Fraud. It’s something that we hope to never come across in a transaction, but the unfortunate reality is that it occurs from time to time and those involved in corporate transactions would be well-served to have at least a basic understanding of how it will be treated by courts.
A recent case – Teva Pharmaceuticals v. Fernando Espinosa Abdala, et. al. (Index No. 655112/2016, (July 31, 2017 N.Y. Sup. Ct.)) – provides some valuable insights in this area. In this case, Teva Pharmaceuticals (“Teva”) acquired a pharmaceutical company (the “Target”) and related intellectual property from two brothers for $2.3 billion, and after the transaction closed, Teva brought a fraud claim against the brothers alleging that: (i) the Target was selling pharmaceutical drugs that had not been approved by the Mexican government and (ii) the brothers had concealed this from Teva.
One of the key issues in this case was whether Teva could use evidence from the due diligence phase of the transaction to support their fraud claim. The sellers argued that this evidence was barred because the purchase agreement contained a non-reliance provision, wherein Teva agreed that it was relying solely on the representations and warranties in the purchase agreement and not on “any materials made available to [Teva], during the course of its Due Diligence Investigation.”
Ultimately, the court sided with the sellers and enforced the non-reliance provision. For some, this may be a surprising result because the alleged fraud goes directly to the very heart of the transaction. A seemingly fundamental expectation of acquiring a pharmaceutical company would be that it is selling its pharmaceutical drugs legally. Moreover, Teva paid a substantial amount for the Target – $2.3 billion. However, the court reasoned that the non-reliance provision in the contract was “specific” and thus, reflected the intent of the parties to be bound by it. It also pointed to the fact that Teva “is a sophisticated entity and performed extensive diligence.”
This case contains a number of valuable lessons and reminders for those involved in corporate transactions – namely:
· To not gloss over non-reliance provisions, which are often viewed as part of the “boilerplate;”
· For sellers, to incorporate references to the diligence process in their non-reliance provisions; and
· For buyers, to undertake a thorough diligence process because as seen in the Teva case, the remedies for any issues that are not discovered in the diligence process may be limited.
Over time, public pension funds have become significantly underfunded. There are a lot of factors that explain this. Some are poor planning by the pensions, such as decreasing investments after periods of strong returns; overly optimistic promises to pensioners; changes in demographics; and stock market fluctuations. As a result, pension funds are now $2 trillion underfunded.
Additionally, typical pension investments, such as safer, low-interest bearing investments, are not providing the returns for pension funds to address their unfunded liabilities. So pension funds are under pressure to provide stronger returns from other asset classes, including private equity.
But investing in PE comes with some downsides. For one, management fees are higher than with other asset classes, which digs into the profitability of the funds. Over the past decade, fees have increased by 30%. There are also ongoing monitoring and strategic costs related to PE investments that are greater than other asset allocations.
These high investment costs have not led to great returns. For example, one study showed that New York City’s biggest pensions would have done better had they invested in a stock index fund rather than PE.
So what are pension funds doing about this?
For starters, many are questioning their PE investments, and asking for justification for the high fees. Pension funds are pressing funds to provide more transparency of their fees and are looking most closely at their most expensive funds.
Some pension funds are also making private equity investments directly, rather than through a separate PE fund. Pensions are looking at co-investment opportunities, which allows for direct investment and often without management fees or with lower overall fees.
Pension funds are decreasing their allocations in private equity as compared with other asset classes. One article notes that pensions have reduced by one-half their allocations in PE in 2017. Pensions are also decreasing the number of funds that they invest in. The New York City pension fund invests in over 200 funds, which is a huge amount. They intend to decrease that to 60 funds.
Pensions like the Illinois State Board of Investment are looking to index funds rather than PE and hedge fund managers. They feel that investment returns are the same over the long term, at a fraction of the cost. And they don’t need to monitor the performance of individual investment managers.
Most notable for PE funds, in some cases, pensions are trying to bring as much work in-house as possible. This may be impractical for most funds, given the cost and difficulty to obtain the talent needed to carry out complex investment strategies. Pensions are trying to reduce their reliance on pension consultant firms, which larger pensions pay tens of millions of dollars per year, and are hiring their own consultants at lower rates than what they pay outside firms. Particularly large funds have also considered buying a PE firm or creating a separate entity that would make its own investments.
