Two recent decisions by the Delaware Supreme Court clarify the fiduciary duties owed to creditors by directors of Delaware corporations that are insolvent or operating in the zone of insolvency. First, in North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, the Delaware Supreme Court, in a case of first impression, addressed the ability of creditors to assert claims for breach of fiduciary duty against directors of a Delaware corporation that is insolvent or operating within the zone of insolvency. The Delaware Supreme Court unequivocally held that, as a matter of law, a creditor cannot assert a direct claim in either situation and that, when a corporation is insolvent, a creditor can only assert a derivative claim for breach of fiduciary duty against the corporation’s directors. See Gheewalla, 930 A.2d 92, 103 (Del. 2007).
Second, in Trenwick America Litigation Trust v. Ernst & Young, the Delaware Court of Chancery addressed the ability of creditors to assert a direct tort claim for “deepening insolvency” against directors of a Delaware corporation that is insolvent. Deepening insolvency is a judge-made cause of action, first recognized by the Third Circuit Court of Appeals, that could be asserted against a corporation’s directors, officers, lawyers, accountants and other professionals for damages resulting from improper acts that cause the corporation to become insolvent or more insolvent. In Trenwick, the Delaware Court of Chancery definitively held, and the Delaware Supreme Court subsequently affirmed, that Delaware law does not recognize deepening insolvency as an independent cause of action. See Trenwick Am. Litg. Trust v. Billet, 931 A.3d 438 (Del. 2007), aff’g Trenwick Am. Litig. Trust v. Ernst & Young L.L.P., 906 A.3d 168, 174-75, 195, 205 (Del. Ch. 2006).
As a result of these decisions, the Delaware Supreme Court has effectively eliminated creditors’ ability to assert direct claims against directors of Delaware corporations that are insolvent or operating in the zone of insolvency.
One of the questions that remains unanswered in the Gheewalla and Trenwick opinions is whether a creditor can assert derivative claims for breach of fiduciary duty against directors when the corporation is operating within the zone of insolvency. While neither the Delaware Supreme Court nor the Delaware Court of Chancery specifically address this issue in Gheewalla or Trenwick, the Delaware Supreme Court in Gheewalla strongly suggested that creditors are precluded from asserting derivative claims in such a situation. First, the Delaware Supreme Court observed that, in questioning whether it was necessary for creditors to have a right to assert claims for breach of fiduciary duty against directors of a corporation operating within the zone of insolvency, creditors already have specific legal protections through “their negotiated agreements, their security instruments, the implied covenant of good faith and fair dealing, fraudulent conveyance law, and bankruptcy law.” Gheewalla, supra, at 99 (citing North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 2006 WL 2588971, at *13 (Del. Ch. Sept. 1, 2006); Production Resources Group, L.L.C. v. NCT Group, Inc., 863 A.2d 772, 790 (Del. Ch. 2004); Big Lots Stores, Inc. v. Bain Capital Fund VVI, LLC, 2006 WL 846121, at *8 (Del. Ch. Mar. 28, 2006)). Second, the Delaware Supreme Court pointedly noted that directors of a Delaware corporation owe their fiduciary duties to the corporation’s shareholders and that such duties do not change when a corporation begins to operate within the zone of insolvency. The Delaware Supreme Court stressed that “[w]hen a solvent corporation is navigating in the zone of insolvency, directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners.” Id. at 101. Finally, the Delaware Supreme Court stressed that insolvency, and not the zone of insolvency, is the dividing line when derivative claims of breach of fiduciary duty shift from the stockholders of a corporation to its creditors.
“When a corporation is solvent, [directors’] fiduciary duties may be enforced by its shareholders, who have standing to bring derivative actions on behalf of the corporation because they are the ultimate beneficiaries of the corporation’s growth and increased value. When a corporation is insolvent, however, its creditors take the place of the shareholders as the residual beneficiaries of any increase in value.” Id., at 101 (emphasis in original).
As a result, the Delaware Supreme Court’s highlighting of the existing legal protections available to creditors, strong focus on the fiduciary duties owed by directors to the corporation’s shareholders, and emphasis on creditors’ ability to enforce derivative claims only after a corporation’s insolvency all strongly suggest that the Delaware Supreme Court views creditors as having no right to bring derivative claims for breach of fiduciary claims against directors of a corporation that is operating within the zone of insolvency.
The opinions in Gheewalla and Trenwick provide guidance to boards of Delaware corporations that are insolvent or operating within the zone of insolvency, including those considering whether to incur additional indebtedness or those considering a sale or comparable transaction involving a change of control of the corporation. While a Delaware corporation is operating within the zone of insolvency, directors owe fiduciary duties to the corporation’s stockholders and must exercise their business judgment in the best interests of the corporation and its stockholders. After a Delaware corporation becomes insolvent, directors continue to owe the same fiduciary duties, but the corporation’s creditors replace its stockholders as the primary constituency affected by any breach of such duties. As a result, as long as directors of an insolvent corporation continue to make good faith business judgments on an informed basis that they believe are in the best interests of the corporation and its creditors, such creditors will have difficulty successfully asserting any claim of breach of fiduciary duty.
