The new rules of going private

?Financing, financing, financing, financing and financing,? is what Joshua Berick, a partner at law firm Linklaters in New York, says is key to any going private transaction, particularly as the credit markets have turned for the worse. A number of high-profile private equity deals have been put on hold while sponsors scramble to secure the financing needed for closing the deal. But the landscape for taking publicly listed companies private has also changed in other ways, as well.

Regulators who have viewed the surge in going private transactions have sought stricter protections for shareholders, particularly minority investors. They are watching like hawks for cases of management conflicts of interest. In both the US and the UK, regulators and shareholders are watching ? and influencing ? the way these deals are put together, from management incentives to comminication between parties and due diligence reports.

If private equity GPs run afoul of the rules below, they risk getting probed, sued or fined after attempting to take a company off the public markets.

In the US
In the US, sellers have been pushing for greater control through the ?go-shop? provision in legal documents, while regulators are scrutinizing deals in search of evidence that management conflicts of interest are under control. The latter are on the lookout for insider trading as the parties privy to privatization discussions have multiplied. And last, but not least, the material adverse effect clause may be the boon ? or bane? ? to sponsors looking to walk away from, or hang on to, going private transactions.

Go-shop: The go-shop provision is a post-signing merger check that allows the seller to continue ?shopping? the company for a designated period of time, which can range from 40 to 50 days, after a merger agreement is signed. The purpose of this provision is to make sure that the seller receives the best price in a sale.

Recent private equity deals that have carried this clause include Topps Co, and Lear Corp.

The Delaware Court of Chancery, the most important judicial court in determining the fate of acquisitions as it is the state in which most US companies are incorporated and file for mergers, has been focusing on the fiduciary duties of the seller's board of directors and special committee in an auction and negotiation process. In particular, the court has been wary of management teams favoring private equity sponsors over strategic buyers because of superior compensation packages offered by private equity sponsors. Therefore, the court is increasingly focusing on whether sellers are adequately shopped.

?Make sure that you have analyzed with your own financial advisers the risks of other bidders appearing,? says Ira White, a partner at law firm Morgan, Lewis & Bockius in New York.

Geoffrey Levin, a partner at law firm Kirkland & Ellis in New York advises sponsors to ensure there are explicit rules governing how the go-shop period is handled. These include specific deadlines within which potential alternative purchasers must express their interest and demonstrate that they are ?real? before they can be deemed to be an excluded party, and any lockup requirements.

Management incentives: Regulators are scrutinizing two aspects of the seller's management team for conflicts of interest: manager ownership and compensation.

In both cases, sellers may have to make additional disclosures under the Securities and Exchange Commission's Section 13E-3 rules governing going private transactions. Where the management team also owns five percent or more of shares of the target, additional disclosure under Section 13D also may be required.

When sponsors partner with the existing management team in going private transactions, particularly if management is already a material shareholder of seller, sponsors should set up a process to ensure that they will be able to withstand more probing.

?Having an active and informed special committee comprising disinterested directors with separate counsel to view the transaction will help insulate the interested directors from liability and shift the burden to the shareholder in the event of a challenge that the process was not fair,? says Berick. The special committee should be set up ?the earlier, the better.?

Sponsors may also be barred from speaking to management about their compensation packages until after the deal is signed. Shareholders and the media have questioned whether management has negotiated the sale price possible, as management stays on while public shareholders get cashed out. Broad-based discussions around options, however, may be permissible.

Not only is there a higher standard of disclosure necessary in going-private transactions, but ?there's also a likelihood that the deal will be reviewed by the SEC, which will add timing considerations to the transaction,? says David Sirignano, a partner at law firm Morgan, Lewis & Bockius in Washington, DC.

Insider trading: More outside investors are joining mega private equity deals, either as joint acquirers, co-investors or financing providers, thus creating a situation ripe for information leaks and insider trading before the deal is announced.

?There's a real concern to properly document the confidentiality agreement and make anybody you talk to and expose to the deal aware of the restrictions on trading,? says Sirignano.

Hedge funds, in particular, have been activist shareholders as well as providers of capital to deals. Would their involvement result in insider trading? A hedge fund could be shopping a deal idea to various private equity firms, and then participate in the acquisition of a company.

Sirignano advises sponsors entering into discussions that involve the ?exchange of material non-public information? to get ?very strong confidentiality agreements? between both parties.

