Michael H. Knight is a partner, and Larissa Bergin is an ... · proposed merger between American...

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September 2013 n Volume 17 n Issue 8

FTC Attorney Advisor Sheds Light on Evidence Likely to Lead to Second Request RecommendationsB y L A r I s s A C . B E r G I N A N D M I C h A E L h . K N I G h T

Michael H. Knight is a partner, and Larissa Bergin is an associate, in the Washington, D.C. office of Jones Day. Contact: [email protected] or [email protected].

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Negotiating the antitrust risk in a trans-action is often a key part of a buyer and seller reaching a deal. To assist their M&A counterparts, antitrust attorneys assess the likelihood of, among other things, the re-viewing federal antitrust agency issuing a Second Request, which is a very burden-some request for information and docu-ments. Because it typically takes months to complete, the issuance of a Second Request can impact a number of provisions of the merger agreement, including the drop dead date and required efforts clauses. A recent study,1 conducted by a (now former) At-torney Advisor at the Federal Trade Com-mission (“FTC”), analyzes the types of evidence often relied upon by FTC staff attorneys when recommending the issu-ance of a Second Request. The study also discusses whether certain indicia of com-petitive effects that were added to the 2010 Horizontal Merger Guidelines (“Guide-lines”)2 increased in frequency within these memoranda. The study is insightful because it provides an inside look into in-

ternal FTC thought processes, otherwise unavailable to the public. In this article, we analyze the results, with the ultimate goal of helping practitioners prioritize available evidence.

The HSR Review ProcessTransactions that meet certain mini-

mum size thresholds are subject to the

Wiped-Out Common Stockholders: Delaware Chancery Court Finds “Foul” But No “Harm” in the Sale of a Venture-Backed CompanyBy J. D. Weinberg and Daniel Nazar......................... 15

Viacom Int’l, Inc. v. Winshall: Delaware Supreme Court Reinforces Accounting Experts’ Authority to Decide Purchase Price Disputes, Restricting Collateral Attack by Disgruntled PartiesBy Elizabeth Clough Kitslaar and James White ......... 20

2 ©2013ThomsonReuTeRs

The M&A Lawyer September 2013 n Volume 17 n Issue 8

Table of CONTENTS

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Editorial Board

BOARD OF EDITORS:

BERNARD S. BLACkUniversity of Texas Law SchoolAustin, TX

FRANCi J. BLASSBERgDebevoise & PlimptonNew York, NY

DENNiS J. BLOCkCadwalader, Wickersham & TaftNew York, NY

ANDREW E. BOgENGibson, Dunn & Crutcher LLP Los Angeles, CA

H. RODgiN COHENSullivan & CromwellNew York, NY

STEPHEN i. gLOVERGibson, Dunn & Crutcher LLPWashington, DC

EDWARD D. HERLiHyWachtell, Lipton, Rosen & KatzNew York, NY

ViCTOR i. LEWkOWCleary Gottlieb Steen & Hamilton LLPNew York, NY

PETER D. LyONSShearman & SterlingNew York, NY

DiDiER MARTiNBredin Prat Paris, France

FRANCiSCO ANTuNES MACiEL MuSSNiCHBarbosa, Mussnich & Aragão Advogados,Rio de Janeiro, Brasil

PHiLLiP A. PROgERJones DayWashington, DC

PHiLiP RiCHTERFried Frank Harris Shriver & JacobsonNew York, NY

MiCHAEL S. RiNgLERWilson Sonsini Goodrich & RosatiSan Francisco, CA

PAuL S. RykOWSkiErnst & YoungNew York, NY

FAizA J. SAEEDCravath, Swaine & Moore LLPNew York, NY

CAROLE SCHiFFMANDavis Polk & WardwellNew York, NY

ROBERT E. SPATTSimpson Thacher & BartlettNew York, NY

ECkART WiLCkEHogan LovellsFrankfurt, Germany

gREgORy P. WiLLiAMSRichards, Layton & FingerWilmington, DE

WiLLiAM F. WyNNE, JR White & Case New York, NY

CHAiRMAN:PAuL T. SCHNELL Skadden, Arps, Slate, Meagher & Flom LLP New York, NY

MANAgiNg EDiTOR:CHRiS O’LEARy

FTC Attorney Advisor Sheds Light on Evidence Likely to Lead to Second Request Recommendations

A recent study conducted by a former Attorney Advisor at the Federal Trade Commission analyses, among other things, the types of evidence often relied upon by FTC staff attorneys when recommending the issuance of a Second Request. The study is insightful because it provides an inside look into internal FTC thought processes, otherwise unavailable to the public.

By Larissa C. Bergin and Michael H. Knight, Jones Day (Washington D.C.)............................................................................1

From the EditorBy Chris O’Leary, Managing Editor .................................................3

Revisiting Management Compensation in LBOs

Of the many issues that arise in connection with LBOs, perhaps none is as critical as properly incentivizing management. With the rekindling of the LBO market thus far in 2013, it is time to reexamine the current state of play for executive compensation in connection with LBOs.

By Matthew Friestedt and Henrik Patel, Sullivan & Cromwell LLP (New York) ...............................................................................8

Wiped-Out Common Stockholders: Delaware Chancery Court Finds “Foul” But No “Harm” in the Sale of a Venture-Backed Company

In re Trados Incorporated Shareholder Litigation provides useful guidance for directors in conducting a sale process for private investor-backed companies and helps clarify for buyers of such companies the risks involved where a properly structured sale process may not be utilized.

By J. D. Weinberg and Daniel Nazar, Covington & Burling LLP (New York) .....................................................................................15

Viacom Int’l, Inc. v. Winshall: Delaware Supreme Court Reinforces Accounting Experts’ Authority to Decide Purchase Price Disputes, Restricting Collateral Attack by Disgruntled Parties

A recent opinion confirms and clarifies the scope of an accounting expert’s authority to resolve post-closing financial disputes that parties have agreed to submit for resolution under the terms of a definitive business acquisition agreement. It reaffirms alternative dispute resolution as the procedure of choice for quickly resolving complicated, technical financial issues that arise in the context of purchase price adjustments.

By Elizabeth Clough Kitslaar and James A. White, Jones Day (Chicago) ........................................................................................20

The M&A Lawyer

©2013ThomsonReuTeRs 3


The Battle of the AirLast month the Justice Department, joined by

the attorneys general of six states (and Washing-ton, D.C.), said it would file a lawsuit to block the proposed merger between American Airlines and US Airways. The DOJ claimed that the merger of American and US Air, which would create the world’s largest airline, was a case of consolidation gone too far, and had the potential to hurt con-sumers by decreasing competition and potentially raising airfares and fees.

As William Baer, assistant attorney general in charge of the DOJ’s antitrust division bluntly told the New York Times, “we looked very carefully for six months at this deal and we think it’s pretty messed up...We think a full-stop injunction is the right course for the consumer.”

For antitrust lawyers, the lawsuit marks a sharp break from recent precedent. After all, the DOJ gave the all clear to several big-ticket airline merg-ers over the past five years, like Delta and North-west, Continental and United, and Southwest and AirTran. In the Times, Dechert’s Paul Denis said the current play suggested the DOJ had “aban-doned the framework it used in approving the last three airline mergers...Now they’re saying those prior mergers were anticompetitive. That’s sur-prising.”

It can seem like the DOJ simply has it out for US Air—after all, the Bush-era DOJ said it would file an antitrust suit when United proposed buy-ing US Air, causing that deal to collapse, and the department considering suing five years later when US Air made a hostile bid for Delta (which was also abandoned).

But the change in the DOJ’s attitude is more a case of US Air/American having the misfortune to be the last legacy airline merger left at the gate. Their merger would reduce the legacy carriers to three survivors, which critics have claimed would

concentrate power and diminish customer choice, pointing to fare increases already noted after the merger of Continental and United (up 57% high-er on the airline’s Chicago-Houston route than they were three years earlier, the Times noted, cit-ing PlaneStats.com).

Another factor is the maturing of the discount airlines, which had ratcheted down airline fares in the 2000s. Southwest, for example, had offered well below-average fares in its bid to gain market share, but following its own merger with AirTran, it’s no longer that potent a force to reduce fares. Especially as Southwest often pays as much for jet fuel as its rivals (in the past, Southwest’s price hedging had contained its energy costs).

And the airline industry may be a victim of its good health. The sector had been in critical con-dition, with a string of airliner bankruptcies, and mergers were seen as necessary actions to get ail-ing companies into fighting shape. Now, with US Air posting record profits last year and American posting solid revenues while under bankruptcy court protection, claims that a merger is needed for their survival are more questionable. As of press time, it was unknown if the airliners would battle the DOJ in court, or if once again US Air would have to walk away from a deal.

