer asset deals. The preferences here are driven mainly by taxes, which impact the net financial benefit for purchasers, targets and shareholders of targets. For example, target shareholders avoid the double taxation (corporate and individual taxes) present in an asset deal through a stock deal. Conversely, purchasers can improve profits post-closing as a result of the depreciation deductions available in an asset deal. Moreover, purchasers can hand pick the assets acquired and liabilities assumed in an asset deal unless otherwise dictated by operation of law. Deal structure also factors into whether the deal requires regulatory, shareholder or third-party consent.

Lawyers spanning a number of specialties help Business Leaders evaluate the benefits

and risks of M&A deals. The legal due diligence process extends beyond business synergies and aims to protect the property acquired, be it assets (tangible and intangible) or the value of the stock acquired. In the end, however, the parties must agree to a structure on mutually agreeable terms that they can live with, or move on to the next M&A opportunity in pursuit of growth.

M&A deals are governed by state law (corporate and tax) and federal law (including,

securities, tax and antitrust laws). On the state front, Delaware is the preeminent jurisdiction for corporate law. Delaware’s statutory law and caselaw define the duties directors owe to shareholders, and the applicable standards of review and the extent of liability when a director fails to fulfill those duties. The Business Judgement Rule is the foundational standard, and shields directors from courts second-guessing decisions of independent, disinterested directors. Delaware also enacted a forum selection law that helps corporations manage litigation exposure from internal claims more efficiently. Business Leaders of public corporations must stay abreast of Delaware law to ensure compliance before, during and after the M&A process. Compliance should aim to mitigate litigation risks arising out of M&A transactions, but also take advantage of the opportunities afforded under Delaware law as appropriate.

This is not a comprehensive review of M&A, legal or otherwise. I do not cover tax free reorganizations or antitrust issues, for example. Instead, I hope to bridge the communication gap between legal and business professionals. Thus, I encourage Business Leaders to further examine the wonderful world of M&A, a place littered with successes and failures.

Mergers and Acquisitions for Business Leaders of Public

Corporations in the U.S.

M&A

Mergers and Acquisitions for Business Leaders of Public Corporations in the U.S.

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I. INTRODUCTION

This paper provides a high level review of mergers and acquisitions (“M&A”). The

purpose of this paper is to enable Business Leaders1 to discuss M&A issues within their

respective organizations. First, I examine M&A as a tool for value creation and the role of

lawyers in the M&A process. In Section III, I describe stock, asset and mergers transactions and

discuss the legal and tax implications of each. Finally, I examine trending issues in M&A in

Section IV. I focus the discussion in Section IV on Delaware law since 64% of Fortune 500

companies are incorporated in the state.2

II. MERGERS & ACQUISITIONS AND THE ROLE OF LAWYERS

A “merger” is the fusion of one [corporation] into another.3 In contrast, a company

purchases and absorbs another by way of an “acquisition.” A merger differs from an acquisition

in that the former usually involves two similarly sized companies that agree to operate as a

single, new company going forward, whereas an acquisition results in the acquired company

ceasing to exist as a separate entity. Yet, parties may publicize an acquisition as a merger to

signal a “friendly acquisition” to shape public perception.4 Because parties can blur the

difference between a merger and acquisition, I use “M&A” to describe these transactions

generally. See Exhibit 1 for a list of notable M&A deals.

Business Leaders endure the never ending obligation to “create value.” M&A is one tool

leaders can leverage to find and deliver additional value to shareholders. Through an M&A

transaction, a company simultaneously shortens the runway to launch a product or service or

acquire a new capability and eliminates a competitor in the space.

1 “Business leaders” include current officers and directors and those on track to serve in those roles. 2 "About Agency," State of Delaware, 25 Sept. 2016, https://corp.delaware.gov/aboutagency.shtml. 3 Black's Law Dictionary Online (2nd ed.). 4 I use “friendly acquisition” in contrast to a “hostile acquisition” where a target’s board attempts to prevent the transaction.


