Debevoise & Plimpton Private Equity Report/media/files/insights/publications/2007... · reemerged as LBO targets, both sellers and private equity sponsors looked for ways to ... Hertz

The Private Equity Report generally features aguest column written by, or based on, aninterview with a leading member of theprivate equity community. In this issue, webreak from tradition and introduce you toLord Peter Goldsmith, who served in TonyBlair’s cabinet for more than six years asAttorney General of the United Kingdom.Peter has recently joined us as a partner andEuropean Chair of Litigation where he willbe a hands-on lawyer, advising clients and

being an advocate in court and in arbitrationproceedings. Peter will be based in London,but actively working with the rest of the firmin solving legal problems that involve multi-national and multi-jurisdictional issues.

On one of Peter’s recent trips to the NewYork office, Franci Blassberg sat down withhim to get a sense of his perspective on cross-border issues affecting private equity and thecommercial environment in Europe.

In business transactions in Europe or withEuropean parties, Americans have traditionallybeen far more comfortable with English lawas opposed to the laws of the continentaljurisdictions, perhaps because of theirfamiliarity with common law. Manycommentators have suggested that English law isconverging with European law. Do you thinkU.S. private equity investors should now feel lesscomfortable with English law?

I think English law remains the right choiceof law for many transactions. It is

correct that there are some areaswhere EU law has fashionedEnglish law, but the core aspectsof English commercial law reallyremain as they have always been.Most importantly, in interpretingcontracts, English judges, likeU.S. judges, continue to look veryhard at the actual language ofdocuments to deduce the business

The London Perspective

on Cross-Border Private Equity:

An Interview with Lord Peter Goldsmith

W H A T ’ S I N S I D E

3 Acquisition Agreements After the Credit Crunch:What’s Next?

5 Mixed Clubbing: Do PE Firms and StrategicsMake Good Dance Partners?

7 The Impact of the NewJapanese Securities Law on Fund Sponsors

9 What Private Equity Needs to Know About Changes tothe U.S.-Canada Tax Treaty

11 Alert: Where’s the Beef? SEC Critiques First Round of Proxy CD&A Disclosure

13 Alert: Risk of AppraisalProceeding May Not Be So Problematic

15 Is There Good News forPrivate Equity Investors in France?

17 Material Adverse Change(MAC) Clauses from a UKPerspective

Fall 2007 Volume 8 Number 1

D e b e v o i s e & P l i m p t o nP r i v a t e E q u i t y Re p o r t

© C

arto

onb

ank.

com

CONTINUED ON PAGE 19“Religious freedom is my immediate goal, but my long-range plan is to go into real estate.”

The popular media loves to bash private equity. How many

articles have we all read about the deals that have not closed and

those that were restructured? Or about the proposed changes to

taxation of carry? Or about the labor opposition to private equity

transactions? That slice of the private equity scene makes good

headlines.

While the business press is busy reporting on a small subset of

private equity transactions, the rest of the private equity

community has been working away on actually closing

transactions, raising new funds, monitoring the debt markets for

a return to normalcy, contemplating new structures and generally

devising ways to transform their limited partners’ commitments

into good returns.

One of the themes of our current issue is the increasingly

global nature of the private equity asset class. In a break with

tradition, our Guest Column is actually an interview with our

new partner, the former Attorney General of the United

Kingdom in the Blair administration, Lord Peter Goldsmith.

Peter offers insight on cross-border issues affecting private

equity and the commercial environment for private equity in

Europe as only someone who has been personally involved in EU

treaty negotiations can. For those of us who think there are a lot

of constituencies in private equity merger agreement

negotiations, Peter is a true source of perspective.

Elsewhere in this issue, we report on the French private equity

scene, recent legislation in Japan that may make raising funds in

Japan or from Japanese investors more cumbersome, and, more

happily, proposed changes to the U.S.- Canada tax treaty which

may have some favorable ramifications for U.S. funds with

investments in Canada.

We do not have to tell you that the recent shakeup in the

financial markets is already being felt in deal structures. Paul Bird

and Jonathan Levitsky describe how the changing environment

can impact acquisition agreement terms and their relationship to

financing commitments. Peter Hockless, of our London office,

reports on the UK perspective on MAC clauses. While the days

of covenant-lite loans may be over for at least a while, the role of

consortia in private equity deals seems to be a permanent fixture

on the deal landscape. We continue our ongoing discussion of

club deals by analyzing the benefits and challenges of adding a

strategic partner to the investor mix, particularly in certain

regulated industries like insurance and gaming.

We also have several news updates on recent legal

developments of interest to the private equity community on

issues as diverse as proxy disclosure rules and appraisal rights.

Franci J. Blassberg

Editor-in-Chief

page 2 l Debevoise & Plimpton Private Equity Report l Fall 2007

The Debevoise & PlimptonPrivate Equity Report is apublication of

Debevoise & Plimpton LLP

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www.debevoise.com

Washington, D.C.1 202 383 8000

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Please address inquiriesregarding topics covered in thispublication to the authors orany other member of thePractice Group.

All contents ©2007 Debevoise& Plimpton LLP. All rightsreserved.

Franci J. Blassberg Editor-in-Chief

Stephen R. Hertz Andrew L. Sommer Associate Editors

Ann Heilman Murphy Managing Editor

The Private Equity Practice GroupAll lawyers based in New York, except where noted.

Private Equity FundsMarwan Al-Turki – LondonAnn G. Baker – ParisKenneth J. Berman– Washington, D.C.Jennifer J. BurleighWoodrow W. Campbell, Jr.Sherri G. CaplanJane EngelhardtMichael P. HarrellGeoffrey Kittredge – London

Marcia L. MacHarg – Frankfurt Anthony McWhirter – London Jordan C. Murray Andrew M. Ostrognai – Hong KongDavid J. SchwartzRebecca F. Silberstein

Hedge FundsByungkwon Lim

Mergers & AcquisitionsAndrew L. BabE. Raman Bet-Mansour – ParisPaul S. BirdFranci J. BlassbergRichard D. BohmThomas M. Britt III – Hong KongGeoffrey P. Burgess – LondonMarc Castagnède – ParisMargaret A. DavenportE. Drew Dutton Gregory V. GoodingStephen R. HertzDavid F. Hickok – FrankfurtJames A. Kiernan, III – London

Antoine F. Kirry – ParisJonathan E. LevitskyLi Li – ShanghaiChristopher Mullen – LondonDmitri V. Nikiforov – MoscowRobert F. Quaintance, Jr.William D. RegnerKevin A. RinkerJeffrey J. RosenKevin M. SchmidtThomas Schürrle – FrankfurtWendy A. Semel – LondonAndrew L. SommerStefan P. Stauder James C. Swank – ParisJohn M. Vasily Peter Wand – Frankfurt

Leveraged FinanceKatherine Ashton – LondonWilliam B. BeekmanDavid A. BrittenhamPaul D. BrusiloffPierre Clermontel – Paris Alan J. Davies – London

Letter from the Editor

“Seller friendly” is the way private equityacquisition contracts were generally describedearlier this year in what was clearly a highlycompetitive buyout market. Conventionalwisdom suggested that private equity firms hadbeen forced to accept a number of seller-favorable terms, including the disappearance offinancing conditions, non-survival ofrepresentations and warranties, tighterfinancing covenants requiring bridge financingdrawdowns and what became nearly a page ofexceptions to the “Material Adverse Effect” or“MAE” definition in acquisition agreementsfor large buyouts over the past several years.

However, the recent market turmoil hasrevealed that, in fact, private equity buyershad successfully negotiated contracts thatincluded important and innovativeprotections—considerably more so than hadgenerally been appreciated before the melt-down of the credit markets.

