United States: A Special Report On Mergers & Acquisitions

Takeovers of major public companies understandably grab the headlines, but the vast majority of mergers and acquisitions in the US continue to be transactions that are privately negotiated by the parties. Far from routine, most such transactions involve a multitude of legal, tax and business issues and the way these are handled will normally be critical to the success of the deal. And when a European or other international company is acquiring a US business, additional special issues are presented. The purpose of this article is to provide an overview of the more important issues that typically arise in connection with such transactions.

A vital issue is whether there are restrictions on foreign investment in the target company's industry or other regulatory factors that might present a problem for a proposed merger or acquisition. While the US prides itself on being open to foreign investment, restrictions are present in several areas.

If the target company has government contracts or provides goods or services as a subcontractor, the company may be required to have a facility security clearance (FCL) under the US Department of Defence's National Industrial Security Programme (NISP). The acquisition of such a company by a European or other international investor presents what is known as a foreign ownership, control or influence (FOCI) problem. The NISP Operating Manual (NISPOM), which in January 1995 replaced the ISM for Safeguarding Classified Information (ISM), specifies that a US company determined to be under FOCI is ineligible for a FCL, or an existing FCL shall be suspended or revoked, unless security measures are taken as necessary to safeguard classified information.

Fortunately, there are techniques for dealing with the FOCI problem which may permit the acquisition to proceed while effectively preserving the target company's FCL. The NISPOM sets forth four methods to accomplish this:

• Board Resolution: If the foreign buyer acquires only a minority position in the target company not entitling it to board representation, and is not otherwise entitled to such representation, the FOCI problem can be handled merely through a board of directors resolution appropriately restricting access of the foreign buyer.
• Voting Trust Or Proxy Agreement: The second method involves establishment of a voting trust or proxy agreement pursuant to which three trustees or proxy holders, who must be US citizens approved by the government, are effectively vested with all prerogatives of ownership with respect to the acquired company and have the authority to act independently of the foreign owner. However, actions such as sale of the business, dissolution or bankruptcy can be reserved to the legal owners, and the new NISPOM now permits consultation between the trustees or proxy holders and the foreign owners on other important company matters.
• Special Security Agreement: The third method involves a Special Security Agreement (SSA) or a Security Control Agreement (SCA). These agreements provide a mechanism to preserve the foreign owner's right of direct involvement in the business management of the acquired company while denying unauthorized access to classified information through a system of institutionalized controls and procedures.
• Limited Facility Clearance: Finally, the US government has entered into Industrial Security Agreements with certain foreign governments. Under these agreements, foreign-owned U.S. companies may be eligible for FCLs, subject to certain limitations.

The Exon-Florio Amendment (Exon-Florio) authorizes the president or his designee (presently the secretary of the treasury) to suspend temporarily or prohibit a merger or acquisition by a foreign buyer of a US business if he finds the transaction would threaten US national security and no other laws would adequately protect such security. A review by an inter-agency Committee on Foreign Investment in the US (CFIUS) must occur before any such action can be taken.

Exon-Florio issues have become a standard area of inquiry in connection with mergers or acquisitions involving foreign buyers. Where national security issues are raised, there is a procedure for filing a notice with the CFIUS, which must decide whether to investigate the transaction within 30 days after receipt of notice from one of the parties to a transaction or from a CFIUS member. Transactions notified for review under Exon-Florio now include a parallel review to determine whether the transaction would require FOCI negation measures.

Despite the original concerns, data released by the Department of Treasury show that the initial surge of notifications under Exon-Florio has dropped off significantly and that there have been relatively few CFIUS investigations of proposed transactions.

Moreover, of the transactions investigated, only the proposed acquisition of MAMCO Inc., engaged in the manufacture of aircraft components, by China National Aero Technology Import and Export Corp, owned by China, has been blocked.

Thus, in practice, Exon-Florio has not proven to be a significant barrier to direct foreign investment in the US.

In addition to restrictions presented by the NISP and Exon-Florio, particular industries may include federal or state restrictions on foreign ownership. That is true, for example, with natural resources, communications and air transportation, among others. Thus, it is important to consider whether any such restrictions might apply to an acquisition of the target company.

