CSG Corporate & Securities Insights Q4 | 2017
CSG’s Corporate & Securities Group is pleased to provide the latest installment of Insights, which highlights recent news, activities, judicial decisions, legislative actions and regulatory announcements of interest.
CSG is pleased to announce that the firm has earned top honors in numerous practice areas in the “2018 Best Law Firms” rankings published by U.S. News & World Report and Best Lawyers, including a national Tier 3 ranking in Mergers & Acquisitions Law, a New Jersey Tier 1 ranking in Corporate Law and a New York City Tier 3 ranking in Mergers & Acquisitions Law. Click here for a full list of recognized practice areas.
Michelle Schaap was the 2017 recipient of the Professional Lawyer of the Year Award presented at the New Jersey Commission on Professionalism in the Law Awards Luncheon on November 9, 2017. The award is given annually to attorneys held in the highest regard by their colleagues for character, competence and exemplary professional behavior.
CSG member Jeff Chiesa was named to PolitickerNJ‘s 2017 Power List, ranking 7th in a list of New Jersey’s most politically influential individuals. In addition, Jeff was honored alongside senior members Armen Shahinian and Frank Giantomasi as they were collectively named to InsiderNJ’s 2017 Insider 100 Power list, ranking 65th among New Jersey’s political elite.
CSG has been recognized as a client service leader by BTI Consulting Group in its annual report, BTI Client Service A-Team 2018. The 315 law firms included in the BTI Client Service A-Team 2018 report are the result of 350 in-depth interviews with top legal decision makers at the world’s leading organizations.
Judicial Decisions, Legislative Actions and Regulatory Announcements
Court Enforces Term Sheet Break-Up Fee Provision
The United States District Court for the District of New Jersey recently interpreted and enforced a $500,000 break-up fee provision in a term sheet in favor of an equity lender in White Winston Select Asset Funds, LLC v. Intercloud Sys., Inc., CV 13-7825-BRM-DEA, 2017 WL 4390104 (D.N.J. Oct. 3, 2017).
Intercloud System, Inc. and White Winston Select Asset Funds, LLC, a private equity firm, executed a term sheet providing for up to $5,000,000 in secured financing by White Winston to Intercloud in the form of a senior secured convertible debenture. The financing would be secured using all of Intercloud’s assets as collateral and would be junior only to the existing senior priority security interest held by MidMarket Capital. As a condition to closing the financing, White Winston was to enter into an intercreditor agreement with MidMarket. The term sheet also included a break-up fee of up to $500,000 payable to White Winston if, despite being ready to close, it does not because Intercloud arranges financing with another lender.
Intercloud did, in fact, obtain financing from another lender – PNC Bank, which was granted a first priority security interest in Intercloud’s assets, senior to MidMarket’s security interest. As a result, the financing did not close and White Winston sought the break-up fee because, though prepared to close, its security interest would be subordinate to both MidMarket and PNC. Intercloud disputed the claims, in part, because certain conditions precedent, including entering into the intercreditor agreement with MidMarket, were not satisfied. They also claimed that White Winston was not “prepared to close” because it did not complete its due diligence.
The court, however, found that the PNC financing and PNC’s senior security interest made it impossible for White Winston and MidMarket to enter an intercreditor agreement consistent with the term sheet since White Winston’s security interest was to be junior only to MidMarket. The court also found that White Winston did not have to complete its due diligence to be “prepared to close,” rather, it must only have engaged in some due diligence and be willing to close. As such, the court enforced the break-up fee, finding that White Winston satisfied or was excused from satisfying all conditions precedent and was prepared to close but could not under the term sheet because of the PNC financing.
This case highlights the importance of carefully negotiated term sheets, particularly provisions dealing with break-up fees and their triggering events.
Delaware Court Rejects Shareholder Books and Records Demand
Recently, in Wilkinson v. A. Schulman, Inc., No. CV 2017-0138-VCL, 2017 WL 5289553 (Del. Ch. Nov. 13, 2017), the Delaware Chancery Court rejected a shareholder request demanding access to company books and records, finding that the stockholder-plaintiff lacked proper purpose for the demand.
Under Section 220 of the Delaware General Corporation Law, a shareholder has the right to inspect corporate books and records for any proper purpose. “Proper purpose” is defined as a purpose reasonably related to such person’s interest as a stockholder.
