Mergers And Acquisitions – The Merger Transaction
A merger transaction can take various forms, including a straightforward acquisition where the acquiring company maintains control. Another option is a reverse merger, particularly a reverse triangular merger. In a reverse merger, the shareholders of the target company exchange their shares for either new or existing shares of the public company. Consequently, post-transaction, the target company's shareholders hold a majority stake in the acquiring public company, and the target company becomes a wholly owned subsidiary of the public company. The public company then assumes the operational responsibilities of the target company.
In a reverse triangular merger, the acquiring company establishes a new subsidiary, which subsequently merges with the target company. This structure offers advantages such as simplified shareholder consent procedures and perceived tax benefits. The choice of the specific transaction form should be based on careful consideration of the relevant tax, accounting, and business objectives of the overall transaction.
The Confidentiality Agreement
The initial phase of an M&A transaction typically involves the execution of a confidentiality agreement and a letter of intent, which can be drafted separately or as a combined document. When parties are sharing information before reaching the letter of intent stage, it is essential to first establish a confidentiality agreement.
Beyond the general requirement for both parties to maintain confidentiality, this agreement outlines key parameters governing the use of shared information. For instance, it addresses potential disclosure obligations related to initial transaction negotiations, necessitating exemptions from the confidentiality provisions. Additionally, a confidentiality agreement may include provisions unrelated to confidentiality, such as restrictions on soliciting customers or employees (non-competition), and other restrictive covenants. Standstill and exclusivity provisions may also be incorporated, particularly when the confidentiality agreement is a distinct document from the letter of intent.
The Letter of Intent
A letter of intent (LOI) is typically not legally binding and outlines the fundamental aspects of a transaction. Its purpose is to identify and address key issues in negotiations, streamlining the resolution of outstanding matters before the commitment of resources to due diligence and drafting contracts. The LOI covers essential elements such as price, due diligence parameters, pre-deal recapitalizations, confidentiality, exclusivity, and specific time frames for each stage of the process. Simultaneously, parties' attorneys create a transaction checklist detailing tasks and assigning responsibilities.
Clients often inquire about safeguarding their interests during merger or acquisition negotiations, recognizing the investment of time, expenses, and exchange of confidential information. While a confidentiality agreement protects sensitive data, additional measures are necessary to prevent wasted resources. Most LOIs include exclusivity provisions, termed "no shop" or "window shop," restricting parties from engaging with third parties that could impact the potential transaction for a specified period.
A "no shop" provision bars discussions with third parties that could negatively influence the deal for a set time, based on conditions or a combination of both. A "window shop" provision allows limited third-party negotiation, potentially permitting the exploration of unsolicited proposals or seeking better deals. These provisions often involve termination fees for early exits, with drafters considering the impact on SEC reporting and disclosure requirements.
In contrast, a "go shop" provision permits the target to actively seek better deals upfront, addressing a board's fiduciary duty and maximizing shareholder value. This controlled process precedes significant resource expenditures, particularly when the board's "Revlon Duties" are triggered. Another protective measure is a standstill agreement, preventing parties from making substantial business changes during negotiations.
To secure interests, companies may also require significant stockholders to agree to lock-ups until deal closure. Lock-up agreements may include commitments to vote shares in favor of the deal and restrictions on transferring or divesting shares.
The Merger Agreement
In summary, the Merger Agreement outlines the financial terms and legal obligations of the parties involved in the transaction. It furnishes the buyer with a detailed overview of the business being acquired and establishes rights and remedies in case of material inaccuracies in this description. The agreement delineates closing procedures, preconditions, and post-closing obligations, along with representations and warranties by all parties and the corresponding rights and remedies for inaccuracies.
Key components of the Merger Agreement include:
Representations and Warranties: These provide a snapshot of facts as of the closing date. Sellers represent facts related to the business, such as ownership of assets, absence of undisclosed liabilities, litigation status, tax compliance, and employee issues. Buyers represent their legal capacity, authority, and ability to enter into a binding contract. Both parties also represent the accuracy of public filings, financial statements, contracts, tax matters, and organizational structure.
Covenants: These govern the actions of the parties before and after closing. For example, a seller may be required to continue operating the business in the ordinary course and maintain assets until closing, while post-closing payouts should continue. All covenants necessitate good faith compliance.