Leveling the Playing Field for Strategic and Private Equity BuyersEnd of the Financing Out/Rise of the“Reverse Break-Up Fee”The most important seller-friendly

developments relate to the sponsor’scommitment to a transaction in the event ofadverse developments in the leveraged financemarket or the performance of the targetbusiness.

Until early 2005, private equity dealsgenerally permitted buyers to terminate theacquisition agreement without penalty if—despite the buyer’s reasonable (or reasonablebest) efforts—the debt financing necessary toconsummate the transaction proved to beunavailable. A “financing condition” wasviewed by sponsors and their counsel asindispensable. The proposed acquisition was,after all, a leveraged buyout: how couldanyone expect it to proceed, and for thesponsor’s equity to be funded, if the leveragewas not available? The need for a financingcondition, however, at times put privateequity firms at a competitive disadvantagecompared to strategic buyers. As favorablefinancing terms became readily available,sponsors’ funds grew larger, club dealsbecame more common and public companiesreemerged as LBO targets, both sellers andprivate equity sponsors looked for ways toeliminate the financing condition and putLBO buyers on an equal footing with

corporate buyers. For an early viewon the evolving marketplace in thisregard, see “Are Private Equity andStrategic Deal Terms Converging?”in Vol. 5, Number 4, of the PrivateEquity Report and for a follow upanalysis, see “Trendwatch: 2005Deal Terms” in Vol. 6, Number 2 ofthe Private Equity Report.Reverse Termination FeesThe Sungard, Neiman Marcus andHertz buyouts in 2005 ushered in anew market practice. There werevariations and nuances, but thebasic structure required the privateequity buyer to proceed without afinancing condition and to pay afixed amount (generally ranging

from one to three percent of transaction valueand referred to as a “reverse break-up fee” or“reverse termination fee”) if the deal was notconsummated by the drop dead date specifiedin the acquisition agreement, whether due tothe unavailability of the debt financing oranother unexcused reason—assuming that atsuch time all other conditions to closing weresatisfied. Sponsors also agreed to provideguarantees by their funds of the payment ofthe reverse break-up or termination fee.

The advent of the reverse break-up feepermitted corporate sellers and publiccompany boards to announce that theagreement was not subject to financing.There was much more to the bargain,however, than the simple elimination of adebt financing condition. From the privateequity firm’s perspective, being on the hookfor a damages payment of several tens tohundreds of millions of dollars if the debtfinancing was not available at closing was amaterial change in buyout terms (comparedto limited or no exposure from a specialpurpose acquisition vehicle separated fromthe sponsor fund by the corporate veil, astructure relied upon by private equity firmsand accepted by corporate sellers for years),and they wanted to make sure that the reversetermination fee amount would be the limit oftheir exposure under any circumstances.

To achieve this goal, as deal terms evolved,sponsors began to bargain for two otherimportant deal terms relating to reversetermination fees: first, that their liability forany breach of the acquisition agreementwould be capped at the amount of the reversetermination fee (or, in two-tier structures,some larger amount up to two times thereverse termination fee for a subset of certaintypes of breaches); and second, that the sellerwould expressly acknowledge its waiver of aright to specific performance and that thereverse termination fee (or the two-tier fee)would cap the liability of the acquisition

Debevoise & Plimpton Private Equity Report l Fall 2007 l page 3

Peter Hockless – LondonAlan V. Kartashkin – Moscow Pierre Maugüé A. David ReynoldsMatthew D. Saronson – LondonPhilipp von Holst – FrankfurtGregory H. Woods III

TaxEric Bérengier – ParisAndrew N. BergPierre-Pascal Bruneau – ParisGary M. FriedmanPeter A. FurciFriedrich Hey – FrankfurtAdele M. KarigVadim MahmoudovDavid H. SchnabelPeter F. G. Schuur – LondonMarcus H. StrockRichard Ward – London

Trust & Estate PlanningJonathan J. RikoonCristine M. Sapers

Employee Compensation & BenefitsLawrence K. CagneyDavid P. MasonAlicia C. McCarthyElizabeth Pagel Serebransky

The articles appearing in thispublication provide summaryinformation only and are notintended as legal advice. Readersshould seek specific legal advicebefore taking any action withrespect to the matters discussedherein. Any discussion of U.S.Federal tax law contained in thesearticles was not intended orwritten to be used, and it cannotbe used by any taxpayer, for thepurpose of avoiding penalties thatmay be imposed on the taxpayerunder U.S. Federal tax law.

Acquisition Agreements After the Credit Crunch: What’s Next?

CONTINUED ON PAGE 4


vehicle and the sponsor fund for any breachof the agreement.

Specific PerformanceThe emergence of the seller’s waiver of theright to specific performance was a hard-fought term that was several deals in themaking. As noted above, the disappearanceof the financing condition and the reversetermination fee went hand-in-hand;corporate sellers rarely resisted the premisethat, at the end of the day, a private equityfirm needed a right to get out of deal, albeitby paying a stiff fee, if the debt financingsimply was not available. The eliminationof the right to specific performance was notso obviously related to these developments,however, and some sellers bargained for theright to compel the buyer to close (and thesponsor firm to fund its equitycommitment) in the event that the debtfinancing was available at closing, but thesponsor balked. Even this limited right tospecific performance created a powerfulincentive for the corporate seller to attemptto deal directly with the financing banks, or

with alternate financing banks, to ensurethat debt financing would be made availableto the buyer. A seller’s right to compel aclosing if the debt is available, combinedwith various forms of buyer covenants toobtain alternate financing, even on termsless favorable than the originally committedfinancing, could put the private equitybuyer in a position of having lost control ofthe economic terms on which it agreed tobuy the target business.

By bargaining for a waiver of the seller’sright to specific performance under anycircumstances, even when the debtfinancing was available, together with a capon liability for monetary damages, privateequity buyers substantially enhanced theirleverage in the event of an adverse change inthe leveraged finance market or the targetbusiness. The developments of the pastsummer put such provisions to the test,with outcomes that appear to be largelyattributable to the negotiating leveragethose terms created.

Real World ExamplesThe issue at stake in the pending Sallie Maetransaction litigation is whether the reversetermination fee of $900 million will bepayable by the sponsor firms, or whetherthey have a right to walk by virtue of anMAE. In either case, the sponsors will notbe obligated to close the deal and put over$8 billion of equity at risk on debtfinancing terms less favorable than thoseoriginally committed. In August, threeprivate equity firms behind the HD Supplybuyout from The Home Depot negotiateda $1.8 billion purchase price reduction tobring the capital structure of the targetbusiness into line with the acceleration inthe decline in the housing and buildingmarkets and the then current market fordebt financing. And in October, twoprivate equity firms walked away from a $3billion deal to buy Acxiom Corp. by payinga $65 million reverse termination fee, andthe sponsors behind the $8 billion Harman

International buyout, after calling an MAEand terminating the merger agreement,agreed to purchase $400 million in thetarget’s debt securities convertible at a strikeprice 13% below the per share price of theoriginal merger. In all four transactions,MAE issues were raised, but the principallevers operating in favor of the privateequity firms were the absence of a specificperformance remedy for the seller and aclear cap on the buyer’s liability for breachof the acquisition agreement.

Whittling Away Material Adverse EffectAnother contract term that has beensubstantially modified in private equitydeals over the past few years to eliminate aperceived gap in the risk profile of strategicversus private equity buyers has been thedefinition of “Material Adverse Effect” or“MAE.”

Although, in light of the case law, theMAE condition or termination right can betriggered only by very substantial adversechanges to the target business, the abilitynot to close a transaction in which theeconomic benefit to the buyer has beenradically altered by intervening eventsremains a fundamental contract right. Thedispute, of course, is what constitutes a“material adverse effect.” While there arefew reported decisions in this area, courtshave generally required, in cases such as the2001 Tyson Foods dispute, that the materialadverse effect be serious and have long-termconsequences for the target business, bywhich the court implied an adverse impacton earnings for two or more years into thefuture. Even though private equity firmstypically rely on financial models thatextend over five or more years, immediateand material one to two year shortfalls inoperating cash flow can substantially impairthe firm’s equity in the new company andconstrain operating flexibility.

