Dealmaking Remedies To Cushion the Jolt of Regulatory Rejection In a dicey regulatory climate, merger parties should take up-front steps to pick the right partner, assess risk of failure, and provide compensation for loss of the deal.

Regulatory approvals are a fact of life in most m&a deals. Whether it be antitrust, energy, national security, communications, financial services, transportation, public utility, or insurance regulation, governmental jurisdiction over a deal often is the most time-consuming and critical condition to its completion. While deregulation and privatization remain popular mantras, the scope of regulatory oversight over m&a transactions and the willingness of bureaucrats to delay, restructure, or kill deals has not diminished. Just ask General Electric Co., which wanted to buy Honeywell International Inc. Or UAL Corp., which attempted to buy US Airways Group Inc. Or WorldCom Inc., which wanted to buy Sprint Corp. Or Cardinal Health Inc., which wanted to acquire Bergen Brunswig Corp. Or Staples Inc., which tried to acquire Office Depot Inc. Each of these transactions failed in recent years for want of regulatory approval. Getting to the finish line is the most important contractual goal for buyers and sellers alike, but as these broken deals indicate, getting the transaction over the regulatory hurdle can be a formidable task. Most major deals are screened by antitrust regulators, who were responsible for the aborting of the deals cited above. But in many industries the regulatory risk intensifies because the merger partners are in a regulated industry and may have to satisfy both an industry-specific regulatory agency and antitrust authorities in general. This article explores creative solutions to meeting regulatory conditions in deals and managing the risk associated with the possibility that regulators will modify or kill a deal. Fighting for the Deal At the outset the parties need to address a few basic philosophical issues regarding the allocation of regula-tory risk in the contract. Which regulatory filings and approvals will they seek? Which of those will actually hold up the deal if they are not made or obtained? How hard will the parties push to obtain any required approvals? Will the buyer be required to agree to hold some assets separate or make divestitures if that is required to get the deal approved by the regulators? Are the parties committing to litigate with the government if necessary? How long will the parties wait for the necessary approvals to come through before they throw in the towel? All of these issues are interrelated. Granted, both parties want to see the deal closed, but a busted deal is a far worse outcome for the seller. While the buyer is out time and expenses, the seller’s management has had its focus diverted from ongoing operations. Key managers may have left or may plan to leave. Existing and potential customers may be looking elsewhere because of the uncertainty. New initiatives are placed on hold pending the outcome of the deal. A consolation transaction with a second bidder is likely to be at a lower – perhaps substantially lower – valuation. Yet the regulatory approval process is typically driven by the buyer. The buyer is on the front lines providing information to and negotiating with the regulators, while the seller typically is less involved. The critical power to grease the skids by agreeing to solutions rests with the buyer. Therefore, the seller’s best opportunity to influence this process is by setting clear standards for the conduct of both sides in the purchase agreement. Assessing Risk The regulatory risk that a deal may not close can have an impact well beyond the need to allocate that risk in the contract. Rather than bull ahead with what may ultimately turn out to be a broken deal, a seller may trade purchase price for the certainty of closing with another buyer. Take a large conglomerate that decides to divest a non-core business. The highest bidder is offering $1.25 billion, while the next highest bidder is offering only $1.1 billion. Easy decision? Maybe not. Suppose the high bidder and the target division are the two leading competitors in the market. One of the reasons the bidder can offer a substantial premium is that major synergies will develop through the consolidation and the reduction of the excess manufacturing capacity that has depressed product prices in the industry. Antitrust counsel advises, however, that there is only a 40% chance that the transaction will be approved by the regulators because the combined business will control an extraordinary share of the market. The investment banker running the seller’s auction initially encourages it to pursue the higher bid (thereby maximizing the banker’s transaction fee). But when asked what price the business will fetch six to nine months out if the first transaction is shot down by regulators, the banker advises that the seller will be fortunate to receive $1 billion at the later date. The business will likely be damaged goods, the operating performance will deteriorate in the interim because of loss of management focus, there will be supplier, customer, and employee instability, and bidder interest will decline, among other value drags. What’s a dealmaker to do? It may be useful to try to quantify the risk and potential loss in value when confronted with a sticky regulatory environment. The process, centering on application of quantitative rigor involving expected value, risk aversion, the time value of money, and probability theory, can help discipline an inherently fluid and judgmental thought process. Consider the following formula that our antitrust colleagues have used to help clients analyze potential transactions and isolate the key variables to be considered when deciding how to proceed: B1 = present value of bid from high bidder with the regulatory problem B2 = present value of bid