Inside M&A - January/February 2010
January/February 2010
What You Don’t Know Can Hurt You: FCPA Risks in Cross-Border M&A Deals
Removal of Tax Gross-Ups Results in Heightened Sensitivity to Golden Parachute Rules in Corporate Transactions
California Court Clarifies Directors’ Duties When a Corporation Is Insolvent or in the Zone of Insolvency
On October 29, 2009, the California Court of Appeal, Sixth District, in Berg & Berg Enterprises, LLC v. Boyle, et al., unequivocally ruled that, under California law, directors of either an insolvent corporation or a corporation in the more elusively defined “zone of insolvency” do not owe a fiduciary duty of care or loyalty to creditors. In so ruling, California joins Delaware in clarifying directors’ duties when the corporation is insolvent or in the zone of insolvency.
Background
Berg & Berg Enterprises LLC was the largest creditor of the failed Pluris, Inc. In July 2002, Pluris’s directors elected to enter into an assignment for the benefit of creditors (ABC) under California law. Berg brought a complaint against Pluris’s directors alleging that while Pluris was insolvent or in the zone of insolvency, Pluris’s directors breached their fiduciary duties to Pluris’s creditors by failing to examine a range of possible courses of action to maximize the value of the remaining assets and not merely to take the most expedient step of entering into the ABC. Berg alleged that the directors failed to explore ways to preserve, among other things, the value of $50 million in net operating losses (NOLs) that were lost upon the execution of the ABC. Further, Berg alleged that the directors failed to do the following:
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Seek alternative sources of financing
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Make any reasonable inquiry into alternative ways to derive additional value for Pluris’s creditors
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Consider other benefits of a chapter 11 reorganization, such as Berg’s purported agreement to reduce its claim and contribute cash for the benefit of Pluris’s other creditors
Berg alleged that once the directors determined that Pluris’s equity interests had no value, the directors abdicated their duty to Pluris’s creditors by entering into the ABC.
The directors moved to dismiss the complaint, and the trial court granted the motion. The trial court based its decision on CarrAmerica Realty Corp. v. nVIDIA Corp., a 2006 case from the U.S. District Court for the Northern District of California. CarrAmerica held that California follows the “trust fund doctrine” with respect to a director’s fiduciary duty to creditors. According to the trial court, CarrAmerica held that a director’s fiduciary duty to creditors only arises upon a corporation’s insolvency. The scope of this fiduciary duty is to avoid self-dealing, preferential treatment of creditors, diversion, dissipation or undue risk to the insolvent corporation’s assets. Because Berg could not allege that the directors breached such a duty by entering into the ABC, the trial court granted the motion to dismiss without leave to amend. Berg appealed.
The Appeals Court’s Analysis
On appeal, the California Court of Appeal analyzed what, if any, fiduciary duty individual directors owe to creditors. The appeals court first noted that under California statute, “corporate directors owe a fiduciary duty to the corporation and its shareholders . . . and must serve ‘in good faith, in a manner such director believes to be in the best interests of the corporation and its shareholders.’” Next, the appeals court noted that with respect to a duty to creditors, there is “no analogous statutory authority in California establishing or recognizing that upon a corporation’s insolvency, or more vaguely when it enters into a ‘zone of insolvency,’ directors instead or also owe a duty to the corporation’s creditors.” The appeals court further noted that it was “easy to see that especially when a corporation is in financial distress, the interests of the shareholders and the corporation itself may inherently collide with those of the creditors, making any respective duties owed by directors to each constituency potentially in conflict and making the scope of each respective duty elusive and difficult to ascertain.”
Credit Lyonnais and the Evolution of the Purported Duty of Care and Loyalty to Creditors
The appeals court next considered California and other post–Credit Lyonnais Bank Nederland N.V. v. Pathe Communications Corp. decisions addressing a director’s fiduciary duties of care and loyalty to creditors upon insolvency. The appeals court noted the well-known footnote in Credit Lyonnais in which the Delaware Court of Chancery posited that where a corporation was operating in the vicinity of insolvency, a board of directors is not merely the agent to the shareholders but also to the creditors. The appeals court further noted that a recognition of such expanded fiduciary duties of care and loyalty was thought to minimize the risk to creditors of “opportunistic behavior” such as the sale of corporate property at “fire-sale prices” or unreasonable risk taking with corporate assets for the sole benefit of shareholders.