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M&A is increasingly a tool of choice. Leaders may reason that an M&A deal allows the

company to achieve economies of scale, obtain new capabilities, or gain greater market share. In

fact, 2015 was a record setting year, with deals valued at over $5 trillion.5

Lawyers serve a valuable role in the M&A process. M&A deals are interdisciplinary,

requiring input from attorneys across several specialties. For example, M&A deals often involve

corporate, real estate, environmental, antitrust, intellectual property, tax and labor lawyers. The

legal team analyzes thousands of documents during the due diligence phase to mitigate risks.

This review includes analyzing any existing and pending intellectual property, as well as

governing documents and various other agreements to determine consent requirements and

assess assignability restrictions. Importantly, lawyers negotiate and draft the substantive legal

documents that define the terms of the deal, including post-closing matters. See Exhibit 2 for the

various stages of an M&A deal and Exhibit 3 for a list of typical transaction documents.

III. DEAL STRUCTURES AND LEGAL IMPLICATIONS

Professionals view M&A deals through at least two lenses. Business Leaders examine

M&A transactions based on the competitive position of the firms involved. The business view

defines M&A deals as either horizontal,6 vertical7 or conglomerate.8 Attorneys assess M&A

deals based on the legal structure – asset, stock or merger – that reflects the agreement of the

parties.9 Important legal considerations include liabilities assumed and assets acquired,

stockholder approvals, anti-assignability clauses and third-party consent requirements, and tax

concerns. Based on the stated goal, I examine M&A deals through a legal lens.

5 "2016 M&A Global Outlook," J.P. Morgan Chase, Sept. 14, 2016, https://www.jpmorgan.com/global/insights/maglobaloutlook 6 A merger between companies that operate and compete in the same line of business. 7 A merger between companies that produce different goods and/or services for one common finished product. 8 Merger between companies that operate in completely different and unrelated industries. 9 Click the respective hyperlinks to view an example of an Asset Purchase, a Stock Purchase and Merger agreement submitted by various companies and stored on the Security and Exchange Commission's website.


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I refer to the corporation acquiring another as “Purchaser” and the acquired corporation

as “Target” throughout. I define an affiliate of Purchaser as “Subsidiary.”

A. Stock Purchase

A Purchaser may acquire a Target by acquiring its outstanding shares as demonstrated in

Exhibit 4(a). Purchaser acquires Target upon buying all of Target’s shares from Target’s

shareholders.10 Purchaser may provide cash, stock or a combination of cash and stock in

exchange for Target’s shares. If Purchaser offers stock as consideration, Target’s shareholders

will receive stock of Purchaser based on an agreed exchange ratio, which could result in a tax

free transaction.

To acquire shares of a public company, Purchaser must make a “tender offer” to

shareholders of Target. A tender offer is an open invitation from Purchaser to shareholders of a

Target to sell shares, usually at a premium over the then market price. A tender offer allows

Purchaser to purchase Target shares only after a specified number of shares have been tendered.

The number of shares tendered is usually enough for Purchaser to obtain control of the Target.

Legal Implications

Upon acquiring a company through a stock purchase, Purchaser assumes all of Target’s

assets and liabilities, known and unknown, by operation of law unless the parties agree

otherwise. Shareholders consent to stock deals by agreeing to sell shares held. Stock exchange

rules require that Purchaser’s shareholders approve any transaction where Purchaser finances the

deal by issuing new shares that exceed 20% of outstanding shares.11 Unless specified by contract

or operation of law, Target is not required to obtain third party consents because the parties to the

10A purchaser may also acquire a target through a statutory short-form merger pursuant to §253 of the Delaware General Corporations Law (“DGCL”). A short form merger occurs when a purchaser acquires less than 100% (but generally at least 90%) of a target’s outstanding stock. This allows purchaser to acquire the remaining minority interests without a stockholder vote. 11 312.03(c) of the NYSE Listed Company Manual


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contract remain the same post-closing. Purchaser and Target will consummate the stock purchase

at closing after executing a Stock Purchase Agreement.

