CSG's Corporate & Securities Group is pleased to provide the latest installment of Insights – which highlights recent judicial decisions, legislative actions and regulatory announcements of interest.
Judicial Decisions, Legislative Actions and Regulatory Announcements
M&A Trend Alert: 'Weinstein Clause' Representation and Warranty on the Rise
Over the last year, there has been a rising trend for M&A buyers to mitigate risks that could potentially arise from a transaction where the seller has pending or looming sexual harassment claims or allegations against senior level executives. In light of the #MeToo movement, risks arising from sexual harassment claims include material damages from brand deterioration, litigation and C-suite controversy. Thus, the inclusion of so-called ‘Weinsten clauses’ or ‘#MeToo reps’ are on the rise and are becoming more frequently used in M&A deals.
These clauses provide a warranty from the selling company that there are no sexual harassment claims or accusations pending against any key employee or company executive at or above a certain level. If there are pending cases, such matters need to be disclosed. Recent M&A deals have required that seller escrow funds be put in place (in some cases, 10% of the total purchase price) to protect buyers in the event a pre-closing sexual harassment claim is discovered post-closing.
While these provisions get their name from the high-profile sexual harassment case against Hollywood producer, Harvey Weinstein, they cut across all industries, and we've recently seen examples in retail, healthcare, utilities, real estate, food and media transactions.
In the M&A due diligence context, buyers are conducting more thorough reviews of sellers to ensure employees are adequately trained, and that compliance channels and best practices are in place to warrant against sexual harassment claims arising post-closing. Whereas buyers historically focused on financial and operational due diligence, they are now going beyond the numbers to diligence the corporate culture and behaviors of the seller's executives in an effort to avoid sexual harassment-related liabilities post-closing.
Arbitration Provision Not Applicable to Employee Who Transferred To Affiliated Company
In a recent decision, the New Jersey Appellate Division analyzed whether an arbitration provision in a job application was enforceable against an applicant/employee who was subsequently employed by an affiliate of the company at which he initially applied.
On July 27, 2017, Tian K. Reid (“Reid”) filed an employment discrimination and retaliation claim against his former employer, which moved to compel arbitration of the dispute based on an arbitration provision in Reid’s employment application with the former employer. The arbitration provision stated that Reid and “the Company” agreed to arbitrate any dispute concerning Reid’s employment. During the period in question, Reid worked for three different car dealerships, each of which was a separate corporate entity, but was a commonly owned affiliate of the initial employer. While the Court found the agreement to arbitrate valid, the Court decided the dispute was not within the scope of the arbitration provision, since the arbitration provision failed to inform Reid that if he transferred to a separate affiliated company, the provision would continue to govern. The Court noted “[i]f defendant intended the provision to apply to future employment relationships between plaintiff and affiliates of DCH Academy Honda, then the language in the arbitration provision needed to reflect that intent.”
This opinion emphasizes the importance of not only considering how an employer is defined in any agreement with an employee, but also accounting in any such agreement for possible internal transfers.
Reid v. DCH Auto Group, Inc. et. al., Superior Court of New Jersey, Appellate Division, November 8, 2018, Not Reported in Atl. Rptr., 2018 WL 5831291
Court Upholds Waiver of Appraisal Rights
The Delaware Court of Chancery recently upheld a provision in a stockholders' agreement that restricted the shareholders' exercise of statutory appraisal rights under Section 262 of the Delaware General Corporation Law (“DGCL”).
In Manti Holdings LLC v. Authentix Acquisition Co., the shareholders of Authentix Acquisition Co. (the “Company”) entered into a shareholders' agreement which provided, in part, that upon a sale of the Company, the shareholders shall consent to the sale and refrain from exercising appraisal rights with respect to the sale. The Company was sold, and from the proceeds, certain shareholders received little or nothing for their equity interest. These shareholders then exercised their appraisal rights and challenged the purchase price, notwithstanding the shareholders' agreement. In yet another display of the Court of Chancery upholding shareholder freedom of contract, the court found that despite the statutory appraisal rights provided under Section 262 of the DGCL, the shareholders were contractually bound to refrain from seeking appraisal pursuant to the shareholders' agreement.
This decision highlights the Delaware Court's deference to shareholders' ability to govern their affairs by contract where not prohibited by applicable statute.
Manti Holdings, LLC v. Authentix Acquisition Co., No. CV 2017-0887-SG, 2018 WL 4698255 (Del. Ch. Oct. 1, 2018).
Delaware Court of Chancery Refuses to Rely on Deal Price in Stockholders Appraisal Action
In another recent appraisal case, the Delaware Court of Chancery in Blueblade Capital Opportunities LLC v. Norcraft Companies, Inc., 2018 WL 3602940 (Del. Ch. July 27, 2018) refused to rely on the negotiated deal price as an estimate of the fair value of the target company’s shares and instead used its own discounted cash flow ("DCF") analysis to estimate fair value.
The statutory appraisal action arose out of a May 12, 2015 merger whereby Fortune Brands Home & Security, Inc. (“Fortune”) acquired Norcraft Companies, Inc. (“Norcraft” or the “Company”) for $25.50 per share (the “Merger Price”). Petitioners, Blueblade Capital Opportunities LLC and Blueblade Capital Opportunities CI LLC, stockholders of Norcraft on the merger’s effective date, sought judicial determination of the fair value of their Norcraft shares as of that date. While the Court was mindful of the Delaware Supreme Court’s recent cases weighting deal price as a “strong indicator” of fair value for a public company that engages in a sales process, the Court nonetheless found that the Merger Price did not reflect the fair value of the Company due to flaws in the pre-signing and post-signing sales process.