The appeals court next observed that the establishment of a director’s fiduciary duties of care and loyalty to creditors has generated controversy and broad criticism from commentators. The criticism largely focuses on “the difficulty in perceiving insolvency, or worse, the zone of insolvency, which is when such duties arise, and the practical difficulties and inefficiencies inherent in directors managing conflicting duties owed to disparate interests, thereby diluting the continuing and historic duty owed by directors to shareholders.” Finally, the appeals court noted that there are no published decisions that rely on, or post-date, Credit Lyonnais that determine that corporate insolvency triggers fiduciary duties of care and loyalty to creditors. However, there are decisions that rely on the trust fund doctrine to satisfy a creditor’s claim against an insolvent corporation.
The Trust Fund Doctrine
The appeals court next analyzed the trust fund doctrine, which numerous courts have relied on since it was first espoused in the 1939 seminal decision by the Supreme Court of the United States in Pepper v. Litton. Under the trust fund doctrine, “all of the assets of a corporation, immediately upon becoming insolvent, become a trust fund for the benefit of all creditors” in order to satisfy their claims. In California, application of the trust fund doctrine requires a showing “that directors have engaged in conduct that diverted, dissipated, or unduly risked corporate assets that might otherwise have been used to satisfy creditor claims.”
The Appeals Court’s Decision
No Fiduciary Duty of Care or Loyalty to Creditors
Relying on its analysis of California statutory and common law, Credit Lyonnais and subsequent decisions, and on the application of the trust fund doctrine, the appeals court concluded that “under the current state of California law, there is no broad paramount fiduciary duty of due care or loyalty that directors of an insolvent corporation owe the corporation’s creditors solely because of a state of insolvency, whether derived from Credit Lyonnais or otherwise.” The appeals court “decline[ed] to create such a duty, which would conflict with and dilute the statutory and common law duties that directors already owe to shareholders and the corporation. We also perceive practical problems with creating such a duty, among them a director’s ability to objectively and concretely determine when a state of insolvency actually exists such that his or her duties to creditors have been triggered.”
The appeals court held that “the scope of any extra-contractual duty owed by directors to the insolvent corporation’s creditors is limited in California, consistently with the trust fund doctrine, to the avoidance of actions that divert, dissipate, or unduly risk corporate assets that might otherwise be used to pay creditors [sic] claims . . . [including] acts that involve self-dealing or the preferential treatment of creditors.” Further, the appeals court held that because all California cases applying the trust fund doctrine have done so solely with respect to insolvent entities “and because the existence of a zone or vicinity of insolvency is even less objectively determinable than actual insolvency, . . . there is no fiduciary duty prescribed under California law that is owed to creditors by directors of a corporation solely by virtue of its operating in the ‘zone’ or ‘vicinity’ of insolvency.”
Applying the scope of a director’s fiduciary duty under California law, the appeals court affirmed the trial court’s decision that Berg’s complaint failed to plead adequate facts to support a claim that the Pluris directors breached their fiduciary duties under the trust fund doctrine. The appeals court agreed with the trial court that Berg’s complaint did not plead that Pluris’s directors had diverted, dissipated or unduly risked corporate assets. Instead, Berg merely asserted that the Pluris directors had not done enough (i.e., had not investigated or explored whether a chapter 11 reorganization would have maximized the value of Pluris’s NOLs). The facts as alleged did not involve self-dealing or prohibited preferential treatment of creditors and did not constitute any diversion, dissipation or undue risking of the corporate assets that otherwise could have been used to satisfy creditors’ claims. Accordingly, the appeals court concluded that “no matter how Berg . . . characterizes or packages the basic factual underpinnings of its claim,” as a matter of law, Berg’s claim was inadequate to sustain a cause of action that the Pluris directors breached their fiduciary duties under the trust fund doctrine in California.
Business Judgment Rule
Further, the appeals court addressed the protection offered to directors under the business judgment rule. The business judgment rule, which is well-settled statutory and common law in California, “immunizes directors from personal liability if they act in accordance with” California law. The business judgment rule establishes a presumption that “directors’ decisions are based on sound business judgment and it prohibits courts from interfering in business decisions made by directors in good faith and in the absence of a conflict of interest.” The appeals court concluded that Berg’s allegations did not rebut the presumption afforded by the business judgment rule. Accordingly, even if Berg had otherwise stated a claim for which relief could be granted, its claim would still be barred by the business judgment rule.
