Legal & Business Issues: Module 1 of 5
An Introduction to Mergers & Acquisitions: Legal & Business Issues
Mergers and acquisitions are the legal mechanisms by which companies join forces to create new, hopefully more efficient, organizations. An acquisition occurs when one company acquires 100% of another, non-related company. The company being acquired is the “target company” while the company doing the acquisition is the “acquirer.” A merger occurs when two companies join to create a third company that is distinct from each of the original two.
After a standard acquisition, in which the acquirer purchases all stock of the target, the acquirer company owns all the assets and liabilities of the target company. Shares of the stock of the acquirer are often given to the target’s stockholders as compensation for the dissolution of the target. The same is true in a merger – the shareholders of both companies are given stock in the resulting company instead of their now-worthless stock in the merging companies that no longer exist. In a stock for stock merger or acquisition, the target company is completely “swallowed up by a larger fish”; thus the target company ceases to exist. The same holds true for both companies in the case of a merger.
In the alternative, an acquirer may buy some or all of the assets, and perhaps assume some of the liabilities, of the target company. This type of acquisition structure is referred to as an “asset purchase” and is a common tool in the acquisition of a private, non-public company. Unlike the “stock for stock” acquisition structure, in an asset purchase, the acquirer may decide to “pick and choose” what assets to acquire and which liabilities it will assume. In an asset purchase acquisition, the target company may continue in business using different assets, though the acquirer will typically insist on including a “non-compete” agreement to ensure that the target does not compete with the acquirer after the acquisition.
The first substantial merger activity involving major industries of the US began in the 1890’s and continued through the early 19th Century. During this early period, merger activity was mostly between large corporate entities, involving horizontal mergers. In a “horizontal merger,” two competitors merge, forming a larger entity in the same industry and markets. These types of mergers added to the concentration of market power in the hands of a few managers. The 1960’s saw a second phase of merger activity. This period, beginning around 1965, is often referred to as the “Conglomerate Era,” as it witnessed the combination and merger of companies across different industries. Rather than concentrating in one industry, which may have been stopped by antitrust laws, companies acquired other companies outside their core markets. Companies such as Proctor and Gamble, Westinghouse and General Electric became “conglomerates,” building corporate empires comprised of a host of companies operating in wide range of markets. They would acquire smaller companies and grow them through centralized management and financing. If successful, the conglomerate would realize increased revenue and profits, and higher stock prices. The Conglomerate Era produced inefficiencies from heavy cost structures, resulting in a drag on corporate earnings. Poor management of far ranging corporate entities, products, and markets sometimes inspired shareholder revolts. Enter the “hostile takeover artists” who rode the wave of the shareholder revolt by leading hostile takeover efforts against major targets whose stock had depreciated in value due to falling earnings. Individual corporate raiders, inspiring the fictionalized Gordon Gekko in the 1987 movie “Wall Street,” often led these takeover attempts. The 1990s saw a merger wave fueled by deregulation of certain industries such as banking, finance and communications innovation, via the pairing of computers and Internet technology. The 1999 repeal of the Glass Steagall Act of the 1930’s removed barriers to merging for investment banks and commercial banks. The Internet technology launched many new companies, such as Yahoo!, Google, Apple, Amazon and AOL. In 2000, AOL closed one of the biggest mergers in history by combining with Time Warner.
Strategic Reasons for Business Mergers and Acquisitions
There are five strategic reasons why companies seek to merge, acquire or be acquired.
1. Target Companies’ Assets Are Cheap!
Cheap assets are at the center of many companies’ motivations to acquire or merge. Management teams of publicly held companies must realize high returns on investment or face shareholder dissatisfaction. They are publicly entrusted with shareholders’ invested funds to produce optimal returns in exchange for capital. The acquisition of another company is like any other investment, presenting an opportunity for upside return and positive cash flow.