Parties to acquisition agreements typically agree to limit the survival of certain or all of the representations and warranties made in the agreement to a period shorter than the applicable jurisdiction’s statute of limitations. Generally, such provisions governing the survival periods of representations and warranties are also understood by the parties to limit the period during which a claim may be brought for a breach or failure of a representation or warranty. However, the U.S. Court of Appeals for the Ninth Circuit recently held in Western Filter Corp. v. Argan, Inc. (9th Cir. August 25, 2008) that contractual language limiting the survival period of representations and warranties may not be construed to also limit the period during which a claim may be brought for a breach of the same in the absence of explicit language intended to shorten the claims period. Although it remains unclear whether the court’s decision in Western Filter will be followed by other courts, practitioners should ensure that any acquisition or other agreement governed by California law explicitly states the parties’ intentions with respect to both the survival period for representations and warranties and whether such period shall also constitute the period during which a party may file a claim relating to a breach of the same, notwithstanding any applicable statute of limitations.
On October 30, 2003, Western Filter Corporation and Argan, Inc., entered into a Stock Purchase Agreement (the Purchase Agreement) pursuant to which Western Filter acquired all of the outstanding shares of Puroflow, Inc., a wholly owned subsidiary of Argan, for $3.5 million. Section 8.1 of the Purchase Agreement provided that “[t]he representations and warranties of [Western Filter] and [Argan] in this Agreement shall survive the Closing for a period of one year, except the representations and warranties contained in Section 3.1(a), (b), (c) and (f) and 3.2(a) and (b) shall survive indefinitely.”
Following the consummation of the acquisition, Western Filter allegedly discovered that the value of Puroflow’s inventory was substantially less than had been represented. In September 2004, Western Filter sent written notice to Argan claiming that Argan had grossly misrepresented the financial condition of Puroflow and claiming damages in the amount of $2,002,850. In its notice, Western Filter offered to immediately settle its claims for $700,000 in order to avoid protracted litigation. In late September 2004, Argan responded to Western Filter’s notice and indicated that the issues could be solved without the involvement of counsel, and in late October 2004 Western Filter confirmed with Argan that the $300,000 escrow would be retained pending resolution of the dispute. However, six months later, on March 22, 2005, Western Filter filed suit in Los Angeles County Superior Court against Argan, claiming, among other things, breach of contract and intentional misrepresentation. The case was later moved to federal court, upon which Argan filed for summary judgment.
The federal district court granted Argan’s motion for summary judgment, holding that Western Filter’s claims were barred by the survival period limitations set forth in the Purchase Agreement. The court concluded that the plain meaning of the provisions of Section 8.1 of the Purchase Agreement clearly indicated that a claim could only be filed for the breach of certain representations and warranties within one year of the consummation of the acquisition. However, as more than one year had passed since that date, the court held that Western Filter’s claim was barred.
Ninth Circuit Decision
On appeal, the Ninth Circuit reversed the district court’s holding, concluding that the language in the Purchase Agreement relating to the survival of the representations and warranties was ambiguous and did not explicitly serve to limit the period during which a claim for a breach of a representation or warranty could be made. The court based its holding in part on its view that California law favors strict construction with respect to contractual provisions that purport to reduce the statute of limitations in regard to the right to sue against the party seeking to invoke the limitation. The court drew a distinction between the survival point for representations and warranties and the period during which a claim can be made. The court noted that while the provisions of Section 8.1 of the Purchase Agreement explicitly addressed the period during which the representations and warranties survived, the period during which a claim for damages arising from or relating to such a breach could be brought was not explicitly limited. As a result, the court concluded that Western Filter filed its claim within California’s four year statute of limitations for contract claims and that the breach of the representations and warranties underlying the claim had occurred prior to the expiration of the survival period delineated in the Purchase Agreement.
The implications of the decision for practitioners are clear. Acquisition and other agreements governed by California law that contain survival provisions should clearly and explicitly express the parties’ intent in regard to (i) the survival period for the representations and warranties and (ii) the period during which claims for the breach of such representations and warranties may be brought. An example of such a survival provision is the following:
The representations and warranties of Target contained in this Agreement, the Target Disclosure Schedule, the other Transaction Documents to which Target is a party and the certificates of Target delivered pursuant to this Agreement shall survive the Closing and remain in full force and effect, regardless of any investigation or disclosure made by or on behalf of any of the parties to this Agreement, until the close of business on the one-year anniversary of the Closing Date (the “Expiration Date”). The parties to this Agreement further agree that notwithstanding any provision of applicable Law to the contrary, any action, claim or proceeding relating to the representations and warranties of Target contained in this Agreement, the Target Disclosure Schedule, the other Transaction Documents to which Target is a party and the certificates of Target delivered pursuant to this Agreement must be brought, filed or noticed, as applicable, on or prior to the Expiration Date.