Specifically, Norcraft did not engage in a pre-signing market check. Norcraft did not instruct its financial advisors to canvass the market for other potential bids and failed to look past Fortune as a potential merger partner prior to signing the merger agreement. Furthermore, Company’s CEO, who served as Company’s lead negotiator throughout the sales process, was also negotiating with Fortune certain benefits for himself, including his post-merger employment with the buyer, waiver of a non-compete covenant, and the possibility of buying one of Fortune’s business divisions for himself. The Court also found that the post-signing go-shop period was similarly flawed. Before the go-shop period, it was not widely known that the Company was for sale, disadvantaging possible bidders. Fortune’s financial advisors also reached out to potential bidders during the go-shop period attempting to dissuade them from pursuing a bid.
The petitioning stockholders argued that the pre-signing and post-signing sales process was so flawed that the Merger Price was unreliable as a proxy for fair value. The Court agreed and applied a DCF analysis to calculate Norcraft’s fair value, incorporating the most credible testimonies from both expert witnesses. The Court determined that the fair value of Norcraft shares at the time of the merger was $26.16 per share. The Court used the Merger Price as a “reality check,” and was satisfied that the difference between the Merger Price and the DCF value was not so great as to question whether the DCF value was grounded in reality. This case highlights the importance of a company’s sales process for purposes of assessing fair value in an appraisal.
Blueblade Capital Opportunities LLC v. Norcraft Companies, Inc., 2018 WL 3602940 (Del. Ch. July 27, 2018)
Delaware Chancery Court Upholds Use of "Material Adverse Event" Clause for the First Time
In what some are calling a landmark decision, the Delaware Court of Chancery (the “Court”) has for the first time found an occurrence of a material adverse effect (an “MAE”) in a merger transaction, allowing the purchaser the right to terminate the merger agreement and walk away from the transaction. In Akorn, Inc. v. Fresenius Kabi AG, No. CV 2018-0300-JTL, 2018 WL 4719347 (Del. Ch. Oct. 1, 2018), the Court held, following a five day trial, that Fresenius Kabi AG (“Fresenius”) properly terminated the parties’ merger agreement due to an MAE under the terms of the merger agreement and pertinent Delaware case law. No prior decision of the Court has resulted in finding an MAE.
The parties signed a merger agreement in April 2017 in which Fresenius agreed to acquire Akorn, Inc. (“Akorn”) for $4.75 billion. After signing, however, Akorn’s financial performance rapidly declined and Fresenius identified serious regulatory compliance issues at Akorn. Consequently, in April 2018 Fresenius notified Akorn it was terminating the merger agreement on the grounds that (1) significant declines in Akorn’s financial performance amounted to an MAE (and therefore, a failure of the standalone material adverse effect condition), and (2) serious Food and Drug Administration (“FDA”) compliance failures breached Akorn’s regulatory compliance representations in a manner that constituted an MAE (and therefore, a failure of Akorn’s ability to “bring-down” its representations and warranties at closing). In response, Akorn filed suit seeking specific performance to compel Fresenius to close the acquisition.
In its 246-page opinion, the Court ruled Fresenius had validly terminated the merger agreement because of an MAE. The Court explained that an MAE must “substantially threaten the overall earnings potential of the target in a durationally-significant manner.” The Court also reaffirmed that the target’s performance should be considered on its own as a standalone business and not in light of its value to a potential acquirer. With this in mind, the Court found Akorn’s quarterly results reflected very significant year-over-year decline – revenue declined 27%–34%, operating income declined 84%–292%, and earnings per share fell 96%–300%. The Court also noted that in the year after signing, annual EBITDA fell 86% and adjusted EBITDA fell 51%. This was in stark contrast to Akorn’s consistent growth and financial success during the time period preceding the signing of the merger agreement. The Court further found that the causes of these declines in Akorn were durationally significant, citing forward-looking analyst estimates for 2018, 2019, and 2020, which had fallen by approximately 65%. Even though the merger agreement contained standard provisions carving out, among other things, “general industry conditions” from the scope of an MAE, the Court held that the financial performance issues were specific to Akorn and not the result of general industry conditions and that, therefore, an MAE had occurred.
Further, the Court determined Akorn breached its legal and regulatory compliance representation and that such breach would “reasonably be expected” to constitute an MAE as well. The Court reviewed Akorn’s representation that it was in compliance with all applicable regulatory requirements, such as FDA rules and regulations, and analyzed the materiality of the alleged inaccuracies from both a qualitative and quantitative perspective. As to the qualitative factors, the Court noted that FDA compliance for Akorn, a generic drug manufacturer, was an essential part of Akorn’s business and that there was “overwhelming evidence of widespread regulatory violations and pervasive compliance problems” at Akorn. As to the quantitative factors, the Court analyzed the costs of remediating Akorn’s regulatory noncompliance, and determined such costs would reduce Akorn’s value by about $900 million, a decline of 21% from the merger price. The Court determined that Akorn’s FDA regulatory issues, and subsequent 21% decline in value, would reasonably be expected to result in an MAE under the facts of the case.
Although this is the first time a Delaware court has allowed a purchaser to terminate an acquisition because of an MAE, it does not appear that Akorn represents a sea change in Delaware law on what constitutes an MAE. The Court reaffirmed its prior decisions requiring an adverse change to threaten earnings potential in a “durationally-significant manner” that is “material when viewed from the longer-term perspective of a reasonable acquiror.” While the Akorn ruling is specific to the facts and circumstances of the transaction, it nonetheless provides useful interpretive guidance regarding often-used M&A clauses and leaves practitioners with much to consider when negotiating acquisition agreements. Akorn has announced it intends to appeal the Court’s decision, so there may be more to come in this case.