from second highest bidder (without a regulatory problem) B3 = present value of bid from highest bidder without a regulatory problem at a second auction staged after the first transaction craters E = additional transaction expenses incurred in connection with failed B1 transaction p = probability that B1 transaction will close One way to look at the problem is to calculate the expected present value of the risky first bid (B1), adding to it the expected present value of the lower bid from a second auction if the first transaction does not close (B3), and then comparing that result with the present value of the safe second bid (B2). The formula is: (p x B1) + ((1-p) x (B3-E)) If the result is greater than B2, then accept B1 (the risky bid). If the result is less than B2, then B2 (the safe bid) should be accepted. The first part of the formula values the risky first bid and its probability of success. The second part values the estimated proceeds from a second auction if the risky first bid does not close (after deducting the expenses of the failed transaction). The sum of these two amounts is compared with the value that would have been received if the safe second bid was accepted in the first auction. A discount rate is applied to each bid because a dollar received a month from now is worth more to the seller than the same dollar received a year from now. In our scenario, the seller was considering a questionable $1.25 billion bid and a safe $1.1 billion bid, with a likely “worst-case” bid of $1 billion if the first deal fell through. Surveying the landscape, the seller estimates that: * There is a 40% chance (p) that a deal with the high bidder will survive antitrust scrutiny; * The safe bid will close in 30 days while the risky bid will close in six months; * Closing a deal with an alternate buyer after a failed transaction will take a full year from now; * 9% per annum is a reasonable discount rate; and * A new deal will require an additional $2 million of transaction expenses (E). The following analysis (with symbols converted to numbers) applies: The expected present value of accepting the risky bid (B1) is calculated as: (0.40 x $1,250,000,000/1.045) + ((1-0.40) x ($1,000,000,000/1.09-$2,000,000)) = $1,027,727,615 The expected present value of accepting the safe bid (B2) is: $1,100,000,000/1.0075 = $1,091,811,414 In this example, on these assumptions, the safe $1.1 billion bid is preferable to the risky $1.25 billion bid because it carries a higher present value. Of course, the foregoing analysis is not foolproof. It is difficult to forecast a specific value that might be received in the future from a second auction, and often the possible antitrust outcome is not a binary yes or no decision. Various degrees of divestitures may present possibilities that need to be weighted, assessed, and built into the model. Where to File The increasingly international scope of many deals results in multi-jurisdictional review. Even relatively small transactions may involve operations or sales in dozens of countries, each of which may impose its own antitrust filing requirements, filing fees, and potential substantive review of the deal. A buyer may insist on making all filings that are or may be required by law. But this can create problems. Suppose the buyer has a plant in a small country where the seller has a modest amount of sales. Local law ostensibly requires premerger notification and observance of a waiting period. The buyer wants to file because it wants to maintain good relations with the local authorities, while the seller views the country as immaterial and one that should not impede a swift closing. One potential compromise is to require the parties to make filings wherever they may be technically required but to hold up the deal only if the country has jurisdiction over a material portion of the business. Materiality can be measured with respect to the seller only, or it can encompass the buyer’s operations or those of the combined entity. Another approach is to confine the closing condition to those countries in which the failure to obtain the approval materially and adversely affects the business. However, a buyer still may insist that statutory waiting periods in immaterial jurisdictions be observed and may be unwilling to close if the failure to observe local niceties might subject it or its employees to criminal liability. Divestiture Covenants The overriding goal of antitrust regulators is to make sure that deals do not reduce competition to any significant extent. The regulators’ arsenal to accomplish this usually consists of one or more of the following options: * Blocking the entire deal; * Requiring divestiture of an entire ongoing business and related assets, or a partial divestiture, which may come out of the seller, buyer, or both partners; * Requiring special contractual arrangements, such as licensing of intellectual property or a supply agreement; or * Forcing behavioral changes, such as agreements to open facilities or operations to competitors or other anti-discriminatory steps. In serious cases, the preferred solution for regulators almost always includes some form of divestiture. Ideally, the seller wants to impose a “hell or high water” requirement on the buyer in order to get the deal done. This means that the buyer agrees to do everything and anything necessary to negotiate a solution and secure regulatory approval. When the seller is receiving cash, it is mostly indifferent to any material disruptions in the business going forward, and all the economic risk is on the buyer. However, when the currency is the buyer’s stock and the assets that may have to be divested are a material part of the combined entity going forward, the seller will need to assess the economic risk of potential remedies as well. In most cases the imperative to get the deal closed wins out. If regulatory problems are anticipated, sellers