As a result of recent challenges and competition among PE fund managers, commentators have opined that pension funds will likely continue to seek more favorable fees and reevaluate their PE investments. This may mean that PE funds will face more difficulty raising capital, and will have less cash to carry out investments. However, despite these changes, commentators think it is unlikely that public pension plans will exit private funds as an asset class in the near future, given the ability of PE to historically outpace returns of other investment classes and the need to cure unfunded liabilities.
There have been two recent changes to cybersecurity laws in the European Union, specifically relating to the use of personal data of E.U. residents, which are further summarized below. M&A professionals will need to keep these two laws in mind when (a) a target company uses the personal data of E.U. residents in its ordinary course of business or (b) a U.S. acquirer needs to access the personal data of E.U. residents during the due diligence process.
First, the Privacy Shield Data Transfer Pact (the “Privacy Shield”) was approved by the E.U. member states on July 12, 2016 and sets forth how companies established or using equipment in the E.U. can share the personal data of E.U. residents with U.S. companies. The Privacy Shield replaces the invalidated Safe Harbor program that was previously relied on by both U.S. and E.U. based companies to legally transfer the personal data of E.U. residents from the E.U. to the U.S. In addition to imposing stronger obligation on U.S. companies to protect the personal data of Europeans and mandating tougher monitoring and enforcement by the U.S. Department of Commerce and the Federal Trade Commission, the Privacy Shield also includes written assurances from the U.S. that any access to the data by law enforcement will be subject to clear limitations to prevent surveillance of European citizens’ data. For more detail on the specific requirements of the Privacy Shield, please see this NP Privacy Partner Blog Post.
One of the ways a U.S. company can be in compliance with the Privacy Shield is to complete a self-certification, which includes name and contact details of the recipient of the personal data, a description of the activities that will be completed with respect to the personal data received from the E.U., and a description of how the U.S. company is in compliance with the Privacy Shield. The U.S. Department of Commerce and the Federal Trade Commission have expressed their commitment to enforce the Privacy Shield and violations of the Privacy Shield can result in penalties of up to $40,000 per violation or $40,000 per day for continuing violations. More information on the enforcement of the Privacy Shield can be found at this website.
Second, the General Data Protection Regulation (the “GDPR”) is the next iteration of E.U. data protection laws and will be effective on May 25, 2018. The GDPR applies to all companies based in the E.U. as well as any foreign companies processing the personal data of E.U. residents. The GDPR is intended to strengthen and unify data protection for all individuals within the E.U. and requires companies to completely transform the way that they collect, process, securely store, share and securely wipe personal data. The changes that GDPR will implement include requirements for companies to appoint a data protection officer responsible for implementing and monitoring compliance with GDPR. In addition, companies will be required to implement privacy by design meaning that they must take a proactive approach to ensure that an appropriate standard of data protection is the default position taken when personal data is being processed. GDPR also includes a clear focus on data subjects’ consent to processing and accessing data, as well as requiring a data breach notification obligation to notify the E.U. protection authority of a breach without undue delay and, where feasible, within 72 hours. Companies must also notify the individuals where there is a high risk to the individuals concerned.
In the event GDPR is violated, then the penalties can be significant: for breaches, including security and data breach notification obligations, the penalties can be up to €10,000,000 or 2% of worldwide revenue, whichever is higher; and for more significant breaches, including consent violations and transfer restriction violations, the penalties can be up to €20,000,000 or 4% of worldwide revenue, whichever is higher.
Given the potential penalties for violations of both the Privacy Shield and the GDPR, M&A professionals will want to include in their due diligence of a target company an analysis as to whether the target company is in compliance with both laws. If the due diligence results conclude that the target company is not currently in compliance with the Privacy Shield, or that the target is not in compliance with the GDPR when it takes effect in May 2018, then these issues may require some changes to the purchase agreement, including the exclusion of certain non-compliance liabilities from the transaction, the addition of certain specific indemnities relating to such non-compliance issues, the inclusion of a covenant enabling for ongoing safeguards of sensitive information by the target company in between signing and closing, or the addition of a new closing condition requiring the target company to take steps to address non-compliance issues or the implementation of missing IT safeguards.
