From time to time, a private equity firm or other financial sponsor (directly or through a fund that it manages) may find itself owning a significant stake, perhaps even a controlling stake, in a publicly traded company. For instance, the sponsor might have bought shares of the company in the open market, invested privately in a “PIPE” transaction, or simply retained shares in a portfolio company that it has taken public.
A sponsor that wishes to acquire the outstanding public float of a company in which it already owns a meaningful stake is said to engage in a “going private” transaction. A U.S. going private transaction is accomplished through a one-step merger or a tender offer followed by a back-end merger, just like any other public deal. However, two bodies of law—the U.S. federal securities laws and state fiduciary duty law—create additional layers of process, disclosure and timing challenges. A sponsor engaging in a going private transaction should carefully consider its tactics and approach, weigh the risk of premature disclosure, prepare for the likelihood of a drawn-out process and steel itself against probable litigation. If the sponsor is a controlling stockholder, the going private process presents additional challenges.
In most cases, a financial sponsor that holds more than 5% of the shares of a public company will have already filed a Schedule 13D describing any “plans or proposals [the firm] may have which relate to or would result in . . . an extraordinary corporate transaction, such as a merger . . . .” Any material changes to the disclosure in the Schedule 13D require the “prompt” filing of an amendment.
When must a sponsor amend its Schedule 13D disclosure to tell the world of its plans to take the target private? Ideally, not until the parties are ready to announce the deal. Premature disclosure may put the target “in play” or cause the stock price to rise, putting pressure on the deal negotiations.
The general practice has been to include generic disclosure in the Schedule 13D, indicating that the sponsor may in the future consider a going private transaction. Then, when the sponsor actually makes a proposal to the target, it would amend its disclosure to provide more detail about the sponsor’s plan. Steps taken prior to the formal submission of an offer typically did not trigger an amendment. Some buyers have taken the position that they have not formulated a plan or proposal until they have become comfortable with diligence and are prepared to enter into definitive agreements—until then, they are simply exploring the possibility of taking the target private.
The SEC may be less likely these days to accept this latter position. In March 2015, the SEC announced three settlements in which various insiders, including a major stockholder, were charged with 13D violations, became subject to cease and desist orders, and agreed to pay civil penalties to the SEC. The steps taken by those shareholders that the SEC viewed as indications that they planned to effect going-private transactions (and thus should have promptly amended their 13Ds) included:
- informing target company management of their intention to take the company private;
- forming a consortium of shareholders to participate in the going private;
- determining the structure of the transaction to take the company private; and
- obtaining waivers from preferred shareholders to facilitate the going private.
The SEC’s position in these cases seems to be not only that buyers may have formulated plans that require a 13D amendment before any proposal is made to the target, but also that a shareholder that has taken significant steps toward effecting a going private has an obligation to amend its 13D even before it has formulated a going private plan, let alone made a formal proposal to a target. There is no bright line test. Sponsors should carefully consider with counsel the implications of (1) discussing potential terms with financing sources, bankers or consortium partners, (2) undertaking feasibility studies and (3) other steps taken in advance of a formal offer. Sponsors must be sensitive to the 13D rules and the SEC’s views on disclosure, and should recognize before embarking on a going private transaction that they may be required to disclose their plans before any transaction is actually announced.
Some sponsors who are truly passive investors or who acquired their shares prior to the initial public offering (“IPO”) of the company may have filed the simpler Schedule 13G in lieu of a Schedule 13D. Nevertheless, except in the case of a Schedule 13G filed upon an IPO, the same facts and circumstances that would trigger the filing of an amendment to a Schedule 13D would also cause the Schedule 13G filer to convert its Schedule 13G to a Schedule 13D, creating the same premature disclosure issue. The sponsor who acquired shares before an IPO has an advantage in that it will not need to convert or promptly amend its 13G to reflect the formulation of a going private plan.
Even a sponsor who is not a current 13D or 13G filer with respect to the target company should be mindful of these considerations, as taking significant steps with an existing 13D filer of a company could trigger the same premature disclosure concerns on the part of that shareholder, if, for instance, it is a member of management holding a 5% or more stake or a large shareholder.
Standard of Care
The law of the state in which the target company is organized governs the standard of fiduciary care to which the board or a controlling stockholder will be held. In Delaware, as in most states, courts will generally defer to the business judgment of directors, and there is a (rebuttable) presumption that directors acted in good faith and in the best interests of the corporation. In the context of a change of control, including a going private transaction, instead of the business judgment rule, Delaware courts will apply the higher Revlon standard, which requires that directors seek the best price reasonably available for the company. A court applying the Revlon standard will examine the reasonableness of the directors’ conduct, an inquiry that necessarily involves a certain amount of discovery and, thus, means that litigation will survive a motion to dismiss.