Following Tyson, market developmentsmade reliance on the MAE condition even

Acquisition Agreements After the Credit Crunch (cont. from page 3)

... [T]he recent market

turmoil has revealed

that ... private equity

buyers had successfully

negotiated contracts that

included important and

innovative protections—

considerably more so

than had generally been

appreciated before the

melt-down of the credit

markets. CONTINUED ON PAGE 23


Transactions in which a group of privateequity firms join together to pursue anacquisition target are an established part oftoday’s deal landscape. Indeed, in manyinstances, specific market terms haveemerged for governance decision-making atdifferent points in the deal life cycle, frombidding through exit. (In this regard,please see our prior articles on Club Dealsin the Winter 2006, Fall 2006 and Winter2003 issues of the Private Equity Report.)But increasingly, acquisition clubs are nowincluding industry players as well as PEfirms. Examples of such mixed clubarrangements include Sony’s partnershipwith PE firms in the acquisition of MGM,and in the financial services sector,Prudential participating in a Carlyle-ledconsortium to acquire a substantialminority stake in China Pacific Life, andthe acquisition of Scottish Re by Cerberusand Mass Mutual. Going one step further,in the recent ABN-AMRO acquisition, aclub made up entirely of strategic players(Banco Santander, Royal Bank of Scotlandand Fortis) teamed up to do the deal.

In PE-only club deals, the investors’interests are generally straightforward andaligned: the proverbial buy low and sell high(as quickly as possible). This alignment ofinterests tends to result in deals in which theparticipants’ roles are reasonably well-established. Although there are inevitablyissues among club members such as howmuch control the individual investors willhave over the negotiations, the ongoingoperations of the business and the timing andnature of the exit, the issues are predictableand recurring and can generally be addressedwith relative ease because of the overallalignment of interests and othercommonalities among the club members.

The dynamics can change, however,once a strategic investor joins the club.Strategics often have different commercial

objectives in pursuing a given deal ascompared to private equity investors.Strategics may be more interested, forexample, in distributing their productsthrough the acquired company andcontinuing to own the investment beyond aprivate equity firm’s typical exit timehorizon (and possibly ultimately buying outthe private equity investors’ interestentirely).

This article discusses some of the uniqueissues in mixed private equity/strategic clubdeals, with a particular emphasis on thesepartnerships in the financial servicesindustry.

Rationale of the ParticipantsOf course, having a clear sense of theparticipants’ rationale for partnering iscritical to anticipating the key process,governance and exit issues that will need tobe discussed and agreed in any deal,including mixed club transactions.

A strategic investor might enter into aclub deal with private equity firms for avariety of reasons, including to (1) gain a“toehold” in a particular market segment orcountry, (2) gain access to deals that privateequity firms may hear about first, (3) acquirea key asset or line of business from thetarget company that is not core to the othermembers’ investment thesis and (4) have anopportunity to participate in the outsizereturns enjoyed by some PE firms in themost successful deals.

From the perspective of the PE clubmembers, inviting in a strategic may be drivenby a desire to (1) obtain and leverage off ofindustry or country expertise, (2) providecomfort to the regulators that the targetcompany will be operated prudently, (3) assist in financing and evaluating thetransaction, (4) tap into a potential sourceof management talent to help operate thetarget and (5) provide a potential exitopportunity for the private equity firms.

The BidIn a private equity club deal, there is oftenone investor who leads the day-to-daydiscussions with the seller and consults withthe balance of the group off-line and ishence largely invisible to the seller.Importantly, this can allow the bid toremain nimble and responsive and avoid anuncompetitive “too many chefs in thekitchen” dynamic. A strategic investor, onthe other hand, may be more likely to seeka greater role in the deal than a typical clubinvestor, and in fact may want to lead ormeaningfully participate in dealings withregulators (particularly in an industry likeinsurance or other another financial service)and in due diligence. As noted above, thisarrangement may make sense: strategicscan add enormous value to the duediligence process (and cut down on feespayable to outside consultants and otherservice providers), shrewdly evaluatecontingent risks, and effectively deal withregulators and other commercial

Mixed Clubbing: Do PE Firms and Strategics

Make Good Dance Partners?

CONTINUED ON PAGE 6

In PE-only club deals,

the investors’ interests

are generally straight-

forward and aligned:

the proverbial buy low

and sell high (as quickly

as possible) .... The

dynamics can change,

however, once a

strategic investor joins

the club.


constituents of the target. On the otherhand, a strategic may seek moreinformation from the seller than a straightPE club investor, particularly as tocompliance, regulatory and litigationmatters, due to heightened reputationalconcerns. It may also be more averse toassuming unknown and contingent risks.Also, if the strategic is not an activeparticipant in today’s M&A market, itmay seek greater rights of indemnificationfrom the seller than is the norm in acompetitive bidding situation, andotherwise have less realistic expectationsconcerning other deal terms and processmore generally.

Regulatory Issues The involvement of a strategic will alsorequire greater sensitivity to antitrustissues arising from disclosure of certaincompetitively sensitive informationbetween the target, on the one hand, andthe strategic investor, on the other hand,and may complicate the antitrust approvalprocess. If the strategic is a non-U.S.company, its involvement may also raisequestions if the target’s business is viewedas sensitive to national security. In certaincircumstances, the club’s consortium

agreement may need to allow for theremoval of the strategic member if itsparticipation prevents needed antitrust orother governmental approval.

In the case of a club deal in thefinancial services sector in particular, theprivate equity firms should anticipate thatan industry player will want to lead alldiscussions with the regulators. Probablyno issue is more near and dear to the heartof an insurance company than itsrelationship with its regulators. This canbe a double-edged sword: having aninsurance company with a stellarregulatory reputation gives the clubsignificant credibility with the regulators.However, there can be a tendency for astrategic to be more conservative than theprivate equity investors may wish to be indealing with the regulators so as to protectthe strategic’s reputation. Nevertheless, onbalance, there is significant value added inmost cases by having a blue chip strategicspeaking for the club before the regulatorand advising the group on related issues,such as restrictions on leverage anddividends and other inter-company oraffiliate transactions.

As private equity firms start pursuingdeals in highly regulated industries, suchas the insurance and gaming sectors, theyshould be aware of heightened disclosurerequirements to the regulators. Inparticular, the principals of the privateequity firms in the club may need tomake detailed disclosures about theirpersonal wealth, which may come as anunwelcome surprise for private equity andhedge fund principals who are notaccustomed to this type of public scrutiny.The presence of a strategic partner mayresult in the regulators showing someflexibility regarding the manner in whichinformation relating to the private equityfirms is disclosed, but will not eliminate

the need for fairly comprehensiveinformation from the principals. Inregulated industries, the target’s operationsmay also be subject to restrictions such asin the insurance sector where a targetcannot be leveraged in the same manneras a typical LBO.

Post-Closing GovernanceNegotiations regarding post-closinggovernance arrangements with a strategicmay be more difficult than negotiationsamong private equity firms (where thegovernance regime is largely influenced bythe relative size of the equity contributionsand other reasonably establishedcommercial norms). A strategic mayargue that it should have governance rightsthat are disproportionately large relative toits investment size. This may beappropriate if the private equity firms arelooking to the strategic to bringoperational expertise or personnel to thebusiness. Additionally, in the financialservices industry, there may bereputational concerns about beingaffiliated with the target entity that justify(or so the strategic will argue) greatergovernance control for the strategic,particularly in dealings with regulators.