Here, the shareholder requested access to the company’s records to determine if the company’s directors breached their fiduciary duty in approving a stock award to the company’s former CEO upon his retirement. The company rejected the demand and the shareholder sued to enforce his rights under Section 220.
In denying shareholder’s request, Vice Chancellor J. Travis Laster found that the record established that “the purpose for the inspection belonged to [the Plaintiff’s] counsel, and not the [Plaintiff] himself”. The court found that the Plaintiff “simply lent his name to a lawyer-driven effort by entrepreneurial plaintiffs’ counsel.” Testimony in the case revealed that the Plaintiff began seeking access to books and records because he was unhappy with the company’s performance, and not that he suspected or was aware of any wrongdoing in connection with the CEO’s retirement. Additionally, the Plaintiff admitted that his attorneys “came up with” the purposes for the records request in the demand letter. Furthermore, the Plaintiff did not participate in any follow-up subsequent to the demand and when testifying admitted he was not even sure the Company and his attorneys had communicated about the demand. The court also pointed out that this behavior was not uncommon for this particular plaintiff, who had served as a plaintiff for the law firm involved here on seven other occasions. Ultimately, the court ruled that a stockholder lacking a proper purpose is not entitled to inspect books and records.
This case demonstrates the court’s hesitation to let attorney-driven suits drive records requests, and sheds light on what the court deems a proper purpose for a demand.
CSG’s M&A team advises clients on a variety of transactions, such as complex mergers, sales, joint ventures, acquisitions and recapitalizations, including leveraged buyouts and spin-offs. Supported by our colleagues in various practice areas throughout the firm – including tax, labor and employment, intellectual property, real estate, environmental and regulatory – we provide practical, strategic advice at every stage of the transaction.
Delaware Court of Chancery Finds Lack of Jurisdiction Because of Arbitration Clause
In a recent opinion, the Delaware Court of Chancery determined it lacked jurisdiction to consider a dispute over a term sheet, where the term sheet expressly referred all disputes to a specific individual who, pursuant to the term sheet, “shall have the sole authority and exclusive jurisdiction to resolve any such disputes.”
The specific individual, in this case, was unable to decide the issues in dispute because of a conflict in the matter. Thus he proposed a successor arbitrator to hear the dispute.
Here, the court found that the dispute resolution clause “constitutes an agreement to arbitrate,” even though the word “arbitration” is not used. According to the court, “[a] clause is sufficient if it provides for a final and binding remedy by a neutral third party.” The court’s finding was not altered by the fact that any settlement in this case will require court approval. The court also deemed the selection of an alternative arbitrator to be a “procedural” question to be left to the arbitrator, and even if the initial arbitrator could not select a successor arbitrator, the court determined that the court’s role would be limited to appointing the successor.
This case highlights the broad deference given by the Court of Chancery to arbitration clauses and also demonstrates the importance for parties to not only consider the implications of including such clauses in any agreement, but also to carefully consider both the person selected as the arbitrator and whether to specifically address successor arbitrators.
Delaware Supreme Court Reverses Chancery Court in Appraisal Proceeding of Shares of Target Company
The Delaware Supreme Court recently held, in DFC Global Corporation v. Muirfield Value Partners, L.P., et. al., that a private equity buyer of stock in connection with its acquisition of payday lender, DFC Global Corporation, paid “fair value” for its shares, reversing the Chancery Court’s decision and contrary findings. In its decision, the Supreme Court reiterated the statutory principles of appraisal rights under Section 262(h) of the Delaware General Corporation Law (the “DGCL”), which gives the Chancery Court, in the first instance, the discretion to “determine the fair value of the shares” in an appraisal proceeding by taking into account “all relevant factors”. However, in an important distinction, the Supreme Court held that, following a robust sale process, “economic principles suggest that the best evidence of fair value was the deal price,” and rejected the Chancery Court’s determination that the deal value was unreliable due to regulatory uncertainty affecting DFC Global and the fact that the prevailing private equity firm buyer was a financial buyer, not a strategic one. The Supreme Court’s ruling reflects that in an appraisal proceeding the deal price in an arms-length transaction will be accorded significant weight regardless of whether the target corporation is acquired by a strategic corporate buyer or a private equity buyer.