Conclusion
The appeals court’s clear holding in Berg will aid directors and officers in the performance of their well-established statutory and common law duties to shareholders and the corporation. The Berg decision makes clear that, in California, directors owe no fiduciary duty of care or loyalty to creditors, whether the corporation is insolvent or otherwise. However, liabilities may arise under the trust fund doctrine where self-dealing, preferential treatment of creditors, and diversion, dissipation or undue risk of corporate assets is proved.
As the appeals court noted in Berg, the Credit Lyonnais decision has generated substantial controversy and commentary over the last 19 years regarding a director’s fiduciary duties to creditors. The Berg decision joins the Delaware Supreme Court’s 2007 decision in North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, et al., in clarifying a director’s duties when a corporation is insolvent or in the zone of insolvency. The Gheewalla decision held that “the creditors of a Delaware corporation that is either insolvent or in the zone of insolvency have no right, as a matter of law, to assert direct claims for breach of fiduciary duty against a corporation’s directors.” The Delaware court held that “[w]hen a solvent corporation is navigating in the zone of insolvency, the focus for Delaware directors does not change: directors must discharge their duty to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of the shareholder owners.” However, when a corporation is insolvent, a creditor has standing to maintain derivative claims against directors for breach of their fiduciary duties of care and loyalty. Together, the Berg and the Gheewalla decisions form what is expected to be a growing body of case law clarifying a director’s fiduciary duties to a corporation’s constituents when the corporation is insolvent or in the zone of insolvency.
See Berg & Berg Enterprises, LLC v. Boyle, et al., 178 Cal.App.4th 1020 (Cal.App. 2009).
Jeffrey L. Rothschild contributed to this article.
What You Don’t Know Can Hurt You: FCPA Risks in Cross-Border M&A Deals
By Obiamaka P. Madubuko
Foreign Corrupt Practices Act (FCPA) risks in cross-border deals should never be taken lightly. Although international acquisitions often involve many complexities, time pressures and significant business interests, U.S. companies and issuers should always include an FCPA due diligence checklist as part of their overall pre-acquisition due diligence. Failing to do proper FCPA due diligence in the pre-acquisition phase can result in big headaches, ranging from delays or possible cancellation of the deal to the unwitting buyer being exposed to successor civil and criminal liability for prior FCPA violations, whether or not they were known at the time of the sale.
Background
The FCPA, 15 U.S.C. §§ 78dd-1, et seq., was first enacted in 1977 to ban U.S. persons and issuers from bribing foreign officials to obtain or retain business abroad. The statute has a broad reach and covers all U.S. companies and citizens doing business abroad as well as some foreign companies with sufficient contacts in the United States (e.g., those companies trading on U.S. exchanges or that use U.S. banks to transact business). The statute also contains books and records provisions requiring companies to keep appropriate records and have adequate internal controls to prevent and detect possible FCPA violations.
The FCPA prohibits corrupt payments, gifts or giving anything of value to foreign officials in order to get or keep business (whether or not the bribe resulted in any actual business). It also outlaws improper payments or gifts through agents, consultants or other third parties that are made for the benefit of or done at the behest of foreign officials (note that this may include charitable, social or political contributions solicited by foreign officials). The definition of foreign official is also quite broad and covers not only those holding public office but also local citizens affiliated with state-run or owned organizations (e.g., doctors at a state-run hospital or employees at a state-owned oil company). Depending on the geographic market and industry involved, the FCPA risks can be high and should be addressed, and any violations resolved in the pre-acquisition phase.
Big Penalties for FCPA Violations
In recent years, U.S. law enforcement authorities have given heightened priority to FCPA investigations and prosecutions, which have resulted in record-breaking fines, penalties and untold damage to the business reputations of the violating companies and individuals. Law enforcement authorities have also assessed large penalties in civil and criminal fines for FCPA violations occurring in the M&A context. For example, in February 2009, the U.S. Department of Justice (DOJ) and Securities and Exchange Commission (SEC) assessed $579 million in civil and criminal fines and penalties relating to an FCPA investigation stemming from a reorganization of a corporate subsidiary through an initial public offering. These stiff fines were levied even though there was no evidence that the new board or management of the reorganized subsidiary had actual knowledge of any FCPA violations found to have been committed by the old subsidiary. The clear lesson is that companies should understand that FCPA successor liability is very real and cannot be avoided by a corporate reorganization or other M&A activity, even when there is no actual knowledge of the FCPA violations.
