Category: Mergers & Acquistions

Unclaimed Property in M&A Transactions: The Potential for an Unwelcome Surprise

The National Law Review recently published an article written by Jonathan I. Lessner, Marc J. Musyl, and Sarah Niemiec Seedig of Greenberg Traurig, LLP regarding M&A Transactions:

GT Law

As the economy continues to recover, an increase in M&A activity is expected. A target company’s historical compliance with unclaimed property laws is an important, but often overlooked, area for due diligence in M&A transactions. A target company’s failure to comply with unclaimed property laws can potentially create multi-million dollar exposure for the buyer. The transaction itself may have the effect of drawing the attention of state unclaimed property regulators and third party contingency fee auditors. There are various ways, as discussed below, for the buyer to control or limit its potential exposure.

A Brief Introduction to Unclaimed Property

While the exact parameters of what constitutes “unclaimed property” vary from state to state, unclaimed property generally consists of a wide range of both tangible and intangible property held by a business. Once the business has held the property for a statutorily mandated holding period without communication with the owner, it becomes unclaimed property subject to escheat. Some examples of unclaimed property include: un-cashed rebate checks and other customer credits; unused gift certificates and gift cards; un-cashed vendor checks; un-cashed dividend checks; insurance proceeds; and the underlying stock or other evidence of an ownership interest in a business.

Businesses are responsible for reporting unclaimed property to the states on an annual basis in accordance with priority rules established by the U.S. Supreme Court. The first-priority rule is that unclaimed property escheats to the state of the apparent owner’s last known address, as shown on the company’s books and records. The second-priority rule provides that the unclaimed property escheats to the state of the company’s incorporation if: (1) the apparent owner’s address is unknown, (2) the last known address is in a foreign country, or (3) the last known address is in a state that does not provide for escheat of the property in question. As the unclaimed property laws vary from state to state, the outcome of this jurisdictional priority analysis can have a meaningful impact on the property required to be escheated. Some states even require negative reports to be filed, stating that no unclaimed property is due and owing to the state.

The Importance of the Transaction’s Structure

A transaction’s structure can significantly impact the unclaimed property exposure that a buyer may inherit from the target. In an asset purchase, the buyer acquires only those liabilities specifically identified in the purchase document. While it is still possible for the buyer to acquire certain unclaimed property liabilities in an asset purchase (such as those associated with bank accounts, accounts receivable, or gift cards), the buyer’s potential exposure for the target’s failure to comply with unclaimed property laws will typically be less than in a stock purchase where the buyer generally acquires all of the target’s disclosed and undisclosed liabilities, including its unclaimed property liabilities.

In addition, unclaimed property can arise in the context of a merger involving a share exchange, where the former stockholders (who now cannot be located) fail to receive the shares issuable to them in the merger. At least one SEC reporting company recently entered into a settlement with the State of Delaware as a result of more than four million shares which were reserved for issuance in the merger, but which were not claimed by former stockholders. The settlement resulted in the SEC reporting company making a $20,000,000 cash payment to the State of Delaware.

The Impact of a Target’s Failure to Comply with Unclaimed Property Laws

There are a number of factors that can make a target’s failure to comply with the unclaimed property laws very costly for a buyer. In many states, there is no statute of limitations on unclaimed property. As a result, even voluntary compliance arrangements with the states can result in a look-back period of five to ten years or even longer. Audit look-back periods can be significantly longer. Oftentimes, the buyer will not have complete records from the target. In such situations, state regulators in a post acquisition audit have been known to use various formula to estimate the liability. The target may have made acquisitions itself prior to being acquired, further compounding the potential for non-compliance. Once interest (and potentially even penalties) is added to the equation, a potential multi-million dollar exposure can be created — definitely an unwelcome surprise for the buyer.

Methods for Avoiding an Unwelcome Surprise

Prospective buyers can take proactive steps to manage and minimize potential exposure. Below are a few such steps:

Structure of Transaction. If possible, buyers should consider structuring a transaction as an asset purchase to minimize the unclaimed property liabilities inherited from the target. The purchase document should be carefully drafted and negotiated to leave any unclaimed property liabilities out of those liabilities acquired by the buyer.

Due Diligence. Oftentimes, unclaimed property compliance is overlooked in the due diligence process. As a starting point, buyers should request copies of the target’s unclaimed property policies and procedures, a description of the target’s unclaimed property due diligence process, copies of historical unclaimed property reports filed by the target, correspondence with state unclaimed property regulators, and any unclaimed property audit notifications. Given the current interest, especially in Delaware, in equity property (e.g., stock, dividends, etc.), buyers should make sure the target’s response includes materials that permit the buyer to determine the target’s compliance for this property type, especially because this information may be in possession of the target’s transfer agent or other third party. Depending on the materials provided, additional due diligence may be warranted.

Representations and Warranties. Unclaimed property is not a tax and thus is typically not covered by the tax representations and warranties. The purchase document should include specific representations and warranties of the target, backed by an indemnity and an escrow if possible, regarding the target’s historical unclaimed property compliance. The target’s indemnity obligations should be excluded from any basket and cap exceptions applicable to indemnities. Most representations and warranties only survive for a specified period following the closing of the transaction. However, as discussed above, oftentimes there is no statute of limitations with respect to unclaimed property compliance. If possible, the target’s representations and warranties regarding unclaimed property compliance should survive closing indefinitely. Additionally, even if the target is current in its compliance, provision should be made for property still in its dormancy period, i.e., property that may be abandoned but not yet subject to escheat.

Voluntary Compliance Initiatives. If it is determined that the target is not in compliance with the unclaimed property laws, the buyer should consider whether voluntary compliance is a viable option. Many states offer voluntary compliance programs with limited look-back periods.

©2012 Greenberg Traurig, LLP

Transformation. Repositioning. Adjustment.