The strategic may also be concernedabout the need to maintain the creditrating of the target so that the strategic’sreputation is not tarnished by having acontrolled entity with a lower rating thanthe strategic. Similarly, the strategic maywant an agreement upfront on how theneed for future capital contributions willbe addressed. Since the strategic willlikely want to keep the target’s rating andregulatory reputation unimpaired, toavoid collateral damage to its brand,tensions could result as to whether futurecapital contributions should bediscretionary or mandatory. It is likely

Do PE Firms and Strategics Make Good Dance Partners? (cont. from page 5)

As private equity firms

start pursuing deals in

highly regulated

industries, such as the

insurance and gaming

sectors, they should be

aware of heightened

disclosure requirements

to the regulators. CONTINUED ON PAGE 12


Marketing private equity funds in Japan or toJapanese investors has just gotten morecomplicated. New legislation significantlybroadens the oversight authority of theJapanese regulator with respect to bothboutique private equity firms andinstitutionally sponsored funds. However,potential fund sponsors should not be undulyconcerned about marketing in Japan oradmitting Japanese investors. The goal formost private equity sponsors will be to limittheir obligations in Japan to mere notificationfilings, rather than registration obligations,which are far more cumbersome under thenew regime.

Registration or Notification?Under the new Japanese FinancialInstruments and Exchange Law (the “FIEL”),a general partner (rather than the sponsor) ofa private equity fund structured as a limitedpartnership may be required to register withthe Japanese regulator, both in connectionwith offering fund interests in Japan andserving as an “investment manager” of a fundwith Japanese investors. Registration is adocument-intensive and time-consumingprocess, and once registered, the generalpartner will have considerable ongoingreporting obligations. In addition, ifregistration is required, the general partnerwill need to be organized as a corporationand meet certain other qualitativerequirements.

The key to minimizing the impact of thenew legislation is to satisfy certain statutoryexemptions. If those statutory exemptionsare met, the general partner will be exemptfrom registration and may be required to fileonly a simple notice, if anything, with theJapanese regulator. Failure to make arequired registration or notification may leadto criminal and civil sanctions and/or finesfor representatives of the general partner.

Japanese Qualified InstitutionalInvestorsA key concept to the application of theregistration exemptions is whether a fund’sJapanese investors are “Qualified InstitutionalInvestors” (“QIIs”). The different categoriesof QIIs, which include Japanese banks andinsurance companies, are listed in the FIEL.Investors that do not fall within a pre-approved category but satisfy certainminimum economic criteria may becomeQIIs by registering with the Japaneseregulator. For this reason, a general partnershould obtain written assurances from eachof its Japanese fund investors regarding itsQII status prior to admitting such investor toits fund and, particularly with respect to aninvestor that is required to renew itsregistration biennially to maintain its QIIstatus, that the investor will continue toqualify as a QII for the duration of itsinvestment in the fund.

QII-Targeted Exemption for Marketing and FundManagementA general partner will be exempt fromregistering with the Japanese regulator forpurposes of offering and managing fundinterests if it can comply with the “QII-Targeted Exemption.” In order to qualify,(1) at least one investor in the fund must bea QII and (2) there can be no more than 49Japanese fund investors that are not QIIs.Note that qualifying for the QII-TargetedExemption becomes extremely complicated ifa fund has Japanese investors that areorganized as certain types of special purposevehicles, silent partnerships (tokumei kumiai)or other collective investment schemes thathave investors that are not QIIs.

De Minimis QII Exemption forFund Management OnlyA second exemption from registration with

respect to managing a fund with Japaneseinvestors, but not with respect to offeringfund interests in Japan, is the “De MinimisQII Exemption.” In order to qualify, (1) thefund, directly or indirectly, may have nomore than nine Japanese investors, all ofwhich must be QIIs, and (2) the aggregatecapital contributions of such investors to thefund may not equal or exceed one-third ofthe total capital contributions to the fund.Since the De Minimis QII Exemptionexempts a general partner from theregistration and notice filing requirementsonly with respect to the investmentmanagement of the fund, the general partnerwill still need to make a filing in respect of itsoffering activities in Japan unless either it has

The Impact of the New JapaneseSecurities Law on Fund Sponsors

... [P]otential fund

sponsors should not be

unduly concerned about

marketing in Japan or

admitting Japanese

investors. The goal for

most private equity

sponsors will be to limit

their obligations to mere

notification filings,

rather than registration

obligations, which are far

more cumbersome under

the new regime.

CONTINUED ON PAGE 8


completed its offering of fund interests inJapan prior to September 30, 2007 (the“Effective Date”) or can rely on theOutsourcing Exemption (describedimmediately below).

Outsourcing Exemption for Marketing OnlyUnder the Outsourcing Exemption, if allmarketing activities in Japan are carried outby a licensed placement agent in Japan(which could be an affiliate of a fund’sgeneral partner), the general partnergenerally will not need to register or file anotice in respect of such offering activities.However, if representatives of the generalpartner conduct any aspect of the offeringin Japan, this exemption will not be

available. Representatives of the generalpartner who are considering participating inmeetings with prospective investors solelyfor informational purposes should proceedwith caution in this regard, since there areno specific rules or guidelines concerningwhat constitutes prohibited offeringactivities in a joint visit. Japanesepractitioners advise that the Japaneseregulator is likely to interpret theOutsourcing Exemption strictly.

Even if an offering qualifies for theOutsourcing Exemption, if a fund admits aJapanese investor, its general partner willneed to rely on another exemption inrespect of the investment management ofthe fund since there are few scenarios inwhich a general partner would outsource allof its management responsibilities. Thepractical effect of the OutsourcingExemption is that a general partnergenerally may wait to file its notification (ifit needs to file one at all) until either a non-QII Japanese investor or a tenth QII isadmitted to its fund.

Here are some basic guidelines that canhelp fund sponsors evaluate whetherofferings in Japan and to Japanese investorswill involve registration and/or notificationrequirements. The rules are complex andsponsors should consult Japanese counsel inspecific cases.

Actions Required of a General Partner

� No Marketing in Japan After theEffective Date: A general partner of afund that completes all of its marketingactivities in Japan prior to the EffectiveDate is still subject to the FIELrequirements with respect to funds thathave Japanese investors.

��De Minimis QII Exemption. If ageneral partner can rely on this

exemption, no further action isrequired.

��QII-Targeted Exemption. If a generalpartner cannot rely on the DeMinimis QII Exemption, but the QII-Targeted Exemption is available, thegeneral partner will have to file anotice with the Japanese regulator byDecember 31, 2007. This notice maybe submitted in English.

��Grandfathered Status. A generalpartner that cannot rely on any of theaforementioned exemptions may beexempt from registering by virtue of agrandfathered status, but will have tofile a special notice with the Japaneseregulator by December 31, 2007 toqualify for such status. This noticemust be submitted in Japanese.

��Investment Period. Even funds thathave completed their activeinvestment period are subject to thesenotification requirements.

� Marketing in Japan Both Before andAfter the Effective Date:

��FIEL Exemptions. If a general partnercommenced an offering in Japan priorto the Effective Date and it is eligiblefor one of the registration exemptionsunder the FIEL, but is relying on theQII Targeted Exemption, it will stillbe required to make the appropriatenotification to the Japanese regulatorby the earlier of (1) December 31,2007 and (2) the admission of aJapanese investor after the EffectiveDate.

��Grandfathered Status. If a generalpartner commenced an offering inJapan prior to the Effective Date, butcannot rely upon one of the

The Impact of the New Japanese Securities Law on Fund Sponsors (cont. from page 7)

CONTINUED ON PAGE 14

The enactment of the

FIEL will add another

layer of complexity to

offering fund interests in

Japan and admitting

Japanese investors into

private equity funds

structured as limited

partnerships. In most

cases, however, the

impact will largely be

administrative, and most

general partners should

be able to rely on the

exemptions available

from registration.