CHRIS O ’LEARY

MANAGING ED ITOR

From the EDITOR



Hart-Scott-Rodino Act (“HSR”), which requires transacting parties to notify the FTC and the De-partment of Justice Antitrust Division (“DOJ”) of their transaction prior to consummation. Under the Act, each party must file a formal notifica-tion form and submit specific information and documents relating to the transaction, including the agreement itself and certain other ordinary course business documents analyzing the deal. The filing triggers a 30-day HSR waiting period during which the transaction cannot close.3 The reviewing agency must determine within this ini-tial waiting period whether to allow the transac-tion to proceed or instead issue a Second Request. If a Second Request is issued the merging parties must respond to it, usually by producing substan-tial volumes of documents and information about their businesses, competition in the industry and the proposed merger. The parties then must ob-serve a second 30-day waiting4 period prior to closing, during which time the reviewing agency must determine whether to commence litigation to block the transaction.

Although practitioners gain some transparency into agency review methodology through public speeches5 and published reports,6 few sources provide much insight into how an agency decides whether to issue Second Requests. The most re-lied upon resource used by antitrust practitioners is the Guidelines. The Guidelines outline the fac-tors considered by agencies when they analyze the potential competitive effects of a transaction. While the evidence on these factors is likely to be underdeveloped at the Second Request decision-making stage, practitioners nonetheless use the Guidelines to assess whether the reviewing agency is likely to have concerns early on that are suf-ficient to propel further investigation. The most recent version of the Guidelines included new forms of evidence considered during review such as financial terms of the transaction and “natural experiments.” However, it has been unclear how much weight these forms of evidence have on any given review or, more generally, what forms of ev-idence are more important during the initial HSR waiting period over others.

The Results of the StudyIn a recent article, former FTC Attorney Advi-

sor Darren Tucker published the results of a study (conducted while Tucker was at the agency) in which he analyzed FTC staff “merger screening” memoranda in 77 merger investigations from Au-gust 2008 to August 2012.7 (These non-public memoranda are the formal vehicle by which an investigating staff recommends that the agency is-sue a Second Request.) Tucker’s article discusses what evidence is most relied upon by FTC staff when recommending a Second Request during the initial HSR waiting period. Two main cat-egories of evidence are discussed further below: 1) “traditional” forms of evidence such as market structure, customer complaints, competitor com-plaints, hot documents, and significant barriers to entry; and 2) evidence new to the 2010 Guide-lines: natural experiments, buyer power, and fi-nancial terms of the deal.

It is important to note that Tucker’s study does not provide any information about internal meet-ings discussing the available evidence, nor does it discuss what evidence the ultimate FTC decision-makers found most persuasive in issuing a Second Request. Moreover, as Tucker notes, the study is not based on a random sample of merger inves-tigations and indeed reflects only those matters in which the staff actually recommended that a Second Request be issued. Thus, the study is not particularly scientific, nor does it offer concrete conclusions about FTC decision-making. Keep in mind that the significance of some forms of evi-dence is in the eye of the beholder. That is, Tuck-er’s view of what is or is not evidence, e.g. a hot document, may not be the same as that of another attorney within the FTC. Nevertheless, there are a number of insights practitioners can glean from the results and it is evident, based on Tucker’s findings, that agency staff continues to rely heav-ily on more traditional forms of evidence.

Below are Tucker’s findings along with exam-ples of specific evidence cited in actual FTC com-plaints during the relevant time period. Although these complaints represent a different milestone in the FTC’s review, the types of information docu-mented are typically found during the HSR wait-ing period or Second Request process.

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Traditional Forms of Evidence

Market StructureWhen analyzing a transaction in which the par-

ties compete in at least one market, staff will assess among other things the number of competitors in the overlapping segment and their relative mar-ket positions. Tucker found that market structure was addressed in every staff memorandum. Mar-ket structure evidence often ties directly into two common theories of harm: unilateral effects and coordinated effects. In almost all memoranda, the FTC staff alleged a unilateral theory of harm, meaning that the transaction presumably will re-sult in market power that allows a transacting party to increase prices, reduce output, decrease quality, or reduce innovation by itself—without requiring cooperation from its remaining compet-itors. Note that staff’s perception of the market may be different than how the parties perceive the market. If staff is not aware of all competitors in the market in question (or doubts that an entity is indeed a realistic competitor), then it is likely that they will presume the market is more concentrat-ed. Staff also raised coordinated effects in about half of the cases, suggesting that staff believed that there were a small enough number of com-petitors in a given market that they could collec-tively alter their behavior to raise prices or reduce output. When conducting due diligence, lawyers can assess potential market structure concerns by looking for the hallmarks of unilateral effects or coordinated effects. For example:

Evidence stating that the transacting parties are top competitors or will have a significant market share in a given segment will likely raise concerns of unilateral effects post-transaction. Staff can obtain such market evidence from the HSR filing documents in addition to publicly available mate-rial. In one complaint, the FTC cited a publicly issued statement, which was made by the Board of Directors requesting that shareholders not ten-der their shares, to support its unilateral effects theory of harm. The statement read: “Antitrust clearance to combine competitors with #1 and #2 market share in institutional pharmacy is likely to

be difficult to achieve and involve lengthy admin-istrative and court proceedings.”8

When there are few competitors in the market in question and competitive intelligence is read-ily available, then the FTC will likely investigate whether there is an opportunity for coordinated effects. For example, in In re Grifols, S.A., the FTC stated that there were only a few firms in certain plasma-derived product markets and that these firms could readily assess competitor move-ments in pricing and output of these products through reports, market analyses, discussions with purchasers, and trade associations.9

Significant Barriers to EntryBarriers to entry can prevent new competitors

from entering and creating adequate competition to offset potential anticompetitive effects from the transaction. Staff cited significant barriers to entry in 86% of their memoranda. Although significant barriers to entry are often found in heavily regu-lated industries, such as pharmaceuticals,10 sig-nificant barriers to entry can also be found when large amounts of capital, resources, and reputa-tion are required to enter. Therefore, during due diligence, information identifying costs, assets, regulatory approvals, and start-up commitments necessary for entry often are used as evidence.

Manufacturing industries, among others, can be targets for significant barriers to entry argu-ments because of the capital investment involved to start a competing business. For example, in the In re Graco complaint, the FTC cited a Board of Director’s presentation that listed barriers to en-try in certain industrial liquid finishing equipment markets including “Breadth of product line,” “Large installed base,” “Well developed [dis-tributor] channel,” “Market leadership position with strong brand recognition,” “Manufacturing capital investment,” and “Product design capabil-ity.”11

Customer and Competitor ComplaintsCustomer and competitor complaints refer to

competitive concerns raised about the transaction from these interested parties. Customer complaints were referenced 47% of the time in staff memo-



randa. Competitor complaints, on the other hand, were referenced only 14% of the time, likely be-cause competitors often show discontent from in-creased competition as a result from the merger.

It is possible that such evidence may be found in party documents; however, in the vast majority of instances, it will come from meetings or telephone calls held between the FTC staff and customers/competitors of the merging parties. The FTC staff routinely seeks out customer reaction through phone calls, during which it gathers information about alternative sources of supply and customer relationships with the various suppliers. Staff is more likely to recommend a Second Request if customers express concern about current supply levels and high prices, anticipating that the situa-tion will worsen after consummation of the trans-action. Staff will also look for evidence regarding aggressive contracting practices, where a trans-acting party is able to strong-arm customers into certain prices or terms because of existing leverage pre-transaction. Although not all complaints are found to be credible, negative comments made by customers will make staff think twice about clear-ing a transaction during the HSR waiting period.

Hot DocumentsSomewhat surprisingly, hot documents were

referenced in only 29% of the memoranda Tucker reviewed. Note, however, that Tucker limited the “hot” classification to documents that, on their face, “predict that a transaction will result in an-ticompetitive effects or a significant loss of com-petition.” In practice, there may be many other types of documents that bear on the agency’s de-cision at the Second Request stage, even though Tucker would not necessarily classify these docu-ments as “hot.” For instance, strategic planning documents that discuss how the transaction will bring together the top two competitors in a three-competitor market may very well be considered “hot” by many practitioners, and may be quite relevant to the staff’s initial assessment, even though they do not expressly predict likely anti-competitive effects.