Carried interest is the contractual right received by a private equity or hedge fund manager representing their share of profits or gains from the fund’s investments, which amount is unrelated to any capital invested by the manager. When properly structured, carried interest is taxed at the lower long term capital gains tax rate of 20% (plus 3.8% investment income tax or “NIIT”) instead of the higher ordinary income tax rate of 39.6% (assuming such manager is taxed in the highest federal income tax bracket, plus 3.8% investment income tax or “NIIT”). President Donald Trump vowed on the campaign trail to eliminate what he characterized as the “carried interest loophole” by changing tax laws so that carried interest would be taxed at the ordinary income tax rate; however, the Trump administration has not given any indication as to how they want to deal with this change through legislation and private equity groups and lobbyists have not been shy about continuing to lobby against any such tax change making it into a final law.
On March 27, 2017, the Wall Street Journal reported that Treasury Secretary Steven Mnuchin signaled that the Trump administration wanted hedge funds taxed more heavily, but was still deciding whether or not higher taxes on carried interest could hurt private equity’s ability to drive jobs and economic growth because higher taxes could disincentive investments by pensions, state funds and other investors into infrastructure, real estate and energy. This was an early signal that the Trump administration may have been considering handling the taxation of carried interest differently between hedge fund managers and private equity managers.
In addition on April 26, 2017, the Trump administration released its outline of a tax plan, which was silent on the treatment of any changes to the taxation of carried interest. According to a New York Times article, several tax experts and lawyers have stated that by not mentioning the matter at all, the Trump administration could be signaling that the tax proposal would effectively eliminate the unique taxation of carried interest. However, this does not mean that carried interest necessarily would be taxed at a higher rate because the outline of the tax plan stated that certain “small” pass-through entities, which could include the management entities used by private equity firms and hedge funds, would be subject to a 15% tax rate, which tax rate is lower than the long-term capital gains tax rate of 20%.
However on April 30, 2017, White House Chief of Staff, Reince Priebus, reiterated in an interview that carried interest could be on the chopping block and warned against analysts taking the view that fund managers would continue to benefit from the loophole. Mr. Priebus reiterated President Trump’s campaign message that he wants to get rid of the loophole. It remains to be seen how the Trump administration’s final tax plan will look as well as how lawmakers will change such proposed tax plan prior to some, all or none of it being enacted into law.
In the event that the taxation relating to carried interest is increased to the ordinary income tax rate, fund managers could find their carried interest taxed as high as 43.4% (current rates) or as low as 25% if Trump follows through and slashes ordinary income tax rates and repeals the so-called Obama Care tax (3.8% NIIT).
As a matter of course, a seller of a business includes a provision in a sale agreement to limit its liability to breaches of specific representations and warranties included in the sale agreement and not for representations made outside of the contract such as management presentations, data room disclosures and projections. The seller’s goal is to eliminate all such extra contractual claims including fraud claims. The buyer, on the other hand, will generally push back that if a seller commits fraud (i.e. intentionally misleads or omits to disclose a material fact) in extra contractual communications, most likely found in projections, the seller should not be able to avoid liability. But how does each accomplish its goals?
Of recent date, the Delaware courts have given guidance on this matter. See IAC Search, LLC v. Conversant LLC; C.A. No. 11774–CB Submitted: September 20, 2016. Decided: November 30, 2016; Anvil Holding Corporation v. Iron Acquisition Company, Inc., C.A. Nos. 7975–VCP, N12C–11–053–DFP [CCLD]. Submitted: April 22, 2013. Decided: May 17, 2013; and TransDigm Inc. v. Alcoa Global Fasteners, Inc., C.A. No. 7135–VCP. Submitted: Feb. 1, 2013. Decided: May 29, 2013.
A seller looking to bar claims based on extra-contractual statements, including fraud claims, should include an affirmative, comprehensive buyer acknowledgement clause with a clear statement that the buyer did not rely on any extra-contractual information, and that no other representations or warranties were made, including with respect to virtual data rooms, due diligence materials, management presentations, etc., unless such information is expressly included in a representation and warranty in the sale agreement. A seller should also include a standard integration clause to compliment the buyer acknowledgement clause to properly limit the documents that constitute the parties’ agreement. A buyer must be diligent when negotiating a buyer acknowledgement clause and should confirm the scope of the acknowledgement to prevent the seller from overreaching. Moreover, a buyer should ask for a specific fraud carve out to preserve its right to claims for fraud based on extra-contractual statements and representations.