Conditions: These refer to pre-closing conditions, including shareholder and board approvals, obtaining third-party consents, and signing necessary documents. Closing conditions often involve the payment of compensation by the buyer. Failure to meet all conditions allows parties to cancel the transaction.
Indemnification/Remedies: These delineate the rights and remedies in case of a breach, such as material inaccuracies in representations and warranties or unforeseen third-party claims related to the agreement or the business.
Deal Protections: Similar to the LOI, the Merger Agreement includes deal protection terms, such as no-shop or window-shop provisions, requirements for business operations before closing, breakup fees, voting agreements, and other relevant terms.
Schedules: These provide detailed information about what the seller is offering, including a comprehensive list of customers, contracts, equity holders, individual creditors, and terms of obligations.
In cases where a letter of intent or confidentiality agreement hasn't been previously established for due diligence, the Merger Agreement may include due diligence provisions. Similarly, it may encompass no-shop provisions, breakup fees, non-compete clauses, and confidentiality provisions if not agreed upon separately.
Disclosure Matters
In a merger or acquisition transaction, there are three basic steps that could invoke the disclosure requirements of the federal securities laws: (i) the negotiation period or pre-definitive agreement period; (ii) the definitive agreement; and (iii) closing.
(i) Negotiation Period (Pre-Definitive Agreement)
Generally speaking, the federal securities laws do not require the disclosure of a potential merger or acquisition until such time as the transaction has been reduced to a definitive agreement. Companies and individuals with information regarding non-public merger or acquisition transactions should be mindful of the rules and regulations preventing insider trading on such information. However, there are at least three cases where pre-definitive agreement disclosure may be necessary or mandated.
The first would be in the Management, Discussion and Analysis section of a company’s quarterly or annual report on Form 10-Q or 10-K, respectively. Item 303 of Regulation S-K, which governs the disclosure requirement for Management’s Discussion and Analysis of Financial Condition and Results of Operations, requires, as part of this disclosure, that the registrant identify any known trends or any known demands, commitments, events or uncertainties that will result in, or that are reasonably likely to result in, the registrant’s liquidity increasing or decreasing in any material way. Furthermore, descriptions of known material trends in the registrant’s capital resources and expected changes in the mix and cost of such resources are required. Disclosure of known trends or uncertainties that the registrant reasonably expects will have a material impact on net sales, revenues, or income from continuing operations is also required. Finally, the Instructions to Item 303 state that MD&A “shall focus specifically on material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition.”
It seems pretty clear that a potential merger or acquisition would fit firmly within the required MD&A discussion. However, realizing that disclosure of such negotiations and inclusion of such information could, and often would, jeopardize completing the transaction at all, the SEC has provided guidance. In SEC Release No. 33-6835 (1989), the SEC eliminated uncertainty regarding disclosure of preliminary merger negotiations by confirming that it did not intend for Item 303 to apply, and has not applied, and does not apply to preliminary merger negotiations. In general, the SEC’s recognition that companies have an interest in preserving the confidentiality of such negotiations is clearest in the context of a company’s continuous reporting obligations under the Exchange Act, where disclosure on Form 8-K of acquisitions or dispositions of assets not in the ordinary course of business is triggered by completion of the transaction (more on this below). Clearly, this is a perfect example and illustration of the importance of having competent legal counsel assist in interpreting and unraveling the numerous and complicated securities laws disclosure requirements.
In contrast, where a company registers securities for sale under the Securities Act, the SEC requires disclosure of material probable acquisitions and dispositions of businesses, including the financial statements of the business to be acquired or sold. Where the proceeds from the sale of the securities being registered are to be used to finance an acquisition of a business, the registration statement must disclose the intended use of proceeds. Again, accommodating the need for confidentiality of negotiations, registrants are specifically permitted not to disclose in registration statements the identity of the parties and the nature of the business sought if the acquisition is not yet probable and the board of directors determines that the acquisition would be jeopardized. Although beyond the scope of this blog, many merger and/or acquisition transactions require registration under Form S-4.
Accordingly, where disclosure is not otherwise required and has not otherwise been made, the MD&A need not contain a discussion of the impact of such negotiations where, in the company’s view, inclusion of such information would jeopardize completion of the transaction. Where disclosure is otherwise required or has otherwise been made by or on behalf of the company, the interests in avoiding premature disclosure no longer exist. In such case, the negotiations would be subject to the same disclosure standards under Item 303 as any other known trend, demand, commitment, event or uncertainty.