FCPA successor liability can also be minimized by utilizing the DOJ’s advisory opinion process. For example, in FCPA Opinion Procedure Release 08-02, the DOJ provided a six month post-acquisition “grace period,” agreeing not to prosecute the company at issue for any post-acquisition FCPA violations occurring within the first six months of closing. The DOJ conditioned the grace period on the company providing DOJ with a comprehensive post-acquisition due diligence workplan within ten days of the closing, and agreeing to retain outside counsel and forensic accountants to perform a detailed compliance review of FCPA risk areas throughout the business and to report back to DOJ by a certain date. The company also had to agree to initiate a stringent compliance program and to disclose any pre-acquisition conduct it discovered.
In order to avoid costly enforcement actions, FCPA due diligence should become a routine part of the overall due diligence process in any cross-border deal involving U.S. persons or issuers.
What’s at Stake?
FCPA successor liability in the M&A context is not solely an issue for those investors acquiring a majority equity stake in a deal. FCPA enforcement risks exist even for investors who acquire less than a 50 percent ownership interest, depending on the level of control acquired in a deal (e.g., board seats or involvement in managing the investment). FCPA violations can result in high fines and penalties, criminal sanctions, disbarment, collateral civil or shareholder lawsuits, and long-standing damage to a company’s business reputation. In the M&A context, failure to detect, isolate and resolve FCPA violations at the pre-acquisition stage can also result in expensive and lengthy investigations, intrusive compliance monitors, involvement of U.S. and/or foreign law enforcement authorities, negative tax treatment and a host of other unpleasant consequences such as a dramatic downward swing in the market value or stock price of the asset(s) recently purchased. In order to prevent this parade of horribles, it is important for FCPA due diligence to be an integral component of the overall pre-acquisition due diligence plan.
What Are FCPA “Red Flags”?
Knowing what FCPA “red flags” to look for can help streamline the due diligence process. The level of FCPA due diligence that needs to be undertaken will vary depending on the level of FCPA risks involved. For example, if the deal involves business dealings in a high-risk country or in an industry that the U.S. government has already signaled poses FCPA concerns, then more due diligence should be performed. However, in preparing a basic FCPA due diligence checklist, the following are examples of FCPA “red flags” that should signal that further review is needed:
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Target company has been subject of a prior FCPA or corruption-related investigation
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Target company has prior allegations relating to business integrity, ethics or other violations of local law
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Business performed in a high-risk industry or high-risk country (as reflected on the Transparency International Corporation Perception Index)
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Excessive or unusually high compensation without sufficient supporting detail
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Payments to third parties not well known in the industry
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Payments made to third parties outside of the country where the goods/services are to be provided
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Use of shell companies or cash transactions
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Lack of anti-bribery policies, trainings or code of conduct at target company
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Lack of written agreements with consultants, agents or business partners
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Close relationships to government officials or significant interaction with government regulators
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Misrepresentation or failure of the target company to cooperate in due diligence process.
Tips on How to Avoid FCPA Successor Liability
If any of the above FCPA red flags are noted, the FCPA due diligence team needs to do further review to be satisfied that there are no lurking FCPA issues. Having an FCPA trained professional who has the background to know what to look for and, more importantly, what kinds of questions to ask is invaluable. While corporate counsel may be able to oversee the overall M&A due diligence process, FCPA due diligence is an area in which it is advisable to retain counsel experienced in FCPA matters, and who are knowledgeable about international regulatory compliance, securities law, and criminal law and procedure.
The following steps will prevent or at least minimize FCPA successor liability in cross-border deals:
Determine the FCPA risk level involved in the deal. The first step in any FCPA due diligence review should be to assess whether the FCPA risks presented by the deal are low, medium or high. Categorizing the risk level will dictate the amount of time, energy and resources that need to be spent on the FCPA due diligence process. Depending on the level of risk presented, build in enough time to do a sufficient FCPA risk review before the deal closes—no matter how attractive the returns or anticipated profits! While there are certainly time pressures involved in many cross-border deals, FCPA due diligence is not an area to be glossed over or overlooked. Involve knowledgeable counsel to advise on how to properly handle any FCPA red flags that may be present.