Canadian companies often figureprominently in private equity transactions,either as direct targets, or as subsidiaries ofU.S. targets. After all, Canada is the U.S.’sbiggest trading partner, and the bilateraltrade relationship is the world’s largest.Canada is, among other things, the largestenergy exporter to the U.S. The economiesof the two countries are highly integrated.Approximately 80% of Canada’s populationlives within 200 miles of the border withthe U.S. Structuring financing forCanadian companies and maximizing taxadvantages in connection with acquisitionsinvolving Canadian companies are frequentchallenges for private equity firms and theiradvisers.

The U.S.-Canada tax treaty is expectedto be amended shortly when the protocolsigned by Secretary Paulson and MinisterFlaherty earlier this Fall is ratified by bothcountries. For private equity, the protocolcontains a number of helpful provisionsand presents some new opportunities.

Good News: Elimination ofWithholding Tax on InterestThe current treaty between the U.S. andCanada reduces withholding on interest to10%. (Canada’s normal rate is 25%.)Under the protocol, the rate will be reducedto zero. The zero rate will apply shortlyafter ratification in the case of interest paidto unrelated parties (e.g., payments made byCanadian companies to unrelated U.S.financial institutions) and will be phased inover an approximate two-year period in thecase of interest paid to related parties.

U.S. institutions are frequently sole orlead lenders to Canadian companies inleveraged buyouts. Under today’s rules,U.S. financial institutions either have tolend through Canadian subsidiaries orbranches, or they have to structure theirloans to comply with Canada’s “5/25

exemption” (the loan must have a term ofat least 5 years and the Canadian borrowercannot be obligated to repay more than25% of the principal within the first 5years). Otherwise, Canada will impose itsinterest withholding tax. Once the zerorate goes into effect, these cumbersomestructures and arrangements will no longerbe necessary.

In early October of this year, Canadaannounced legislative plans to eliminate itswithholding tax on interest paid byCanadian companies to unrelated lenders inall jurisdictions. The elimination would beeffective when the corresponding provisionof the U.S. protocol becomes effective.This means that lending syndicatesincluding non-U.S. lenders will enjoy thezero rate on interest as well. The result ofthe legislation will be greatly to expand thepool of syndicate members eligible forautomatic zero withholding.

Good News: Treatment ofLLCs and Other TransparentEntities More FavorableCanada treats U.S. LLCs as corporationseven though the U.S. generally treats themas flow-through or “transparent” entities.This has led to anomalous situations whereU.S. members of an LLC have been deniedtreaty benefits by Canada (for example, ondividends paid by a Canadian company to aU.S. LLC with U.S. members). Canadahas denied treaty benefits under the theorythat it regards the LLC as a U.S. corporationbut not as a “resident” of the U.S.; underthe treaty, a “resident” of the U.S. has to bean entity generally subject to U.S. tax.Because the U.S. does not tax the LLC (butinstead taxes the members), Canada hasclaimed that neither the LLC nor its membersare entitled to treaty relief. This is whyU.S. private equity funds and their generalpartners rarely take the form of LLCs.

The protocol changes this unhappyresult. Under the protocol, Canada willlook through a non-Canadian entity such asan LLC and grant treaty relief to the entity’sU.S. owners provided that the U.S. treatsthe entity as transparent for U.S. taxpurposes (which will generally be true inthe case of the LLC). Does this mean thatprivate equity funds and their generalpartners should henceforth organizethemselves as LLCs? Not necessarily. Theprotocol affects only U.S. members of anLLC. If an LLC has non-U.S. members,Canada will still deny treaty benefits tothem. However, the protocol, onceeffective, will allow LLCs to be used much

What Private Equity Needs to Know About

Changes to the U.S.-Canada Tax Treaty


... [L]egislative plans to

eliminate withholding

tax on interest paid by

Canadian companies to

unrelated lenders in all

jurisdictions ... [will]

mean[ ] that lending

syndicates including

non-U.S. lenders will

enjoy the zero rate on

interest as well ... [and

will greatly] expand the

pool of syndicate

members eligible for

automatic zero

withholding.


more frequently when U.S. corporateportfolio companies make investmentsinto Canada. The LLC will be the entityof choice where U.S. portfolio companiesdesire the flexibility of a partnership butalso require limited liability.

Caution: Earnings-StrippingOpportunities Need to Be Re-evaluatedThe zero withholding rate on related-partyinterest (once fully phased in), has thepotential to open new opportunities towithdraw profits from Canada on a tax-deductible basis. This was apparently notlost on the Canadian governmentnegotiators, who placed some newlimitations in the treaty. To illustrate,suppose a U.S. portfolio company forms aCanadian unlimited liability company (a“ULC’) to conduct a Canadian business.The U.S. company capitalizes the ULC inpart with debt and elects to treat the ULCas transparent for U.S. tax purposes. Insuch a case, the interest disappears for

U.S. tax purposes (the ULC is transparentand hence is just a branch of the U.S.portfolio company), but is recognized forCanadian tax purposes, which treats theULC as a taxable corporation. If theinterest is not subject to Canadianwithholding tax, the result is that theCanadian tax rate is driven down with notax cost in the U.S.

The protocol defeats this arrangementby denying treaty benefits in the casewhere the U.S., because of its entityclassification rules, does not recognize theinterest for U.S. tax purposes. If treatybenefits are denied, the Canadiandomestic withholding rate of 25% willapply, which will make the arrangementmuch more expensive than is the casetoday, where the maximum withholdingrate under the treaty is 10%.

Because many U.S. companies investedinto Canada (and Canadian companiesinvested into the U.S.) in a mannerdesigned to take advantage of earnings-stripping opportunities, the protocol willrequire those arrangements to bereevaluated and in some cases unwound.The anti-earnings stripping rules,however, will first be effective two yearsafter ratification.

Even after the anti-earnings strippingrules of the protocol become effective,there may still be opportunities, by usinga third country’s treaty with Canada, tostrip earnings out of Canada on adeductible basis without incurringCanada’s full 25% withholding tax. Forexample, a U.S. portfolio company couldestablish a Luxembourg subsidiary andcapitalize it in part with debt and in part

with equity. The Luxembourg subsidiary,in turn, could capitalize a Canadian ULCwith an equal amount of debt and equity.If the U.S. portfolio company elects totreat the Luxembourg subsidiary and theCanadian ULC as transparent, the interestwill disappear for U.S. tax purposes butcontinue to exist for Canadian taxpurposes. Under these circumstances, it isexpected that Canada will subject theinterest payments to withholding tax at arate of 10% under the Canada-Luxembourg treaty (which contains noneof the limitations introduced in the newprotocol with the U.S.), but not to itsregular 25% withholding tax,notwithstanding ultimate U.S. ownership.To date, Canada has generally not beensuccessful in challenging similarstructures, but it remains to be seen howthe Canadian courts and legislature willreact to such structures in the future.

* * *In sum, the protocol will simplify thefinancing of Canadian targets andCanadian subsidiaries of targets, createnew opportunities to use LLCs inconnection with Canadian holdings andwill require private equity firms and theiradvisers to be imaginative whenconsidering earnings-strippingopportunities.

Gary M. Friedman [email protected]

Matthew O’[email protected]

Changes to the U.S.-Canada Tax Treaty (cont. from page 9)

Even after the anti-

earnings stripping rules

of the protocol become

effective, there may still

be opportunities, by

using a third country’s

treaty with Canada, to

strip earnings out of

Canada on a deductible

basis without incurring

Canada’s full 25%

withholding tax.