If the sponsor controls the target, a very high standard called entire fairness will apply, on the theory that in these sorts of transactions the minority stockholders require special protection. The “entire fairness” standard permits a court to examine both the fairness of the price and of the process. Delaware courts have, however, recently decided that even in these circumstances the business judgment rule can apply, provided that:
- the transaction is negotiated by an independent and disinterested special committee of the board, authorized to retain its own advisors, negotiate and reject or recommend a deal; and
- the transaction is conditioned on a non-waivable condition that it be approved by a majority of the minority stockholders or, in the case of a tender offer, that a majority of the minority stockholders tender into the offer (the so-called "MOM" condition).
To be effective, these conditions should be included in the buyer’s initial going private proposal. They should not be first discussed midway through negotiations or traded out during a price negotiation. A sponsor that controls a Delaware target should be thoughtful about its initial approaches to the portfolio company’s board, as it is easy to omit or misstate these critical conditions at the outset, providing disgruntled stockholders and others a basis for complaining that the transaction was not entirely fair. A controlling sponsor should also avoid involvement in the establishment of the special committee and the selection of its advisors. Finally, if a sponsor is a buyer only (and clearly not a seller), it should make this position clear in its initial overture to the target company board.
For these purposes, a “controlling” stockholder either holds a majority of the target’s shares or actually controls the target, through some combination of equity ownership, participation on the board, and management or contractual governance rights. Sponsors are likely to have some of these non-equity influences on their portfolio companies, so it is always good to check with counsel to determine whether the sponsor should consider itself a controlling stockholder for these purposes.
Going private transactions may implicate the enhanced disclosure requirements under Rule 13e-3 of the federal securities laws. The rule applies when an “affiliate” of the issuer engages in an acquisition transaction that has a reasonable likelihood or purpose of taking the issuer private. An “affiliate” of the issuer includes a sponsor that controls the issuer, but control under the securities laws is based on a lower threshold than under Delaware law: a common rule of thumb is that a party that owns 10% of a company and has a seat on the board is presumed to control the company.
If Rule 13e-3 applies, the sponsor must file a Schedule 13E-3 together with the normal proxy statement or tender offer documents. Preparing the disclosure can be somewhat time-consuming, but is generally not difficult to do. The most challenging task is to explain why the buyer believes that the transaction is fair to the minority stockholders. This somewhat counterintuitive disclosure requirement is often addressed by focusing on process rather than valuation.
In addition, a copy of every report, opinion or appraisal must be filed (typically without confidentiality protection) with the SEC as an exhibit to the Schedule 13E-3. The SEC takes an especially broad view of what this obligation encompasses and, for instance, often expects every board book, including preliminary decks, presentations and other materials relating to valuation—whether or not prepared specifically for the transaction—to be filed. It is possible that this could pick up materials (including projections) prepared by or for the sponsor. Sponsors should talk with counsel in advance about what they plan to prepare or have prepared.
Projections and Access to Management
A sponsor preparing for a going private should also be aware that any projections prepared in connection with the transaction may not only be disclosed but may also be examined for their conformity to past forecasting practices of the target company. In the Delaware litigation arising out of the Dole Food Company going private, the court was highly critical of the attempt by the controlling shareholder to change the manner in which updated forecasts were prepared for the special committee, which the court found resulted in misleading and artificially depressed projections.
A sponsor will often have enjoyed a close relationship with company management during the period of its investment. Indeed, such close relations and the “hands on” approach taken by sponsors is often cited as a hallmark of the added value that sponsors bring to their investments. What a sponsor may rightly view as conscientious monitoring of an investment during the ordinary course operations of a company can be characterized as preferential access in the context of a going private transaction. After the Dole decision, a sponsor should also expect that the special committee will seek to exert some measure of control over the sponsor’s access to management, not to prevent such access but rather to ensure that it occurs with the knowledge and participation of the special committee and its advisors.
Sponsors seeking to engage in going private transactions should steel themselves for a potentially frustrating timetable. The company’s special committee will take particular care to create a record demonstrating how hard it has negotiated on behalf of the unaffiliated stockholders and the tangible improvements in the transaction terms it has obtained. One negotiating technique is delay itself. Moreover, both the company’s and the special committee’s advisors often participate in the process, generating further holdups.
Moreover, the SEC intenselyscrutinizes transactions subject to Rule 13e-3 and often comments heavily on the disclosure, which can prolong the process, sometimes for several weeks. A sponsor should also realize that if it owns a significant equity stake in the target but concludes that it is nevertheless not an affiliate and that Rule 13e-3 does not apply, it is almost certain to get a comment from the SEC asking it to defend its position. This could result in back and forth that could take some time to resolve.
Finally, of course, there is litigation. The inherent conflicts perceived in going private transactions ensure that they are likely to attract shareholder litigation. Litigation takes time and can interfere with the closing schedule for the transaction.
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Going private transactions can be challenging, complicated and frustrating. But they are eminently doable. The trick is to understand the pitfalls and prepare for them in advance. Take nothing for granted; actions taken early on could well have consequences as the process unfolds and will always be viewed by courts and the SEC with the benefit of hindsight. Having experienced counsel on board from the beginning is the right call.