The cheap assets scenario develops when the stock market investors undervalue a company. Often, a company’s true value may be missed when investors exit from a declining stock market due to the weakening of the general economy, or an unusual occurrence like a geopolitical event. In such a market situation, even an efficient US stock market may produce mispricing of certain stocks. Another type of stock market mispricing may occur when the stock price of a company underestimates the intrinsic value of certain assets or their potential future value. For example, a company with a real estate portfolio that is valued on the balance sheet based on real estate’s historic value, not its current market value, may lead to a mispricing of those assets and is reflected in the lower share price of the company’s stock. When assets are undervalued, other investors will look for these buying opportunities, correcting the mispricing of these stock shares. However, the “correction” in valuation may take time, leaving these stock shares (and target companies) vulnerable to the “Gordon Gekkos” of the world. Moreover, if the acquiring company has a high price-to-earnings ratio (which means it’s overvalued relative to its earnings), it may be able to leverage its high-value shares by using them to purchase the stock of other companies with strong earnings relatively cheaply.
2. Acquire Strategic Assets Such as Intellectual Property (IP)
A corporate strategy aimed at acquiring “strategic assets” is usually part of a broader operating strategy to expand or reposition in the acquirer’s product line, or to enter new markets, domestic or international. For example, the landmark merger of America OnLine and Time Warner in 2000 was an attempt by both management teams to expand into new markets and to merge new technology with old technology. AOL was seeking access to Time Warner’s entertainment assets (such as its library of videos and movies), while Time Warner was seeking entry into the “new” Internet market via AOL’s distribution channel. Ultimately, though, the merger failed, as the combined management was unable to implement a winning business strategy for growing the new company.
3. Diversification of Products: The “Make or Buy” Decision
An important reason to merge may be to acquire a product, technology or manufacturing capability for something that company needs. It’s sometimes cheaper and faster to acquire a company that already makes or has what one needs than to make it oneself. Many products can be legally “reverse engineered”, and, perhaps even improved in the process; however, a new product development may require a new supply chain as well as distribution network of dealers and retailers. That’s when companies may decide that it is cheaper, faster, and better to acquire another company’s product, manufacturing, marketing, and distribution network assets.
4. Diversification of Markets
A company may seek market diversification to market an existing product line to new customers. While product diversification strategies are available on local, regional, national or international levels, in a world of complex international trade rules filled with tariffs, quotas, and “content” regulations, companies may avoid trade restrictions by producing their products within the borders of countries previously reached only via exports from the US. For example, an American exporter of cars to China may decide to acquire a Chinese car manufacturer and work to ensure its products meet the company’s specifications and manufacture in China rather than continuing to export from the United States.
5. Implementing Financial or Operating Strategies
In mature industries where a few companies dominate market share- such as computer hardware and software, banking and financial services, or health insurance- mergers play a major strategic role in further consolidation in these industries. “Consolidation” is the process by which giant, dominant firms merge to reduce their operating and financial costs, gain new customers and revenues, and reduce or eliminate industry competition.
In the US, proposed mergers involving dominant firms operating within the same vertical market will normally be reviewed (a “pre-merger review”) by either the Department of Justice’s Antitrust Division or the Federal Trade Commission to determine whether the proposed merger should be allowed to go forward. A vertical market is a marketplace where both the acquirer and the target companies compete for the same customers, providing them with competing goods and services. A merger could result in a greater concentration of market share for the surviving firm. Typically, in a pre-merger review, the DOJ’s Antitrust Department determines whether the proposed merger would violate Section 7 of the Clayton Act that prohibits mergers or acquisitions that will lessen competition in the relevant market. In a pre-merger review, the DOJ has discretion to modify the terms of the proposed merger, approve or reject the proposed deal.