The US antitrust laws apply to acquisitions of US businesses by foreign as well as domestic buyers. Procedurally, the Antitrust Improvements Act of 1976, commonly called Hart-Scott, requires remerge notification to the Department of Justice and the Federal Trade Commission of mergers and acquisitions which affect commerce and meet the size of person and size of transaction tests. If one of the parties has annual net sales or total assets of at least $100 million and the other party has annual net sales or total assets of at least $10 million, the size of person test will be met. The size of transaction test will be met if the buyer acquires assets or voting securities of the acquired person exceeding $15 million in value, or voting control of an entity which, together with the entities it controls, has $25 million or more in annual net sales or total assets.

If Hart-Scott applies to a transaction, both parties must file the required notification which includes substantial financial data. The purpose is to permit the relevant agencies to review the transaction from an antitrust standpoint. The 30 day waiting period (which may be extended for an additional 20 days) makes it important to file as early in the transaction as possible, particularly if it is on a fast track. It may, however, be possible to secure early termination of the waiting period if reasonable justification can be presented.

Noncompliance with Hart-Scott may result in a court order requiring compliance and a civil penalty of up to $10,000 for each day the violation continues.

The highly-publicized takeovers, particularly the hostile ones, are typically done on the basis of information which is of public record as a result of required filings under the securities laws. Negotiated transactions, on the other hand, commonly involve privately-owned companies not subject to such filing requirements or divisions of public companies for which publicly-reported information cannot readily be segregated by operating unit. This places a premium on the buyer's due diligence investigation. If the acquisition agreement is entered into prior to the time the due diligence investigation is completed, it is essential for the buyer to have a right of termination if it is not satisfied with the results.

The due diligence investigation normally will cover all aspects of the target company's legal, financial and business affairs. Areas of particular importance include:

• Environmental: Environmental liabilities can be a major issue in a merger or acquisition because of clean-up liability under the Comprehensive Environmental Response, Compensation and Liability Act (CERCAL). Consequently, a so-called Phase I environmental audit of the target company by an environmental consulting firm has become standard procedure if the company owns or leases real property. If the Phase I audit discloses indication of possible contamination, a Phase II audit involving soil or other tests may be advisable.
• Retirement Plan Liability: The investigation should include analysis of possible unfounded liability under the target company's pension plans, and also withdrawal liability if the company is a party to a multi-employer (i.e. union) plan. Defined benefit retirement plans that have the potential unfunded liability problems usually must file actuarial reports as part of their Form 5500 annual reports. An analysis of those actuarial reports should provide a good indication of whether there is a problem and, if so, the magnitude.
• Other Employee Liability: Other areas of inquiry in the employee area should include employment agreements, consulting agreements, deferred compensation agreements, and cash or other bonus and incentive plans. If some of the target company's employees are unionized, the bargaining unit agreement and the history of labour relations should be reviewed. Finally, the target company's employee handbook and other personnel policies should be reviewed to determine if they might form the basis for employment contract claims by terminated employees.
• Government Regulation: If the target company is in an industry that is heavily regulated by the federal or state government, the status of any required regulatory authorizations should be reviewed, as should the issue of whether any government approvals will be required in connection with the transaction. Similarly, it is necessary to be mindful of special circumstances, such as an FCL held by the target company, which might present particular problems for a foreign acquiror for the reasons discussed above.
• Tax Liability: Another important area of inquiry is the target company's tax position and potential tax deficiencies and related penalties and interest for open tax years. Since under the US system tax years remain open, and returns therefore remain subject to audit, for the applicable statute of limitations (three years, but longer in certain circumstances), the review should cover the last three years at a minimum.
• Litigation: Finally, claims against and litigation involving the target company should be reviewed. Assuming the target company has audited financial statements, ask for and review all lawyers letters to the auditors reporting on such matters. Also, as computerized databases continue to expand and improve, it has become increasingly easy to independently verify the existence of litigation through computer searches.

There are numerous ways to structure a transaction. Among them are a purchase of shares, a purchase of assets, a merger of the target company into the acquiring company, a merger of the acquiring company into the target company, or a merger of a subsidiary of the acquiring company with the target company. In the latter case, the merger can go either way depending on the circumstances. Factors that will influence the choice of structure from the buyer's standpoint include:

• Tax Objectives: A prime tax objective of the buyer often is to be able to write off as much of the purchase price as possible as quickly as possible. This is usually best achieved through an assets transaction whereby the purchase price can be allocated among the assets acquired and then depreciated or amortized.