The National Law Review recently published an article by Lisa L. Mueller of Michael Best & Friedrich LLP regarding the 2012 China (Suzhou) Service Outsourcing Innovation Development and Investment Promotion Summit:

Transformation. Repositioning. Adjustment. Service + Innovation = Jobs. These were the keys from today’s 2012 China (Suzhou) Service Outsourcing Innovation Development and Investment Promotion Summit in Suzhou, China.

The summit was attended by the Delegation, a number of local government officials, business leaders from Suzhou and other business leaders from around the world. The stage used for the formal presentations contained a large multimedia screen and was surrounded with red flowers, and the podium top had a dozen red roses on it. I was told by an attendee that decorating the stage with flowers is very common in China. Also, the introduction of each speaker was very unique. When introduced and while approaching the podium, a “theme” song was played, the morning session featured the “Star Wars” theme song. Although most of the speakers presented in Chinese, simultaneous translation into English was provided.

As emphasized several times by the various speakers during today’s presentations, service outsourcing has contributed greatly to China’s economic growth. As part of China’s 12th Five Year Plan, and in view of the recent global economic downturn, it is a top priority of the Chinese government to restructure and transform China’s economy. The fundamental purpose of this restructuring and transformation is to ensure the quality of economic growth and enhance the overall competitive strength of China. Therefore, the recurring theme throughout the day was the refocusing of China’s service industry from manufacturing outsourcing, considered to be low-end or low-tech outsourcing, to high-end/high-tech service and international service outsourcing. Innovation is considered to be the key in making the change away from low-end industrial and increasing the overall competitiveness of China’s service outsourcing enterprises. Clearly, China wants to be the worldwide leader in service outsourcing enterprises and is willing to invest the time and resources to achieve this goal.

In 2009, China’s state council approved setting up 21 cities as models of service outsourcing. These cities receive preferential treatment in terms of tax benefits and receipt of certain subsidies. The selected cities themselves have invested heavily in public infrastructure, industrial parks and education and training. One such selected city is Suzhou, the location of today’s summit.

Service outsourcing originated in Suzhou in the 1990′s and has developed rapidly. As of 2011, Suzhou had more than 1,600 service outsourcing enterprises employing approximately 160,000 people. In fact, in 2011, 488 new service outsourcing enterprises were established in Suzhou. Additionally, the signed contract value of Suzhou’s offshore outsourcing services in 2011 was 3.57 billion US dollars, an increase of 57.4% over 2010 with an executed contract value of 2.01 billion US dollars, an increase of 58.6%.

Suzhou hopes to lead the way in the transformation from low-end services to high-end service outsourcing and it appears to be well positioned to do so. Specifically, the city is the source of a lot of talent: (1) it’s home to 20 colleges and universities; (2) it has over 30 Chinese-foreign cooperatively run institutions; and (3) it has a variety of projects with universities such as University of Liverpool, National University of Singapore and the University of Dayton. In addition, Suzhou established the first service outsourcing institute having a capacity to train over 20,000 professionals per year.

Today, government officials described in detail Suzhou’s aggressive economic plan to create a unique service outsourcing industry in the following ten areas:

  1. Software development outsourcing – focus will be on software development in the areas of user operations, production, supply chain, customer relations, human resources and financial control, computer aided design, embedded software, system software, and software testing.
  2. Research and development design outsourcing – focus will be on providing design services in the automotive, electronic products, chip design, and other industries.
  3. Biomedicine research and development outsourcing – focus will be on the development of medical test technology services, animal experiment services, medical non-clinical research and evaluation services, biotechnology services, clinical trials for new pharmaceuticals, preclinical services, drug safety and evaluation, and medical apparatus design, research and development.
  4. Financial background service outsourcing – focus will be on the development of financial outsourcing businesses, including data mining and analysis, financial payment services, credit analysis and rating, insurance services, and financial consulting services.
  5. Animation and creativity outsourcing – focus will be on the development of international animation processing, original animation development, comic digitized applications, and special effects production.
  6. Logistics and supply chain management outsourcing – focus will be on the development of total logistics and supply chain management services in the areas of e-communication, chemicals and pharmaceuticals.
  7. Testing and inspection outsourcing – focus will be to establish “world-renowned” testing and inspection outsourcing enterprises and to actively develop professional analysis and testing services, including software evaluation services, quality inspection and testing services, and consulting services.
  8. Outsourcing in the field of cloud computing – focus will be on the development of software operation services including on-line software delivery services, on-line system maintenance services, IT infrastructure management, data centers, trust and call centers.
  9. Outsourcing in the field of Internet of Things – focus will be on the construction of a smart city and expansion in the business fields including the Internet of Things, development of information processing platforms, development of intelligent building equipment, sensor networks, small grids, and intelligent equipment.
  10. Shared service centers for transnational companies – focus will be on those transnational companies that have settled in Suzhou and encouraging them to establish shared service centers by separating their service businesses.

The government officials of Suzhou are very proud of all that they have achieved with respect to their service outsourcing enterprises and are confident that they can achieve a service outsourcing industry in the above areas. Time will tell.

© MICHAEL BEST & FRIEDRICH LLP

13th Great-Idea China Sourcing & New Industrial Delegation to China – Day 2

Recently an article by Lisa L. Mueller of Michael Best & Friedrich LLP regarding the 13th Great-Idea China Delegation appeared in The National Law Review:

We woke up to a bright, beautiful and warm morning in Shanghai. The nice weather was greatly appreciated as the Delegation was up and out early, traveling to the Shanghai Pudong Software Park (Park). The Park is only 12 years old and is currently home to 1,086 companies. Two of these companies are in Forbes’ Top 20. Additionally, companies such as Citi, Texas Instruments, Olympus, Sony, Kyocera, Tell Labs and Qualcomm, each have offices within the Park.