In a major case, the Department of Justice rejected a proposed AT&T merger with Time Warner, finding that the proposed combination would violate the Clayton Act by permitting the merged companies to stifle market competition by lowering the costs to AT&T’s customers of Time Warner’s movie libraries and increasing movie acquisition costs to other cable-TV competitors. The DOJ filed suit in the Federal District Court for the District of Columbia in 2017. After trial on June 12, 2018, Judge Leon issued his opinion finding in favor of the defendants AT&T and Time Warner and rejecting the Government’s argument to block the proposed merger. He found that the merger of these two digital entertainment giants would not impact the competitiveness of new digital entrants like Netflix, Hulu and Amazon. In August, 2018, the U.S. filed its appeal asking for relief from the incorrect decision of J. Leon. The appeal is pending as of this writing.
The “Players” in the Mergers and Acquisitions Market
An industry has many participants, playing different roles in the process. These may include financial professionals, human resource management and strategists. Let’s examine a few of these and their roles in the industry.
1. Investment Bankers
For management of public or privately-held companies, the merger process begins with soliciting the advice of an investment banker. One major reason to talk to investment bankers first is that they have the experience of closing these types of deals. Furthermore, investment bankers’ services include the full range often required in starting and closing a transaction, including finding a target company, valuing the target company, structuring the transaction, financing the transaction and negotiating the deal.
2. Lawyers and Accountants
Lawyers and accountants specializing in mergers and acquisitions will be needed early in the process. After identifying a target company, a lawyer will prepare a “Letter of Intent,” which includes provisions necessary for further discussions between the acquirer and the target. These provisions may include “disclosure agreements” regarding confidential materials such as internal, non-public financial statements and tax records,a “due diligence clause,” giving each side the opportunity to conduct its investigation before the transaction is completed and financing contingencies, ensuring that companies have escape hatches if financing falls through. Accountants assist investment bankers and lawyers with developing a tax-favorable transaction structure and with developing post-transaction tax profiles for the new companies.
Acquirers face complex webs of regulations and regulators, both at the state and federal levels. Federal regulators include the DOJ, FTC and the Committee on Foreign Investment where cross-border transactions are concerned. State laws impacting mergers may include environmental, employee benefits or state securities laws, sometimes referred to as “blue sky” laws.
4. Debt & Equity Capital Sources
These are the entities that provide the funding for the transactions, often in exchange for shares of the new company in a merger or in the acquirer in an acquisition. They may include:
a. Insurance Companies: Insurance companies are limited by state regulators to reinvest insurance premiums in only high-grade, low-risk investments. Typically, insurance companies purchase debt, such as bonds, that are issued as part of the financing structure of a transaction. They typically stay away from the higher risk equity investments offered in the financing.
b. Pension Funds: These institutional investors are limited by federal and state laws in how they can invest pensioners’ retirement funds. Most of these funds invest in common stock offerings issued by the newly formed merged firms or in their corporate bonds. Pension funds also hold influence over corporate managers because these funds control large blocks of common shares which some “activist” pension funds will use to influence management’s acceptance or rejection of an offer to merge or sell out.
c. Sovereign Wealth Funds: A growing source of funding for mergers and acquisitions are the state-controlled investment funds of foreign governments, such as China.
d. Hedge Funds: These generally off-shore funds seek high return assets and investments and they have invested heavily in major public M&A deals in recent years. These are global funds usually operated outside of U.S. regulations to avoid Securities and Exchange Commission and Treasury Department oversight.
e. Private Equity Funds: Private Equity funds are a leading source of financing for private company acquisitions in the US. These funds inject equity capital and provide debt financing for transactions. They raise their funds from institutional and private wealthy investors and usually provide expansion, growth or merger funding to medium or large companies.
5. Proxy Solicitors
When shareholders are displeased with the performance of the management of a public company, they can remove and replace the company’s board of directors. Soliciting and collecting the votes of millions of shareholders to do this is difficult. Proxy soliciting firms were created to address this problem. A proxy firm collects the shareholders’ votes and assigns their voting power to a third-party who casts their votes in a shareholders’ meeting.
6. Public Relations Firms
These firms may be employed to address shareholders’ concerns or opposition to a merger.
7. Management Buyout Teams
A management buyout occurs when a group of incumbent managers submit a competing offer to buy the company from the other shareholders. This may result in converting a public company into a privately-held company once all the outstanding public shares are bought. This process of converting a public company to privately-held status is referred to as “going private”.