Based on the Ninth Circuit’s decision in Western Filter,parties should pay careful attention to the language used in an agreement’s survival provision, which can no longer be considered boilerplate.
The recent Hexion v. Huntsman decision by the Delaware Court of Chancery addresses several significant issues that companies and their counsel should take into account when drafting transaction agreements.
On September 29, 2008, the Delaware Court of Chancery issued an opinion refusing to allow Hexion Specialty Chemicals, Inc., owned primarily by private equity firm Apollo Global Management, LLC, to terminate its merger agreement with Huntsman Corporation, a global manufacturer and marketer of chemical products. In an 89-page opinion by Vice Chancellor Stephen P. Lamb, the court held that Huntsman had not suffered a material adverse effect, and that Hexion “knowingly and intentionally” breached its covenant in the merger agreement that it would use “reasonable best efforts” to consummate financing for the deal, in fact acting to ensure that it would be unable to secure financing. The court granted specific performance to Huntsman to the extent permitted under the merger agreement, “requiring Hexion to perform all of its covenants and obligations (other than the ultimate obligation to close).”
The dispute stemmed from a merger agreement between the two chemical companies negotiated in July 2007, in which Hexion agreed to pay $28 per share for 100 percent of Huntsman’s stock, a $10.6 billion transaction that would have produced one of the largest chemical companies in the world. The terms of the agreement did not include a “financing out,” preventing Hexion from being excused from performance if it was unable to obtain adequate financing by closing. Accordingly, Hexion covenanted to use its “reasonable best efforts” to take all actions and do all things “necessary, proper or advisable” to consummate financing. The agreement further provided that if Hexion committed a “knowing and intentional breach” of this covenant, damages would be uncapped, while for any other breach they would be limited to $325 million.
After Huntsman reported several disappointing quarterly results, Hexion hired a well-known valuation firm to assess the solvency of the combined entity. When the valuation firm opined that the combined entity would not be solvent, Hexion issued a press release claiming that it was unable to obtain financing, as Huntsman had suffered a material adverse effect (MAE), as defined in the agreement, and the resulting entity would be insolvent.
In June 2008, Hexion filed suit, seeking a declaratory judgment that (i) it would not be obligated to close if the resulting company would be insolvent; (ii) Huntsman suffered an MAE by materially underperforming its industry peers and failing to meet projections; and (iii) it had satisfied its interim covenant to use reasonable best efforts to secure the financing for the transaction and, as a result and absent an MAE, its liability for failing to obtain financing to close the transaction was capped at $325 million. Huntsman, in turn, counterclaimed, asking the court to order Hexion to specifically perform its obligations under the merger agreement.
No MAE Suffered
Hexion based its argument that Huntsman had suffered an MAE on Huntsman’s disproportionately poor financial performance during the second half of 2007 and the first half of 2008 in comparison to other similarly situated companies in the same industry. The court rejected this argument, noting that the argument presumed an MAE had in fact occurred. Instead, the court reinforced the holding from In re IBP, Inc. Shareholders Litigation that, in order to prove an MAE has occurred, a party must show that “there has been an adverse change in the target’s business that is consequential to the company’s long-term earnings power over a commercially reasonable period, which one would expect to be measured in years rather than months.” The fact that Delaware courts have never found an MAE to have occurred in the context of a merger agreement, the court said, was no coincidence, as only “durationally-significant” events, not a “short-term hiccup,” would constitute an MAE. As in IBP, the court held that a strategic acquirer such as Hexion can be assumed to be purchasing Huntsman as part of its long-term strategy, and that the degree of Huntsman’s underperformance and failure to meet forecasts was not sufficient to constitute an MAE. The court rejected Hexion’s argument that Huntsman had the burden of proof to demonstrate the absence of an MAE and held that, absent clear language to the contrary, the buyer had the burden to show the existence of an MAE.
It is notable that while in IBP the Delaware Court of Chancery was interpreting a provision in a contract governed by New York law rather than Delaware law, the court has since held that IBP principles govern contracts under Delaware law as well. The court’s reliance on IBP in Hexion reaffirms the court’s belief that there is no material difference between New York law and Delaware law with respect to determining whether an MAE has occurred.