Among the sources of potentially “hot” docu-ments are HSR filing documents, other docu-

ments obtained from the merging parties volun-tarily during the initial phase of an investigation and, where available, public information. For ex-ample, in prior unilateral and coordinated effects cases, the FTC has alleged that competitors were using investor calls to incite coordination. Thus, “hot” content need not only come from docu-ments in the HSR filing, but rather, it may also be readily available, such as on a client’s investor relations website, during the HSR waiting period.

Forms of Evidence New to the 2010 guidelines

As mentioned above, the agencies discussed in detail evidence of natural experiments, buyer power, and financial terms of the deal for the first time in the 2010 Guidelines. According to Tuck-er’s study, however, these forms of evidence were not cited with regularity in the 39 staff merger-screening memoranda authored after the 2010 Guidelines went into effect.

Natural ExperimentsNatural experiment evidence derives from prior

merger, entry, or exit events that may have had an effect on competition in the market in question. Natural experiments were referenced in 13% of staff memoranda both before and after the issu-ance of the new Guidelines. In In re Grifols, S.A., the FTC noted that prior vertical integrations and horizontal mergers in the relevant market resulted in “supply shortages and dramatic year-over-year price increases.”12 The FTC may become aware of natural experiment evidence, such as supply short-ages after a merger, through HSR documents, but it is more likely that such evidence is found and evaluated during the Second Request process.

Buyer PowerBuyer power refers to the argument that a

transaction will not result in anticompetitive ef-fects because large customers have disciplined the parties in the past, have the ability to spon-sor entry, or have switched to another supplier if the transacting parties attempted to raise prices or reduce output. References to buyer power as

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a factor in the analysis increased from 5% to 23% after the new Guidelines. Tucker noted in his study that parties have frequently made this defense both pre- and post- the 2010 Guidelines; however, Tucker’s results suggest that the FTC staff has found buyer power arguments to be at least somewhat more worthy of investigation in the wake of the 2010 Guidelines.

Financial Terms of the TransactionFinancial terms of the transaction can include

all aspects of the agreement including the pur-chase price. For instance, the purchase price of the transaction may indicate that the buyer is purchasing the assets at a premium because it can recoup the cost by raising the prices charged to customers. Other examples include revenue syn-ergies, changes in debt levels, and valuations of comparable companies.13 Although the agencies recently added this form of evidence to the new Guidelines, the staff cited such evidence only 5% of the time after issuance. Previously, staff memo-randa cited it 13% of the time. Because the trans-action agreement is included with the HSR filing, it is likely that the decrease is due to the nature of the transactions filed rather than because of the availability of the evidence during the HSR review stage.

ConclusionOverall, Tucker’s study indicates that traditional

forms of evidence continue to be cited more often in staff memoranda than the “new” forms of evi-dence discussed in the 2010 Guidelines. This may be because these traditional forms are more likely to be identified during the initial HSR waiting period. Newly-cited forms of evidence have been used prior to the 2010 Guidelines, but reference to these types of evidence appears to be dictated more by the type of matter and the availability of the evidence within the early stages after HSR filing. Perhaps over time, the HSR filing requirements will be amended to include documentation likely to show these new forms of evidence (to the extent it exists). In the meantime, practitioners can refer to agency complaints and studies like Tucker’s to assess how the agencies use both internal and pub-

licly available material to assess competitive effects and to look out for evidence likely to be important to the Second Request decision.

NOTES1. Darrens.Tucker,AsurveyofevidenceLeading

tosecondRequestsattheFTC,78AntitrustL.J.591(2013).

2. u.s. Dept. of Justice and the Fed. Trade.Comm’n,horizontalmergerGuidelines(2010).

3. Thewaitingperiod is15days incasesofcashtenderoffersandcompaniesinbankruptcy.

4. The second waiting period is 10 days in thecases of cash tender offers and companies inbankruptcy.

5. Forexample,in2011,ChristineVarney(formerAssistant Attorney General in charge of theDoJ Antitrust Division), acknowledged in aspeech that m&A agreements, and the risk-shifting provisions within those agreements,are used during agency evaluation stating,“I’m not going to say don’t worry about [anagreement]beingaroadmap.”

6. See e.g., u.s. Dept. of Justice and the Fed.Trade. Comm’n, hart-scott-Rodino AnnualReport, Fiscal Year 2012, available at http://www.ftc.gov/os/2013/04/130430hsrreport.pdf.

7. Darrens.Tucker,AsurveyofevidenceLeadingtosecondRequestsattheFTC,78AntitrustL.J.591(2013).

8. Complaint at 2, In re Omnicare, Inc.,no. 111-0239 (F.T.C., Jan. 27, 2012)available at http://www.ftc.gov/os/adjpro/d9352/120127omnicareadmincmpt.pdf.

9. Complaintat6,In re Grifols, S.A.,no.101-0153(F.T.C., June 1, 2011) available at http://www.ftc.gov/os/caselist/1010153/110601grifolsacmpt.pdf.

10. See, e.g., Complaint at 4, In re Sun Pharmaceutical Industries, Ltd., no. 071-0193(F.T.C., Aug. 13, 2008) available at http://www.ftc.gov/os/caselist/0710193/080813sunpharmcmpt.pdf. (alleging that competingpharmaceutical“[e]ntrywouldnottakeplaceinatimelymannerbecauseofthecombinationof …drug development times and FDA drugapprovalrequirements….”).

11. Complaintat2,In re Graco, Inc.,no.111-0169(F.T.C.,Dec.15,2011)available athttp://ftc.gov/os/adjpro/d9350/111215gracoadmincmpt.pdf.

12. Complaintat6,In re Grifols, S.A.,no.101-0153(F.T.C., June 1, 2011) available at http://www.ftc.gov/os/caselist/1010153/110601grifolsacmpt.pdf.

13. Darrens.Tucker,AsurveyofevidenceLeadingtosecondRequestsattheFTC,78AntitrustL.J.591,613(2013).



Revisiting Management Compensation in LBOsB y M AT T h E w F r I E s T E D T A N D h E N r I K PAT E L

Matthew Friestedt is a partner and Henrik Patel is a spe-cial counsel in the executive compensation and benefits group of Sullivan & Cromwell LLP. We would like to thank Steve Kotran, who provided helpful corporate law com-ments on this article, and David Spitzer, who provided helpful tax comments on this article.

With the Dow Jones Industrial Average having broken the 15,000-point threshold and the debt markets having been reopened for the past year, leveraged buyouts or “LBOs” are popping up again. Of the many issues that arise in connection with LBOs, perhaps none is as critical as properly incentivizing management. With the rekindling of the LBO market, as seen by Silver Lake’s pursuit of Dell, Berkshire Hathaway and 3G Capital’s acquisition of H.J. Heinz, Apax’s acquisition of rue21, Madison Dearborn’s acquisition of Na-tional Financial Partners and KKR’s acquisition of Gardner Denver thus far in 2013, it is time to reexamine the current state of play for executive compensation in connection with LBOs.

In most LBOs, the private equity buyer will rely on the existing management team to run the busi-ness after the transaction. In order to properly incentivize management and align management’s interests with the new buyer’s interests follow-ing the LBO, management often receives various forms of compensation which will be discussed in detail below. These include: (1) new equity awards that are granted in connection with the closing of the LBO (the “New Equity Awards”); (2) existing stock options that are rolled over in connection with the closing of the LBO (the “Rollover Options”) and any shares of stock that are either purchased in connection with the clos-ing of the LBO or through exercise of Rollover

Options (the “Purchased Shares,” and together with the Rollover Options, the “Rollover Equi-ty”); (3) new or revised employment agreements; and (4) certain other protections through share-holders agreements and the like. While many of these forms of compensation are similar in name to the compensation used in public companies, they often contain materially different terms.

Timing of Entry into New Compensation Arrangements

Before mid-2007, management typically would finalize new post-closing compensation arrange-ments concurrently with the LBO negotiations and before the merger agreement was signed up. However, partially as a result of the Lear and Topps cases in mid-2007, target boards of di-rectors began greatly restricting management’s discussions of post-closing arrangements during the LBO negotiations so that management com-pensation negotiations often occurred well after signing up the merger agreement.1 For a period, target boards of directors rarely allowed man-agement to sign definitive agreements concern-ing post-closing employment arrangements until well after the deal was signed up. However, the tide has turned again in recent transactions due to pressure from LBO buyers who have insisted on negotiating with target management prior to signing of the merger agreement. Thus, it is once again common for target boards of directors to allow management to negotiate post-closing ar-rangements with LBO buyers before signing the merger agreement but after primary deal terms (including price and principal deal protections) have been agreed.