During our visit we were taken to the first location and given a short presentation describing the size of the Park, the various campuses that comprise the Park and the development cost of each campus. After the presentation, we traveled to a second location which was quite stunning, as it contained a central lake surrounded by several buildings and beautiful landscaping. The lake contained docks that were staffed with paddle and small motor boats. Interestingly, the campus was very quiet; there was very little activity, at least on the outside, and strangely, we saw very few people during our visit.

After completing our visit to the Park, the Delegation traveled to a restaurant in downtown Shanghai specializing in Peking duck. The duck arrived after course number two, each course being anywhere from 2-3 different dishes, and was followed thereafter, by four additional courses. Favorites among the Delegation included the duck skin and meat, which were presented on separate plates, deep-fried fish in red sauce, and wheat rolls stuffed with duck. I particularly enjoyed the spicy jellyfish, which was a new experience for me.

After lunch, we boarded a bus to travel to the town of Suzhou. Suzhou was founded in 514 B.C. and its history dates back more than 2,500 years. Suzhou is frequently referred to as the “Venice of the East” or the “Venice of China” for its beautiful canals and stone bridges. Suzhou also has a number of magnificent gardens. In fact, several of Suzhou’s classical gardens were named UNESCO World Heritage Sites in 1997 and 2000.

Upon our arrival in Suzhou we were taken to Dushu Lake Hotel. The hotel blends traditional Suzhou architecture with cutting-edge contemporary design. There is a beautiful story the locals tell regarding Dushu Lake:

“Ancient stores tell the tale
of a small branch that fell
from the moon into the lake
and grew into a large single-branch there.

Locals believe that those who live
around the lake will be
Blessed with happiness.”

The hotel is located in the Suzhou Industrial Park (SIP). The SIP is the largest cooperative project between the Chinese and Singapore governments. SIP covers an area of 288 square kilometers, of which, the China-Singapore cooperation area covers 80 square kilometers.

After a wonderful buffet dinner, the Delegation was treated to a nighttime cruise on Jinji Lake.

Tomorrow the Delegation will participate in the 2012 China Service Outsourcing Innovation Development and Investment Promotion Summit and China-Europe CIO Summit.

In addition to reporting on the day’s activities, I thought it might be interesting to profile some of the people comprising the Delegation. Therefore, I will try in each blog to introduce you to one or two people in the Delegation.

Delegate Spotlight: Thomas Gephart from Irvine, California, US.

Tom is the founder and managing partner of “Ventana,” which is Spanish for “window”. Ventana was founded in 1974 and is a leading multi-stage equity firm. Specifically, Ventana invests in the best of breed innovative companies with technology products and services that meet the challenging global demands of commercial industrial, technological, federal, and international customers. Most impressively, Ventana has provided more than 30 years of syndicated financing for 100 plus portfolio companies totaling 3.2 billion US dollars from Southern California to Latin America, and Europe to Asia.

Tom has an engineering degree and worked for several years for Hughes Aircraft and then TRW, Inc.  After TRW, Tom was hired to find and develop new products for AMP, Inc. After AMP, Tom started his own electronic components business that ultimately had two divisions. Three years after Tom started his business he sold it and founded Ventana.

Tom is currently working on forming a China-US strategic alliance and innovation region cross-border fund and hopes to launch the fund later this year. In working on forming this fund, Tom has observed that the Chinese government seems particularly interested in moving technology to China, and once here has no problem paying for its commercial development. Specifically, in Tom’s opinion, the Chinese government is interested in things that are “explosive” and beneficial to Chinese society and is willing to pay for them. Once this China-US fund has been completed, Tom hopes to form a similar fund between India and the US.

Delegate Spotlight: Martin Venzky-Stalling from Hamburg, Germany.

Martin works as a senior advisor for the Technology Development Center for Industry (TDCI) at Chiang Mai University in Chiang Mai, Northern Thailand. Martin’s role with TDCI is to assist with the development of a Science and Software Park and creating links between government, universities and private sectors. In addition to the Science and Software Park project, Martin also supports the local government with a creative economy initiative called, “Chiang Mai Creative City.” This initiative aims to establish Chiang Mai as the international center for creative industries, including software, crafts, and graphic design.

Prior to moving to Chiang Mai, Martin was Senior Vice President for International Operations at PCCW (Hong Kong Telecoms), Director of Consulting at Ovum in London and Associate Director with the Global IT, Communications, and Entertainment (ICE) Strategy Group of PricewaterhouseCoopers. Martin specializes in strategy development, market entry, technology enabled business transformation, and launching new entities.

© MICHAEL BEST & FRIEDRICH LLP

Opening of the 13th Great-Idea China Sourcing & New Industrial Delegation to China

The National Law Review recently published an article by Lisa L. Mueller of Michael Best & Friedrich LLP regarding The New Industrial Delegation to China:

Today was the first day of the 13th Great-Idea China Sourcing & New Industrial Delegation (Delegation). The first stop: Shanghai.

Because this was my first time to China, I really did not know what to expect when my plane landed in Shanghai. All I really knew about China before leaving home is that from a geographical standpoint, it is an extremely large-sized country with an equally large population, and that many of the products that I rely on day in and day out in my life (my running shoes, many of my clothes, etc.) are made in China. Well, I was certainly not prepared for what I found when my plane landed in Shanghai. What struck me immediately was that Shanghai is absolutely enormous in a multitude of different ways. First, the sheer number of people who live and work in Shanghai is colossal. Since my arrival, I have heard that the number of residents in Shanghai to be anywhere from 20 to 23 million. Regardless of the actual number, I can tell you that there are simply people everywhere and they seem to be going in every direction. In fact, there are so many people in Shanghai that there is not enough room for people to walk on the sidewalks, so they frequently travel in the streets along with the buses, cars, mopeds, motorcycles and bicycles that make up traffic.

