Risk Allocation Between Signing and Closing an M&A Deal

Difference between signing and closing 

Signing is when you just sign a contract about buying a company, and closing is when you actually buy the company. Now, in a lot of transactions, there's a gap between signing and closing. If you're buying a public company, in all likelihood, there will be a substantial gap between signing and closing. There are a couple of reasons why the gap exists.

1. Regulatory approval -  In the US, a deal over a certain size, like a hundred million dollars of the purchase price, requires an HSR filing. And after you make the HSR filing, you have to wait 30 days until you are permitted to close as the buyer. 
2. Corporate approval - typically from the target, but sometimes also from the buyer as well. For a public company, you need to hold a shareholder meeting in order to get that approval.
3. Commercial and deal-specific approvals -  For example, if there's a very important customer contract, and they have a termination right or a consent right. It could also be some bad consequence triggered by the transaction and the buyer doesn't want to go through with the deal. If that customer doesn't consent, the buyer may be willing to sign but not willing to close until we get the customer consent. 

Transitional Service Agreement

TSA is something you have when you do a carve-out, because you're standing up a business, and you need services from the seller of the business. If you have the TSA ready to go, you know everything that's going to be in it, you know all the services that are going to be provided. I don't think there's any inherent reason why the TSA itself should cause there to be a gap. 

Although you could imagine a circumstance where time is needed to do certain operational things to actually separate the business, or time is needed to actually figure out the details of the TSA services, and that could be a reason for that.

Pros and Cons

Time creates uncertainty. From the moment the buyer and the seller have a meeting of minds, the longer it takes for the sale actually to happen, they could change their minds. And there are a couple reasons why: 

Generally, buyers want more flexibility than sellers, although that's not always true. Look at the Elon Musk and Twitter deal. As soon as Elon signed the deal, the market went down. So for some period of time, he thought he was getting a bad deal, and he was trying to get out of it. 

There's a lot buyers don't know about the company and are generally at an information disadvantage. So the chance that a buyer finds something out, or if something happens to the market, or something happens to the target company between the time the buyer decides they want to buy the company. There's a decent chance they may not make the same decision.

From a seller's perspective, they like selling the company because they think they're getting a reasonable price. And so generally, they want the buyer to be locked up as much as possible. But there are also circumstances where the market goes up or they find gold in their headquarters or somebody calls them up and says they'll pay twice the price. The target may not want to go through the deal in those circumstances. 

What is HSR?  

It's the Hart Scott Rodino Antitrust Improvement Acts. It's alerting the DOJ, FTC, and the antitrust regulators in the US that we're doing a deal of a certain size. 

And there are certain documents you have to produce in that filing, showing information about your view of market share and revenue that the two parties have in the particular industry subject to the acquisition. So the agencies can decide whether it poses an antitrust risk that they should investigate further.

And the way it works is they don't give you a stamp of approval, but they have 30 days to alert you that they want to do a further investigation. So a so-called second request is a more in-depth investigation that could result in them blocking the deal.

Most deals that don't overlap between the buyer and the seller, like private equity deals, sail through. After that 30-day waiting period, you are legally allowed to close. 

The other reason you have a gap between signing and closing is financing. Particularly for private equity buyers, if they're financing the purchase with a mixture of equity and debt. 

The debt comes from third-party lenders, and typically you're signing with just a commitment letter from the lenders. You need time to turn that commitment letter into a long, formal credit agreement that you can actually draw on from the lenders.

And that's another source of gap between signing and closing because you need the cooperation of the target company in order to get that credit agreement done. And the target's not going to help you unless you sign and promise to buy them. 

So even if you don't have HSR, there might still be a need for a gap between signing and closing so the financing can be arranged.

I'm not an HSR expert, but my general understanding is it's a description of the deal and it's a bunch of internal documents where you describe the party's view of the deal or how they looked at their view of the deal from a competition perspective.

Negotiating with Anti Trust

They're not just going to sue you immediately because they don't have enough information. And the burden of proof is on them to prove that there is actual harm to the competition. 

What they would do is launch an investigation. They would issue a second request, demand luminous volume information, and then come to you and say this transaction doesn't work from a competitive perspective.

I'll take a silly example. In a three-person market, number one is buying number two, and antitrust will not allow that. They'll sue you to block it if you try and do the deal.

Or, on a more nuanced situation, if you have a supermarket chain in New York and want to buy a supermarket chain in New Jersey. For the most part, there's no overlap.

But there are a bunch of supermarkets on the New Jersey - New York border, where they actually do compete with one another. If you have the same person owning all of those, you're gonna reduce competition in that little strip of the market.

So the goverment agencies might say you can't combine those. You gotta take those stores or some of them and sell them to a third party who is able to run them in a competitive way. 