A buyer and seller each have compelling arguments for their respective positions and the outcome is found in the art of persuasion and negotiation of the sale agreement terms.
President Trump recently issued an Executive Order called “Buy American and Hire American,” requiring certain federal agency heads to suggest reforms to the H-1B visa program including how - and to whom - these visas are awarded. (Additional coverage of this development is available here).
H-1B visas are offered to foreign workers who are coming to the United States temporarily to perform services in a “specialty occupation,” and typically require the applicants to have highly specific knowledge and a specialized degree. The White House has asserted that the H-1B program is harmful to Americans because companies routinely pay H-1B workers below-market rates, which makes it more likely that these visa holders will replace similarly qualified American workers.
Reaction to this Executive Order from the business community – and particularly the tech industry – has been cautious. The tech industry, which is the most reliant on the H-1B program, has contended that this order will impede their ability to attract and retain top talent. The industry has asserted that a visa program that favors higher-paid workers will give larger, more established companies an advantage. Silicon Valley leaders have pointed to the large number of employees that are foreign born, arguing that immigration is an economic benefit, not a burden. The industry has also asserted that the H-1B program is essential to their ability to keep foreign high-tech students with unique qualifications in the US after getting their degrees, and that there is a shortage of qualified Americans for these jobs.
Specific implications from this Executive Order remain to be seen, but it is fair to say that those companies that have traditionally benefited from the H-1B program will be paying close attention to the reforms recommended by federal agencies.
Following discussions with a number of boutique investment banks, there appears to be a trend that some engagements relating to sell-side deals at such investment banks are being slowed down or temporarily put on hold as the targets await the outcome of proposed tax law and regulatory changes that have been promised by the Trump administration, which include cutting business regulations, reducing the corporate income tax rate and implementing an import tax or tariff.
The overall economic environment is healthy and macroeconomic indicators are pointing in a positive direction (http://www.focus-economics.com/countries/united-states). This positive information bodes well for the overall M&A environment and most market participants believe this year we will see continued growth in M&A activity in the current economic expansion. That being said, it appears that private company owners are being cautious about entering into a possible sale of their respective companies as they believe the regulatory and tax changes will have positive value indications for their businesses and for their own personal finances (i.e., as an outcome of liquidity events).
The outlook for M&A this year still suggests that parties are interested in pursuing M&A activities this year, but that sellers are adopting a wait and see approach for now, hoping that the promised regulatory and tax changes proposed by the Trump administration will have a near-term effect on the outcomes, including, from a regulatory perspective, potential impacts would be priced into the target’s value on a forward-looking basis. This outlook, however is somewhat disconnected from what we are seeing in the public markets, where the anticipated tax changes appear to have been priced into some equity values, as public equities overall have seen a significant run-up post-election, assuming that the Trump administration will have a positive effect on business performance in the future.
On February 2, 2017, Nixon Peabody LLP hosted a Hot Topics in the Middle Market event entitled “2017 Private Equity and M&A Outlook – Trends & Opportunities” at the Casa Del Mar Hotel in Santa Monica. Los Angeles partners Marc Kenny and Matt Grazier (Private Equity & Investment Funds) moderated a lively discussion featuring the following speakers:
· Nino Cordoves, MidCap Financial Services, LLC
· Paul Kacik, Opus Financial Partners
· Vince Lawler, Bernstein Global Wealth Management
· Bill Lemos, Aon Risk Services
· Brad Meadow, SPK Capital, Pardis Nasseri
· Palm Tree Advisors, Craig Wickwire RSM US LLP
· Matt Young, CriticalPoint Partners.
Here are some of the key takeaways from the discussion:
· Deal Environment. In general, 2016 remained a “sellers’ market” with various buyers competing for fewer quality assets and such buyers paying top dollar in the process. Panelists noted that the number of funds competing in the lower middle market have increased over the past few years leading to an increase of potential buyers competing for the same assets. The panel agreed that strategic buyers continue to perform well in this competitive market and were often willing to pay higher multiples relative to private equity buyers.