Size of New Equity Award PoolThe pool of New Equity Awards will often en-

compass approximately 10% of the fully diluted shares outstanding immediately after closing but it can be as high as 20% or as low as 5%. The percentage is typically calculated on a “fully di-luted” basis, which results in the equity pool be-ing larger than if it was instead calculated as a simple percentage of the shares outstanding. In addition, the equity pool size is calculated from

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the number of shares outstanding immediately after the closing, so that if the buyer is funding a portion of the purchase price through debt, the number of shares outstanding immediately after the closing typically will be a lot smaller than the number of shares outstanding immediately prior to closing.

Timing and Allocation of grantsOften over 80% of the entire new equity pool

will be granted at closing, with the size of the grants being determined by the LBO buyer in consultation with the CEO. Typically, New Eq-uity Awards are issued only to a select group of senior management who have a direct ability to influence company performance.2 Depending upon the number of employees receiving New Equity Awards, it is not unusual for the CEO to receive 40% or more of the entire pool and for the second-in-command to receive 20% of the pool. Any portion of the pool that is not granted at closing (and any awards that revert to the pool upon forfeiture) is typically reserved for future grants as determined by the board of directors in consultation with the CEO.

Types of New Equity AwardsNew Equity Awards most commonly take the

form of stock options (or profits interests if a partnership structure is used), although, in certain transactions, restricted stock or restricted stock units are also used.3 If the New Equity Awards consist of options, the options are typically grant-ed with an exercise price that is equal to fair mar-ket value (“FMV”)4 on the date of grant (which is the deal price for the initial grants made at clos-ing). Occasionally, a portion of the options are granted with an exercise price in excess of FMV (e.g., half granted at FMV and half granted at 150% of FMV).5

Regular Vesting of New Equity Awards

New Equity Awards generally are subject to vesting on both time-based and performance-based conditions. Generally, between one-third

and one-half of the New Equity Awards are sub-ject to annual time-based vesting over four or five years (typically matching the LBO buyer’s invest-ment horizon) and, although not unusual in the public company and tech start-up context, it is unusual to see quarterly or monthly vesting. The remaining New Equity Awards typically perfor-mance-vest over four or five years based upon (1) the money on money (“MoM”) cash return to the LBO buyer,6 (2) the internal rate of return (“IRR”) to the LBO buyer, or (3) the budgeted EBITDA (and can also require continued em-ployment through the four- or five-year term7). Target management may require guidance in understanding the performance metrics as these conditions are different than what public compa-nies use, which generally relate to stock price or total shareholder return rather than actual inves-tor cash return.

The MoM cash return is the actual cash re-turn to the LBO buyer, whether in the form of distributions or equity sales, relative to the LBO buyer’s cash investment. So that if an LBO buyer invests $1 billion and gets $3 billion cash back, it has achieved a 3x MoM return. When the LBO buyer makes vesting of New Equity Awards con-tingent on the target company reaching specific MoM hurdles, the MoM hurdles usually are cal-culated on an aggregate basis for all shares the LBO buyer holds (and usually exclude manage-ment fees received by the LBO buyer, usually are calculated net of dilution from the New Equity Awards and do not include any debt funding pro-vided by the LBO buyer), but in some instances they can be calculated on each individual sale of equity in the company by the LBO buyer. In situ-ations where MoM returns are calculated on each individual sale by the LBO buyer, there may be a “catch up” provision for instances when initial sales by the LBO buyer do not hit the vesting tar-gets but the aggregate sales across later years do achieve cumulative targets. It is also common that MoM hurdles will range from 1.5x to 3x the in-vested money (equating to a 50% to 200% cash profit). In some LBOs, different MoM schedules may be used for meeting the hurdles based upon when cash is received by the LBO buyer. In these cases, if full vesting would occur at a 3x MoM



return and the investment horizon is four years, then, for example, if the sale by the LBO buyer occurred after two years, a 2x MoM return could result in full vesting. If EBITDA targets are used, it is not uncommon for there to be a “catch up” provision for prior year misses.

Additionally, LBO buyers should give careful consideration to whether the IRR is an adequate measure of performance for incentive-based com-pensation in connection with an LBO. If an LBO buyer is able to sell its equity stake in a company within only a short period after the close of the purchase, the LBO buyer’s IRR will be decep-tively high. In this circumstance, management could be rewarded in a situation where its per-formance did not achieve any significant returns on the LBO buyer’s cash investment. Conversely, where as a 3x MoM cash return over four years yields a 31% IRR (obviously a home run), a 3x cash MoM return over 10 years yields only an 11% IRR (more like a double). To address this perceived flaw, an IRR floor could be added to a MoM hurdle.

Special Vesting of New Equity Awards

Time-vested awards usually fully vest in the event of a change in control (single trigger), although oc-casionally such awards will only vest upon a ter-mination without cause or resignation for good reason following a change in control (double trig-ger). There will sometimes be an additional year (or pro-rata current year) vesting upon death, dis-ability, termination without cause or resignation for good reason (each a “Good Leaver Event”). There is usually no accelerated vesting specifically upon an IPO. For the performance-vested awards, full vesting (single trigger) only occurs if either a specified MoM or IRR target has been achieved or a cumulative budgeted EBITDA target has been achieved (in other words, the performance-vesting condition needs to be satisfied in connection with such change in control). Additionally, perfor-mance-vested awards may provide for a deemed sale at the then FMV for purposes of determining vesting of performance-vested awards in a Good Leaver Event or may leave a pro-rata portion of

the award outstanding to see if performance vest-ing conditions are achieved in the 6-12 months af-ter termination of employment.

When awards have single trigger or double trig-ger CIC provisions, the definition of “change in control” can be a heavily negotiated. On one end of the spectrum, a change in control could be trig-gered only when an unrelated third party acquires over 50% of the company’s stock and the LBO buyer has also sold a majority of its stock. On the other end of the spectrum, a change in con-trol could be triggered once the LBO buyer has lost control of the company even if it still holds a material amount of the company’s stock (this in theory could be triggered in connection with an IPO). There are also endless middle ground alternatives.8

Other New Equity Award TermsIf options are awarded, they typically will have

a term of 10 years and a relatively short exercise period following a termination of employment (typically 30 to 90 days following a resignation without good reason, 90 to 180 days follow-ing a termination without cause or resignation for good reason and one to two years follow-ing death or disability). One key item for target management to be aware of when negotiating the terms of the option awards is whether and how the options will be adjusted in the case of cash distributions to common stock holders. Unlike public companies where options generally do not expressly provide for an adjustment upon a cash dividend, in portfolio companies LBO buyers of-ten monetize their investment through dividends of excess cash or dividend recapitalizations. Thus, LBO portfolio company options generally will provide for some form of an adjustment in the event of an extraordinary cash dividend. This is typically done either by (1) reducing the option exercise price (but not below 20% of the FMV of a share) or (2) paying a cash dividend equivalent either immediately or upon vesting of the option. It is worth noting that because Section 409A is-sues are raised if an option’s exercise price was to be reduced or adjusted in respect of “regular” cash dividends, private companies generally only

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are able to reduce the option exercise price in re-spect of “extraordinary” dividends. Since LBO portfolio companies usually do not pay “regular” dividends (choosing instead to dividend out ex-cess cash on an irregular, “when available” basis), this distinction between “regular” and “extraor-dinary” dividends is of less practical effect than in the public company context. As is common in public companies, employees often are permit-ted to satisfy the option exercise price and all associated taxes with shares underlying options based on the FMV on the exercise date, provided, however, that the company must ensure that its credit agreement allows for such cashless exercise and tax withholding.9 New Equity Awards may also be subject to post-termination non-compete and non-solicit provisions that can be enforced through an injunction and/or clawback.10

Put/Call Rights Associated with New Equity Awards

Unlike public companies, generally, LBO port-folio companies usually retain broad call rights to repurchase stock awarded pursuant to the New Equity Awards from an executive after his/her termination of employment. Upon a termi-nation for cause, the company typically can call shares acquired upon the vesting or exercise of New Equity Awards (the “New Shares”) at lower of cost and FMV and all outstanding New Eq-uity Awards are cancelled. Sometimes a resigna-tion without good reason is also subject to such a “lower of” call provision.11 However, even in such circumstances, upon a resignation without good reason following a specified period of time (e.g., three years after closing), it is not unusual for the call on New Shares to be at FMV (this ensures that if the employee works for the compa-ny for a reasonable period of time he/she will be entitled to retain the appreciation achieved while he/she worked for the company). Upon a Good Leaver Event or retirement, a company can typi-cally call New Shares at FMV. Occasionally there will be a “tail top up” right (so-called “schmuck insurance”) where additional consideration will be paid to the employee in the event that a com-pany undergoes a change in control within three

to six months after the employee terminates em-ployment or the call right is exercised (note that a similar issue could arise from an IPO that occurs shortly after termination or exercise of the call). Call rights usually terminate on an IPO or change in control and may also terminate or be modified in a Good Leaver Event. Call rights may have a limited duration (e.g., one year after termination of employment) or unlimited duration. Typically the call right is only exercisable by the company, but occasionally the shareholders (and/or other management holders) will be permitted to exer-cise the call right if the company does not do so. The call right is applied to options based on the intrinsic value of the option at the call price.