?They need to abide by them, put the name [of the security] on the security owners' restricted list so there's no trading in the security until there's been a public announcement in one way or another,? Sirignano says. ?We get calls all the time from clients about whether they can trade based on this very informal call they got. They want to know whether they're now locked up.?

He adds: ?Another thing to keep in mind is that there are many markets in which these issues can arise: equity, debt securities, bank loans. People are starting to focus on insider trading issues with bank loan trading.?

Material adverse effects: The material adverse effect or material adverse change clause allows the buyer or seller to walk away from the deal due to change, circumstance or effect that is materially adverse to the business, financial condition, prospects or results of the operations of the company and its subsidiaries; or the ability of the buyer to consummate the transaction.

What has changed is that there have been more exceptions, or carve outs, to the clause. ?The question will be the extent of, on the M&A side, how much protection you can get either in the form of financing contingencies or contingencies that speak directly to market conditions,? says Linklaters' Berick.

This clause is currently being disputed in three deals: JC Flowers' acquisition of Sallie Mae, The Carlyle Group and Clayton Dubilier & Rice's acquisition of the professional supply division of Home Depot, and Lone Star's acquisition of Accredited Home Lenders.

Morgan Lewis' White says: ?Although there have been instances where buyers have asserted that the material adverse effect has occurred, it is more often used in the context of negotiation than an actual termination.?

But should the deals go to court over the invocation of the clause, the ruling can have wide-ranging effects on future merger deals.

Go-shop provisions are still relatively untested, so whether it will become a feature in going private transactions in the US in the future is unknown. According to MergerMetrics, a research firm, go-shop provisions have appeared in 62 deals involving US targets since 2003, and none were extended.

The emphasis on making sure that shareholders get the best deal they possibly can, however, is here to stay. Both regulators and shareholder activists will make sure it does.

?There's a real concern to properly document the confidentiality agreement and make anybody you talk to and expose to the deal aware of the restrictions on trading.?

Also uncertain is the direction of the credit markets and the fate of multibillion dollar private equity deals. Sponsors must navigate these waters as they look to take public companies private in the US.

In the UK
The Takeover Panel, the regulatory body responsible for administering the City Code on Mergers and Takeovers, continues to be the primary focus for compliance in public M&A deals in the UK.

Over the past few years, both the Panel and Code have a renewed priority on shareholders not involved with buyers, from ensuring a fair final price, to avoiding artificial fluctuations of share prices attributed to the interest of a particular buyer.

For buyout groups, the Panel expects genuine rigor from buyers on management incentives, inducement fees, stake-building and disclosing due diligence information. While the takeover process isn't necessarily adversarial, buyers involved with going private deals in the UK shouldn't expect the benefit of the doubt from regulators anytime soon.

Management incentives: Buyers must consult the Panel whether the incentives for management to stay on post acquisition constitute a ?special arrangement.? Rule 16 of the Takeover Code forbids favorable arrangements in relation to the acceptance of the offer, which are not available to all shareholders. If any members of the management team are to receive shares in the newly private company upon completion of the deal while the other target shareholders only receive cash, that arrangement may be caught by this prohibition.

?Given the common desire for keeping management in place post-completion, the Panel is generally prepared to allow special deals with management, but those deals must share the risks along with the rewards associated with equity shareholding,? says Paul Harkin, a partner and leader of the Midlands private equity practice at law firm Pinsent Masons in London.

Harkin continues: ?For example, the Panel would rarely find an option arrangement acceptable that guarantees the original offer price as a minimum.? Linking management incentives with the target's future performance alleviates the appearance of conflicts of interest that has haunted many a bid.

The Panel's consent to management incentives also requires the approval of the seller's independent financial advisor. This advisor must publicly state its belief that the proposed arrangement with management is fair and reasonable. Furthermore, these incentives must be approved at a general meeting of the seller's shareholders, and that approval must be by the independent shareholders using a poll process, not simply by a show of hands.

Inducement fees: The concern over fixed incentives for management clashes with the idea of inducement fees, payable to the buyer in the event of a failed bid. Such fees safeguard the buyer's investment of time and money, and avoid the offer being used to flush out other bids. How can these fees be arranged without prompting concerns about conflicts of interest?