Hexion’s Knowing and Intentional Breach of Covenants Results in Uncapped Damages
The court likewise denied Hexion’s request for a declaratory judgment that it had not committed a “knowing and intentional” breach of the merger agreement, which would have capped its liability at $325 million. In a noteworthy discussion that will likely bear influence on future contract drafting, the court analogized the merger agreement’s breach standard to criminal law, reasoning that “[i]f one man intentionally kills another, it is no defense to a charge of murder to claim that the killer was unaware that killing is unlawful.” Similarly, Hexion need not have actual knowledge that its actions breached a covenant; rather, it need only have taken a “deliberate act” in breach of a covenant.
Hexion’s Failure to Use “Reasonable Best Efforts” to Close the Deal
Having thus defined “knowing and intentional,” the court found that Hexion failed to use “reasonable best efforts” to obtain financing for the merger. The court held that Hexion was obligated under the merger agreement to take any act that “was both commercially reasonable and advisable to enhance the likelihood of the consummation of the financing.” Instead, the court found that Hexion acted to avoid the consummation of the financing, thereby committing a knowing and intentional breach of its covenant.
Specifically, the court said, Hexion breached its covenant under the merger agreement both by failing to act by not approaching Huntsman management to discuss possible ways to address the solvency issue, and by affirmatively acting to “scuttle” the financing. Upon receiving the insolvency opinion, Hexion had a clear obligation under the merger agreement to discuss the appropriate course of action with Huntsman, and to put Huntsman on notice of its concerns. Instead, Hexion’s board adopted the findings of the insolvency opinion, filed suit and sent a copy of the opinion to the lead lending bank, which effectively prevented consummation of the financing. In addition, the court found that Hexion was intentionally “dragging its feet” in obtaining antitrust clearance from the Federal Trade Commission (FTC) pending outcome of its attempt to obstruct financing, in further violation of its covenants under the merger agreement.
Hexion further argued that a reasonable best efforts covenant does not prevent a company from seeking expert advice to assess its own future insolvency, nor from taking actions to prevent that insolvency, including, in this case, actions to terminate the merger. The court agreed with this basic contention, but noted that regardless Hexion must first take all commercially reasonable steps to meet its obligations under the merger agreement. Here, that meant: (i) taking affirmative action to obtaining financing, (ii) notifying Huntsman of its concerns and (iii) pursuing antitrust clearance from the FTC. Only if Hexion had followed this course of action, the court said, and still believed in good faith that insolvency would ensue, could it take affirmative steps to avoid such insolvency by terminating its agreement with Huntsman.
Specific Peformance Granted, but Limited
Finally, the court ordered Hexion to specifically perform its covenants and obligations under the merger agreement, but did not require Hexion to consummate the merger. While the agreement provided generally that a non-breaching party could seek and obtain specific performance for breaches of the other party’s covenants, it also contained what the court stated was a “virtually impenetrable” provision wherein the parties agreed that Huntsman would not be entitled to specifically enforce Hexion’s obligation to consummate the merger. Huntsman argued that in order to have meaning, such provision could apply only prior to or during the debt marketing period but not after such period had passed or the termination date under the merger agreement had arrived. The court disagreed and found that the “inartfully” drafted provision simply did not support the argument. Accordingly, Hexion remained free to refuse to close, subject only to damages if such refusal constituted a breach of contract.
The court’s limitation on Huntsman’s specific performance remedy in this manner, however, does little to help Hexion. Having already interpreted “knowing and intentional” to include Hexion’s breach, the court precluded the $325 million damages cap from applying. Hexion is thus left with few options: it is forced to either obtain financing and proceed with the merger, or be subject to uncapped damages. Such damages, under the merger agreement, stand to be substantial, as they would amount to the difference between Huntsman’s current stock price and the $28 per share agreed to by Hexion, multiplied by the number of outstanding shares of Huntsman stock.
Lessons from Hexion
Hexion reinforced precedent that courts are unlikely to find that an MAE has occurred in the merger context. The court’s reliance on IBP and its emphasis on the “durational significance” of an MAE display a lack of sympathy for buyers in the current economic climate, as courts are continuing to enforce contractual obligations despite drastic changes in the market. Attempts to shift the burden of proof from the buyer require clear and unambiguous language.
“KNOWING AND INTENTIONAL”
The court’s interpretation of a “knowing and intentional” breach holds particular importance, indicating a need to reassess the use of this phrase in contract drafting. Vice Chancellor Lamb points out that the phrase has no roots in contract law, turning to criminal and tort law analogies to advance his interpretation, and ultimately adopting Black’s Law Dictionary’s definition of “knowing” as “deliberate.” Presumably, because of the nature of contract law, parties can expressly change the interpretation of any clause; future drafters are not bound by this interpretation. Nonetheless, deal lawyers must be aware that the court adopted this seller-favoring definition, which will govern in the absence of an express alternative definition.