DFC Global provides consumer financial services, primarily payday loans, to its customers. In 2014, DFC Global was taken private by a private equity sponsor. In connection with that transaction, certain former DFC Global stockholders exercised appraisal rights under Section 262 of the DGCL and asked the Chancery Court to determine the “fair value” of their shares as required under Section 262 of the DGCL.
In its July 2016 decision, the Chancery Court considered the relevance of the $9.50 per share deal price paid in the transaction in assessing the fair value of the DFC shares. Recognizing that “[t]he merger price in an arm’s-length transaction that was subjected to a robust market check is a strong indication of fair value,” the Chancery Court observed that DFC was purchased by a third-party buyer in an arm’s-length transaction and that the sale process had lasted approximately two years and involved dozens of financial sponsors as well as several potential strategic buyers. Notwithstanding this “robust” market check, the Chancery Court concluded that the deal price should not be given more than one-third weight in calculating fair value. In particular, the Chancery Court discounted the reliability of the deal price as an indicator of fair value for two reasons. First, DFC Global’s performance appeared to be in a trough, “with future performance depending on the outcome of regulatory decision making.” Second, the Chancery Court concluded that the buyer’s status as a financial sponsor, “focused its attention on achieving a certain internal rate of return and on reaching a deal within its financing constraints, rather than on DFC Global’s fair value.” The Chancery Court ultimately gave equal weight to each of a discounted cash flow valuation, a multiples-based valuation and the deal price and concluded that the fair value of DFC Global was $10.21 per share, an approximately 7.5% increase in the deal price paid to former stockholders of DFC Global.
On appeal, DFC Global argued, among other things, that the Delaware Supreme Court should reverse the Chancery Court and establish a presumption that the deal price is the best evidence of fair value when the transaction giving rise to appraisal rights results from an open market check and when certain other conditions prevail. DFC further argued that the reasons given by the Chancery Court for not giving full weight to the deal price – that DFC faced increasing regulatory constraints that could not be priced by equity market participants and the fact that the prevailing buyer was a private equity rather than a strategic buyer – were not supported by the evidentiary record.
As an initial matter, the Supreme Court declined to adopt a judicial presumption that the deal price in arms-length transactions is the best evidence of fair value. First, the Court noted that the statutory language of Section 262 required the Court to “take into account all relevant factors” in assessing fair value. Accordingly, the Supreme Court found that the statutory language of Section 262 does not invite the imposition of a presumption and that “[i]f the General Assembly determines that a presumption of the kind sought is in order, it has proven its attentiveness to our appraisal statute and is free to create one itself.” The Supreme Court further observed that there was little need to adopt such a presumption “given the proven record of our Court of Chancery in exercising discretion to give the deal price predominant, and indeed exclusive weight, when it determines, based on the precise facts before it that led to the transaction, that the deal price is the most reliable evidence of fair value.”
Although the Supreme Court declined to adopt the presumption that the deal price is the best evidence of fair value, it reversed and remanded the Chancery Court’s decision observing that there are circumstances where “real world transaction prices can be the most probative evidence of fair value even through appraisal’s particular lens.” The Supreme Court noted that DFC Global’s stock price had often moved as a result of potential regulation of the payday lending industry and that the Chancery Court did not cite any basis to conclude that market participants failed to account for regulatory risk in their assessments of DFC Global’s value. Accordingly, the Supreme Court concluded that the Chancery Court erred in finding that the deal price failed to adequately account for regulatory risk in DFC’s pricing. Critically, the Supreme Court also rejected the Chancery Court’s decision not to give dispositive weight to the deal price because the prevailing bidder was a financial buyer. In the Supreme Court’s view, all rational purchasers, both strategic and financial, should have a targeted rate of return that justifies the risks associated with acquiring a business. According to the Supreme Court, “[t]he ‘private equity carve out’ that the Court of Chancery seemed to recognize, in which the deal price resulting in a transaction won by a private equity buyer is not a reliable indication of fair value, is not one grounded in economic literature or this record.” The Supreme Court concluded that the evidentiary record could not sustain “the Chancellor’s decision to give only one-third weight to the deal price” and remanded the case, instructing the Chancellor to reassess the weight afforded to various factors potentially relevant to fair value.