Additionally, executives sometimes have limit-ed rights to sell or “put” stock to a company after their termination of employment. Upon death or disability, executives typically can put New Shares at FMV and vested options at spread based on FMV. Upon termination without cause, resigna-tion for good reason or retirement, there occa-sionally are limited put rights but there would not be any put rights on a resignation without good reason or termination for cause. As with call rights, put rights usually expire upon a change in control or IPO. Typically a put right is exercisable only for a limited period of time after termination (e.g., one year after termination).

It is common for the Company to have the abil-ity to force exercise of options and have any put/call rights occur six months after such forced ex-ercise in order to avoid unfavorable accounting expense (the FMV should be based on the value on the date of the actual put or call, as opposed to the value on the date of employment termina-tion).12 Most often the put/call exercise price is paid in cash, but it is not unusual when a com-pany is prohibited from buying the shares for cash under its credit agreement either for (1) the put/call exercise period to be extended until the company is permitted to repurchase the shares for cash or (2) the company to be permitted to pur-chase the shares in exchange for a subordinated non-transferable note (the interest rate on these notes can vary from as low as the applicable Fed-eral rate to as high as the company’s average ef-fective borrowing rate on its subordinated debt).



Rollover EquityIt is typical for a handful of the top executives

to be required to roll over a portion of their ex-isting options and other existing equity compen-sation awards that are outstanding at closing. A common formulation is for 25% to 50% of the after-tax value of the outstanding options and equity compensation awards to be rolled over, with the final rollover amount often linked to how generous the LBO buyer is in granting New Equity Awards. Additionally, some LBO buyers will also require existing executives to purchase an amount of shares equal to 25% to 50% of the after-tax value of any other equity in the company that the executives own outright. This “Rollover Equity” is designed to ensure that these execu-tives have “skin in the game,” just like the LBO buyer. In addition, certain other mid-level execu-tives may be permitted to elect to roll over their existing equity awards and/or buy shares of the company at the deal price. To the extent that ex-ecutives are rolling over a portion of the shares they own and selling the balance of their shares, careful attention needs to be paid to ensure that the rollover is tax-free (and that the separate sales proceeds do not taint the rollover). In fact, management’s decision to sign post-buyout em-ployment agreements may be contingent on an acquisition structure where the Rollover Equity is actually tax-free. This typically is achieved either through a merger where the rollover shares re-main outstanding or through the use of a holding company acquisition structure where the rollover shares are contributed to the holding company.

Rollover Options will have the same spread value as existed immediately prior to closing, but the exercise price and number of options typically will often be reduced to the maximum extent permitted under applicable tax rules. For example, 100 outstanding options with a $30 exercise price and $50 FMV ($2,000 aggregate spread) will often be converted into 50 Rollover Options with a $10 exercise price and $50 FMV (still with a $2,000 aggregate spread). This sort of conversion essentially deleverages the options and will result in underwater options being can-celled and slightly in-the-money options being converted into a very small number of current

options.13 Rollover equity awards will either fully vest on closing or have vesting that matches the terms of the equity awards that were rolled over. Rollover Options should be subject to the same anti-dilution and net exercise provisions as the New Equity Awards. For Rollover Equity, the events triggering a company call right will typi-cally be significantly more limited than for New Equity Awards and the call price will typically be at then-current FMV. Additionally, for Rollover Equity, it is more likely that executives will have put rights, the events triggering an executive’s put right will often be more generous than for New Equity Awards, and the put price will almost al-ways be the then-current FMV.14

Revised Employment AgreementsExecutives’ current employment and sever-

ance agreements usually continue unchanged, although it is not unusual for the LBO buyer to request that good reason triggers relating to go-ing from a public company to a private company be waived.15 Occasionally, potential severance en-titlements that are triggered in connection with closing will be restructured, although, in the event of any restructuring, careful attention needs to be paid to Section 409A of the Code.

Other Shareholder AgreementsExecutives will often be prohibited or se-

verely limited in their ability to sell or transfer their shares prior to an IPO or complete sale of the company (and where sales are permitted the LBO buyer will often have a right of first refusal or right of first offer).16 In addition, executives will usually be subject to being dragged along on sales of over 10% to 25% by the LBO buyer and executives will usually have certain rights to tag along on sales of over 25% to 50% by the LBO buyer. Typically, executives will have cer-tain rights to piggyback on share registrations by the LBO buyer. Given that LBO buyers often use holding companies to own company shares, it is important to address any change in control, IPO and tag/drag impacts that could occur if shares of a parent holding company are sold instead of shares in the portfolio company (since manage-

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ment typically only owns shares in the portfolio company). Management usually does not receive any preemptive rights.

Options will be continued after an IPO, but, if a partnership structure is used, it is possible that the partnership will be liquidated in connection with the IPO. This would mean that any profits interests would be cashed out at the time of the IPO and would not be entitled to participate in any post-IPO appreciation, and this fact needs to be balanced against the preferential tax treatment that profits interests currently enjoy. If profits in-terests are cashed out in connection with an IPO, management could receive new equity grants in the public company to replace cashed-out prof-its interests. In this manner, management would continue to have a financial interest in the perfor-mance of the company and would be rewarded for continued future performance (although there is no guarantee that the new equity awards will cover the same portion of the company’s capital structure that the profits interests initially cov-ered).

Super-CapitalizationsSuper-capitalization transactions (i.e., where

a small or start-up company is overcapitalized in order to fund future growth or acquisitions), which have been occurring in recent years, espe-cially in the banking world, raise similar issues as LBOs. However, these super-capitalization transactions also raise a host of different issues. In super-capitalization transactions, sometimes only a portion of the sponsor money comes in upfront (and subsequent money is committed to be invested over the next few years). In these circumstances, it is common for the new equity pool size to be calculated off the entire commit-ted amount and the company will hold a claw-back right to equity granted to management if a portion of the money committed is not actually invested. Additionally, these super-capitalizations sometimes provide executives with “founder’s equity” that is intended to not be compensatory. Finally, in bank super-capitalizations, contingent value rights or convertible preferred stock may be used to protect against excess loan losses. In those

bank super-capitalization transactions, careful at-tention needs to be given to both the economic and Section 409A tax issues associated with let-ting management participate in such contingent value rights or convertible securities.

ConclusionWhile only time will tell if the stock market re-

bound will mark another “golden age” of private equity deal-making, one thing remains clear—the fundamental need to compensate management teams will endure. Accordingly, even as the LBO market continues to evolve, the compensation of management teams in such LBO transactions is likely to continue to be a topic of much discussion and debate.

NOTES1. See In re Lear Corp. Shareholder Litigation,

926A2d94(Del.Ch.2007)andIn re Topps Co. Shareholder Litigation, 926 A2d 58 (Del. Ch.2007).TheToppsandLearcasesbothinvolved“goingprivate”transactionswhere,ratherthanconducting an auction, the target companysigned up with an LBo buyer that then gavethe target companies a “go-shop” windowto seek other bids. In both of these cases,plaintiffs alleged that the target boards ofdirectorsallowingtheLBobuyertonegotiatepost-closing employment arrangements withcertain members of senior managementbefore signing the merger agreement wasinadequately disclosed and also violateddirectors’fiduciaryduties.TheCourtacceptedplaintiffs’claimsthatthedeficientdisclosureinthesecaseswouldrequirethetargetcompaniesto amend their proxy statements but did notfindviolationsoffiduciaryduties.however,intheimmediatewakeofthesedecisions,targetboards of directors often sought to prohibittarget management from negotiating theirpost-closing employment arrangements withanLBobuyeruntilafterclosingofatransactionoraftertheshareholdervotesoastolimitanypossible fiduciary duty or disclosure claims inshareholder strike suits. moreover, the seC’srenewedemphasisaroundthistimeon“going-private” transactions under Rule 13e-3 mayalsohaveledsometargetboardstorefusetoallowmanagementtonegotiatedirectlywithpotential LBo buyers in order to hopefullyavoidtheenhanceddisclosurerequiredbyRule13e-3.