On October 9, 2007, the Securities andExchange Commission’s Division ofCorporation Finance publishedobservations from its review of theexecutive compensation and relateddisclosure of 350 public companies underthe SEC’s new executive compensationrules. The new rules apply to allSecurities Exchange Act filers, includingportfolio companies with outstandingpublic debt.

The Staff ’s observations focusedprimarily on the new CompensationDiscussion and Analysis (CD&A) inproxies – and more particularly, what theStaff viewed as a significant lack of “A” inthe CD&A. The release of the Division’sobservations coincided with publicappearances by John White, Chief of theDivision of Corporation Finance, andother Division of Corporation Financestaff members, echoing the observations inits published review. Following arehighlights of what the Staff had to say,and what issuers should be prepared toprovide in next year’s filings:

� More Analysis (or We Know What YouDid; Now Tell Us Why). Both the Staffin its published report and John Whitein his public comments took ampleopportunity to tell issuers that, by andlarge, they failed to provide sufficientexplanations for how and why theirCompensation Committee made thedecisions it did, as opposed to simplystating what the Committee’sdeterminations were and providingplan descriptions. In the words of theStaff: “The focus should be on helpingthe reader understand the basis and the

context for granting different types andamounts of executive compensation.”

� Focus on What’s Material. Longer, moretechnical discussions were not what theSEC was looking for. The 15 examplesof items an issuer might discuss thatwere included in the new rules shouldbe viewed as just that – examples – andnot as a checklist. Issuers shoulddiscuss elements from the 15 examplesonly if they are material to theirspecific compensation decisions, andinclude a discussion of any otherelements that had a material impact ontheir executive compensation decisions,even if they are not one of the 15identified examples.

� Connect Compensation Philosophies andDecision Mechanics to the Numbers. TheStaff noted that while many issuersdiscussed their compensation philosophiesand decision mechanics in great detail,many issuers failed to explain how theyanalyzed information, and why theiranalysis resulted in the compensationthey paid (including the specificnumbers reflected in the tables).

� Focus on Analysis. The SEC alsorequested that issuers providediscussions of how the amounts paid orawarded under each compensationelement affected decisions they maderegarding amounts paid or awardedunder other compensation elements.The Staff emphasized that the CD&Ashould focus on analysis, whiledescriptions of plan mechanics areappropriately situated in the narrativedescriptions accompanying therequired tables.

� Explain Differences in Named ExecutiveOfficer (“NEO”) Pay. The Staffreminded issuers that, when it adoptedthe new rules, the SEC stated that theCD&A should identify materialdifferences in compensation policies forindividual named executives. Thus, forinstance, if an issuer reports CEOcompensation that is five times greaterthan the next NEO, it should explainthe reasons for the difference.

� Be Prepared to Disclose Your PerformanceTargets (or Fiercely Defend Non-Disclosure). Disclosure (or rather, non-disclosure) of performance targets wasthe #1 area for comments in the Staff ’sreview of these 350 companies. Whereit appeared that performance targetswere material to a company’s decision-making process, the Staff asked thecompany to disclose its targets ordemonstrate why that disclosure wouldcause it competitive harm. If you don’tdisclose the targets, you should beprepared to give a “pretty specificanalysis” of how disclosure wouldcreate competitive harm.

Where individual performance was afactor in compensation decisions, theStaff also asked issuers to provide morespecific analysis of how theCompensation Committee consideredand used individual performance todetermine compensation levels.

� Explain Your Use of ComparativeCompensation Information. In asubstantial number of comment letters,the Staff asked issuers to provide amore detailed explanation of how they

Where’s the Beef?SEC Critiques First Round of Proxy CD&A Disclosure

A L E R T



used comparative compensationinformation to make compensationdecisions, and how and why bench-marking data was adjusted indetermining compensation levels.

� Situate Your Change in Control andTermination Arrangements in the BiggerPicture – (and By the Way, Tell Us HowMuch). Consistent with itsobservations that companies need toexplain how amounts paid or awardedunder one element of compensationimpacted the other elements, the Staffwants to see discussion of why anissuer structured its change in controland termination arrangements the wayit did, as well as how potentialpayments under these arrangementsmay have influenced an issuer’s

decisions regarding other compensationelements. The Staff encouraged tabularpresentations of potential change incontrol and termination payments andsuggested including in the table a sumtotal of the amounts they would berequired to pay.

� Presentation Matters. The Staffindicated that approximately two-thirdsof the companies reviewed includedcharts, tables and graphs that are notrequired by the new rules. In almostall instances, the Staff found theadditional presentations to be helpful –and in particular, tables providinginformation about potential change incontrol and termination payments.One notable exception outside theCD&A was the use of alternative

summary compensation tables, whichthe Staff discourages. Any alternativetables should be presented if at all, in amanner that does not detract attentionfrom the required tables, such as byusing a smaller font and differentcolumn headings.

� ... And Don’t Forget to Call. The Staffencouraged issuers and their counsel inadvance of filing to reach out to theirSEC reviewers and discuss theirquestions over the phone.

Elizabeth Pagel [email protected]

Heidi H.S. [email protected]

SEC Critiques First Round of Proxy CD&A Disclosure (cont. from page 11)

that the strategic may want to require theprivate equity investors to match anycontributions made by the strategic or bediluted.

ExitPrivate equity firms invariably want a clearpath to exit the investment, with thespecifics of whether that exit will happenin months or years driven by the overallbusiness plan and market dynamics. Thestrategic may or may not have a similarvision regarding an exit. If the strategic’srationale for doing the deal is toultimately absorb the target’s business orto acquire a particular asset, it will want tonegotiate a right of first refusal or a hard-wired buy-sell arrangement when itspartners want to exit. The dynamics ofexit will impact the operations of thebusiness from day one, as the strategic and

the private equity investors may jockey forleverage in the final exit negotiation if thestrategic player is or is perceived as apotential exit buyer. The threat of a saleof the target to a competitor could be a

strong motivating factor to force thestrategic investor to step up and buy outthe private equity club. On the otherhand, if the value of the target companydepends upon its continued relationshipwith the strategic player, the strategicplayer could have the ultimate leverage inthe exit negotiations. Viewed against thisframework, virtually every major businessdecision could have ramifications withrespect to the exit.

ConclusionMixed club deals present some unique andpotentially complex issues not present inpure play PE club deals. However, they

generally create commercial opportunitiesnot present in PE only club deals. Forthis reason, these types of bids are likely tocontinue to develop as an importantelement of the overall deal landscape,

particularly in industries where thecommercial advantages of including astrategic on the bid team are mostsignificant, such as insurance, gaming andother regulated industries.

Kevin M. [email protected]

John M. [email protected]

Do PE Firms and Strategics Make Good Dance Partners? (cont. from page 6)


The risk to a PE buyer of an adverse resultin a Delaware appraisal proceeding inmany types of going private transactionsand other public deals suddenly seems lessweighty.

On August 27, 2007, Vice ChancellorLamb, acting for the Delaware ChanceryCourt (the “Court”), determined in aDelaware appraisal proceeding that the fairvalue of each share in The MONY Group,Inc. (“MONY”) at the time of its 2004acquisition by AXA Financial, Inc. (“AXA”)was $24.97 per share. This was $5.03 pershare less than the deal price. The suit wasbrought by Highfields Capital, LTD andcertain of its affiliates (“Highfields”), as theculmination of a vigorous effort byHighfields, as the holder of 4.4% ofMONY’s float at the time of the merger,and a number of other disgruntled MONYshareholders, to oppose the merger. Underthe high stakes game of poker that is theDelaware appraisal rights statute,Highfields is now required to accept theCourt’s valuation, even though it is lowerthan the deal price.