Tax Implications

Target shareholders will have a capital gain or loss on the sale of shares to Purchaser. The

gain or loss is subject to 15-percent tax rate if the shareholder held the stock for a year or more.12

The tax rate is 20-percent for upper income shareholders. As such, shareholders prefer stock

deals. Purchaser will receive shareholder’s cost basis in the stock acquired.13 For example, if a

shareholder paid $50 per share, Purchaser will receive a $50 basis in each share, despite paying

shareholder $75 per share. Purchaser benefits from the transferred basis once it sells the stock.

Additionally, Purchaser will receive Target’s tax basis in the assets of the company. A stock deal

is a non-taxable event for Target, a preferable outcome. Conversely, Purchasers prefer asset deals

in light of the tax disadvantages of stock deals (ex. the transferred tax basis on assets and the

inability to depreciate shares).

B. Asset Purchase

An asset purchase involves a Purchaser buying all or part of Target’s assets as depicted in

Exhibit 4(b). Asset purchases may involve tangible (real property, machinery, inventory, etc.)

and/or intangible assets (goodwill, trademarks, patents, etc.). Here, Purchaser pays the purchase

price (stock, cash or both) directly to Target, followed by the distribution of the proceeds to

Target shareholders at liquidation. This may be Purchaser’s structure of choice if Target has

various divisions and Purchaser does not want to acquire all of Target’s operations.

12 See, generally, Subchapter P of Title 26 of the U.S. Code for a review of treatment for capital gains and losses. 13Per IRS Publication 551, the cost basis of property is usually its cost. The cost is the amount you pay in cash, debt obligations, other property, or services. A “tax basis” is the value of an asset, used for computing gain or loss when the asset is sold. A basis is used to figure the gain or loss on the sale, exchange, or other disposition of property. It is also used it to calculate deductions for depreciation, amortization, depletion, and casualty losses.


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Legal Implications

Asset deals are more complicated than stock deals and mergers.14 In an asset deal,

Purchaser assumes designated liabilities unless otherwise required by law.15 Target will settle its

non-designated liabilities, usually at closing. Whether the deal requires shareholder approval will

depend Target’s obligations per state law and its bylaws.16 It is not uncommon for a company’s

bylaws to require shareholder approval if the sale involves “all or substantially all” of the

company’s assets. Dissenting shareholders may have appraisal rights17 under §262 of the DGCL.

As previously noted, stock exchange rules may require that Purchaser’s shareholders approve the

transaction. Generally, asset deals require third-party consent because, post-closing, third-parties

must enter into new contracts with Purchaser, a potential risk for third-parties. Parties

consummate an asset purchase at closing after executing an Asset Purchase Agreement.

Tax Implications

Asset deals have tax consequences for Purchaser, Target and its shareholders. Purchaser

will receive a tax basis in the acquired assets equal to the purchase price (or fair market value)18

of the assets, including assumed liabilities. If the purchase price for the assets is more than

Target’s tax basis in the assets, Purchaser’s tax basis will be “stepped up” to the purchase price.

The step-up allows Purchaser to take depreciation deductions on the acquired assets, which will

increase net income. Target will recognize a gain or loss on the sale of the assets, taxed at

Target’s corporate tax rate. Target’s shareholders will also pay taxes on any subsequent

14 For example, asset deals require the parties to specifically identify each asset included, and may require target to legally transfer ownership of real estate, leases, vehicles, equipment, intellectual property. 15 Successor liability rules may also hold a purchaser liable for a target’s liabilities despite an agreement to the contrary. There are nine theories by which successor liability may be imposed on purchaser. See Tressler LLP’s 50 State Summary here. 16 DGCL requires shareholder consent: See § 251 (requiring stockholder approval of a merger); § 271 (requiring stockholder approval of the sale of all or substantially all assets); § 275 (requiring stockholder approval of the dissolution). 17Appraisal rights give dissenting shareholders the right to obtain a “fair value” assessment for shares held in a company subject of a merger or consolidation under the DGCL. Fair value can be determined through a judicial proceeding or an independent valuator. Purchaser is then obligated to purchase the shares at the appraised price. 18 Purchase price is allocated across the purchased assets. Parties to a M&A usually work together to allocate the purchase price shortly after closing the transaction.