2. Rank and file employees who historicallyreceived equity compensation awards willoften receive long-term cash awards insteadonagoing-forwardbasis.

3. In europe, it is common for an LBo buyer tofundacquisitionsthroughstapledcommonandfixed-ratepreferredstock,wherethecommonstock is expected to generate super-sizedreturns.Inthistypeofstructure,theLBobuyermaygrantnewequityAwardsbyallowingthemanagement simply tobuy the superchargedcommon stock (often referred to as “sweet”equity)withouthaving toalsobuy thefixed-ratepreferredstock.

4. LBo buyers often request that FmV bedeterminedbytheboardofdirectorsingoodfaithafterconsultationwiththeCeo.however,it is not unusual for management to requestthat(a)FmVbedeterminedbyanindependentthirdpartyappraisalor(b)theyhavetherightto challenge the board’s FmV determinationbased upon an independent third partyappraisal (in the latter case, management isoften asked to pay the appraisal fees if theappraisedpriceisnotmateriallydifferentthanthe board’s determination). The FmV may ormaynotexpressly includeorexcludeminorityandlackoftransferabilitydiscountsandcontrolpremiums.TheFmVdefinitionisoftenapointthatishighlynegotiated.

5. Ifan increasedexerciseprice isused, thiswilltypically take the place of the performancevestingconditionsdiscussedbelow.

6. Because private equity funds typically getpaid off the actual cash profit they make (asopposed to the IRR), it is more typical to seemomhurdles.

7. Note, if there are separate performance andtimed-based vesting conditions, then thismeansthatifthereisafour-yearvestingperiodand the mom return is fully achieved afterthree years, the performance awards wouldonlybe75%vestedafterthreeyearsandtheremaining portion would vest on the fourthanniversaryofgrant.

8. Note, if there are single trigger payments ofnon-qualified deferred compensation, thena section 409A change in control override ora section 409A compliant change in controldefinitionmaybenecessary.

9. Note,thepaymentoftheexercisepricethrougha net exercise does not cost a company anycash,butthepaymentofthewithholdingtaxesthrough a net exercise does cost a companycash because the company has to remit thewithholdingamounttotheIRs.

10. Ifawardsaregrantedtolower-levelemployees,it is possible that the non-compete will beeliminatedorlimitedtoaveryshortperiod.

11. Note, a “lower of” call right effectivelymeansthattheemployeewillnotreceiveanyeconomic value from the equity award, evenif the employee had previously vested in allor a portion of the award. If a resignationwithout good reason does trigger a “lowerof”call right, thenthestock is still subject toa substantial risk of forfeiture under section83oftheCodeandan83(b)electionshouldbemadeatthetimeofoptionexercisetoensurenofurthercompensationincomeisrecognizedwithrespecttothestock.

12. Note, theput/callprovisionsshouldbevettedby a company’s accountants to ensure thatthese provisions do not give rise to variable/liabilityaccounting.This isoneofthereasonsthattheput/callprovisionsterminateuponanIPo.

13. Theexercisepricewilltypicallynotbereducedbelow20%ofthedealpriceinordertoensurethat theoption remains treatedasanoptionfortaxpurposes.

14. Whiletheput/callrightsinrespectofRolloverequity are usually at then-current FmV, someLBobuyershaveaskedthattheput/callrightsbeateither(i)thelowerofdealpriceorFmVor(ii)80%ofFmViftheexecutiveterminateswithoutgoodreasonwithinalimitedperiodoftimeafterclosing.

15. Note, such a waiver (and any new awards orenhancements)wouldneedtocomplywiththesection409Asubstitutionrule.

16. Inarightoffirst refusal (“RoFR”),amemberofmanagementwhoreceivesanofferfromathirdparty tobuyhisorher sharesmustfirstoffer his or her shares to the LBo buyer atthesamepriceasthethirdpartyofferbeforeselling to the third party. Third-party buyersmay be less willing to invest the time andmoneyinpursuingthepurchaseofnewequityfrom executives where the LBo buyer holdstheRoFR.AsanalternativetotheRoFR,LBobuyers may possess a less restrictive right offirstoffer (“RoFo”)over the shares,wherebytheholderofsharesmustfirstofferthesharesto the LBo buyer before attempting to sellthemtoathird-partybuyer.

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Wiped-Out Common Stockholders: Delaware Chancery Court Finds “Foul” But No “Harm” in the Sale of a Venture-Backed CompanyB y J . D . w E I N B E r G A N D D A N I E L N A z A r

J. D. Weinberg is a partner, and Daniel Nazar is an associ-

ate, in the New York office of Covington & Burling LLP.

Contact: [email protected].

On August 16, 2013, after a full trial, Vice Chancellor Laster of the Delaware Court of Chan-cery issued a detailed 114-page opinion in In re Trados Incorporated Shareholder Litigation, rul-ing that the Trados directors did not breach their fiduciary duties by approving a merger between Trados and SDL plc in which the Trados common stock would receive nothing. Laster held that, de-spite the failure of the directors to follow a fair process and their improper focus on the interests of the holders of preferred stock, the approval of the merger was entirely fair to the holders of common stock because the common stock had zero value at the time of the merger. The opin-ion contains a detailed analysis of the fiduciary duties of directors during an exit-motivated sale in which the preferred stockholders’ contractual rights to liquidation preferences may conflict with the common stockholders’ residual interest. The case provides useful guidance for directors in con-ducting a sale process for private investor-backed companies and helps clarify for buyers of such companies the risks involved where a properly structured sale process may not be utilized.

BackgroundTrados, a company which developed and mar-

keted translation software, obtained multiple rounds of venture capital funding, and, as a result of these investments, VC firms held a majority of Trados’ preferred stock and were entitled to des-ignate four of Trados’ seven directors.

Following a period of underperformance, the board decided in 2004 to replace the CEO and explore the possibility of a near-term sale. The board ultimately hired a new CEO who had prior success in turning around and selling technology companies. The CEO, as well as Trados’ CFO, also served as directors on Trados’ board. In or-der to incentivize management to pursue a sale, the board adopted a management incentive plan (“MIP”) that would compensate management for achieving a sale of the company regardless of whether the common stock received any value in the sale.

Under the new CEO’s leadership, Trados post-ed record revenue and record profit in the fourth quarter of 2004. At the same time, the CEO and the board continued to pursue a sale of the com-pany, and in June 2005, the Trados board of di-rectors approved a merger between Trados and SDL for $50 million in cash and $10 million in SDL stock. Of the $60 million received in the merger, $7.8 million went to management under the MIP and the remaining $52.2 million went to the preferred stockholders, while the common stockholders received nothing.

An individual who owned about 5% of Trados’ common stock sought appraisal of his shares in the Court of Chancery and also sued the directors on behalf of the common stockholders, arguing that the directors had breached their fiduciary du-ties in connection with the sale.

Standard of Conduct and ReviewLaster considered the standard of conduct ap-

plicable to the board’s actions in considering and approving the merger. While directors have a fiduciary duty to take actions for the benefit of the stockholders, the Vice Chancellor noted that the special rights of preferred stockholders are contractual in nature and that a board owes no



fiduciary duty to maximize the value of these spe-cial contractual rights.1 Laster noted that under existing Delaware case law, “generally it will be the duty of the board, where discretionary judg-ment is to be exercised, to prefer the interests of the common stock—as the good faith judgment of the board sees them to be—to the interests cre-ated by the special rights, preferences, etc. … of preferred stock.”

Laster then considered the standard of review to apply while evaluating whether the directors met the standard of conduct, with a focus on ac-tual conflicts of interest. The plaintiff successfully argued that six of the seven members of the board had personal interests in the merger which con-flicted with their duty to maximize value for the common stockholders.

Management Directors. The Vice Chancellor found that the two management directors were interested in the merger because the personal ben-efits they would receive from a sale were material enough to influence their judgment in favor of the merger. Under the MIP, the CEO received $2.34 million and the CFO received $1.092 million in connection with the merger. The plaintiff also showed that the CEO negotiated for post-merger employment as an executive and officer at SDL.

VC Directors. Laster found that the plaintiff proved the three VC Directors faced a conflict of interest as “dual fiduciaries” because of their competing duties to the common stockholders and to their VC firms as preferred stockhold-ers. In a previous ruling on a motion to dismiss, Chandler rejected the directors’ argument that be-cause the preferred stockholders did not receive their full liquidation preference, their interests were aligned with the common stockholders in achieving a higher price. While Laster agreed with Chandler, his opinion provided a more detailed analysis of the specific interests of VC firms.