The Supreme Court’s decision confirms the importance of deal price as an indicator of fair value in appraisal proceedings, especially in connection with transactions resulting from a robust sale process. In addition, targets in highly regulated industries should not be subject to increased appraisal risk, as regulatory uncertainty will generally not limit the significance of deal price in determining fair value. Finally, private equity buyers should not be targeted for appraisal challenges, as the deal prices in such transactions will generally be accorded the same weight as transactions involving strategic buyers.
U.S. Third Circuit Rules on Liability for Disclosure of Hypothetical Risk
The U.S. Third Circuit Court recently affirmed a ruling by a Pennsylvania District Court that a public company’s disclosure of a risk as hypothetical was not misleading under federal securities laws even though the circumstances underlying the risk already existed at the time. The decision highlights the Court’s views on how securities disclosure cases should be decided in the Third Circuit.
In Williams et al v. Globus Medical, Inc., et al., No. 16-3607, 2017 WL 3611996 (3rd Cir. August 23, 2017), the shareholders of Globus Medical, Inc., a publicly traded medical device company, brought suit against Globus for failure to disclosure the company’s decision to terminate one of its distributors in the spring of 2014. Globus relied on both in-house sales representatives and independent distributors, and embarked on a strategy to increase its reliance on in-house sales representatives. At that time, Globus’ contract with one of its significant distributors was set to expire at the end of 2013, and Globus extended the existing distributorship agreement through April 2014 and allegedly told the dealer that they would use the extension period to negotiate a new contract while actually using that time to develop its own in-house sales force to cover that sales territory. During that extension period, Globus management projected sales and earnings for 2014 during earnings conference calls and filed its 2013 Form 10-K annual report with the SEC in March 2014. In the risks section of its 10-K, Globus acknowledged that some of its independent distributors accounted for a significant portion of its sales and cautioned that losses of its direct sales representatives or independent distributors could adversely affect the company’s sales revenue.
In April 2014, Globus informed the independent distributor that it had designated a new in-house sales representative to cover that territory and terminated the distributorship agreement. Shortly thereafter, Globus filed its Form 10-Q Quarterly Report with the SEC (for the period ending March 31, 2014), and stated that there had been no significant changes to the information about market risk disclosed in the 2013 Form 10-K. In August 2014, Globus announced its results for the second fiscal quarter of 2014 and lowered its revenue projections due, in part, to its decision not to renew its contract with a significant U.S. distributor. Globus’ share price dropped significantly after the announcement, and shortly thereafter shareholders brought a class action against Globus. The suit alleged that Globus misled investors in violation of the Securities Exchange Act by failing to disclose its decision to terminate the distributor contract and issuing revenue projections that failed to account for it while warning investors at the same time that such an event could adversely affect sales. The trial court dismissed the shareholders’ suit on the basis that the risk being disclosed by the company was the possible adverse effects on sales, which had yet not materialized at that time.
The Third Circuit affirmed the decision, recognizing that while a public company does not have an independent obligation to address every potential issue, once it has determined to address and disclose a particular issue it cannot omit material facts related to that issue so as to make its disclosure misleading. The Court further acknowledged that a company may be liable under Section 10(b) of the Securities Exchange Act and Rule 10b-5 for misleading investors by describing a risk as hypothetical when it had already come to fruition. However, the Third Circuit also agreed with the District Court that in this case the risk the company was actually warning its investors of was the risk of adverse effects on sales, and not losing independent distributors generally. As such, the Court stated, the company’s obligation to disclose arises only when the risk at issue materializes. In other words, although the event ultimately resulting in the adverse sales (terminating the distributor) existed at the time of disclosure, the Court ruled that the risk did not materialize until sales were actually affected and decreased (at which time the company did in fact disclose the sales decreases and the reasons behind them).
In rendering its decision, the Court relied, in part, on the heightened pleading standards imposed by the Public Securities Litigation Reform Act, and the fact that plaintiffs did not allege Globus was already experiencing an adverse financial impact at the time the company disclosed the potential risks in its SEC filings. In addition, the Court noted that plaintiffs did not sufficiently show that a drop in sales is an inevitable result of losing a large distributor and, in fact, by the end of the fiscal year, Globus ultimately came very close to its initial sales revenue projections and actually exceeded its earning per share projections.