“REASONABLE BEST EFFORTS”
The court’s scrutiny of Hexion’s behavior leading up to its filing of the lawsuit serves as a reminder of the importance of documenting all efforts to satisfy closing conditions. The court not only looked at Hexion’s failure to obtain financing and its publication of the insolvency opinion, but also its failure to take other necessary steps toward closing. In particular, the court found that Hexion had been “dragging its feet” with respect to obtaining antitrust clearance, a finding that proved damaging to its case. Particularly in the merger context, it is crucial not only to take contractually obligatory steps toward closing, but also to maintain evidence of such efforts.
The court’s decision to grant specific performance to Huntsman on all measures except that of ultimately closing the deal holds a final noteworthy lesson. The parties’ dispute over specific performance was reminiscent of United Rentals, Inc. v. RAM Holdings, Inc., in which the court looked to extrinsic evidence—including negotiation and drafting history—to interpret a merger agreement that was ambiguous with respect to specific performance. In Hexion, the court likewise considered parole evidence, such as the testimony of Hexion’s drafting lawyer, ultimately deferring to the “virtually impenetrable language” of one of the provisions. In both cases the merger agreements contained specific performance provisions that may have been clear as stand-alone provisions, but conflicted with other provisions elsewhere in the agreements, resulting in dispute. These cases strongly suggest that specific performance provisions must be drafted with as much specificity as possible, and must be carefully considered within the broader context of the complete agreement.
This article was originally published as a McDermott On the Subject.
On July 14, 2008, family-owned conglomerate Schaeffler KG announced its voluntary takeover offer for Continental AG, a German DAX 30 company, at an offer price of EUR 70.12 per share. With targeted annual sales of more than EUR 26.4 billion in 2008, Continental is one of the top automotive suppliers worldwide.
When its bid was announced, Schaeffler already held 2.97 percent of Continental’s shares and another 4.95 percent in physically settled call options. In addition, Schaeffler had entered into cash-settled equity swaps with an investment bank backed by other investment banks for approximately 28 percent of Continental’s shares. These cash-settled equity swaps could be terminated by Schaeffler at any time, in particular during the acceptance period of the tender offer. In general, the risks under the swap agreement are hedged by entering into corresponding hedging positions (i.e., either by the counter party purchasing shares by itself or by entering into derivative contracts with third parties). After the swap agreement was terminated, the investment bank was obliged to dissolve the position in Continental shares in a commercially reasonable manner (including the acceptance of the tender offer by Schaeffler).
Continental’s CEO rejected Schaeffler’s unsolicited bid in unusually harsh words, alleging that Schaeffler had, with the help of banks and derivative positions, “secured access to 36% of Continental’s shares in an unlawful manner” in contravention of reporting and notification requirements. Continental characterized the methods used by Schaeffler, namely the entering into swap agreements, as a clear infringement of the reporting and notification provisions of the German Securities Trading Act (Wertpapierhandelsgesetz) and Securities Acquisition and Takeover Act (Wertpapiererwerbs und Übernahmegesetz). Continental demanded that the Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, or BaFin) take measures to redress this situation.
Schaeffler responded that its takeover strategy fully complied with the law. Germany’s BaFin decided to launch a probe and, after consideration, concluded that Schaeffler did not violate its reporting and notification obligations.
This incident sparked an intense public debate in Germany regarding the use of cash-settled equity derivatives and similar financial instruments to build up stakes prior to a takeover bid without notifying BaFin and the issuer. Similar takeover approaches are being discussed and evaluated in other European countries.
The legal treatment for Schaeffler’s first two positions (i.e., 2.97 percent of Continental’s shares and another 4.95 percent in physically settled call options) is as follows: The German Securities Trading Act requires any party that acquires 3 percent or more of the voting rights of a German issuer to notify the issuer company and BaFin within four trading days. Notification must also be made when a party holds other financial instruments that give it the right to acquire at least 5 percent of the voting rights. The term “financial instrument” is broadly defined and includes physically settled equity derivatives. At the time when Schaeffler announced its takeover offer, shares and financial instruments triggered separate reporting requirements. Thus, with both positions falling below the reporting requirement, Schaeffler did not trigger any notification obligation. However, the new Risk Limitation Act (Risikobegrenzungsgesetz), which came into effect on August 19, 2008, closed this loophole. Under the new law, if a party holds a stake in a German issuer consisting of both shares and financial instruments, all voting rights arising out of both positions are to be aggregated. This new aggregation rule is intended to make it more difficult to acquire a significant position without triggering the notification requirements.
Even so, the cornerstone of Schaeffler’s strategy was its use of cash-settled equity swaps. Cash-settled equity swaps are contracts referenced to an underlying bundle of shares pursuant to which the investor gives or receives cash payments from the swap counterparty equal to the decrease or increase in the underlying share price and dividend payments between the date of the agreement and maturity of the swap. In return, the investor agrees to pay a fixed return by way of a financing charge. Generally, the swap counterparty will hedge its position by acquiring the underlying shares. In this case, Schaeffler entered into swap agreements with the investment bank, backed by a number of other investment banks, the majority of which held 2.999 percent each of the underlying Continental shares in order to avoid the banks’ own notification requirements. Schaeffler stated in its offer document that it was not legally entitled to purchase the underlying shares, but it had the right to terminate the swaps at any time. After such a termination of the swaps, the banks would be obliged to dissolve the position in Continental shares in a commercially reasonable manner, including the tender of the underlying shares into the tender offer.