Conduct a reasonable risk-based FCPA due diligence review pre-acquisition. In order to know what FCPA risks are involved, it is important to ask the right questions. Look for any FCPA red flags and thoroughly investigate and resolve any FCPA violations that are uncovered. Utilize the DOJ advisory opinion process, if appropriate. The FCPA due diligence team should keep detailed documentation of all due diligence efforts when evaluating potential FCPA violations. FCPA due diligence review documentation should be timely, accurate and thorough. Remember, it is not enough to rely on information provided solely by the seller—independent verification of critical information (e.g., consultant contracts, ownership structure/interests of key business partners or customers, and third-party payment detail) is required.
Take appropriate action for all FCPA violations uncovered. Establish all relevant facts relating to any apparent, actionable FCPA violation. Determine whether a voluntary disclosure is advisable. If a voluntary disclosure is pursued, be thorough and involve the relevant law enforcement authorities, including local authorities, in any remediation plans or internal investigations contemplated. Early disclosure can mitigate or eliminate successor liability for any violations uncovered pre-acquisition or those that occur shortly after closing. To the extent practicable, all FCPA investigations should be concluded and any violations resolved prior to closing. When faced with the existence of possible FCPA violations, a buyer must decide whether to delay, renegotiate or even cancel the deal. Depending on the nature and extent of the violations uncovered, they may have a significant impact on the purchase price and the buyer’s willingness to acquire the assets being purchased. Other remedial steps may include requiring the target company to make specific undertakings by set deadlines, broadening the investigation to other markets, individuals or time periods, and/or for the target company to pay the costs associated with investigating and remedying the violation(s).
Preserve relevant documents and do not create collateral damage. All relevant documents should be preserved and immediate action taken (e.g., litigation hold protocols) to ensure that employees do not destroy documents. Create an internal investigation plan to detail the document collection process (be aware of data protection and privacy laws in the relevant jurisdictions) and determine the order and priority of interviews to be undertaken. Deal counsel should also be mindful of any disclosure requirements that may be needed once an FCPA violation has been discovered. For example, if the seller or prospective joint venture partner is a publicly traded company, there may be disclosure requirements under the Securities and Exchange Act. Do not create collateral damage when addressing an FCPA violation—involve counsel knowledgeable of the local laws in the jurisdiction(s) involved, and if disciplinary action is contemplated, include employment counsel in that decision. Failure to make the necessary disclosures or making hasty decisions in response to an FCPA violation can further complicate the deal and invite unintended liability.
Ask for FCPA-related representations and warranties from the target company. The target company should be able to provide assurances that it does not have any employees who are foreign officials as defined under the FCPA and that no foreign official has any legal or beneficiary interest in the target company. Requiring employees and/or business partners to sign FCPA compliance statements is advisable. If there is foreign-official involvement in the target company, additional representations or certifications may be required.
Retain audit and termination rights. If any FCPA violations are uncovered in the pre-acquisition due diligence process, the acquiring company should retain audit rights to inspect the books and records of the target company as well as the right to terminate the deal or to be reimbursed for expenses relating to the resolution of any FCPA violation uncovered between signing the purchase agreement and closing. While these contractual protections are all negotiable, the buyer should also consider having the seller indemnify it for any FCPA violations it uncovers.
Tighten up internal controls post-closing. In order to ensure no FCPA problems crop up post-closing, assess whether the internal controls at the new entity are adequate to prevent, detect and address potential FCPA violations. Adopting an effective compliance program that meets the requirements set forth in Chapter 8, Section B.2.1 of the United States Sentencing Guidelines is highly recommended. Reviewing existing anti-corruption policies, trainings and contractual provisions to ensure FCPA compliance is also highly recommended. Again, depending on the investment, obtaining re-certifications of FCPA compliance from employees, key business partners and other third parties may also be recommended.
FCPA Implications for M&A Cross-Border Deals
As the credit markets begin to thaw and cross-border M&A activity heats back up, U.S. companies and issuers in search of that perfect opportunity to buy, merge or establish a joint venture with any company that has operations outside the United States should always be cognizant of the requirements of the FCPA when evaluating the deal. Doing proper FCPA due diligence in the pre-acquisition phase can save your company from big problems down the road. Following the tips mentioned above will also help mitigate against FCPA successor liability, particularly in this heightened FCPA enforcement environment.