Rule 21.2 of the Code details the parameters of such fees, which in most cases cannot exceed one percent of the value of the seller by reference to the buyer's offer price. Much like management incentives, any proposed inducement fee must be brought before the Panel at the earliest opportunity. The target company and its financial adviser must also confirm in writing to the Panel in advance that they believe the fee is in the best interests of target shareholders. Most fees are expressed to be payable only if the buyer actually announces an offer and that offer fails to complete following the announcement of an offer by a third party.

If the target company is fully listed, the Listing Rules provide for a similar financial cap. In theory this cap can be lifted if shareholder approval is received in advance. Also in the case of multiple buyers, Rule 21.2 permits more than one inducement fee to be agreed to by the target. However, the Companies Act financial assistance rules prohibit inducement fees if the payment would involve a material reduction in the target's net assets. Therefore, while a target company can agree to pay inducement fees to more than one potential buyer, arrangements need to be put in place to scale back payments to ensure that total fees paid out do not breach the Companies Act financial assistance rules.

?In some transactions, target companies agree to pay inducement fees even if no offer is eventually announced,? says Mark Vickers, a partner at law firm Ashurst in London. ?The most high profile example of this involved the sale of Debenhams. Under these preannouncement inducement fee arrangements, the target agrees to pay a potential buyer a certain amount at regular intervals during its due diligence process, possibly in return for a regular re-confirmation of their intention to make a bid at a particular price.?

The restrictions on such break fees are the same as other inducement fees so that any amounts paid as a pre-announcement inducement fee will reduce the amount that can subsequently be paid by way of a post announcement inducement fee.

While the takeover process isn't necessarily adversarial, buyers involved with going private deals in the UK shouldn't expect the benefit of the doubt from regulators anytime soon.

Stake-building: The purchase of target shares before any offer is announced is often thought as one way to improve a bid's chance of success and hedge a bidder's position on wasted costs by buying up shares at a pre-offer price. However, such a purchase brings no shortage of regulatory issues to bear on the bidding process itself.

First, shares cannot be bought when the purchaser possesses any sensitive or otherwise inside information relating to the sellers. For the buyer making a preliminary purchase of a seller's shares, knowledge of the offer doesn't constitute inside information. However, if and to the extent due diligence information is shared, or the sellers's management is consulted, then this could inhibit a buyer's ability to buy shares.

?Any share purchase should be done with proper legal counsel, but there are a few hard and fast rules that could sap the benefits of such stake-building,? adds David Stevenson, a partner at Pinsent Masons. According to the Code, once a purchaser has more than three percent of a target, then it is obliged to make this public, and if more than 30 percent of a target is purchased by a buyer or their ?concert parties? then a mandatory cash offer needs to be made immediately.

?Any firm should be aware of any possible concert parties and any proposed share purchases by them. Broadly, ?acting in concert? means that two or more persons co-operate in order to build a position in a target. The definition is extremely wide and the unwary need to take care so as not to make a mistake which could have significant consequences,? says Stevenson.

Due diligence disclosure: Given the advantages of a long and exclusive due diligence process, most buyers loathe sharing any company intel with competing groups. Unfortunately, Rule 20.2 of the Code demands that any information disclosed must be made available to other buyers, even if they are less welcome. In cases where the bidding doesn't involve members of the seller's management team, the definition of what data is disclosed, and what are the proprietary calculations of the buyer is clear.

The Code is applied differently in cases where current management is part of the bidding group. In such a case, the only information covered by 20.2 is that generated by the target company, including the seller's management when acting as such. However, information generated by the seller's management when acting as a member of the bidding group does not need to be disclosed. ?It's often hard to distinguish if a manager was acting on behalf of the target company or the bidding group during the due diligence process,? says Pinsent Mason's Harkin.

Further complicating matters is the requirement of sharing any data produced by the seller's management team with the board of independent directors vetting the bid. The Panel has clarified that this independent board must be granted access to any information produced with the assistance of the management team, which could very well include the business models, plans or due diligence reports which are likely to incorporate management's opinions, estimates and projections based on their underlying knowledge of the target.

On both sides of the Atlantic, regulators are implementing very real hurdles for private equity firms shopping the public markets, largely in response to the sentiment that buyout firms have not been paying a fair price for an asset or a seller's management was lining their pockets at the expense of the rest of the shareholders.

While such excesses may have been the exception, the regulations that followed in the US and UK are in fact, the rules. However, these rules, much like the events that preceded them, are open to interpretation. Time and time again, attorneys advise an open and honest dialogue with regulatory bodies, so even if the regulators don't favor GPs, their rulings might.