Second, the sheer number and size of free-standing skyscrapers in Shanghai is astonishing. Some of the more prominent skyscrapers include the Jin Mao Tower, the Shanghai World Financial Center, which is the tallest skyscraper in mainland China at the moment, the Oriental Pearl Tower and the Development Tower.

Third, the amount of new skyscrapers that are under construction is tremendous. There seems to be skyscrapers under construction no matter which direction you look in Shanghai. Based on the work done thus far, it appears that many of these skyscrapers are going to be just astronomical in size.

Fourth, the traffic in Shanghai is monstrous. Growing up on Long Island, NY, I thought I was used to the immense day-to-day traffic that has long been a staple in the New York Metropolitan area. NOTHING could prepare me for the mammoth traffic in Shanghai. Getting around by car, cab or bus is absolutely painful during what most people would consider “reasonable” waking hours during the day. I took a bike tour on Saturday and I can personally attest that this traffic makes biking a challenge when you have to traverse cars, buses, cabs, mopeds, motorcycles, bicycles and people crossing the streets. In fact, at times, the weaving in and out was better than any amusement park ride I’ve been on in years (and far less expensive).

Fifth, not surprisingly given the number of cars, buses and motorcycles that comprise the traffic in Shanghai, the pollution is gargantuan. It has taken my eyes and lungs a bit of time to adjust to the increased levels of pollution.

In addition to the enormity of China, I was also not prepared for what I have found in terms of the people of China. For the most part, the Chinese people are very friendly and warm. I have found them to be very hard-working and capitalistic. Unfortunately, given the large number people in China, there are far more people than jobs. In view of this, as part of China’s 12th Five-Year Plan for National Economic and Social Development, the Chinese government is trying to spread the benefits of economic growth to a higher number of Chinese citizens. The plan’s key themes involve rebalancing the economy, ameliorating social inequality and protecting the environment. Part of this plan involves changing the export-oriented economy of China from low-end manufacturing outsourcing to advanced manufacturing outsourcing and international service outsourcing. The three main sectors to be targeted by this plan are healthcare, energy and technology.

The Delegation is part of an international summit and forum that has come to China to learn more about the plan, to meet with local business leaders and politicians who will be instrumental in implementation and to foster cooperation and investment opportunities between China and other nations based on the plan of the International delegates. Some are venture capitalists or other types of investors, some are lawyers and others are technology specialists.

This evening, the delegation visited Hand Enterprise Solutions Company (Hand) for a presentation by Mr. Dean Chen, President. Hand was established in Shanghai in 2002 and was one of the first local enterprise resource planning (ERP) consulting firms in China. They currently have over 700 employees and an average growth rate of 30% in recent years. In 2002, IDC named Hand one of the “Top Consulting Companies” in the China IT Industry. Hand currently provides a variety of IT services ranging from traditional IT strategic consulting, business process optimization, ERP implementation service, as well as, mobile solutions and business intelligence. They have provided consulting services in a variety of industries such as machinery, electronics, automotive, pharmaceutical, chemicals, food and beverage, financial services, telecommunications and the Chinese aviation industry. Hand has about 400 customers in China, Japan, Europe and the US and has offices in Beijing and Guangzhou in China and in Tokyo, Japan.

Tomorrow morning the Delegation will tour the Zhangjiang Science and Technology Park in Shanghai before heading to Suzhou.

© MICHAEL BEST & FRIEDRICH LLP

European Commission Considers Taking Over Cartel Investigations to Prevent Exploitation of German Law Loophole

Recently The National Law Review published an article by Martina Maier and Philipp Werner of McDermott Will & Emery regarding the European Commissions Investigation of a German Law Loophole:

Under German law, companies may escape cartel fines by undertaking an internal restructuring. The German competition authority has indicated a willingness to reallocate such cases to the European Commission, which can impose a fine on the corporate group regardless of any internal restructuring. Commission officials speaking at a conference have suggested recently that the Commission would be willing to take over cartel cases from EU Member States, even at a late stage in the proceedings, in order to fine undertakings for their anti-competitive behaviour.

Background

The German competition authority can impose fines on undertakings that have violated European competition law by forming a cartel. Under German law, if the undertaking ceases to exist, for example by merging with another undertaking, only in exceptional circumstances can the legal successors be held liable for the violation of Article 101 TFEU. For the legal successor to bear any liability for the anti-trust infringement, the restructured company must be identical, or nearly identical, to the company that committed the infringement, such as in the case of a mere change of the company’s name or its legal structure.

This has created a loophole that can be exploited by internally restructuring the legal entity that has committed the infringement so it ceases to exist and no other legal entity within the group is (nearly) identical. Companies may thus escape cartel fines by, for example, redistributing their assets to affiliated companies within the corporate group, or by merging with a sister company, even if the original company’s assets remain within the same group and under the control of the same ultimate parent company. This loophole has been confirmed explicitly by the German Supreme Court. Although Germany is currently amending its competition legislation, it is not yet clear whether the proposed changes will be sufficient to solve the problem.

In the European Union, due to the broad interpretation of the concept of an “undertaking”, as well as the possibility of holding parent companies jointly and severally liable, the European Commission has broad discretion when it comes to imposing fines on parent companies, so an internal restructuring does not present a solution for infringing companies.

Reallocation of Cases

According to the Commission Notice on cooperation within the Network of Competition Authorities, reallocation of cases should normally take place within a period of two months, starting from the date of the first information sent by the relevant national competition authority to the European Competition Network. In general, the competition authority that is dealing with a case at the end of the two month period should continue to handle the case until completion of the proceedings. Reallocation of a case after the two month period should only occur where the facts known about the case change materially during the course of the proceedings. After the two month period, the Commission should in principle initiate proceedings only in exceptional cases.