• Avoiding Unwanted Liabilities: Another situation where a purchase of assets may be called for is if the target company has possible environmental or other liabilities the buyer is unwilling to assume. With a purchase of shares or a merger, the buyer will wind up with those liabilities and the only option would be to look to the sellers for indemnification, which might not be satisfactory.

• Preserving Certain Assets Or Attributes: Sometimes the target company has important contracts or accreditations from some body which may not be freely assigned without consent but are not affected by a change in ownership. In such circumstances, the buyer might also prefer a purchase of shares, just as it might if it wishes to minimize disturbance of customer or other business relationships.

An extended treatment of all aspects of a negotiated merger or acquisition agreement is beyond the scope of this article. However, key provisions from the standpoint of controlling the buyer's risk include:

• Representations And Warranties: Representations and warranties by the seller are designed to force the seller to tell the buyer about the business of the target company and are the belt to complement the braces provided by the due diligence investigation. The seller's representations and warranties should cover all relevant aspects of the target company's business. Areas of particular importance include environmental, tax, retirement plan liabilities, intellectual property, claims and litigation, employment practices, title to assets and bring down provisions since the ending date of the most recent audited financial statements. And where the buyer is a European or other international company, representations and warranties concerning FCL’s and other relevant special issues should also be included.

• Structuring Indemnification Provisions: Virtually Every Acquisition Agreement provides for indemnification in the case of misrepresentation or breach of a party's representations and warranties. From the buyer's standpoint, however, it might not be sufficient to rely only on such protection. First, the seller often insists on qualifying its representations and warranties by knowledge and possibly also by adding materiality standards. Second, to the extent the seller discloses on its disclosure schedules matters which constitute exceptions to its representations and warranties, there is no misrepresentation by the seller and therefore no right to indemnification on the buyer's part. And third, proving misrepresentation frequently is difficult.

• Limits On Indemnification: It is common to provide limits on a party's right to indemnification, and terms like baskets and caps permeate the negotiations in this area. A basket is simply a financial threshold (eg $100,000) below which the indemnified party is not entitled to seek indemnification. Baskets can apply on an overall aggregate basis, on a specific liability basis or some combination of the two. A cap establishes a ceiling on one party's obligation to indemnify the other. As with baskets, caps can apply on an individual liability as well as overall basis.

• Formula Indemnification Rights: Sometimes the seller is agreeable in principle to indemnifying the buyer in an area such as environmental but insists that its obligation be phased out over time. Inventive legal counsel can deal with this problem in a variety of ways. For example, the indemnification provision with regard to environmental matters might be structured so that the buyer has an absolute right to indemnification for a certain period and after that the seller's obligation phases out on a percentage basis over some additional period.

• Security For Indemnification: Security for indemnification rights may not be a significant problem where both parties to the transaction are major companies which have substantial assets and reasonably can be expected to be around in the event a claim is made.

• Escrow: Requiring the seller to escrow a portion of the purchase price as security is a common technique, but also an issue which can generate a lot of heat during negotiations. Sellers understandably wish to get their hands on the cash and not have a portion of their gain at risk. However, an escrow sometimes can be made more palatable to the seller through devices such as the progressive release of the funds over time as the risk of particular liabilities materializing diminishes.

• Letter of credit: Another security device which is sometimes used is a standby letter of credit. The cost of the letter of credit is often shared by the parties but the seller still may object on the grounds that it ties up his credit.

• Right of offset: Still another security device is for the buyer to be given a right of offset against future payments due the seller. Obviously, this works only if there is a holdback of a portion of the purchase price or, more commonly, where the transaction includes an earn-out based on the future performance of the acquired business.

• Other indemnification issues: It is common for acquisition agreements to specify that representations and warranties survive the closing for a particular period of time. Care should be taken that such survival provisions do not inadvertently limit a party’s right to claim any indemnification after a certain period unless that is actually intended.

After the merger or acquisition is closed, a European or other international buyer will have certain reporting obligations in the US. These include reporting to the US Commerce Department under the International Investment Survey Act of 1976, which provides for both reporting of direct and portfolio investment into the US and direct and portfolio investment abroad by US companies. In addition, various tax and other reporting obligations might exist, depending on the particular situation.

In conclusion, a European or other international company planning a negotiated merger or acquisition in the US is faced with a number of special issues in addition to those applicable to purely domestic transactions. This places a premium on being aware of the problem areas and knowing how to avoid them through creative structuring when necessary.