Monday, February 8, 2010
How to Read a Merger Agreement
The merger agreement (sometimes called the “DMA”, for definitive merger agreement) is an important step in understanding a deal. The merger agreement is the legal tool through which the parties distribute risks between the target’s and bidder’s shareholders in relation to the road that, hopefully, leads to the closing of the merger. The DMA is usually filed with the SEC within three days of a deal’s announcement. Much of the DMA’s language is usually standard, however, one should never take this granted.
Fully understanding the merger agreement will come handy if the merger process becomes tumultuous somewhere down the road: there may be a counter bidder emerging, the transaction may face unexpected regulatory hurdles, or the economy may deteriorate, rendering the strategic rationale for the merger obsolete.
We will explain how to review a typical merger agreement, and the key sections of the document.
This section is, in general, less important for cash deals. It can be important for stock deals, since this is where the collar, if any, is detailed, and it also describes any pricing period.
Closing and Effective Time
For both cash and stock deals you can find information related to closing and the effective time of the transaction. These are, for the most part, not essential, as they tell within how many days a merger closes once all conditions to the merger are satisfied. However, for private equity deals, this section could be important: in private equity deals there usually is a marketing period for the syndication of loans that finance the takeover. The marketing period could be important: it could delay closing of the merger and could have a negative effect on the deal spread (e.g. have a look at Article 1 of the IMS Health/TPG DMA)
DMA’s are not binding on the parties unless the closing conditions are satisfied or waived (if allowed). In effect, they define the contingencies under which the parties are free to walk away from the deal. This is very important.
The closing conditions fall largely into four categories: (i) representations and warranties, (ii) material adverse change or material adverse effect (MAC/MAE) conditions, (iii) covenants, (iv) exogenous conditions (such as regulatory approvals). Most of these conditions are cross-references with other clauses and articles of the DMA. So every condition has to be analyzed and checked whether it is cross-referenced with some other clauses in the text.
Reps and warranties
These clauses are usually of less importance. To address the substantial gap between the seller’s and buyer’s information concerning the target company, the seller typically makes a set of contractual representations and warranties. It represents that these facts are true both at the time of the agreement and at closing. However, note that MAC is more than likely to show up in the reps and warranties section. In addition, in pharma/biotech transaction material, drugs could be references in this section, so be careful not to miss this section.
Most large acquisitions include a condition that allows the buyer to avoid closing upon the occurrence of a MAC. Definitions vary among agreements. They are usually subject to carve-outs for excluded categories of events (except to the extent that they have a “disproportionate” effect on the target). The carve-outs are very important. The broader the carve-outs, the more risk the acquirer bears. Carve-outs can range from general economic and political conditions, to market prices and revenue projections of the target.
Sometimes MAC clauses very explicitly define what constitutes a material adverse effect: for pharma companies, this could an upcoming FDA approval for a certain drug, or for an oil exploration company, a possible legislative action related to a specific extraction process such as fracturing.
For Delaware incorporated companies, the courts interpret MAC clauses narrowly, to encompass only unanticipated events or changes that materially and adversely affect the longer term value of the target. So, historically, it has been difficult for acquirers to successfully invoke a MAC/MAE clause.
The satisfaction or waiver of the seller’s covenants is a closing condition. A covenant violation triggers the buyer’s option to terminate the DMA. The covenant clause usually contains the so called “reasonable best efforts” language.
Sections that define reasonable best efforts give important clues to the original intentions of the parties, as to what they expect to do in certain circumstances. In relation to regulatory approvals, one can find the timeframe for regulatory approvals, whether the parties are willing to go to court if the deal is challenged. Reasonable best efforts language might also reveal how far the bidder may went to obtain financing for the deal.
The two most common conditions are related to the financing and regulatory approvals of the deal.
The financing section is cross-referenced with a specific section on financing (apart from the reasonable best efforts language). The financing section is where any committed financing is detailed. Some transactions are funded with cash on hand, some by newly issued equity, and others through a combination of sources, which include bonds and loans. Of course, an investor can obtain a more thorough examination of the funding from a study of any credit agreements or indentures. Careful consideration must be given to the reliability of the lenders.
Exogenous conditions also provide a more detailed a list of regulatory approvals required for the deal to close. This condition is usually cross-referenced. The covenant section could limit the parties’ ability to offer remedies to regulatory authorities. Some merger agreements limit the types and value of the assets that could be offered for divestiture to satisfy antitrust authorities. A lot of times, the regulatory approval process is the main reason for a fairly wide deal spread.
The key pieces in this section are the termination date (sometimes called the “outside date”) and the termination fee. The termination date is when the agreement becomes void. It can have an extended date, which upon the election of the target and/or the acquirer, prolongs the agreement, usually for the sake of receiving regulatory approvals. Termination fees generally range between 3% and 4% of the initial deal value. Transactions can also have reverse termination fees, which are payable by the acquirer, and are historically as high or higher than the basic termination fee. The idea behind a higher reverse termination fee is to prohibit the buyer from walking from the deal.
An order of specific performance requires a party to perform a specific act (in this case, complete the merger). Here is an example of a specific performance clause, from Silicon Storage Technology’s merger agreement with Microchip Technology, dated February 2.
“Each of the parties hereto acknowledges and agrees that, in the event of any breach of this Agreement, each nonbreaching party would be irreparably and immediately harmed and could not be made whole by monetary damages. It is accordingly agreed that the parties hereto (a) will waive, in any action for specific performance, the defense of adequacy of a remedy at law and (b) shall be entitled, in addition to any other remedy to which they may be entitled at law or in equity, to compel specific performance of this Agreement in any action…”
This is usually a standard clause, but could become interesting if the merger process hits a rocky road. One recent example for an interesting case is Apollo’s acquisition of Cedar Fair. New York law is the governing law and venue for litigation. Choosing the laws of New York as governing law is a rare event for Delaware incorporated companies. A new research paper by Cain and Davidoff (”Delaware’s Competitive Reach: An Empirical Analysis of Public Company Merger Agreements“) evaluated the selection of governing law and forum clauses in merger agreements between public firms during the period 2004-2008. They found that, among Delaware-incorporated targets, 91% select Delaware law. So the question arises, which party gains by choosing New York as the governing law and venue of litigation? We will come back to this question in a later posting.