If the Commission initiates proceedings, the relevant authorities of the Member States are relived from their competence to apply Article 101 TFEU and Article 102 TFEU. This means, once the Commission has opened proceedings, national competition authorities cannot act under the same legal basis against the same agreement or practices by the same undertaking on the same relevant geographic and product market.

Despite these procedural concerns, the Commission seems to be willing to accept a late reallocation of cases in cooperation with the German competition authority. It is not clear how this principle could or will be extended to other Member States and whether it could be applied under different circumstances where a Member State is prevented from fining a cartelist due to the application of a national law.

© 2012 McDermott Will & Emery

FERC Decides to Retain Existing Merger Review Policies

The National Law Review recently published an article by Daniel E. Hemli and Jacqueline R. Java of Bracewell & Giuliani LLP regarding a recent FERC Decision on Merger Reviews:

On February 16, 2012, FERC issued an order (February 16 Order) reaffirming its existing merger review policies under Section 203 of the Federal Power Act (FPA) and its current framework for analyzing requests for market-based rate authority under section 205 of the FPA. In March of last year, FERC had sought comment in a Notice of Inquiry (NOI) on whether it should amend its existing policies in these two areas in light of new Horizontal Merger Guidelines (2010 HMG) issued jointly by the Federal Trade Commission (FTC) and Department of Justice (DOJ) on August 19, 2010. The NOI explained that the 2010 HMG deemphasize market definition as a starting point for merger analysis and depart from the sequential analysis found in the prior 1992 version of the Horizontal Merger Guidelines (1992 HMG), and instead support the use of a fact-specific inquiry and greater analytical flexibility.

Section 203 of the FPA requires parties to public utility mergers and acquisitions involving jurisdictional facilities to seek FERC authorization before closing. Section 203(a) provides that FERC should approve such transactions if they are consistent with the public interest. As part of that determination, FERC must consider the proposed transaction’s effect on competition in the relevant market(s). FERC currently uses a five-step framework that was adopted from the 1992 HMG, as well as a Competitive Analysis Screen (CAS) which focuses on the first step of the analysis: whether the proposed transaction would significantly increase concentration and result in a concentrated market. One component of the CAS includes an analysis of market concentration using the Herfindahl-Hirschman Index (HHI). Under Section 205 of the FPA, parties that can demonstrate they do not have, or have adequately mitigated, their horizontal and vertical market power are granted authority to make sales of electric energy, capacity and ancillary services at market-based rates. FERC’s analysis under Section 205 includes the use of two indicative screens that rely on market share as well as market concentration as measured by HHI.

In its February 16 Order, FERC declined to follow the 2010 HMG’s approach as the framework for the Commission’s analysis of horizontal market power. The Commission explained that it would retain its five-step framework, including the CAS as part of its first step, as the CAS provides a useful conservative check to allow parties to quickly identify mergers unlikely to present competitive problems at a relatively low cost. The Commission stated that its current approach, which provides analytical and procedural certainty, is also flexible enough to incorporate theories outlined in the 2010 HMG, and that it has previously, and will continue to, look beyond the HHI screens in its review process when warranted.

The Commission also declined to adopt the revised, higher HHI thresholds presented in the 2010 HMG for use in its CAS. Noting its extensive experience with electrical markets and their distinct characteristics, as well as its intent to use the CAS to identify proposed transactions that clearly would have no adverse effect on competition, FERC stated that its current HHI thresholds are appropriate. The Commission also declined to initiate a more formal coordination process with the FTC and DOJ, as requested by one commenter. FERC stated that it will continue to coordinate with the federal antitrust agencies as appropriate, on a case-by-case basis.

Regarding its electric market-based rate program, FERC decided not to modify the current market power analysis and declined to alter the HHI threshold used in that screening process, noting that its current HHI threshold is already consistent with the 2010 HMG approach. With regard to the existing market share screen, FERC explained that, due to the physical and economic characteristics of electricity markets, including low elasticity of demand, market power is more likely to be present at lower market shares. Thus, FERC concluded that the current indicative screens used in its market-based rate analysis provide an appropriate balance between a “conservative but realistic screen” and imposing undue burdens on applicants. FERC also noted that its current analysis provides adequate flexibility to consider additional evidence when raised by an applicant or an intervenor.

© 2012 Bracewell & Giuliani LLP

The Top Five Intellectual Property Traps in M&A Transactions

Recently posted in the National Law Review an article by Carey C. Jordan of McDermott Will & Emery  regarding intellectual rights in M&A transactions:  

 

In M&A transactions, many lawyers assume that intellectual property (IP) rights will automatically transfer with the purchase and that IP issues can be cured by general representations and warranties. While getting strong representations and warranties covering intellectual property is useful, relying on a breach of representations and warranties as the only remedy to protect the covered IP can doom the deal to failure or lead to unexpected surprises after closing, including requiring significant changes to future business plans and opportunities. If the target’s IP rights are important to the ultimate deal, then those IP rights must be investigated thoroughly in the due diligence and fully understood.

A due diligence investigation into a company’s intellectual property assets is essentially a methodical audit which will cover at least the following main areas:

  • Patents
  • Know-how
  • Copyright
  • Trademarks
  • Infringements
  • Licenses and collaboration agreements

Failure to examine these during due diligence in a manner appropriate to the deal at hand can lead to reevaluation, repricing or structural changes of the transaction.

For example, Volkswagen outbid BMW in 1998 to buy Rolls Royce and Bentley and their British factory from Vickers PLC for $917 million. But an odd twist in the deal allowed the Rolls-Royce aerospace company to sell rights to the ROLLS-ROYCE trademark to BMW out from under Volkswagen for $78 million. Thus, after the deal closed, Volkswagen did not have the rights to use the ROLLS-ROYCE mark. Only after a separate deal was made with BMW to avoid litigation, did Volkswagen gain the ability to manufacture a trademarked ROLLS-ROYCE car.