You'd want a legitimate operator or someone who has management team that has experience running supermarket stores to be the divestiture buyer and to solve the issue so that the rest of the deal could take place. 

Announcement

It depends on what you're trying to achieve and what you're worried about.

One source of antitrust risk could be whether customers believe that the transaction is anti-competitive. The more it's known that the transaction is happening, the higher the risk that there are complaints. So an announcement could cause noise in the market that there is some potential antitrust issue.

Now, the parties might want it to be known so that they can find out in advance, whether there is in fact gonna be an issue and whether in fact there's gonna be a complaint, it could be like a fact finding exercise. 

The seller might be worried about employee retention and if everyone leaves because the transaction is announced and they don't like who the buyer is, does that put pressure on the transaction? The same thing about customers, if customers don't like who the buyer is.

And a material adverse effect can give the buyer the ability to walk in those transactions. Like the Twitter situation. Elon Musk says he's gonna buy Twitter. What if all the Twitter employees hate Elon Musk and half the workforce quits. All of a sudden, Twitter stops working and all the advertisers leave and it becomes just like a failing business.

If that happened, Elon Musk will not buy twitter. Half the employees quit. The site's not working anymore. Elon will not be forced to buy this thing and is now worth half of what it was worth before. That is a material adverse effect - If the business is irreparably broken or broken in a way that's gonna take a long time to fix that would be a material adverse effect. 

But the good lawyers representing Twitter would say the material adverse effect clause excludes any effects caused by the nasdaq of the transaction or caused by the buyers identity. 

Elon will now say, well, there's also a provision in the contract that says the seller has to operate the ordinary course, and they have to use reasonable best efforts to preserve the business, employees and customers. And they have not done that because there is no attempt to give a retention package or invite Elon to come and speak to the employees. 

So now the buyer don't have to close the deal because they have not materially complied with its covenants.

Common Closing Requirements 

1. Regulatory approval
2. Financing with an asterisk, because if you look in the condition section, it won't say you need to get financing because there won't be a financing condition. But in the remedies provision, the seller will want something called specific performance, which means they can force the buyer to actually comply with the terms of the contract, actually buy the company, and it will be a condition to the seller's ability to get specific performance that the financing shows up. 
3. Representations and warranties of the target are true to some level of materiality. Materiality is broken into two parts: general business reps and fundamental reps. The general business reps is the standard material adverse effect. So unless the reps are untrue at a level that is a material adverse effect, the buyer still has to close. 

And fundamental reps are so fundamental that nobody should ever screw them up. It should be easy for the seller to give those reps, and it would be disastrous for the buyer if those reps weren't given accurately. If you're doing a stock sale, the person selling you the shares should actually own the shares, and that the shares that you're buying actually represent the entire capitalization of the company. 

      4. The sellers should comply with the covenants. 

Regulatory approvals

You might need to worry about all sorts of regulatory approvals based on the transaction and the industry. So my favorite thing that comes up is what I'll call joint control antitrust approvals.

So certain jurisdictions measure whether you need antitrust approval, not by looking at the buyer and the seller's overlap, but by the overlap of any two parties to the transaction. 

Let's say you have two global private equity firms joining together to buy a company in Texas. Neither of the private equity firms owns any business that competes with the target in Texas, but they each own a hundred other portfolio companies all around the world. 

One of the jurisdictions that has a joint control test is the European union. Essentially if those two private equity firms are each acquiring control of a particular business and they each have a certain amount of revenue in the European union, then a European union antitrust approval is required for that transaction even though the transaction has nothing to do with Europe, it is just to buy business in Texas.

And that can create a timing issue for that transaction, where you have to wait a few months to get the European commission filing approval before you can close. I've never heard of a deal getting blocked from one of these things, and it is just timing and hassle. 

And then if you're doing international deals, if you're from a particular country and you're trying to make an investment in another country that has a foreign investment control regime and they need to approve it first. 

How do Buyers protect themselves from the risks?

It's all about the interplay between conditions and covenants. And this is a very legalistic point. 

Let's say the buyer signs a contract that says I'm going to buy your business whenever I get regulatory approval. And then once I get regulatory approval, I'll give you a hundred dollars. You're going to give me your business and it's going to be awesome, and that's all the contract says. 

There are a lot of problems in that contract. No stipulation dictates who will make the filing. What if the regulatory approval says the buyer has to sell all its other businesses? The buyer will not agree to that. And your contract doesn't say that the buyer needs to use reasonable best efforts to satisfy the conditions to get regulatory approval.

And what are considered reasonable best efforts? There is also a hell-or-high-water covenant which means you have to take all actions necessary or advisable to get approval, including selling any other assets, and agree to whatever the regulator wants me to do.