The conclusion and/or dissolution of cash-settled equity swaps does not trigger disclosure obligations under the German Securities Trading Act. Financial instruments only result in a disclosure obligation if they “entitle the bearer to acquire, on one’s own initiative alone and under a legally binding agreement, shares in an issuer.” Thus, Schaeffler did not have to disclose its cash-settled equity swaps.
More difficult to answer is the question of whether the voting rights attached to the shares underlying such swaps had to be attributed to Schaeffler under the German Securities Trading Act and the German Takeover Act. Shares held by a third party are attributed if they are held “for the account of the bidder.” This rule requires that the bidder (i) bears the economic risks and benefits of the shares, and (ii) is able—at least on a de facto and limited basis—to instruct the third party how to exercise the voting rights of such shares.
It is unclear in this case whether the first condition was satisfied, since the banks were using the shares to hedge their own risk resulting from the swaps. However, since the swaps mirrored the performance of Continental’s shares, there may be support to look through the banks to Schaeffler. And the second condition is even harder to determine whether or not it is satisfied in this case. Did the swaps really confer such a de facto influence to Schaeffler?
Supporters of Continental’s view argue that Schaeffler did have voting control over the shares pursuant to Article 10(g) of the EU Transparency Directive, on which the attribution rule in the German Securities Act is based, and take the position that a narrow reading of the attribution rule will make circumventions easier. Acknowledging that Schaeffler did not legally control the voting of any underlying shares, Schaeffler’s termination rights did, however, increase its ability to buy the Continental shares from the investment banks on termination of the swaps. In addition, the swaps may have created a situation in which the participating investment banks were inclined to follow Schaeffler’s instructions. Moreover, most swap agreements contain provisions under which the banks are excluded from exercising the voting rights resulting from the underlying shares.
Nevertheless, despite its critics, Schaeffler’s takeover strategy in using cash-settled options was viewed as legitimate. The German Finance Minister has also made it clear that there will be no “Lex Conti”—the fact that Schaeffler’s “creeping takeover” of Continental will not trigger new legislation, in addition to the recently adopted Risk Limitation Act.
In fact, a similar takeover strategy was used by Porsche in its “creeping takeover” of Volkswagen. It remains to be seen whether creeping takeovers using swap transactions will occur more frequently in the future. Since BaFin has confirmed that Schaeffler’s strategy was legitimate, we will most likely see similar approaches in hostile takeover situations, in particular where a bidder would like to avoid its intention being revealed by mandatory disclosures under the German Securities Trading Act, which might lead to higher share prices in anticipation of the takeover offer. Although the Risk Limitation Act has made it more complicated to build up secretive stakes, using this strategy still might save a lot of money for flexible bidders.
China Merger Regulations and Anti-Monopoly Law Now in Place
By John Z L Huang and Kevin Qian, MWE China Law Offices
On August 3, 2008, the Anti-Monopoly Enforcement Authority (AEA) issued merger regulations in connection with China’s Anti-Monopoly Law (AML), which took effect August 1, 2008. The AML represents China’s full entry into the world of global competition law and its emerging role as a major player among competition authorities. The AML brings about a profound change for businesses with (or contemplating) operations or investments in China.
In particular, under the new law
As in most industrialized countries, “hard core” anticompetitive agreements among competitors are considered per se illegal and offenders are subject to significant penalties.
With respect to vertical agreements, the AML now subjects a wide range of relatively commonplace distribution arrangements to potential scrutiny and prohibits exclusive territorial arrangements and pricing arrangements (an approach that diverges significantly from the treatment of such arrangements under U.S. antitrust laws).
Leading firms will be subjected to heightened scrutiny under the AML’s provisions regarding abuse of a dominant market position (and significantly, a dominant market position is presumed with a 50 percent market share), with prohibitions that include “unfairly high or unfairly low” pricing and imposing an affirmative duty to deal absent objective business justifications.
Companies contemplating mergers and acquisitions (M&A) activity that may have an appreciable effect on a Chinese market will be subject to merger notification thresholds even if the parties do not have operations in China.
This article (1) summarizes the AML and the merger regulations, (2) contrasts the AML to U.S. and EU competition law, and (3) provides practical guidance for companies doing or intending to do business in China.
Overview of the AML
The AML prohibits monopolistic conduct that occurs in China or foreign conduct that affects competition within China. Article 3 of the AML defines three categories of “monopolistic conduct”: (1) monopoly agreements, (2) abuse of dominant market position and (3) mergers or acquisitions that would result in lessened competition.