often insist on “fix-it-first” arrangements. Solutions are proposed to the regulators at the time the deal is initially reviewed, and valuable time can be saved. This approach also accommodates the frequent desires of regulators in divestiture cases to have up-front buyers in hand and to shorten the selling periods so that a viable, competitive business is preserved and ready to go into operation quickly once the basic deal is completed. Buyers usually will balk at such open-ended contractual commitments for the obvious reason that the economics of the deal may not make sense if the remedies are too drastic or are unanticipated. Buyers therefore will want to take the opposite tack and expressly provide that no divestitures or special accommodations are necessary to secure approvals. Or, as is the case in many financial institution deals, buyers will take the position that they need not agree to structural solutions like divestitures if the sell-offs will result in a substantial diminution of the deal’s benefits. Often the parties may simply agree to a “best efforts,” “reasonable best efforts,” or “commercially reasonable efforts” standard for getting the deal past regulators. These are loose guideposts. To obtain more certainty, many partners agree to a quantified threshold that sets forth the maximum amount of assets the buyer or surviving company is required to divest. The standard may be based on a dollar amount of sales, income, EBIT-DA, or tangible assets, or it may be linked to discrete businesses. Some argue that such specificity is a red flag for regulators, who can be expected to review the transaction documents. However, the use of these benchmarks is so prevalent that many parties find that concern to be exaggerated. Sellers need to make sure that the benchmark is expansive enough to accommodate surprises. Regulators often require divestiture of a greater amount of assets than those that are situated only in overlapping markets in order to preserve competition. Or the regulators often insist that the buyers of the divested assets will need some ancillary assets outside of the problem area to effectively restore or maintain competition. In setting the benchmark, buyers need to be sensitive to the pro forma effects and the impact of the divestitures on their anticipated synergies and also must consider whether the form of the benchmark can result in unanticipated obligations. For instance, a buyer may be willing to divest seller assets, but not its own. Or a buyer may agree to a certain benchmark on the assumption that it can mix and match a combination of buyer and seller assets to meet the regulatory concerns. Yet, the regulators may insist that the divestiture come from only one side to ensure that a functioning, ongoing business is sold off. A prudent buyer that is relying on getting critical “crown jewel” assets may need to explicitly carve them out of the benchmark to ensure that they are obtained. Voting Trusts Although not widely used, voting trust arrangements may, in some circumstances, alleviate regulatory objections to a deal or even accelerate closing. Voting trust arrangements using independent trustees have been used on an interim basis to accommodate regulators such as the Federal Communications Commission (FCC), the Department of Transportation (DOT), and the Surface Transportation Board (STB) when months or even years are needed to review a proposed transaction. Sometimes antitrust regulators use interim trustees to insulate control of a business or facilitate divestitures. Voting trusts or similar devices can be structured to encompass all of the assets under scrutiny or just voting control of the business, depending on the regulatory trigger involved. For instance, a strategic investor may acquire a large percentage of a competitor, with the shares held in a trust with voting power in proportion to the votes cast by all other shares. While such arrangements may appease regulators, the case of Northwest Airlines Corp. and Continental Airlines Inc. illustrates that antitrust concerns may not be completely satisfied by a voting trust arrangement. In connection with a proposed investment in Continental, Northwest proposed to place its stock in a voting trust for six years. Unimpressed by the fact that Northwest would lack voting control, the Department of Justice (DOJ) filed suit to block the transaction, reasoning that such an arrangement would nonetheless temper the competitive vigor between the parties. The Commitment to Litigate In addition to the divestiture issue, dealmakers should consider whether they are willing to litigate with a government agency. For instance, in the United States, the FTC or the DOJ is required to litigate and obtain an injunction if the agency wishes to block the deal. Both the buyer and the seller could be required to fight to the bitter end – at least until some agreed “drop-dead” date. Especially active buyers and sellers, however, may view the prospect of a public spat with regulators with whom they do repeat business as undesirable as a matter of corporate policy. Accordingly, one or both parties might negotiate the flexibility to bail out after litigation has been commenced or overtly threatened by the regulatory agency. Sometimes the parties give each other a window period during which they have a second look at the transaction if litigation with the regulators looks imminent. If both parties agree to fight, they then give up their rights to terminate until the drop-dead date arrives. This approach can be coupled with a breakup fee, which is discussed below. Termination rights in this situation do not necessarily need to be symmetrical. The buyer may be willing to spend six to 12 additional months investing time and expense in what ultimately may be a quixotic quest to obtain approval. But the seller may insist on reasserting control of its destiny by having the