Strategic Alternatives to Mergers
Instead of carrying out complex mergers and acquisitions, companies may choose to seek their benefits through other means.
Companies always have the option to grow via internal or “organic” growth by investing in research and development. Tax policy, new market opportunities and competitor pressures are some of the factors that help companies determine whether to invest in new R&D.
Companies that wish to achieve greater profits may realign or redeploy their corporate assets. Corporate restructuring is a fancy label for reducing debt, eliminating corporate bureaucracy and redundancies and selling low-return assets. If most merger strategy is ultimately about pursuing greater profit margins, the alternative would be to reduce internal operating costs.
Another alternative to employing a merger strategy is to form a joint venture or partnership with an unaffiliated company to develop and market new products. In the pharmaceutical industry, for example, where the development of blockbuster drugs takes years and billions of dollars of invested capital, sharing intellectual property and investment capital may be an efficient and innovative way to proceed with new drug development.
The regulatory scheme applicable to mergers and acquisitions covers a complex web of laws, regulations and regulatory agencies, domestic and potentially foreign as well. The regulatory scheme can be broken down into two general areas. First, the primary statutory framework sets the foundation for antitrust laws, enforcement, and penalties that directly impact proposed mergers and acquisitions.
Section 1 of the Sherman Antitrust Act of 1890 prohibits agreements that unreasonably restrain competition. The statute imposes both criminal and civil penalties for violations. Criminal penalties include up to 10 years in prison and $1,000,000 fines for individuals and $100,000,000 fines for corporations. Civil suit relief includes treble (triple) damages and attorney’s fees. Section 2 of the Sherman Act prohibits monopolization, attempted monopolization and conspiracies to monopolize trade. Today, prosecutors and private plaintiffs rarely use Section 2 in antitrust actions. Under Section 3 of the Clayton Act, parties are prohibited from entering into certain “tying” and “exclusive-dealing” agreements. This statute is civil in nature. Section 7 of the Clayton Act prohibits mergers and all other forms of acquisitions that may substantially lessen competition. The Clayton Act was aimed at addressing a new wave of mergers and acquisitions that began to appear around the early 1900’s. The earlier Sherman Act prohibitions were aimed at monopolization and the attempted creation of monopolies. In contrast, a key purpose of the Clayton Act was to close a loophole in the Sherman Act by prohibiting M&A activities aimed at curbing competition. Section 5(a) of the Federal Trade Commission Act of 1914 prohibits “unfair methods of competition”. The Act is limited to civil actions by the government only, as it does not provide for private antitrust actions. The Act created the Federal Trade Commission. The Act also gives the FTC the authority to take legal action against incipient restraints on trade and other conduct that it determines violate the “spirit of the antitrust laws.”
A host of other federal and state statutes may come into play in the M&A context. These are a secondary group of statutes that may be triggered by a proposed merger or acquisition. These statutes include:
(A) The Securities Act of 1933, which covers registration of securities;
(B) The Securities Act of 1934, which established the S.E.C. and regulates broker-dealers. Section 14 of the 1934 Act dictates disclosure requirements for proxy fights in the context of “hostile takeovers.” Similarly, Sections 16(a) & (b) of the 1934 Act, which define non-public information and penalties for insider trading of securities, may be raised in the context of both hostile and non-hostile acquisitions.
(C) Finally, the Williams Act, Section 13D regulates tender offers.
While the federal government has primary jurisdiction in most merger activity due to the interstate commerce clause of the Constitution, in the absence of federal prosecution, states’ antitrust laws can block a merger. States can also enforce laws that would impact its citizen consumers by limiting competition in the state. States may also first refer such potential enforcement to the federal government agencies to evaluate possible antitrust violations.
In Module Two we will discuss, in further detail, the primary federal regulatory framework affecting merger and acquisition corporate activity as well as the secondary statutory framework impacting merger activity.