When it’s time to sell a company, there are many financial and legal steps a target should consider regarding a merger or acquisition. If the buyer is a U.S. public company, that list may grow. Below are some common issues that develop when a U.S. public company acquires a non-U.S. company: understanding these issues can help ensure a smoother acquisition process for both sides.
PURCHASE PRICE ADJUSTMENT VS. ‘LOCKED BOX’
For most U.S. acquisitions of privately held target companies, the purchase price agreed to at the signing is subject to a closing adjustment or a post-closing adjustment based on the closing date amount of certain financial accounts. This differs from the “locked box” approach more common in Europe.
The U.S. approach generally requires more time be spent on negotiating the complex accounting methodologies and accounts used to adjust the purchase price (e.g., which assets and liabilities should be applied to the adjustment and how will they be measured). Although the “locked box” approach is occasionally used in U.S. acquisitions, it remains a minority position.
FINANCIAL STATEMENT REQUIREMENTS: THE ‘SIGNIFICANCE TEST’
U.S. public companies must report certain items with the Securities and Exchange Commission (SEC), including, in some cases, historical financial statements and pro forma financial information for a target. Rule 3-05 of Regulation S-X requires the filing of separate pre-acquisition historical financial statements when a significant business acquisition takes place or is probable.
There are three tests to determine significance during the acquisition process:
An asset test compares the buyer’s share of the acquired business’s total assets to the buyer’s consolidated total assets;
An investment test compares total GAAP purchase price of the acquired business, as adjusted, to the buyer’s consolidated total assets; and
An investment test compares total GAAP purchase price of the acquired business, as adjusted, to the buyer’s consolidated total assets.
If the significance level of the acquired business under any of these tests exceeds 20 percent, some level of audited financial statements and financial reporting will be required by the target.
Generally, U.S. persons are prohibited from exporting goods, or facilitating the export of goods, to certain countries, including exports to sanctioned countries by non-U.S. subsidiaries if any resources or persons at the U.S. company were involved in facilitating such exports.
If a target has significant contacts or business with sanctioned countries, the buyer will likely seek to terminate those business relationships and/or seek indemnification for any compliance issues. Targets should also be aware of regulations requiring U.S. public companies to disclose transactions in parts of the world that may otherwise be permitted in the target’s non-U.S. jurisdiction and consider whether those relationships can be terminated.
ACCOUNTING AND CONTROLS
U.S. public companies are subject to rules adopted by the SEC in connection with the Sarbanes-Oxley Act of 2002. After closing, the target company will be subject to the buyer’s next audit and be part of the buyer’s test for adequacy of its disclosure controls and procedures.
Since the buyer’s executive officers will be responsible for the target company’s financial statements, public company buyers will be concerned with integrating operations and making sure the target is complying with the requirements of the Sarbanes-Oxley Act and the related rules.
Target companies with systems in place to comply with these controls and procedures may be more attractive to public company buyers. In all cases, U.S. public company targets should prepare for enhanced review of financial statements, internal controls and procedures and involvement by the buyer’s independent registered public accounting firm early in the process.
FOREIGN CORRUPT PRACTICES ACT
U.S. companies are subject to the Foreign Corrupt Practices Act (FCPA), which prohibits businesses from making unlawful payments to foreign officials in exchange for influence or favors.
In some instances, acquirers can be held liable for violations of the FCPA committed by the target company prior to an acquisition. After an acquisition closes, a U.S. buyer will want to ensure its newly acquired business will be in full compliance with the FCPA immediately following closing.
U.S. public companies are required to report their use of certain “conflict minerals” which include tantalum, tin, tungsten or gold sourced from the Democratic Republic of the Congo and surrounding countries. If a target uses any of these conflict minerals, it should be prepared to represent and warrant that the conflict minerals are sourced from somewhere other than the Democratic Republic of the Congo or surrounding countries, are certified conflict free, or originate from scrap or recycled sources.
REPRESENTATIONS AND WARRANTIES
When drafting and/or negotiating an acquisition agreement with a U.S. buyer, it’s best to remember key differences between U.S. and non-U.S. buyer expectations regarding the type and scope of the representations and warranties the target company is expected to make. Although some differences appear technical at first glance, they have potentially broad implications for the target company.
For example, sellers in both U.S. and European deals usually represent that the target’s financial statements “fairly present” the target’s financial situation. A key difference, however, is that over half of 2015 European deals that contained this representation qualified it by requiring that “fair representation” be in accordance with an applicable accounting standard (e.g., GAAP or IFRS). Only about 17 percent of U.S. deals in 2015, on the other hand, contained such a qualification. A nonqualified representation does not provide the seller the benefit of any limitations inherent to the applicable accounting standard, and thus may provide the buyer additional means to make a post-closing indemnification claim if the target is privately owned.
U.S. buyers are also far more likely to insist the target company make a “no undisclosed liabilities” representation versus their European counterparts. This is often considered to be a “catch-all” by sellers for the buyer, as the buyer could allege a breach of this representation even when the target company has not breached any of the other, more focused and specific, representations. Thus, the relative risk allocation for undisclosed and/or unknown liabilities is significantly shifted from the buyer to the seller. A seller should try to limit its risk under a “no undisclosed liabilities” representation with a “knowledge” qualifier (i.e., only those liabilities known to the seller) and/or a “GAAP balance sheet” qualifier (i.e., only those liabilities required to be disclosed on a balance sheet prepared in accordance with GAAP, or alternative standard).
Lastly, U.S. buyers are far less likely to accept a seller-friendly “anti-sandbagging” provision than buyers outside the United States. For example, 47 percent of 2015 European deals contained anti-sandbagging language, compared to only 9 percent of 2015 U.S. deals.
The process of qualifying representations by disclosures in the United States is often considered more buyer-friendly than in non-U.S. jurisdictions. It is common outside the United States for sellers to rely on “general disclosures.”
In the United States, however, buyers almost universally require sellers to make specific, rep-by-rep disclosures. A disclosure made in one section of the disclosure schedules will often only be deemed to qualify a different section if there is an explicit cross-reference therein. “General disclosures” are not an accepted practice in the United States, and non-U.S. sellers need to be aware of the extra time and effort likely required to prepare disclosure schedules that will be both acceptable to a U.S. buyer, and fully and properly disclose all relevant information to minimize the seller’s risk exposure.
U.S. DISCLOSURE LAWS AND CONFIDENTIALITY
When selling to a U.S. public company, a seller should be aware of various U.S. securities laws and requirements that impact the seller’s ability to discuss and disclose the transaction prior to a post-acquisition press release announcing the news. Generally, when a U.S. public company enters into a “material definitive agreement,” that company is required to disclose, within four days after entering into such an agreement, certain information concerning the agreement and related transaction.
U.S. public companies are restricted, however, by “Regulation FD,” which generally requires that when a public company discloses material nonpublic information to certain individuals or entities (e.g., stock analysts) the company must publicly disclose such information.
Because of these and similar regulations, the U.S. company will almost certainly require the seller to agree to various confidentiality agreements, restricting the seller from disclosing the transaction or related discussions until after the formal press release. This way, the buyer doesn’t face any issues with complying with its strict disclosure obligations.