Laster’s opinion noted that the interests of VC firms may be aligned with common stockholders in a highly successful company where “everybody wins” or in a total failure where “everybody los-es”, but that their interests can diverge greatly in intermediate cases where a company is profitable but lacks growth opportunities. In such cases, the VC firms’ interest in liquidating the company and

achieving an exit can conflict with the common stockholders’ interest in achieving value by either holding out for a better deal or continuing to op-erate under a growth strategy. As a result, the VC directors’ duty to their VC firms conflicted with their duty to the common stockholders.

Outside Director. Laster also found that plain-tiff proved that one of the two outside directors was interested in the transaction based on that director’s indirect financial relationships with (i) the VC firm that nominated him to the board and (ii) the VC director designated by the same firm. Laster specifically noted that in a conflict of inter-est between the VC firms and the common stock-holders, such “so-called ‘independent directors’” nominated by VC firms would “have incentives to side with the VCs.”

Because the board lacked a majority of disin-terested and independent directors, Laster deter-mined that, consistent with Delaware law, the board’s actions would be evaluated under the entire fairness standard, which shifts the burden to the directors to prove that they engaged in fair dealing and obtained a fair price for the stock-holders in the transaction.

Fair DealingLaster found that the evidence conclusively

showed a lack of fair dealing by Trados’ board. Importantly, Laster noted that there was no evi-dence contemporaneous to the merger which sug-gested that the directors had attempted to deal with the common stockholders in a procedurally fair manner and dismissed testimony by the direc-tors at trial to depict their actions as having been fair to the common stockholders. Laster consid-ered four different aspects of the deal process and concluded that the directors had acted in a man-ner unfair to the common stockholders in all of them.

Initiating Sale Proceedings. Laster evaluated the Board’s original decision in 2004 to fire the CEO and pursue a sale and determined that the VC directors pushed for a sale without consider-ing the perspective of the common stockholders. Rejecting contrary testimony given by the direc-tors at trial that they had properly evaluated plans

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to continue operating the company and build val-ue as an alternative to the sale, the court found that the VC directors had pushed for an exit and showed no interest in continuing to manage the company to increase value for the common stock, having “initiated a sale process and pursued the Merger to take advantage of their special contrac-tual rights” as preferred stockholders.

Negotiating the Transaction. For purposes of fair dealing, Laster determined that the MIP “skewed the negotiation and structure of the Merger in a manner adverse to the common stockholders.” The MIP provided that manage-ment would be paid first in a sale, and under the deal, the preferred stockholders were then to be paid up to their full liquidation preference. Of the $60 million received in the merger, $7.8 mil-lion went to management under the MIP and the remaining $52.2 million went to the preferred stockholders, while the common stockholders received nothing. Without the MIP in place, the preferred stockholders would have received their full liquidation preference of $57.9 million and the common stockholders would have received $2.1 million in the merger. Under the structure of the MIP, the company had to be sold for at least $66.5 million for the common stock to re-ceive any value, and the common stockholders would have contributed disproportionately, in Laster’s view, to the MIP even at a much higher sale price. Laster observed that at a $70 million sale price, 75% of the common stockholders’ proceeds would go to the MIP while only 25% of the preferred stockholders’ proceeds would fund the MIP.2 In the case of the sale to SDL, Laster noted that the MIP reduced the amount the pre-ferred stockholders ultimately received by 10%, while 100% of the money that would have gone to the common stockholders went to funding the MIP. While the management team held common stock and options which could have incentivized them to hold out for a higher price that would create value for the common stock, Laster consid-ered those incentives to be defeated by the MIP’s “cutback” feature. Under the cutback, the MIP payout would be reduced by any amount that management received for their common stock.

Laster found both the design and effect of the MIP as aligning management with the interests of the preferred stockholders and the CEO and CFO ultimately acting and voting in favor of the pre-ferred stockholders’ interests to be evidence that the board dealt unfairly with the common stock-holders when negotiating the merger. The Vice Chancellor further noted the lack of evidence that the board even considered allocating some of the sale proceeds to the common stockholders.

Director Approval. While six of the seven direc-tors, including the CEO and CFO, had personal incentives to vote in favor of the deal, Laster also found that the directors did not understand their duties to the common stockholders and noted that a “director’s failure to understand the nature of his duties can be evidence of unfairness.” While the directors testified at trial that they had consid-ered the interests of all stockholders in approv-ing the merger, their testimony also indicated that they did not see the conflict that existed between the interests of the preferred and common stock-holders. According to the record before Laster, the directors failed to consider taking steps to en-sure the fairness of the merger, such as forming a special committee to represent the interests of the common stockholders (which Laster noted could have allowed the directors the benefit of the more lenient business judgment review) or obtaining a fairness opinion, which apart from any value it may have provided, could have added to the process an outside analysis of alternatives to the merger and “improved the record” for the direc-tors on fair dealing.

Stockholder Approval. The directors never considered conditioning the merger on the ap-proval of a majority of disinterested common stockholders. Instead, the deal was conditioned on a simple majority vote, which was delivered by the preferred stockholders and certain “friend-ly” common stockholders. One such “friendly” stockholder was the CFO, who indicated having second thoughts prior to the vote but voted his common stock in favor of the merger after his share of the MIP was increased.



Fair PriceWhile Laster found for the plaintiff on the issue

of fair dealing, he agreed with the directors that the common stock had no value at the time of the merger. Laster rejected the directors’ position that the company’s financial position was so dire that it faced bankruptcy and noted that it was realistic that the company could have funded its growth plan and continued to operate independently. However, Laster credited a defense expert’s meth-odology and conclusion that Trados was worth approximately $51.9 million, less than the pre-ferred stockholders’ liquidation preference. Tra-dos also owed an 8% dividend to the preferred investors which accrued as additional liquida-tion preference. Further, Trados faced industry consolidation that removed clients and potential buyers. As a result, Laster found that even if the company remained profitable, it faced significant risks and was unlikely to generate growth high enough to exceed the climbing liquidation prefer-ence amount and generate value for the common stock and the value of the common stock would have remained zero for the foreseeable future.

Laster concluded that while the directors did not follow a fair process, the board’s decision to approve the merger was nonetheless entirely fair to the common stockholders because they had re-ceived a fair price, consistent with Delaware law that unfair process alone does not breach a direc-tor’s fiduciary duties.

Appraisal RightsWhile noting that the legal standard for fair

value in an appraisal is the stock’s ongoing value rather than its value in the context of a merger, Laster reiterated that the common stock had zero value and Trados had no realistic chance to grow fast enough to overcome the preferred stock’s liquidation preferences. As a result, the plaintiff failed in his appraisal claim.

ConclusionsWhile the opinion found in favor of the direc-

tors, it contains several warnings for directors with financial interests in a sale. While the direc-tors were ultimately found not to have breached

their fiduciary duty, their actions in negotiating and approving the sale were found to be unfair dealing, and the question of director liability may have ultimately hinged on the company’s value.

Throughout the opinion, Laster repeatedly not-ed the lack of evidence that the board considered the interests of the common stockholders during the sale process. While the failure to (i) structure the MIP to avoid making the common stockhold-ers bear a disproportionate burden of the MIP’s costs and shifting incentives, (ii) enact protective provisions such as the use of a well-functioning special committee or conditioning the merger on a majority vote of the disinterested common stock-holders or (iii) solicit an independent review of the merger and alternatives by an outside advisor were each factors in the case, the Vice Chancellor also focused on the lack of evidence that the directors even considered taking such actions and the direc-tors’ failure to recognize the conflicts of interest presented by the merger. A Board represented by preferred stockholders in these situations should not only remain aware of the interests of common stockholders, but also take steps to demonstrate the considerations arising therefrom and have them documented. Laster’s opinion makes clear that directors with financial interests in a sale need to focus on the process and not just the outcome.

Left unresolved by the opinion is whether VC funds can effectively contract around such fidu-ciary duties to the common stockholders. Laster noted that the VC investors in Trados did not at-tempt to contractually impose mechanisms for “side-stepping fiduciary duties”, such as drag-along rights, or otherwise realigning the fiduciary duties of the directors, clarifying that his ruling “provides no opportunity for expressing a view as to the effectiveness of any such mechanism or realignment, and it does not intimate one.” Prac-titioners may assume that such mechanisms may well provide relief from the applicability of the exacting review Laster undertook of the Trados’ boards process, but Laster expressly avoided pro-viding any comfort in that regard in Trados.

This case ultimately should be considered impor-tant reading for private investors and advisors, as it provides guidance on how directors may comply with their duties to all stockholders when seeking an exit where not everybody “wins” or “loses.”