Thus, IP due diligence in an M&A transaction should not be overlooked and should be undertaken early in the process. The following are five common IP issues that may impact M&A transactions.

1. Target Does Not Actually Have the Critical Patent Rights

A target company may not actually own the IP rights that it represents that it owns. This may be due to a failure to update the title through corporate name changes or lien releases, or a failure to ensure that employees have properly assigned their rights to IP assets developed with company resources to the target. This latter situation is particularly problematic. For example, under U.S. patent law, each joint inventor has the right to use and to license patented technology to a competitor without accounting to the other owner in the absence of an agreement to the contrary. As a result, a non-assigning employee can license a key competitor of the buyer (and even keep the royalties) without notifying the target. The problem can be more acute in the case of an independent contractor, who may not have an obligation to assign rights to the target. It is therefore important to review contractor agreements related to any IP relevant to the transaction to confirm that the agreements address ownership of any IP created by the contractor.

Trademarks must be evaluated in terms of their goods, services and countries of registration to confirm that they cover the buyer’s intended uses in intended markets. Certain countries recognize common law trademark rights, based on use of a mark, while other jurisdictions give priority to the first party to file a trademark application, regardless of use. Internet domain names are subject to fewer formalities, but must be investigated as well. Domain name registrations may expire and, if expired, the domain names can be bought by anyone. It is also important to confirm that important domain names are owned by an entity relevant to the transaction, as opposed to an information technology (IT) professional within the company, a licensee or another entity.

2. Prior Agreements Limit IP Rights

Sometimes, the target’s IP rights may be subject to prior agreements that restrict their use in other markets or fields of use. The target may have existing licenses or agreements with respect to some or all of its IP rights. For instance, the target may have granted a third party exclusive use in a key field of use, territory or patent, which may limited the buyer’s full and expected use of the IP rights.

For example, when the Clorox Company purchased the PINE-SOL business and trademark from American Cyanamid in 1990, Clorox planned to leverage the strength of the PINE-SOL mark into other products. Clorox purchased the PINE-SOL assets and mark subject to a prior 1987 agreement that Cyanamid had entered into with the owner of the LYSOL trademark to settle a trademark dispute years earlier. That prior agreement restricted Cyanamid (and subsequently Clorox) from expanding the use of the mark beyond the PINE-SOL pine cleaner. Clorox tried to void the terms of the settlement agreement through litigation, but was unsuccessful.

Licensors of intellectual property may argue that a merger in which a licensee does not “survive” as a separate corporate entity may void the license – even if the license agreement contained no prohibition against merger, acquisition or transfer. This argument is based on an arcane line of federal cases holding that patent licenses are not assignable unless expressly made so. More recently, some federal courts have extended this rule in ways that affect corporate mergers, and have found, in effect, that certain mergers can constitute transfers that void patent licenses. This is especially problematic in an acquisition of a licensee.

Additionally, in certain instances in which the U.S. government has provided funding to an entity (usually a nonprofit, university or small business), the U.S. government may retain certain rights to any relevant patents developed from that research, and any subsequent grants relating to those rights (e.g., a license or acquisition) will remain subject to the government’s retained rights. These government “march-in” include the right to license the invention to a third party, without the consent of the patent holder or original licensee, where it determines the invention is not being made available to the public on a reasonable basis.

3. Target is Subject to Pending/Threatened Infringement Claims

No buyer wants to buy an expensive IP-related lawsuit through an acquisition. Any potential litigation or enforcement risks must be assessed and independently analyzed, including evaluating potential indemnifications. Although others exist, two primary areas for inquiry in this context include potential patent infringement and copyright liabilities.

For potential patent liability issues, a purchaser does not want to spend a great deal of time and money to acquire rights that it will not be able to exploit because of third party’s potential infringement lawsuit. Potential litigation and enforcement risks may be identified through the target’s legal opinions, cease and desist letters, freedom to operate studies and similar materials, which should be requested and analyzed in the due diligence process.

As to open-source software, the GNU General Public License governs a large number of open-source products. Open-source code can only be tightly integrated into other open-source products, and a condition of using the code is that the user also publishes its modified version of the code to the public. The Free Software Foundation enforces the GNU General Public License. This can be problematic in an acquisition, especially when the software is a valuable piece of the assets being acquired. There have been instances where an acquiree has been sued by the Free Software Foundation after acquiring a company that had allegedly incorporate open-source code into its software. In at least one instance, the acquirer had to release the acquired software to the public as a result. Open-source liability can kill a deal and affect the value of a transaction. In the absence of insurance, some companies will accept a reduction in deal price.

4. Significant Barriers Exist to Exploitation of the Technology

With regard to patents and the ability to exploit the acquired patented technology, significant barriers may exist. Third parties may have blocking IP rights that prevent the buyer from exploiting the target’s IP or expanding the business as planned. Sometimes, this risk is not specifically known even to a target. Thus, the buyer’s freedom to operate often should be analyzed before completing the transaction, to make sure that the buyer will be able to use the assets purchased as intended in the conduct of the business operations, or as proposed to be used according to the buyer’s future plans. A freedom-to-operate analysis should be performed, which is an assessment of whether making, using sale, offering to sell or importation of a product in the U.S. will infringe any third-party patents.

If third party IP rights are identified that may block or limit the buyer’s use of particular IP rights, and a meaningful design-around is not possible, then it may be necessary to license or acquire ancillary rights to such third party blocking IP rights. Alternatively, the target could seek to invalidate the blocking IP at the United States Patent and Trademark Office (e.g., through a reexamination) or in a court. The inquiry is more complex when pending claims are published yet not issued, so the inquiry not only requires construction of the claims and infringement analysis, but also estimation of whether the published claim(s) will issue. Evolving application of infringement under the doctrine of equivalents and other changing legal standards through judicial decisions only adds to the complexity and cost of the analysis.