The second would be in Form 8-K, Item 1.01 Entry into A Material Definitive Agreement. Yes, this is in the correct category; the material definitive agreement referred to here is a letter of intent or confidentiality agreement. Item 1.01 of Form 8-K requires a company to disclose the entry into a material definitive agreement outside of the ordinary course of business. A “material definitive agreement” is defined as “an agreement that provides for obligations that are material to and enforceable against the registrant or rights that are material to the registrant and enforceable by the registrant against one or more other parties to the agreement, in each case whether or not subject to conditions.” Agreements relating to a merger or acquisition are outside the ordinary course of business. Moreover, although most letters of intent are non-binding by their terms, many include certain binding provisions such as confidentiality provisions, non-compete or non-circumvent provisions, no shop and exclusivity provisions, due diligence provisions, breakup fees and the like. On its face, it appears that a letter of intent would fall within the disclosure requirements in Item 1.01.
Once again, the SEC has offered interpretative guidance. In its final rule release no. 33-8400, the SEC, recognizing that disclosure of letters of intent could result in destroying the underlying transaction as well as create unnecessary market speculation, specifically eliminated the requirement that non-binding letters of intent be disclosed. Moreover, the SEC has taken the position that the binding provisions of the letter, such as non-disclosure and confidentiality, are not necessarily “material” and thus do not require disclosure. However, it is important that legal counsel assist the company in drafting the letter, or in interpreting an existing letter to determine if the binding provisions reach the “materiality” standard and thus become reportable. For example, generally large breakup fees or extraordinary exclusivity provisions are reportable.
The third would be in response to a Regulation FD issue. Regulation FD or fair disclosure prevents selective disclosure of non-public information. Originally Regulation FD was enacted to prevent companies from selectively providing information to fund managers, big brokerage firms and other “large players” in advance of providing the same information to the investment public at large. Regulation FD requires that in the event of an unintentional selective disclosure of insider information, the company take measures to immediately make the disclosure to the public at large through both a Form 8-K and press release.
(ii) The Definitive Agreement
The definitive agreement is disclosable in all aspects. In addition to inclusion in Form 10-Q and 10-K, a definitive agreement must be disclosed in Form 8-K within four (4) days of signing in accordance with Item 1.01 as described above. Moreover, following the entry of a definitive agreement, completion of conditions, such as a shareholder vote, will require in-depth disclosures regarding the potential target company, including their financial statements.
(iii) The Closing
The Closing is disclosable in all aspects, as is the definitive agreement. Moreover, in addition to item 1.01, the Closing may require disclosures under several or even most of the Items in Form 8-K, such as Item 2.01 – Completion of disposal or acquisition of Assets; Item 3.02 – Unregistered sale of securities; Item 4.01 – Changes in Certifying Accountant; Item 5.01 Change in Control; Item 5.06 – Change in Shell Status, etc.
Due Diligence in a Merger Transaction
Due diligence refers to the legal, business and financial investigation of a business prior to entering into a transaction. Although the due diligence process can vary depending on the nature of a transaction (a relatively small acquisition vs. a going public reverse merger), it is arguably the most important component of a transaction (or at least equal with documentation).
At the outset, in addition to requesting copies of corporate records and documents, all contracts, asset chains of title documents, financial statements and the like, due diligence includes becoming familiar with the target’s business, including an understanding of how they make money, what assets are important in revenues, who are their commercial partners and suppliers, and common off-balance-sheet and other hidden arrangements in that business. It is important to have a basic understanding of the business in order to effectively review the documents and information once supplied, to know what to ask for and to isolate potential future problems.
In addition to determining whether the transaction as a whole is worth pursuing, proper due diligence will help in structuring the transaction and preparing the proper documentation to prevent post-closing issues (such as making sure all assignments of contracts are complete, or where an assignment isn’t possible, new contracts are prepared).
In addition to creating due diligence lists of documents and information to be supplied, counsel for parties should perform separate checks for publicly available information. In today’s internet world, this part of the process has become dramatically easier. Counsel should be careful not to miss the basics, such as UCC lien searches, judgment searches, recorded property title and regulatory issues with any of the principals or players involved in the deal, including any bad actor issues that could be problematic going forward.