Recent DOJ Antitrust Actions
By Jon B. Dubrow and Carrie G. Amezcua
On two consecutive days in January 2010, the U.S. Department of Justice (DOJ) announced two antitrust actions that should be of interest to those involved in M&A transactions. One case involved allegations of Hart-Scott-Rodino (HSR) Act “gun jumping,” and the other involved a post-closing challenge to a transaction that was not reportable under the HSR Act.
Smithfield Foods – Gun Jumping
On January 21, 2010, the DOJ Antitrust Division announced a "gun jumping" case involving Smithfield’s acquisition of Premium Standard Farms in 2007. United States v. Smithfield Foods, Inc., No. 1:10-cv-00120; see press release. The case was settled by a consent order, requiring Smithfield to pay a $900,000 civil penalty for violation of the HSR Act. HSR “gun jumping” involves situations where, in the government's view, the buyer in an HSR-reportable transaction is deemed to acquire beneficial ownership of the assets or entity to be acquired prior to the expiration of the HSR Act waiting period. This is the most recent in a number of “gun jumping” cases, and highlights the importance of crafting interim course of conduct provisions in M&A deals in a way that does not give the acquiring firm control over the acquired business prior to the expiration of the statutory HSR Act waiting period. The HSR Act prevents parties from completing a reportable transaction until 30 days after HSR filings are made, unless the period is terminated early or extended by a second request.
The DOJ’s case asserts that the acquiring firm (Smithfield) was consulted and asked to consent to three different contracts that the acquired firm (Premium Standard) entered for the purchase of hogs during the pendency of the acquisition. According to the DOJ, the hog purchases were ordinary course of business transactions for Premium Standard, and so the buyer, Smithfield, should not have had the right to review or approve those transactions. The DOJ's position was that Smithfield obtained beneficial ownership over Premium Standard through that consent process prior to the expiration of the HSR Act waiting period, and therefore violated the HSR Act.
This case highlights how parties must be careful in drafting “ordinary course of business” covenants in merger or acquisition agreements. The DOJ and Federal Trade Commission (FTC) can take an aggressive view that a buyer's review or consent over seller ordinary course of business activities effects a transfer of beneficial ownership of the seller’s business (or part of it), in violation of the HSR Act. In general, while the agencies understand that interim course of conduct provisions are appropriate to ensure that the acquired business operates in the ordinary course of business, consistent with past practices, they may inquire as to whether the buyer's contractual right to review or approve actions by the target limit the target's ability to operate in the ordinary course of business, and bring a challenge when they believe the seller has obtained control over those ordinary course transactions.
Dean Foods – Post-Closing Challenge to a Non-Reportable Transaction
On January 22, 2010, the DOJ filed a complaint, along with the states of Wisconsin, Illinois and Michigan, challenging Dean Foods' April 2009 acquisition of dairies from Foremost Farms. United States v. Dean Foods Co., No. 10-c-0059; see press release. The DOJ alleges in its complaint that the transaction resulted in a substantial lessening of competition in milk processing and sales of school milk in several areas. The DOJ seeks divestiture of the acquired assets, as well as a requirement for Dean to provide prior notice of future acquisitions. The transaction was not large enough to trigger mandatory reporting under the HSR Act.
Another interesting aspect of the Dean Foods complaint is that it quotes extensively from internal company documents that the DOJ asserts demonstrate the rationale for eliminating from the marketplace an "irrational competitor" offering aggressive pricing. This highlights how contemporaneous business planning documents can be important in the merger review process.
This is the most recent among a number of post-closing challenges by the DOJ and FTC. For example, just two days before its Dean Foods complaint, the DOJ reached a settlement with the Daily Gazette, resolving the DOJ’s 2007 challenge to the newspaper’s 2004 acquisition of the Charleston Daily Mail. See the January 20, 2010, press release. The settlement requires the Daily Gazette to restructure the business to enable the Charleston Daily Mail to compete independently. In another recent example, in July 2009 the FTC challenged Carilion Clinic’s 2008 acquisition of two outpatient clinics in Roanoke, Virginia. In the Matter of Carilion Clinic, No. 9338. The FTC and Carilion reached a settlement in 2009 requiring Carilion to divest an imaging center and an outpatient surgical center in Roanoke. These challenges, and others, demonstrate that transactions that are not large enough to trigger HSR Act review may nonetheless be subject to post-closing review, and potentially challenge, by the antitrust agencies.