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distribution made by Target upon liquidation. Thus, shareholders prefer stock deals due to

double taxing in asset deals. Purchasers usually prefer asset deals due to the resulting tax

benefits.

C. Merger

Purchaser acquires the “business” of Target through a merger.19 There are three primary

merger structures - direct, forward triangular and reverse triangular as shown in Exhibit 5. In a

direct merger, Target merges into Purchaser, eliminating Target’s existence. Triangular mergers

involve three companies: Purchaser, Subsidiary and Target. Forward triangular mergers result in

the Subsidiary absorbing Target. Reverse triangular mergers, on the other hand, result in Target

absorbing Subsidiary. In both cases, Subsidiary is capitalized with the consideration to purchase

the Target, resulting in Target as a wholly-owned subsidiary of Purchaser. Target’s shareholders

receive cash and/or shares of Purchaser in exchange for their shares.

Legal Implications

A merger is a statutory combination under state law. In a direct merger, Purchaser

assumes all of Target’s liabilities by operation of law; however, triangular mergers protect

Purchaser from direct liability since Target or Subsidiary, as the case may be, continue to exist

post-closing. Target shareholders must approve a direct merger, and non-consenting shareholders

may have appraisal rights under Delaware law. A majority of Purchaser’s shareholders must also

approve a direct merger that requires that Purchaser issue new shares as consideration to Target’s

shareholders.20 Shareholder approval is generally not required for triangular mergers. Direct and

forward triangular mergers trigger anti-assignment and third-party consent requirements due to

potential performance risks associated with the change of control as Target folds into Purchaser 19 Under § 251of the DGCL, a statutory merger occurs where two or more corporations merge into a single corporation. As such, Delaware law requires the parties to file a certificate of merger, setting forth, among other things, the involved parties and effective date, and that the merger was approved by the involved corporations. 20§251(f) of the DGCL


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or Subsidiary, respectively, post-closing. A merger may also require regulatory consent to

address antitrust issues. Parties consummate a merger at closing after executing a Merger

Agreement.

Reverse triangular mergers have advantages. One advantage is that Target survives,

eliminating the need to obtain new licenses and permits from governing agencies. Furthermore,

since Target remains intact, the transaction will normally not require third-party consent.

Tax Implications

Direct and forward triangular mergers are usually treated as asset deals for tax purposes,

while reverse triangular mergers are treated as stock deals. To muddy the waters a bit, the parties

may jointly elect to treat a stock deal as an asset deal under §338 of the Internal Revenue Code.

IV. TRENDING ISSUES IN M&A

A. Director Duties, the Business Judgment Rule and Director Independence

The business and affairs of a company are managed or controlled by its board of

directors. When making decisions, directors must fulfill their fiduciary obligations to the

corporation and its shareholders. Delaware law imposes two primary duties on directors – the

duties of loyalty and care. Generally speaking, the duty of loyalty requires that directors act in

good faith and free of conflicts of interests.21 If a conflict does exist, directors must insulate

decisions from the conflict. The duty of care requires that directors inform themselves “prior to

making a business decision, of all material information reasonably available to them” with a

critical eye.22 Directors also owe shareholders the related duties of good faith and disclosure.

21 Cede & Co. v. Technicolor, Inc., 634 A.2d 345 (Del. 1993) 22 William Lafferty, Lisa Schmidt & Donald Wolfe, Brief Introduction to the Fiduciary Duties of Directors Under Delaware Law, 116 Penn. St. L. Rev 837(2012) (citing, Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985), where the Court applied a gross negligence standard to the duty of care to assess whether the director displayed a “reckless indifference to or a deliberate disregard of the whole body of stockholders or actions which are without the bounds of reason.”)