The AML provides that two types of monopoly agreements may be deemed illegal and invalid upon investigation and recognition by the AEA: (1) a monopoly agreement between the competing business carriers (i.e., horizontal agreements), and (2) a monopoly agreement between the business carriers and their suppliers or customers (i.e., vertical agreements).
The AML prohibits agreements that are presumed to have a detrimental effect, such as agreements to fix prices or output, to allocate markets, to hamper innovation or to engage in group boycotts, regardless of whether these agreements arise in a horizontal or vertical context. To a large extent, the AML’s treatment of specified horizontal agreements parallel agreements that are considered per se unlawful under the Sherman Act and similarly considered “hardcore” under EU competition rules. Under U.S. and EU rules, agreements to fix prices or restrict output, group boycotts and market allocation agreements are considered per se (or effectively per se in the European Union) unlawful among horizontal competitors. However, with respect to vertical agreements (that is, agreements between companies at different levels of distribution), U.S. antitrust law differs significantly from the AML, as U.S. courts almost always analyze vertical agreements under the more lenient rule of reason test. Likewise, with the exception of air-tight territorial restrictions between Member States, the EU rules pertaining to vertical restraints are markedly less restrictive than the approach seemingly adopted under the AML.
Monopoly agreements may be permitted in certain circumstances, as outlined in Article 15 of the AML, where the transaction is likely to benefit, not reduce, competition, such as an agreement to improve technology or develop new products, or an agreement to improve product quality or reduce costs. While these considerations are similar to rule of reason considerations in the United States and the exemption criteria under Article 81(3) of the EC Treaty, important differences remain. In particular, agreements whereby a supplier allocates its distribution territories using exclusive distribution arrangements would not be tolerated under the AML, whereas these types of agreements have been routinely upheld in the United States and (at least with respect to territorial restrictions on active sales) in the European Union as well.
ABUSE OF DOMINANT MARKET POSITION
The AML prohibits any company with a dominant market position from abusing that position to eliminate or restrict competition in China. Conduct considered an abuse of a dominant market position, as outlined in Article 17 of the AML, include the following:
Selling products at unfairly high prices or buying products at unfairly low prices (note that no justification is permitted for such practices)
Selling products at prices below cost without any justifiable cause
Refusing to trade with a trading party without any justifiable cause
Restricting a trading party so that it may only exclusively conduct business with the dominant company or with the business carriers they designate without any justifiable cause
Implementing tie-in sales or imposing other unreasonable trading conditions at the time of trading without any justifiable cause
Applying discriminatory treatments on prices or other trading conditions to trading parties with equal standing without any justifiable cause
Other acts of abusing the dominant market position as determined by the AEA under the State Council
This catalogue approach is similar to that of Article 82 of the EC Treaty (Article 82 EC), which provides illustrative examples of abusive conduct by dominant firms, many of which (e.g., below-cost pricing and monopsonistic conduct) have likewise been prohibited under Section 2 of the Sherman Act in the United States. Unlike the U.S. rules, however, the AML also calls out “excessive pricing” as a category of abusive conduct, as does Article 82 EC. Further, like the European Union, China treats price discrimination as a category of abuse of a dominant market position, unlike the United States, which may prohibit price discrimination under the Robinson-Patman Act even if the discriminatory firm does not possess a dominant market position. Perhaps most striking, however, is the AML’s affirmative duty to deal. This provision breaks new ground even as compared to the express language of Article 82 EC, but is perhaps directionally consistent with the European Union’s more expansive views on a dominant firm’s duty to deal (as compared to the U.S. approach, which has recognized such a duty under only very narrow circumstances).
Article 18 of the AML identifies several factors that the AEA will consider in determining whether a company dominates the market and, therefore, is prohibited from engaging in the practices outlined above. These factors include (1) “market share” and “competitive status in the relevant market;” (2) control over market inputs, such as raw materials; (3) “financial and technical status;” and (4) ease of entry. Under the AML, companies are presumed to dominate a market if the company’s market share exceeds specified thresholds. Notably, the 50 percent market share threshold in China is substantially lower than the 70 percent benchmark under U.S. law, although similar to EU rules where a dominant position is presumed where a company’s market share exceeds 50 percent. Two- and three-firm concentrations are presumed to dominate a market under the AML if they hold a combined 66.7 percent and 75 percent market share, respectively. There is no U.S. corollary under Section 2 of the Sherman Act to these two- and three-firm concentration ratios under the AML, although oligopoly-based standards have been employed in other jurisdictions (e.g., Germany).