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NOTES1. In a footnote, Laster described the scholarly

viewofa“control-contingentapproach,”whichtheorizes a board elected by the preferredstock can promote the interests of preferredstock over the interests of common stock, asnot consistent with his understanding of therole of fiduciary duties. The Vice Chancelloralso rejected the theory that directors havea duty to maximize enterprise value, definedas the aggregate value of the common andpreferredstockincludingthepreferredstock’scontractual rights, and noted that he readDelaware case law as not supporting thetheory.

2. LasternotedthathemadenodeterminationofwhatwouldbeafairallocationofthecostofthemIP,observingonlythatattheboundaries,funding 100% of the mIP through proceedsotherwisepayabletothepreferredstockraisednofairness issues,whilefunding100%ofthemIP through proceeds otherwise payable tothecommonstockraisedseriousfairnessissues,and that a range of intermediate allocationswerepossible.

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Viacom Int’l, Inc. v. Winshall: Delaware Supreme Court Reinforces Accounting Experts’ Authority to Decide Purchase Price Disputes, Restricting Collateral Attack by Disgruntled PartiesB y E L I z A B E T h C L O U G h K I T s L A A r A N D J A M E s w h I T E

Elizabeth Clough Kitslaar is a partner who oversees the corporate practice of Jones Day’s Chicago office. James White is a partner in Jones Day’s Chicago office. Contact: [email protected] or [email protected].

On July 16, the Delaware Supreme Court1 pub-lished an opinion that confirms and clarifies the scope of an accounting expert’s authority to re-solve post-closing financial disputes that parties have agreed to submit for resolution under the terms of a definitive business acquisition agree-ment. This decision reaffirms alternative dispute resolution as the procedure of choice for quickly resolving complicated, technical financial issues that sometimes arise in the context of purchase price adjustments.

Post-closing purchase price adjustments are al-most universally present in definitive agreements for the sale of a business.2 These provisions—which include earn-out clauses, working capital adjustments, and debt/net debt true-ups—require an adjustment to the purchase price paid at clos-ing, based on calculations relative to pre-closing targets, standards, or formulas. Such provisions set forth not only the methodology for determin-ing the amount of the adjustment, but also a reso-

lution process in the event the parties disagree on the amounts to be paid. These processes typically include: (i) an exchange of the relevant financial calculations and access to work papers and sup-porting documentation; (ii) submission by the re-cipient party of objections to the calculation; (iii) a period of time within which the parties will at-tempt to resolve the dispute in good faith; and (iv) submission of the unresolved issues to a neutral accounting firm for ultimate resolution.3

Resolution dispute provisions sometimes re-fer to the financial arbitrator as an “expert and not as an arbitrator.” Frequently, such provisions state that the resolution of the dispute by the in-dependent accountant shall be “final, binding on and not appealable by the parties.” These dispute resolution provisions otherwise take a variety of forms, including stating the basis upon which a party may bring a claim to dispute the final de-termination (such as fraud or manifest error). Importantly, however, if the provision is intended as a binding agreement to arbitrate in contracts involving interstate commerce, the Federal Arbi-tration Act (“FAA”) applies to resolution of the dispute. The FAA limits the bases upon which a party can avoid the arbitrator’s decision through litigation. It was this approach that the plaintiff pursued in disputing the determination of the in-dependent accountant in the Viacom case.

The Viacom dispute concerned an earn-out pro-vision based on gross profit from the sales of the video game “Rock Band.” As is typical, the parties’ agreement set forth express procedures by which disputes over the earn-out would be identified and decided. As Chancellor Strine noted in his opinion, “the entire contractual resolution process was trig-gered by Viacom’s final Earn-Out Statement and supporting documentation.”4 Viacom made no mention in its documents about inventory write-downs, but then, at hearing, Viacom argued that the earn-out at issue should be reduced to zero because of inventory write-downs. The account-ing firm adjudicating the dispute (BDO) refused to consider the inventory write-down issue unless both parties agreed that the issue should be de-cided in the arbitration, citing the governing con-tract provision limiting the disputes to be resolved to those identified in the submissions that parties exchanged prior to the arbitration, and therefore ruled in favor of the seller.

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In affirming the lower Court’s rejection of Via-com’s request to vacate the arbitrator’s determina-tion, the Delaware Supreme Court articulated the test by which the scope of an arbitrator’s authority under “procedural arbitrability” would be deter-mined. The Viacom Court recognized that, once the parties agree to submit the subject matter of a dispute to arbitration, “‘procedural’ questions that grow out of the dispute and bear on its final dispo-sition should be left to the arbitrator.”5 In so doing, the Delaware Supreme Court stated as follows:

[T]he only question that the court should decide is whether the subject matter in dis-pute falls within it. if the subject matter to be arbitrated is the calculation of an earn-out, or the amount of working capital, or the company’s net worth at closing, all is-sues as to what financial or other informa-tion should be considered in performing the calculation are decided by the arbitrator. in resolving those issues, the arbitrator may well rely on the terms of the underlying agreement, and the arbitrator’s interpreta-tion of the contract is likely to affect the scope of the arbitration. Nonetheless, these decisions fall within the category of proce-dural arbitrability. They are not “gateway” issues about whether the particular dispute should be arbitrated at all. Rather, they are questions about how the subject of the ar-bitration should be decided.6

Practice implicationsIn light of this decision, practitioners should

take note of the following:

• Clients should be aware that binding arbitra-tion of post-closing purchase price adjust-ment disputes is standard deal practice and that it is important to expressly provide that such dispute resolution is to be binding and not appealable.

• If intended to be binding, practitioners should be careful about not including language that the Delaware Chancery Court referred to as creating an “eyebrow-knitting moment”7—such as referring to the independent accoun-

tants as “deemed to be acting as experts and not arbitrators.”8 Rather, provisions should expressly state that resolution of the dispute by the independent accountants will be final, binding, and conclusive, not appealable and not subject to further review, subject to ap-plicable provisions of the FAA.

• If disputes arise (and they often do), clients and their counsel should specifically analyze the purchase price adjustment provisions of their agreement and what issues are pre-sented by the dispute—separating disguised indemnity claims, assertions of fraud, mis-representations, and other issues that are not properly within the scope of such provisions from resolution of the financial accounting items in dispute.

• In preparing initial calculations and respon-sive objection statements, parties should include a thorough list of potential issues, arguments, and theories they intend to rely on to support their positions. Similarly, as they negotiate resolution of purchase price adjustment disputes, and prepare engage-ment letters of independent financial experts to assist with such resolution, parties should prepare, and if possible agree on, an accurate and complete written description of the ac-counting issues in dispute. If not so described, parties risk waiving the right to have such is-sues, arguments, and theories submitted for resolution as not properly presented or not within the scope and subject matter of the dispute resolution procedures.

NOTES1. Viacom Int’l, Inc. v. Winshall (“Viacom II”),

no.513,2012,2013WL3678786(Del.July16,2013).

2. AccordingtotheABA’s2011PrivateTargetm&ADeal Points study, 82% of 2010 transactionsinclude purchase price adjustments, of which79%werebasedonworkingcapitalcalculationsand20%werebasedondebtcalculations.2011 Private Target Mergers & Acquisitions Deal Points Study,Am.BarAss’nBus. Lawsection,13(Jan.17,2012),http://apps.americanbar.org/dch/committee.cfm?com=CL560003. Duringthesameperiod,38%oftransactionsincludedearn-outclauses.Id.at20.



3. For an overview of issues arising in purchasepriceadjustmentdisputeresolutionarbitrationfrom the perspective of an accountingneutral,seeLawrenceF.Ranallo,Resolution of Purchase Price Disputes: Issues, Outcomes and Recommendations, PricewaterhouseCoopers(2009), www.pwc.com/en_us/us/forensic-services/assets/purchase-price-disputes-resolution.pdf.

4. Viacom Int’l, Inc. v. Winshall (“Viacom I”),no.7149-Cs, 2012 WL 3249620, at *18 (Del. Ch.Aug.9,2012).

5. Viacom II, 2013 WL 3678786, at *4 (quotingJohn Wiley and Sons, Inc. v. Livingston,376u.s.543,557(1964)).

6. Id. In Viacom I, Chancellor strine rejectedViacom’s argument that BDo’s authority asarbitrator was confined to pure accountingissues, and did not extend to contractinterpretationbecauseBDo“didnotgotolawschool,”holdingthatsuchfirmcouldinterpretandapplytheacquisitionagreementaspartofitsmandate.

7. Viacom I,2012WL3249620,at*3.8. Id.at*2.

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