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The business judgment rule (“BJR”) shields directors from courts second-guessing

decisions of independent, disinterested directors. The rule presumes directors act on an informed

basis, in good faith, and in the best interests of the company, and applies even if the outcome is

less than stellar. In M&A transactions, Delaware courts review M&A transactions that do not

result in a sale of control under the BJR. Courts apply an enhanced scrutiny test when reviewing

a director’s decision to employ defensive tactics23 or to approve a transaction results in a sale of

control.24 Finally, the court analyzes issues where approval for the transaction involved a

potential conflict of interest or where plaintiff has successfully rebutted the BJR under the “entire

fairness” standard. In summary, Delaware courts apply increasing scrutiny as shareholder and

director interests diverge. Directors must manage corporate affairs with these standards in mind.

Delaware courts recently addressed director independence in Master Fund Ltd. v. Gohl.25

The case involved a challenge by a minority shareholder to a loan to Key Plastics by two

investment funds that together owned more than 90% of Key Plastics’ stock. Plaintiff submitted

evidence that comparable companies would have provided financing at rates 50-90% lower. In

applying the entire fairness test, the court found that the loan was not entirely fair. After Master

Fund, “directors will find it difficult to prove entire fairness of a controlling stockholder

transaction not approved by independent directors, particularly where the board does not retain

independent legal and financial advisors or obtain an independent fairness opinion.”26

B. Disclosure Only Settlements

23 Target’s board may employ defensive tactics such as “white knights” (the injection of a friendly purchaser to prevent a hostile acquisition by a “black knight”) or “poison pills” (shareholder rights plan that allows shareholders, except purchaser, to purchase additional shares at a discount price) 24 See, Revlon Inc. v. MacAndrews & Forbes Holdings, Inc. 506 A.2d 173 (Del. 1986) (where the Delaware Supreme Court imposed an affirmative duty on boards to seek the highest reasonable value for shareholders when a sale becomes inevitable) 25 Master Fund Ltd. v. Gohl, No. 10244-VCN (Del. CH. Sept. 28, 2015) 26 Developments in Corporate Governance and M&A Law in 2015, Orrick, Herrington & Sutcliffe LLP (Mar. 2016)


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More than 90% of public M&A transactions are subject to litigation.27 Some of those

cases involve shareholder class-action suits to challenge the adequacy of disclosure documents,

documents required by the SEC. In settling disclosure-only suits, defendant companies obtained

broad liability releases and agreed to pay plaintiff’s legal fees, but avoided paying monetary

damages to plaintiff-shareholders. Instead, shareholders settled for supplemental disclosures. In

accepting the settlement with a reduction in legal fees In Re Riverbed Technology, Inc.

Stockholders Litigation, the Delaware Chancery Court cautioned against broad releases that “go

far beyond the claims asserted” in the future. The result here should impact the completeness of

disclosure documents. Notwithstanding, Business Leaders should add allowances for monetary

damages to deal budgets for shareholder disclosure-only suits. Furthermore, Business Leaders

should work with attorneys to craft liability releases tailored to the facts and claims of each case.

C. Forum Selection Bylaws

The Delaware legislature amended §115 of the DGCL in 2015 to allow corporations to

make Delaware the state of exclusive jurisdiction for “internal corporate claims.” Section 115

defines internal corporate claims as those based on a duty by a current or former director, officer

or stockholder or claims the DGCL confers jurisdiction to the Court of Chancery.

Section 115, as amended, gives Business Leaders increased control over where plaintiffs

can sue for internal corporate claims, adding a level of predictability previously lacking. Section

115 appears to be a win for shareholders, too, as the exclusive jurisdiction framework may result

in reduced legal expenses (increased retained earnings) by reducing a plaintiff’s ability to file

suit in less deferential jurisdictions. As such, Business Leaders of existing domestic corporations

should work to immediately incorporate §115 by amending the company’s certificate of

incorporation or bylaws. In the M&A context, Purchasers should require that non-Delaware 27 Id.