In a Delaware appraisal proceeding, acourt is required to determine the fairvalue of 100% of the corporation as agoing concern based on all factors andelements which might be reasonablyrelevant to value, including market value,asset value, earnings prospects and thenature of the enterprise. Importantly, thisvalue is to be determined as of the closingof the merger not the signing, and withoutregard to the impact of any operational orsimilar synergies on the deal price or anyother speculative elements of value arisingfrom the merger’s accomplishment orexpectation. Both parties have the burden

of proving their respective valuationpositions by a preponderance of theevidence, but if neither party adducesevidence sufficient to satisfy this burden,the Court must then use its ownindependent judgment to determine fairvalue.

Highfields took the position that thefair value of MONY’s shares as of theclosing of the merger was $43.04 pershare. AXA set the value at $20.80 pershare. Each party presented valuationexperts to bolster their cases. Theseexperts in turn presented a wide array ofmethodologies to support their respectivedeterminations of value, including themethods traditionally used by investmentbankers in similar contexts, such as DCFand comparable company and transactionanalyses, as well as other techniques suchas a shared synergies valuation (calculatingfair value by deducting the value ofsynergies from the deal price) and a “sumof the parts” analysis. The latter metricwas designed to take account of the factthat MONY operated three business units:insurance, brokerage and assetmanagement. Each party’s profferedvaluation also reflected its own subjectiveweighted averaging of its variousalternative measures of value.

But despite (or perhaps because of ) theblizzard of data presented by the partiesand a full trial, including spirited directand cross examination testimony, theCourt seemed to find the parties’ battlingvaluation methodologies confusing, overlytechnical and, ultimately, not particularlyprobative. It concluded simply that in theAXA/MONY deal, with its fully negotiatedagreement and non-preclusive deal

protections, the price negotiated by theparties was a better indication of MONY’sfair value than any of the valuesestablished under any of the techniquesadvanced by Highfields or AXA. Thecourt noted:

“…[A] court may derive fair value in aDelaware appraisal action if the sale ofthe company in question resultedfrom an arm’s length bargainingprocess …. Of equal importance, nomaterial impediments existed [in thistransaction] to prevent another bidderfrom entering the sale process duringthe eight month period between themerger announcement and theMONY stockholder vote. With amarket check of this length, the courtmust conclude that any serious bidderwould have come forward, given that(1) AXA publicly stated it would notincrease its bid beyond $31 per share,(2) industry analysts and executivesunderstood that MONY was “in play”and (3) [the investment banker forMONY] was unaware of any otherentity that had an interest in acquiringMONY at a higher price.”

On this basis, the Court determinedthat the value of MONY under the statutewas no more than $31 per share. Still,because the Delaware dissenters rightsstatute precludes an appraisal award fromreflecting any shared synergies orspeculative factors associated with theconsummation of a merger, the courtconcluded that it also needed to determinethe value of any synergies embedded inAXA’s $31 deal price. For this purpose, it

Risk of Appraisal Proceeding May Not Be So Problematic

A L E R T



begrudgingly opted to utilize, on amodified basis, the “shared synergies” and“sum of the parts” valuation techniquesadvanced by AXA, noting that, likedemocracy was to Churchill, it was theleast worse scheme presented by theparties. Utilizing these techniques toestablish the value of the synergiesembedded in AXA’s price, and assigning aweighting of 75% to the former and 25%to the latter, the Court valued Highfields’stake in MONY at $24.97 a share, or$5.03 a share less than the deal price.

* * *The Court’s decision in the case isconsistent with Delaware precedent in thisarea but is a useful reminder of thedifficult nature of the appraisal rightremedy in Delaware for plaintiffs. Inunique cases, such as squeeze-out mergersinvolving closely-held companies andother instances where the transaction hasnot been market tested in a meaningfulway, an appraisal rights remedy can be avaluable tool for disgruntled sellingstockholders. But in most PE deals, it’scircuitous, protracted and expensive

nature, together with the downside riskinherent in its exercise, will render it atool best left in the tool shed. The goodnews for PE buyers is that the Court’sdecision may often allow them (and theirlenders) to live without a closingcondition tied to the exercise of appraisalrights, thereby creating more dealcertainty for the parties.

Stephen R. [email protected]

Michael A. [email protected]

Risk of Appraisal Proceeding May Not Be So Problematic (cont. from page 13)

registration exemptions under theFIEL, the general partner will nothave to register as long as themarketing of the fund in Japan iscomplete by March 31, 2008. A filingnotice with the Japanese regulatormust nonetheless be made byDecember 31, 2007. There is notclear guidance regarding the level ofmarketing required before theEffective Date in order for a general

partner to be grandfathered under theFIEL as having “commenced” anoffering prior to the Effective Date.Japanese practitioners seem to becomfortable that the threshold will becrossed if a private placementmemorandum has been delivered to aprospective Japanese investor prior tothe Effective Date. However, ageneral partner cannot rely on thisgrandfathered status with respect toJapanese investors contacted after theEffective Date.

� Marketing in Japan after the EffectiveDate: Unless the OutsourcingExemption may be relied upon, a generalpartner commencing marketing activitiesin Japan after the Effective Date mustfile a notification (if an exemption fromregistration applies) or register under theFIEL prior to starting such activities.Unless a general partner relying on theOutsourcing Exemption may also relyon the De Minimis QII Exemption, itgenerally will have to file a notice (orregister if the QII-Targeted Exemption isnot available) with the Japanese regulatorbefore admitting Japanese investors.

Transfer Restrictions RequiredA general partner that is not required toregister under the FIEL must enforcesignificant restrictions regarding transferringfund interests (and, in fact, such restrictionsare specifically mandated by the FIEL forthe QII-Targeted Exemption to apply). Inaddition, the FIEL requires that the relevanttransfer restrictions be set forth in theapplicable fund documentation.

Notification Filing ProceduresThe notice to be filed with the Japaneseregulator is fairly simple and contains littlesensitive information, and may generally bemade in English. However, it is not clearwhether the information filed will bepublicly available, so fund sponsors shouldassume it will be.

ConclusionThe enactment of the FIEL will addanother layer of complexity to offering fundinterests in Japan and admitting Japaneseinvestors into private equity fundsstructured as limited partnerships. In mostcases, however, the impact will largely beadministrative, and most general partnersshould be able to rely on the exemptionsavailable from registration.

Jordan C. [email protected]

Erica [email protected]

The Impact of the New Japanese Securities Law on Fund Sponsors (cont. from page 8)


For those sorting through the news andgossip surrounding Nicolas Sarkozy’s firstseveral months in office, it is difficult todiscern any clear message for private equityinvestors. Sarkozy did rise to power thisSpring buoyed by promises of change and acall to get France moving and working again.Since his election, there has been a flurry ofactivity and media coverage that has earnedSarkozy the titles of “hyperpresident” and“Czar-kozy,” significant criticism that he istoo pro-American and too pro-business and,more recently, widespread coverage of hismarital woes and swift divorce.

Notwithstanding all of the distractioncreated by the popular media, we believe thatthe labor and tax reform initiatives of thenew government and the French privateequity market’s increasing maturity continueto warrant cautious enthusiasm despite thisfall’s credit crunch.

Sarkozy’s attitude towards private equityhas been hard to read. In France, privateequity has largely avoided the scrutiny andcriticism that it has faced recently in otherparts of Europe and the President has rarelyspoken on the issue. But Sarkozy’s policies,both as finance minister under the lastgovernment and as President, stronglysupport France’s movement towards a moremarket-oriented economy, which should, atleast indirectly, continue to spell promise forthe private equity market in France.