Although they involve different issues, these cases show that the Obama administration DOJ and FTC are actively enforcing merger laws, both in terms of pre-merger notification requirements and substantive competition issues.
Removal of Tax Gross-Ups Results in Heightened Sensitivity to Golden Parachute Rules in Corporate Transactions
By Andrew C. Liazos and Daniel Senecoff
A sensitive issue in many corporate transactions is whether amounts to be paid to a target’s executives will be treated as golden parachute payments for tax purposes. Golden parachute payments result in adverse tax consequences for both the executive and the employer: the executive must pay a 20 percent nondeductible excise tax on the excess portion of the golden parachute payments (as discussed below), and the payor loses its deduction on the excess portion of the golden parachute payments. (For purposes of this article, an executive is an employee or director of a public company who was an officer, a one percent or more shareholder, or one of the top one percent highest paid individuals within the 12-month period immediately preceding the change in control.) For several years, many public companies have included tax gross-ups for this excise tax in order to reduce the risk of executives becoming distracted by this issue. Although quite small in relationship to the overall size of the corporate transaction, tax gross-ups provided an important level of assurance to executives that benefits promised under severance and equity compensation plans would be provided as expected.
Tax gross-ups for golden parachute treatment at public companies have recently come under heavy attack. In November 2008, RiskMetrics Group (RMG), formerly known as ISS, announced a policy that, going forward, it would consider tax gross-up payment for golden parachute treatment to be a “poor pay practice.” RMG is an influential shareholder advisory service that determines whether to recommend for or against approval of proposed equity compensation plans, and/or to withhold votes for a director on the compensation committee. It is reasonable to expect that shareholder proposals to eliminate golden parachute payments and the threat to withhold votes by shareholders will result in fewer tax gross-ups in the future. A recent study by Pearl Meyer & Partners for the National Association of Corporate Directors found that 61 Fortune 500 companies made material changes to change in control benefits from November 2008 to August 2009 and that more than 10 percent of these agreements eliminated excise tax gross-up provisions.
Restricting payments that are contingent upon a change in control to amounts that will not trigger golden parachute treatment may result in a significant loss of benefits to executives. Golden parachute treatment results when the present value of payments that are contingent upon a change in control exceeds a tipping point. In general, this occurs when payments are at least three times the executive’s average annual taxable compensation during the five-year period ending before the year of the change in control (the base amount). Assume that an executive’s employment agreement provides for $3 million in payments contingent upon a change in control and that the executive’s base amount was $500,000. The payments in this case would need to be limited to just less than $1.5 million to avoid golden parachute treatment even though the executive might otherwise be expecting twice that amount.
The tipping point calculation does not provide as much room to make payments without triggering golden parachute protection as might appear at first glance. The base amount does not take into account payments that would be made in the year of the change in control. It also includes earlier years in which taxable compensation might have been significantly lower than the value of the payments upon a change in control. This is quite likely to happen when an executive is paid heavily with equity compensation that has not previously been taxed (e.g., no earlier exercise of stock options) or when there have been years without bonuses and/or with salary freezes in exchange for long-term compensation. It is not uncommon to see situations in which the tipping point is between one and one-half and two times the current rate of salary.
Recent changes in equity compensation plan design exacerbate this problem. Until recently, executives often received all or a substantial portion of their long-term incentive in the form of time-vested stock options or restricted stock. Internal Revenue Service (IRS) regulations provide a taxpayer-friendly method for valuing the golden parachute payment that results from the accelerated vesting of these awards. When calculating the tipping point, the golden parachute payment is not the total amount received by the executive. Instead, the golden parachute payment will only reflect the time value of money (i.e., getting paid now instead of at the normal scheduled vesting date) and one percent of the equity award’s value for each month of waived vesting service. Depending upon how much time remains until vesting, the valuation discounts could be quite significant. Recently, however, public companies have increasingly been using performance-based vesting conditions. No matter how likely it is that these conditions will be satisfied, a discount cannot be applied when valuing these awards for purposes of the tipping point calculation.