· Valuations. The general consensus amongst the panelists was that throughout 2016 valuations remained high and that high valuations were likely to continue into 2017. Some panelists, however, thought there was some softening in selective areas, such as retail, especially for retail companies without a robust online presence.
· Trump Administration. The election of President Trump will undoubtedly bring a number of changes. The panelists generally agreed that potential tax changes could have a significant effect on when owners decide to sell. However, the panelists but were uncertain on how the election of President Trump will affect deal flow with so many factors at play. The consensus feeling was that of uncertainty regarding tax changes, trade policy and tariffs and the effect on supply chains, so investors need to get comfortable with being uncomfortable.
· 2017 Forecast. The panelist generally agreed that the M&A environment will continue to remain strong in 2017 and that corporate strategics will remain active on the buy-side. There was some disagreement amongst the panelists as to whether funds that specialize in certain industries would have an advantage in securing quality deals over generalist funds in 2017. A couple of panelist also noted that fundless sponsors are gaining traction and continue to be players in the market. Some panelist are bullish on certain verticals for 2017, such as aerospace, defense and healthcare management.
Yesterday, the U.S. Supreme Court issued the long-awaited decision in United States v. Salman (No. 15-628, December 6, 2016), partially rejecting a limited aspect of the Second Circuit’s landmark ruling in United States v. Newman regarding the "personal benefit" necessary to sustain an insider trading claim. Addressing the narrow question presented in Salman, the unanimous Supreme Court affirmed an insider trading conviction based on a family relationship between the tipper and tippee of inside information, overturning the Second Circuit Court of Appeals to the extent that Newman required that a tipper receive a tangible monetary benefit in exchange for a tip to a family member.
However, the Court emphasized that the question of the sufficiency of personal benefit to a tipper is entirely dependent on the particular facts involved; a tip between two very close brothers was not a difficult question, but the decision leaves open the broader issue of defining the personal benefit required where there is no family relationship. In addition, Salman also does not specifically take on the requirement established by the Second Circuit in Newman that the downstream tippee must know that the original tipper received a personal benefit.
So, while Salman makes clear that a close family relationship is sufficient to infer the necessary "personal benefit" to the tipper, what constitutes a personal benefit in more attenuated or professional relationships remains an open question likely to be sorted out by the lower courts.
As the PE industry well knows, SEC regulators are aggressively prosecuting all violations as potential enforcement cases, no matter whether they come to the agency’s attention through its own investigations or self-reporting by PE managers. Given that self-reporting will almost certainly result in an investigation and enforcement action, PE managers are thinking twice before voluntarily disclosing misconduct or violations to the SEC.
Of course, in the event a PE firm discovers misconduct or violations, they must take every step to stop the conduct, remediate the damage, and take all necessary actions to resolve the issues. Whether to self-report the issues, however, is a different question that involves measuring inchoate benefits against real and significant risks.
In the past, it was an easier decision for PE firms to self-report because a firm would simply inform the SEC of the matter, and that would be the end of it. There was very little risk associated with self-reporting.
In comparison, now, the risk-reward analysis in deciding whether to self-report is skewed in the direction of not self-reporting. Given the highly sophisticated and aggressive SEC staff, particularly in the Asset Management Unit, self-reporting has a very high risk of investigation and an enforcement action.
From a PE manager’s perspective, there is little benefit to counteract this risk. The SEC urges firms to self-report by offering the potential for reduced penalties or, less tangibly, a more benign recitation of the misconduct in an order, or an acknowledgment of the firm’s cooperation, or an “administrative summary” instead of a press release. But, to PE Managers, the reduced penalty is not meaningful when compared to the value of avoiding an enforcement action and the more benign public reporting is not helpful when the firm’s reputation will be damaged nonetheless by the press inevitably reporting on the action.
Furthermore, PE managers have no obligation to self-report, as self-reporting is generally not required. Rather, managers act in good faith by internally handling the matter and moving on.
The result is that more PE managers are deciding to forego self-reporting, preferring instead to handle the matter quietly and hoping that it does not come to the SEC’s attention.
It is the industry’s best interest to reassess this dynamic. In the current circumstances, the SEC is deprived of critical information that could concern a widespread issue. Closing this information gap would enable the SEC to better protect investors.
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