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Targets convert to Delaware corporations pre-closing pursuant to §265 of the DGCL and adopt

§115 in the process.


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EXHIBIT 1 NOTABLE M&A DEALS

Mergers

• Exxon and Mobil merged to form ExxonMobil in 1997 in an $80B deal

• Chrysler and Daimler Benz merged to form DaimlerChrysler in 1998 in a $38B deal

• AOL and Time Warner merged to form AOL-Time Warner in 2000 in a $165B deal

• Yellow Corp. and Roadway Corp. merged to form YRC in 2003 in an $1.05B deal

• Sprint and Nextel merged to form Sprint Nextel in 2006 in a $36B deal

• Johnson Control and Tyco International agreed to merge in 2016 in $16.6B deal

• AB InBev will merge with SABMiller in October 2016 in a $104B deal

Acquisitions

• Pfizer Inc. acquired Warner-Lambert in 2000 for $90B

• HP acquired Compaq in 2002 for $18.6B

• Facebook acquired Instagram in 2012 for $1B

• Google acquired Motorola Mobility in 2014 for $12.5B

• Comcast acquired Time Warner in 2014 for $67.6B

• Facebook acquired WhatsApp in 2014 for $19B

• Marriott International acquired Starwood Hotels and Resorts in 2015 for $13.6B.

• Microsoft is set to acquire LinkedIn in 2016 for $28B

• Abbott is set to acquire St. Jude Medical in 2016 for $31B

• Shire to acquire Baxalta in 2016 for $32B


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EXHIBIT 2 TYPICAL STAGES OF M&A TRANSACTIONS


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EXHIBIT 3

TRANSACTION DOCUMENTS28

1. Confidentiality Agreement (ensures the terms being discussed and information about the parties’ respective businesses will be maintained in confidence)

2. Letters of Intent (non-binding document that provides the framework for the transaction,

including a purchase price range, transaction structure, contingencies and covenants)

3. Exclusivity Agreement (agreement through which target agrees not to begin or continue attempting to sell the company to a third party for a specified period of time)

4. Transaction Agreement (primary transaction document that establishes the terms of the stock, asset deal or merger)

5. Disclosure Schedules (attachments to the Transaction Agreement that provide disclosures about one of the parties to the transaction and to qualify or limit representations)

6. Hart Scott Rodino Filing (filings required to allow the Federal Trade Commission and U.S. Department of Justice to determine whether the proposed transaction may have an anti-competitive effect)

7. Third Party Consent (consent required from a third party that restricts the ability a party to an M&A transaction to consummate the deal)

8. Legal Opinion (opinion to provide additional assurance to a purchaser to confirm certain legal matters made by the target in its representations and warranties)

9. Stock Certificate (physical embodiment of ownership interest in a corporation)

10. Bill of Sale (transfers ownership of personal property from target to purchaser)

11. Assignment and Assumption Agreement (like a bill of sale, except it transfers contracts, permits and similar assets by the target to purchaser in an asset purchase transaction)

12. Escrow Agreement (governs portion of purchase price deposited with third party agent to hold for a period after closing for the purpose of remitting funds to indemnified parties if they become entitled to recover damages)

13. Transition Services Agreement (governs the support provided by the target to purchaser for a period of time post-closing)

28 List and descriptions taken from www.themalawyer.com with modifications for relevance and consistency.


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EXHIBIT 4 STOCK DEAL

(a)

(b)


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EXHIBIT 5

MERGER STRUCTURES (a)

(b)

(c)

Documents

Mergers & Acquisitions for Business Leaders€¦ · Mergers and Acquisitions for Business Leaders of Public Corporations in the U.S. 2 M&A is increasingly a tool of choice. Leaders