Of course, this still leaves unknown barriers to the exploitation of technology. Included in this category are issues such as unpublished patent rights that could block a buyer, misappropriation of technology, reverse engineering by competitors who have then patented improvements to a target’s trade secrets or even competitors who independently discover trade secrets and patent them, and the like. To the extent these can be explored, it is wise to do so. However, there are risks in any deal, and wise IP counsel can consider the impact of potential unknowns based on the industry and technology involved in the contemplated transaction.

5. Target’s IP Rights Are Encumbered by Liens

IP rights may also be encumbered by liens. To record and perfect a lien against both patents and trademarks in the United States, Uniform Commercial Code (UCC) filings need to be made. Although not legally required, most lenders also record the security agreement in the U.S. Patent and Trademark Office (USPTO). Under U.S. copyright law, however, only a lien recorded in the U.S. Copyright Office will perfect a security interest in copyrights. Due diligence should include reviewing reports from all of the applicable filing offices.

In sum, early and comprehensive IP due diligence in M&A transactions is important because it can lead to a reevaluation, repricing or restructuring of the proposed transaction.

© 2011 McDermott Will & Emery

The Top Five Tax Traps in M&A Transactions

Recently posted  in the National Law Review an article by Jeffrey C. Wagner  and Daniel N. Zucker of McDermott Will & Emery regarding tax consequences of acquisition and disposition transactions:

The tax consequences of acquisition and disposition transactions can dramatically impact deal value. Often the potential tax issues can be resolved in a manner that is consistent with the intention of the parties without changing the economics of the deal. If some of these tax issues are not addressed, however, the parties may not obtain the benefit they had bargained for even though it may have otherwise been possible. This puts a premium on the involvement of tax advisors from the outset of a transaction. Although one rarely wants to see tax be the “tail that wags the dog” in a deal, tax issues can present significant economic opportunities or costs that may often warrant tweaking or changing the deal structure to accommodate these issues.

1. Failure to Solicit Tax Advice at the Letter of Intent Stage

Although not binding, the terms of the letter of intent entered into by the parties in the early stages of the acquisition process can put one of the parties in a superior bargaining position as it relates to which party bears the burden or reaps the benefits of the tax costs and benefits associated with a transaction. Too often, a client does not engage its outside advisors (or significantly limits the involvement of its outside advisors) until after a letter of intent is signed. The failure to include the tax advisor at this early stage can mean lost dollars to the seller or additional cost to the buyers.

For example, if the target is an S corporation, in most cases the buyer should be able to secure the benefit of a tax basis step-up for federal income tax purposes without a material increase in the taxes payable by the seller with respect to the sale. However, if the buyer is not well-advised, the letter of intent may simply indicate that the buyer will acquire the stock of the target for the agreed-upon consideration. If, after the letter of intent is executed, the buyer recognizes that a tax basis step-up can be achieved with little or no tax cost to the seller, the buyer may request that the transaction be converted to an asset purchase or that a Section 338(h)(10) election be made by the parties. At this point, the seller has the leverage and can demand additional consideration from the buyer in exchange for the tax benefits that such a structure would provide.

2. Section 197 Anti-Churning Rules

When the acquisition of a business is structured for income tax purposes as an asset purchase (i.e., an asset purchase in form or a stock purchase coupled with a Section 338(h)(10) election), the buyer usually has bargained for the tax benefits that accompany such a transaction—namely, the ability to tax effect the purchase price by depreciating or amortizing the premium paid for the assets, which premium is usually attributable to the goodwill and going concern value of the acquired business. If the business being acquired was in existence on or before August 10, 1993 and, before or after the transaction, the seller or a related party owns, directly or indirectly, greater than twenty percent of the equity of the buyer – which may be the case, for example, if the deal calls for the seller to receive “rollover equity”—the goodwill and going concern value of the target (as well as other Section 197 intangibles) may not be amortizable by the buyer. As a result, the buyer will not obtain the tax benefits that it anticipated and paid for as part of the acquisition. The economic benefit that is lost can amount to as much as 20-25 percent of the purchase price depending on the discount rate used to calculate tax benefits and other factors.

Moreover, if the acquirer is a limited liability company or the corporate acquirer is owned by a limited liability company, and the seller will have an interest in the limited liability company following the acquisition, the anti-churning rules can be an issue even where the seller owns less than twenty percent of the limited liability company. It is therefore critical that any transaction that calls for the seller or a party related to the seller to obtain (or retain) an equity interest in the buyer in connection with the acquisition, the buyer should closely study whether the anti-churning rules could be applicable. A failure to do so can result in a significant – and perhaps needless—reduction in the buyer’s after-tax cash flow and adversely affect the purchase price payable by a subsequent buyer of the business.

3. Qualified Stock Purchase Failure

As an alternative to structuring an acquisition as an asset purchase in form, a buyer can realize the tax benefits of an asset purchase by structuring the acquisition as a stock purchase and making a Section 338 or Section 338(h)(10) election in connection with the transaction (the latter requiring the consent of the seller and being limited to target corporations that are S corporations or subsidiaries of a consolidated group). In order to be eligible to make a Section 338 or 338(h)(10) election, the acquisition must constitute a “qualified stock purchase”, one of the requirements of which is that 80 percent or more of the target corporation’s stock be acquired in a twelve-month period by “purchase”. For this purpose, “purchase” excludes transactions on which gain or loss is not recognized, including exchanges that qualify for tax-free treatment under Section 351. Frequently, when a new corporation is being organized to acquire the stock of the target corporation, one or more of the sellers may “roll over” a portion his or her target corporation stock for stock of the new corporation. When less than 20 percent of the stock of the new corporation is received by the seller(s) in the exchange such that greater than 80 percent of the stock is acquired for cash, it would appear that the requirement that 80 percent or more of the stock of target be acquired by purchase would be satisfied. However, if any seller receives any stock of the new corporation (even one percent) in a transaction that qualifies as a Section 351 exchange, the acquisition will not constitute a qualified stock purchase and will be ineligible for a Section 338 or 338(h)(10) election.