If there is no tax gross-up, allowing payments in excess of the tipping point can result in a lose-lose situation for the parties that only benefits the IRS. The 20 percent golden parachute excise tax is based on the amount by which the payments contingent upon a change in control exceed the base amount, and not the amount by which the tipping point is exceeded. Consider an executive who has a base amount of $100,000. If the payments contingent upon a change in control are $299,999, then there is no excise tax. However, if just one additional dollar is paid, a 20 percent nondeductible excise tax applies to the executive not just on $1, but instead on the entire amount above the base amount, thereby resulting in a $40,000 excise tax ($300,000 - $100,000 * 20 percent). If a tax gross-up payment is to be eliminated, it should be replaced with either a cap on payments so as to avoid the tipping point, or a provision that allows for contingent payments to be made only when doing so would provide a better after-tax net benefit for the executive (at some pre-determined level) after considering all of the executive’s taxes.
So, what is an executive to do? In renegotiating executive pay packages, public companies increasingly are considering a technique that conditions payments that are contingent upon a change in control upon compliance with a non-competition covenant. Any payment that is considered reasonable compensation for services rendered after a change in control is ignored for purposes of calculating the tipping point. IRS regulations provide for compliance with a non-compete to be treated as the equivalent of providing services after a change in control. As a result, post-termination cash payments and equity vesting that would otherwise be subject to a 20 percent excise tax could be exempt from golden parachute treatment.
Achieving this result depends upon the specific circumstances and requires careful advance planning. The non-compete will only have value for future services if it “substantially constrains the individual’s ability to perform services,” and there is a “reasonable likelihood that the agreement will be enforced.” In addition, this standard must be met by “clear and convincing evidence.” As a practical matter, taking advantage of this rule often requires the following:
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Payments expressly contingent upon complying the non-compete
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Legal support that the non-compete is enforceable under applicable state law
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A credible, independent report valuing the non-compete
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A demonstrated willingness by the buyer to enforce the non-compete
A good valuation report will evaluate in detail the potential harm that could result from competition by the executive and the executive’s personal circumstances.
There are several other strategies that are available to public companies and their executives to increase the amount that may be paid under the tipping point. The base amount used to determine the tipping point can be increased by exercising stock options, electing not to defer amounts under a nonqualified deferred compensation plan and paying bonuses during the five- year period ending prior to the year of a change in control. The value of payments for purposes of the tipping point calculation can also be reduced by cashing out options, which limits the value to the cash-out amount (as opposed to a higher Black-Scholes value due to holding the options for a prolonged period of time after a change in control). In addition, reasonable compensation for services to be rendered after a change in control includes payments received by an executive as bona fide damages for breach of contract due to an involuntary termination without cause. This exemption may apply when the payments do not exceed the present value of the compensation that would have been paid during the remainder of the contract term, the executive demonstrates a willingness to work that is rejected by the buyer and the amounts to be paid as damages are reduced to the extent the executive has earned income from other sources during the remainder of the contract term.
It will usually be quite difficult and distracting to grapple with these issues for the first time upon a change in control. A purchase and sale agreement will typically call for a representation by the seller that no agreement or arrangement will result in golden parachute treatment (except as disclosed in a schedule). Calculating the amount of golden parachute payments is quite complicated and often can involve judgment calls, such as whether a payment is truly contingent upon a change in control and, if so, when payment is certain enough to count toward the tipping point. There will also be the procedural issue of who determines whether the tipping point has been exceeded and how the executive’s benefits will be reduced if under the contract, the benefits must be limited to an amount under the tipping point. In addition, a 20 percent addition to tax under Section 409A may apply in certain cases when either the executive has the ability to direct how benefits are to be reduced or if the manner of reduction is unclear.
Further complicating matters is that a well-represented buyer will request evidence from the target that payments contingent upon the change in control do not equal or exceed the tipping point. The executive compensation audit initiative by the IRS is an often-cited reason for requiring more than just a representation by the seller. Audit technique guidelines now provide IRS agents with step-by-step instructions for examining whether buyers are deducting amounts that should be nondeductible due to golden parachute treatment. Because audits often occur years after a corporate transaction, and the information to evaluate golden parachutes may not then be readily accessible, it would normally be a daunting task for the buyer to document its tax position from scratch upon audit.
The shift away from tax gross-up payments will make it more important than ever for public companies and executives to plan ahead and to understand the interplay between golden parachute rules and change in control protection. Failure to do so can result in an executive’s compensation package becoming a significant distraction in completing a corporate transaction.
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The McDermott Difference
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McDermott regularly advises corporations on all aspects of golden parachute planning, and our services include calculation and tax reporting of change in control benefits by professional advisors formerly employed by a major accounting firm. For more information, please contact one of the authors listed above, or click here to learn more about our executive compensation practice. |