If the buyer signed that kind of agreement, then he has to sell his other businesses to satisfy the approval. That's the importance of that covenant. And there's a whole bunch of variations between having nothing and that hell or high water standard that I mentioned. 

Very specific covenants are how buyers and sellers allocate risks between signing and closing. 

Gun Jumping

It means don't do something before you are allowed to do it.

In the securities law world, there's gun-jumping in IPO. There are only certain communications you're allowed to make when you're in an IPO process. If you do those communications too early, you're filing the securities laws. 

So in M&A, you're not allowed to complete the transaction until you get the regulatory approval. That means if you do something completing the transaction, that is considered gun jumping, and that's an offense; that's illegal. 

So what does that mean in practice? It's typical for an M&A agreement to have interim covenants that protect the buyer from the moral hazard that the seller faces when they've already agreed to sell their company for a specific price.

For instance, when waiting for regulatory approval, buyers would want to make sure that the seller is not being lazy and flushing the business down the toilet or selling it to someone else. They have to work had and preserve the value of the business.

To protect against that moral hazard risk, interim covenants will order the seller to operate the business in the ordinary course. Also, you're not gonna do certain enumerated material things without getting my consent.

So you're not going to hire a new CEO, you're not going to enter into new material contracts, or settle material lawsuits, that sort of thing. And that's generally considered, okay. Where you get into trouble is if those interim covenants become too tight. 

For example, if the buyer said before you embark on any new advertising plan for your products that compete with mine, you have to get my approval. That's illegal because you're supposed to be competitors until the government says you can merge.

You are allowed to plan for integration, but not integrate.

So, if you want to discuss what you're going to do with the HR system and ERP systems, which office space to use, those are okay. But implementing it where you're operating as a single enterprise, that is not okay. 

Customer Approval

The buyer would typically ask what the terms of the contract are. Let's assume that the contract says that the customer has a termination right on a change of control. So the question is, can you get them to waive that? Should we get their consent? 

The next question you should ask is, what's their termination right without a change of control? Maybe the customer has a termination for convenience right in 30, 60, 90 days. 

So in that case, even if you got their consent, they could still terminate. There is also the concept of negative consent and positive consent. 

Positive consent means under the terms of the contract, they actually have to say yes, I approve. Versus negative consent, as you send them a notice and if they don't respond, then it's deemed that they've approved it.

Handling Delays

The antitrust regulators and other regulators are just getting more aggressive, and they have more work to do, and things take more time, and more things get investigated. So then, how do you allocate the risk of time? So there are a couple of exciting things that happen there.

One of the other key terms in an agreement for allocating risk is the drop-dead date. It basically says, if you hit this date, as long as it's not your fault, meaning whoever's trying to terminate, as long as the person's terminating is not sort of their fault that it's taken this long, they can terminate the deal. They no longer have the hell or high water covenant, or whatever covenant actually to get the closing to happen. Once you terminate the deal, they tear up the contract more or less. 

That could also be a way of giving the target comfort. For example, if the deal is taken that long, the chance that it's actually going to close is probably lower than if it had already closed if you're a few months earlier. 

And so they may not like being under the thumb of all the interim covenants I mentioned for longer than 3, 4, or 6 months. And so, it buys them comfort. They know if they hit that time period, they have an option to get out instead of continuing to be under the thumb of the interim covenant for a deal that made it happen. 

Another way to address that risk from the seller's perspective is loosening the interim covenants over time. That's a way of giving the target a little more comfort that they can run their business even if the regulatory approval processes take longer.

And then there are economic things you could do. So you could have a ticking fee if it takes longer, the price goes up. You could have termination fees that go up if the process takes longer. You could have fees that somebody pays to extend the outside date.

You could imagine things, where people could sort of, have like interim deals to keep the process going. 

Inability to close

Let's say you don't have the money. So what'll probably happen in that circumstance is that the seller would be making a claim for damages and then look at the contract and remedies other than certain performance.

Commonly, suppose there is a third-party debt financing. In that case, there'll be something called a reverse termination fee where the buyer don't want to close the deal and agree to pay a termination fee of generally around like 4 to 6% of the purchase price as a penalty. 

That could liquidate the damages for the failure to close, but there is a cap, and the buyer can't be forced to pay more. 

If there is no reverse termination fee, the seller could just claim for damages. And then there are all sorts of technicalities about how the deal is structured. Because if you have a merger, the people suffering the damage are the shareholders and the company hasn't actually suffered damages. 

So maybe the company can get its expenses, but they might not actually be able to get the benefit of the bargain that the shareholder lost unless you include something called ConEd language.

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