The solution here is to structure the transaction so as to intentionally not qualify as an exchange under Section 351. Although this will undoubtedly have ramifications to the sellers (who may otherwise have been expecting to not have to recognize gain currently with respect to their rollover equity), the failure to obtain a step-up in basis in the assets of target corporation and consequently, the inability to tax-effect the purchase price (through depreciation and amortization deductions) may have an even larger negative impact on the buyer.

4. Acquisition of Shares of “Loss Stock” from Consolidated Group

A recent overhaul of the so-called “loss disallowance rules” changed the rules that apply when a buyer acquires the stock of a target company out of a U.S. federal consolidated group in a transaction in which the seller recognizes a loss. Prior to the change in the law, any limitation on the recognition of that loss for tax purposes would impact only the seller; the buyer was unaffected. However, under the new rules, if the buyer acquires shares of stock from a consolidated group that constitute “loss stock” (i.e., the consideration paid for the stock is lower than the selling consolidated group’s tax basis of the stock), absent a special election made by the seller, the tax basis in the assets of the target corporation (as well as other target corporation tax attributes) may be subject to reduction in an amount equal to some or all of the seller’s loss.

As a result, in all stock purchase agreements where the seller is a member of a U.S. federal consolidated group, the buyer should insist on a representation that none of the acquired shares are “loss shares” and, to the extent any of the shares are “loss shares”, the buyer should insist on a covenant that would require the seller to make the election that would, in lieu of reducing the target corporation’s tax basis in its assets and other tax attributes, cause the loss recognized by the seller to be reduced. In situations where the tax benefit to the seller from the loss is greater than the tax cost associated with the reduction in tax attributes, the seller should compensate the buyer for this tax cost.

5. Phantom Income/AHYDO Rules

Whenever an acquisition is financed, in part, through borrowing, and interest on the loan is not required to be paid at least annually (or there are warrants or other equity instruments issued to the lender in connection with the loan), the parties should consider the potential application of the original issue discount (OID) rules. Generally, subject to certain de minimis rules, if interest on a debt instrument is not required to be paid at least annually—i.e., the interest simply accrues automatically or accrues at the option of the borrower—the interest income and interest expense will be recognized for tax purposes notwithstanding that the interest is not actually paid on a current basis. This means that the holder of the debt instrument will recognize taxable income without receiving any cash—i.e., the holder recognizes so-called “dry income” or “phantom income.” Although the phantom income resulting from the characterization of a debt instrument as an instrument issued with OID is generally manageable (either because the holders are tax-exempt or that portion of the interest needed to cover taxes can be paid on a current basis), in certain circumstances, there are special rules that may result in the borrower’s tax deduction for the interest/OID being deferred or disallowed.

Specifically, the tax rules defer and, in some circumstances, permanently disallow deductions for OID on certain applicable high yield discount obligations (AHYDOs). An AHYDO is defined as a corporate debt instrument that meets three requirements. First, the debt instrument must have “significant OID.” Second, it must have a term exceeding five years. Third, it must have a yield to maturity that is at least five percentage points above the applicable federal rate (AFR) in effect for the calendar month during which the debt instrument is issued. A debt instrument is treated as having significant OID if, at the end of the first accrual period following the fifth anniversary of the issuance of the debt instrument (and at the end of each subsequent accrual period), an amount greater than one year’s worth of OID (the yield to maturity multiplied by the issue price of the debt instrument) can remain unpaid.

Where warrants or other equity-type instruments are issued along with the debt instrument (i.e., as part of an investment unit), there is a greater potential for OID and classification of the debt instrument as an AHYDO because the issue price of the debt instrument will be reduced by any value attributable to this equity thereby reducing the issue price and creating a greater spread between the instrument’s stated redemption price at maturity and its issue price—thus creating more OID.

Advance planning can often neutralize the effect of these rules without significantly changing the business deal. By simply adding a provision to the debt instrument that requires (i) all accrued but unpaid OID (in excess of one year’s worth) to be paid on the first interest payment date following the five year anniversary of the issuance of the debt instrument and (ii) all interest thereafter to be paid on a current basis, the debt instrument can escape classification as an AHYDO. Of course, this change has the potential for real, economic consequences which should not be minimized. However, where, as is frequently the case, the deal contemplates this debt being refinanced before the five-year anniversary (or the borrower is comfortable that a refinancing can be negotiated at that time), the borrower can avoid having its interest/OID deductions deferred or disallowed. In this regard, it should be noted that a debt instrument is tested for AHYDO classification at the time it is issued and is based on when payments on the debt instrument are unconditionally obligated to be paid. If a debt instrument is characterized as an AHYDO, the borrower’s interest/OID deductions are subject to the rules regarding deferral or disallowance even where the borrower actually pays the interest on a current basis.

Conclusion

The foregoing are just a few of the many tax issues that can arise in any deal. If they are spotted early enough, most tax issues can be addressed with relatively inconsequential structural changes to the deal and/or creative planning without changing the underlying business deal. However, if the opportunity to address the tax issues is missed, there are often material economic consequences to one or more of the parties. To the extent that there are tax costs inherent in the deal that cannot be ameliorated through creative planning, the parties need to address how such costs will be shared among the parties; otherwise, the burden of these tax costs may be borne by the wrong party. 

© 2011 McDermott Will & Emery