ESTABLISHMENT OF ANTI-MONOPOLY AUTHORITIES
At this time, only the merger regulations have been issued, and the agency designated to review concentrations has not yet been established. It is expected that the current merger review procedures will change with the anticipated establishment of a new agency to review mergers and with the issuance of enforcement guidelines. Before the AML became effective, Chinese merger review was governed by the Regulations on the Mergers & Acquisitions of Domestic Enterprises by Foreign Investors (M&A Regulations). The M&A Regulations required notification of certain transactions to both the Ministry of Commerce (MOFCOM) and the State Administration of Industry and Commerce (SAIC). In the absence of any newly established agencies, MOFCOM will continue to review transactions under the merger regulations (discussed below).
Through communication with MOFCOM, we learned that it is preparing to establish an “Anti-Monopoly Investigation Bureau” (the Bureau). The establishment of the Bureau will end the “double examination” system, in place for approximately five years, whereby mergers were notified to both MOFCOM and SAIC. This development will improve the efficiency of examination and align China’s enforcement efforts with the practices of other competition authorities. The Bureau will enforce the merger regulations (discussed below) and review concentrations concerning foreign funded enterprises and Chinese domestic enterprises. At this time, the final name of the Bureau and its specific organization and composition of members have not yet been determined.
We understand that China’s National Development and Reform Commission will establish a new agency responsible for examining unlawful monopoly agreements, and SAIC will establish a new agency responsible for reviewing potentially unlawful abuses of dominant market position.
The AML prohibits concentrations where the effect of those transactions is to restrict competition in China. In other words, China’s AML extends to transactions that do not occur within China, as long as they have a restrictive effect on competition in China. This prohibition may have wide-reaching effects on companies merging throughout the world, depending on how the Chinese antitrust enforcement agencies choose to interpret a merger’s impact on competition in China.
Companies must notify the anti-monopoly enforcement authority identified by State Council of China of all transactions that meet one of the following thresholds:
Total global turnover for the previous fiscal year of all business operators participating in the concentration in excess of RMB 10 billion (approximately $1.5 billion), and at least two of these business operators each had a turnover of more than RMB 400 million (approximately $60 million) within China during the prior fiscal year.
The total turnover within China in the previous fiscal year of all the business operators participating in the concentration in excess of RMB 2 billion (approximately $300 million), and at least two of these business operators each had a turnover of more than RMB 400 million (approximately $60 million) within China during the prior fiscal year.
These notification thresholds represent a critically important change from the prior internal draft of the notification thresholds in that they eliminate the market share threshold of 25 percent. The elimination of this criterion represents an extremely important change since it ensures that the notification thresholds are objective and do not introduce the subjective notion of market share in a “relevant market” for purposes of determining whether merging companies are required to submit a pre-merger notification filing with the Chinese authorities.
Companies that engage in monopolistic conduct prohibited by the AML may be subject to civil penalties under Article 46. These penalties include the following:
Payment of 1 percent to 10 percent of the total sales volume in the relevant market from the previous year
An order requiring the company (or companies) to cease and desist the prohibited conduct
Confiscation of “the illegal gains”
Companies engaged in monopoly agreements may mitigate their fines by “report[ing] their monopolistic conduct to the AEA and provid[ing] important evidence.” This approach is similar to the U.S. Department of Justice’s Amnesty Program, the European Commission’s Leniency Policy and similar programs in place in many countries.
Under the AML, private companies or individuals may also seek compensatory damages through China’s judiciary system, though it is unclear how private litigations will be conducted. This is a notable development as it represents a convergence with remedies available in the United States as well as the European Commission’s recent recommendations to make compensatory damages more readily available within the European Union.
Practical Guidance for Companies with (or Contemplating) Operations in China
In light of the new law, companies doing business or contemplating doing business in China should consider the following:
Review and update internal antitrust compliance programs to ensure business practices do not infringe on AML or merger regulations.
Consider training sessions to educate business personnel of China’s new antitrust enforcement regime.
Conduct a “dominance audit”—review current operations under the AML to determine whether the company is likely to be regarded as “dominant” in any market in China.
Review internal documents prepared in the ordinary course of a company’s Chinese business, such as business plans, strategy plans or marketing plans, to ensure business plans do not include any conduct that may be an abuse of dominant market position under AML.
Review pricing policies vis-à-vis Chinese market position to ensure policies do not suggest an abuse of a dominant market position.
Review “monopoly agreements” to determine whether they may be justified as pro-competitive pursuant to Article 15 of the AML.
Consider offensive uses for prohibitions of anticompetitive conduct against competitors or suppliers that may hold a dominant market position—e.g., leverage prohibition against refusals to deal to prevent suppliers from refusing to deal.
Review distribution policies with regards to Chinese business.
Carefully review participation in trade associations in China—previously, involvement with such groups was lawful and encouraged; however, such conduct my now give rise to antitrust issues in China.
Audit commercial conduct to detect potential problems before the regulators become aware of them and leniency is no longer available.
This article was orginally published as a McDermott White Paper.