unilateral ability to either move on or hang in and litigate. In contest settings the partners also will need to negotiate how far up the ladder the parties must litigate or contest initially adverse regulatory determinations. In the U.S. federal antitrust arena, for instance, the spectrum could run from a regulatory staff determination, a full commission or agency determination, a temporary restraining order issued by a tribunal, a preliminary injunction, or a final, non-appealable order or judgment. The parties often settle on the preliminary injunction as the highest rung on the litigation ladder they will go if a specific level is written into their agreement. Drop-Dead Date Not only must the parties consider how hard to fight but they also must focus on how long to continue the battle. If a seller pushes for a hell-or-high-water deal and secures a strong commitment to negotiate with the regulators or even to litigate, the buyer may lessen the burden by negotiating a short period for getting to the drop-dead date. A recent example of how a drop-dead date influenced a contested transaction was the proposed acquisition of US Airways by the United Air Lines Inc. unit of UAL. Facing seemingly insurmountable opposition from antitrust authorities and an Aug. 1, 2001, drop-dead date, United reportedly approached US Air in June in an attempt to negotiate the termination of the transaction. Rather than walk away from a deal that provided a substantial premium to its shareholders, US Air refused to mutually terminate the transaction prior to the drop-dead date. Despite the perception that government approval was not forthcoming, US Air asserted its right under the merger agreement to force a decision from the DOJ. Instead of committing to contest any regulatory issues to the bitter end, a seller may choose to cut its losses by relying on a short drop-dead date. Or, because buyers essentially control the deal’s destiny in negotiating with regulators, and sellers usually have the most to lose in busted deals, some sellers successfully negotiate for the unilateral right to extend the drop-dead date if a regulatory approval is the ultimate hang-up. That gives the seller time to assess whether the litigation avenue is worth the wait. If a seller is worried that a buyer is not pursuing regulatory relief fast enough, the seller could structure an interest charge or other time-phased penalty should the deal be delayed or ultimately dropped. Breakup Fees Sometimes a seller with leverage can negotiate a breakup or termination fee from the buyer if the transaction is not completed because of a regulatory issue. The fee acts as a consolation payment to the seller for its willingness to take itself off the market and proceed with an uncertain deal. Because it is in essence a penalty to the buyer, the fee is designed to motivate the buyer to bargain with the regulatory authorities if the size of the payment exceeds the economic value of the concessions needed to clear the deal. Setting the right amount of the fee in this area is difficult, and fees vary enormously from deal to deal. Precedents from other contexts are not always helpful. For instance, breakup fees typically range from about 1% to 5% of a deal’s equity value when a target terminates a deal to accept a higher offer under a “fiduciary out” clause. However, this amount may bear no relevance to the seller’s objectives in the regulatory area. The fee should be high enough for the seller to attain its compensation and deterrence objectives. For instance, the fee should ideally compensate the seller for lost value if the buyer has to accept a lower offer in a second auction because the first transaction fails to overcome the regulators’ objections. From a deterrence perspective, the seller should be sensitive to the expected value of the fee in the buyer’s mind. Say that the seller agrees to sell itself for $200 million, with a $20 million termination fee payable by the buyer if it cannot obtain a potentially sticky antitrust approval. Is this really $20 million worth of deterrence? If the buyer thinks it has only a 50% chance of getting the approval, the expected “cost” of the fee might be viewed as only $10 million (0.50 x $20 million). To obtain true parity in deterrence value, the seller might calculate the right fee by dividing the payment by the probability factor. This yields a value of $40 million for the termination fee, in our example. Sellers should use the breakup fee as a complement rather than a complete substitution for the more conventional protections cited earlier. Otherwise, the buyer, which is ultimately in control of its destiny in negotiating possible solutions with regulatory authorities, will be able to use the termination fee as a call option on the target if it decides it wants out. The other safeguards also are more direct and easier to monitor. From the buyer’s perspective, the fee obviously should not be so high as to force through a deal so reconfigured through negotiation that it no longer makes strategic sense. A buyer can expect that the regulatory authorities will see the breakup fee in the transaction document and factor the pressure the possible payment will put on the acquirer in subsequent negotiations with regulators. Some buyers themselves will suggest a breakup fee as an alternative to the economic hurdles discussed above to retain flexibility in dealing with regulators. Why? Because buyers never really know where negotiations with the regulators will end up. For example, the amount of assets that the authorities insist on being divested actually may represent such great value to a buyer, particularly where synergies are involved, that the deal no longer is worth doing. In a difficult case, a savvy buyer might want the option of killing the deal and paying the breakup fee rather than giving up the crown jewels that made the deal attractive in the first place.