In general terms, one of Sarkozy’s keygoals has been to debunk cultural mythsabout the value of work and to level theplaying field for entrepreneurs and the privatesector with a simple slogan, “Work more toearn more.” One of the first initiatives of hisgovernment has been to announce that itintends to align so-called “special regimes,”which can permit civil servants to retireseveral years earlier than private sectorworkers, closer to the less generous schemesin the private sector. Predictably, news of

these plans caused the transport unions tocall massive transit strikes in October andNovember. Less predictably, the strikes havenot elicited particular public sympathy. Insharp contrast with previous strikes, theFrench economic daily, Le Figaro, noted that55-65% of those surveyed indicated that thestrikes were “not justified” and more than80% expected that the government wouldnot back down. The absence of widespreadsupport for the strikes bodes well for thepension reform process, which is a key test ofthe government’s policies. Of course, Sarkozymay well face additional strikes of a similarnature over time that will further test hisresolve and the reformist credentials of hisnew government.

It is widely expected that pension reformwill require alternative private pensionstructures to supplement the special regimes.It is hoped that some of the additionalfunding for private pension funds will flowinto the French private equity sector. Thisseems more likely given that, when he wasFinance Minister, Sarkozy obtained a signif-icant commitment from the French insuranceindustry to allocate a fixed percentage of theirassets to private equity investments.

In more specific and concrete terms,shortly after his election, Sarkozy instituted anumber of tax reforms that, while nottailored to private equity per se, are likely tobe helpful to the general economic andentrepreneurial environment:

� in its tax reform voted during the summerof 2007, the government reduced the capon the aggregate amount of direct taxespayable by French residents (the bouclierfiscal, or income cap, introduced in 2005)from 60% to 50% of annual income, andincluded social contributions (which giverise to a 11% tax on investment incomeand an 8% tax on salaries) in the basket oftaxes included in the cap (income tax,wealth tax and real estate taxes);

� the summer tax reform also includedsignificant tax incentives to the highestFrench taxpayers and allowed a creditagainst the French wealth tax (“Impôt deSolidarité sur la Fortune” or “ISF”) of upto 75% of amounts invested in small ormedium-sized companies (within a limitof €50,000). This comes on top of otherrecent reforms which permit corporateexecutives to exclude shares held for morethan six years from calculation of amountstaxable under the ISF. More investor-friendly measures are promised for the2008 budget, which should further easethe conditions under which up to 75% ofthe value of certain shares and businessassets will be exempt from the ISF anddonation/inheritance taxes;

� taxes and social security charges payableon overtime for salaried workers have beeneliminated to encourage salariedemployees to work more than the 35-hourlimit; and

� the 2008 budget provides that Frenchresidents will be able to opt for a flat taxon dividends (18% according to latestparliamentary discussions), rather thanhaving such dividends taxed as income atprogressive rates of up to 40%.

In addition to recent tax reform, privateequity investors are keeping their eye on theFrench State’s impressive investment portfolioin hopes that the State is getting ready toengage in a new round of privatizations.Since 1986, the French treasury has raised€82 billion from privatizing state-ownedcompanies. However, the government stillholds interests in a number of attractiveFrench companies estimated to be worthmore than €200 billion. In the short term,the French State is likely to reduce its 87%interest in the French electrical utility EDF

Is There Good News for Private Equity Investors in France?



and to list the shares of AREVA on Eurolistof Euronext Paris. In the longer term, theState’s 15% interest in Renault and EADSmay also end up on the block.

Despite these promising signs, theSarkozy government has also alreadypartially demonstrated the truth ofAlphonse Karr’s adage “plus ça change, plusc’est la même chose” (the more it changes, themore it’s the same thing). Most recently,with the government’s promotion of theGaz de France-SUEZ merger as a means ofcreating a French energy powerhouse, thegovernment has shown its continuingpreference for the creation of Frenchnational champions—a persistent Frenchpolicy under both leftist and rightistregimes. In addition, the new governmenthas recently curried political favor byenacting legislation on the amounts payableunder “golden parachutes” pursuant to anAugust 21, 2007 law that outlaws extracompensation that is not keyed toperformance-based criteria.

In light of the new government’s recentrestrictions on executives’ “goldenparachutes,” certain private equity

commentators have observed that Sarkozy’sgovernment may turn its attention toclamping down on the increasingly lucrativemanagement packages in recent Frenchbuy-outs. In contrast to other Europeanmarkets, management deals in France havebeen relatively lucrative as investors appearto have been competing as much on theattractiveness of the management package ason the price of the deal. In France, wherethe attitude towards wealth creation remainsgenerally critical, increased attention to thedisparity between the salaries of managementand French employees could bring privateequity investors unwanted attention.

Ultimately, however, the mostencouraging signs for private equity and theevolution of the French economy lie not inwhat the French government is promisingor doing, but in the stability and diversityof deal flow that has in recent years madeFrance the most mature European privateequity market outside the UK. It is thatgrowing maturity which led the Economistmagazine to identify two very differentkinds of capitalism in France and tocontrast Sarkozy’s intervention on the

GDF-Suez deal with the dynamicdevelopment of a dinosaur of French heavyindustry, the Marine Wendel Group, intoone of the most successful investment fundsin Europe. According to the Economist,Wendel is now Europe’s second-biggestinvestment group—behind Sweden’sInvestor, but ahead of Britain’s 3i and theEuropean arm of KKR. In September,Wendel announced that its net asset valuehas grown by 31% on average in each ofthe past five years and the group recentlyfloated its largest investment, BureauVeritas(BV), which Wendel acquired in 2004 forapproximately €1.4 billion, in an IPO onEuronext Paris that values the BV group inexcess of €4 billion.

At the end of the day, that kind ofperformance is likely to do much more forthe private equity deal market in Francethan any policy initiative of the newPresident.

E. Drew [email protected]

Eric Bé[email protected]

Is There Good News for Private Equity Investors in France? (cont. from page 15)

Recent and Upcoming Speaking Engagements November 1James C. ScovilleHot Topics Cross-Border SecuritiesSecurities Litigation and Enforcement Trends &Developments / Listing and Offering TrendsOutside The U.S., Including Emerging Marketsand Fund IPOsLondon, England

November 9Rebecca F. SilbersteinDow Jones Virtual SeminarFundraising In-Depth: The Key Terms andQuestions LPs & GPs Must KnowWashington, D.C.

November 13-14Paul R. BergerForeign Corrupt Practices ActImplementing and Monitoring a Global Anti-Corruption Compliance ProgramArlington, VA

November 14-16David H. SchnabelTax Strategies for Corporate Acquisitions,Dispositions, Spin-Offs, Joint Ventures,Financings, Reorganizations & RestructuringsTax Strategies for Private EquityLos Angeles, CA

January 18David A. Brittenham, Co-ChairGregory H. Woods, III Private Equity Acquisition Financing Summit2008New York, NY

January 29Noëlle LenoirCross-Border Mergers and European CompanyStatute (SE)Insights from the Diversity of Firms That HaveChosen the European Company Paris, France


Teams of lawyers for private equity sponsorsand their bankers on both sides of theAtlantic are poring over the fine print inacquisition and loan documentation for anumber of pending transactions in the wakeof recent turmoil in credit markets, analyzingthe implications of terminating theseagreements. In particular, material adversechange clauses (MACs) and the risksassociated with invoking them have receivedrenewed scrutiny.

The MAC clause is an unlikely refuge foran acquirer or its financing sources in a UKpublic transaction, but may be of greaterrelevance in a private deal.

Public to Private TransactionsA large proportion of recent private equitydeals in the UK have been in the public listedcompany sector. Although this would havebeen unheard of several years ago, as largerand larger PE funds were raised andfinancing became increasingly available byvirtue of unprecedented liquidity andhistorically low interest rates, biggercompanies, including companies one wouldnot have thought of previously, becamepotential LBO targets for PE buyers. Thistrend culminated in the £11.1 billion buy-out of Alliance Boots, the UK-listedhealthcare company, in summer 2007.

Public to private transactions in the UKare effected by means of an agreed publictakeover of the UK-listed company by theprivate equity sponsor consortium. Thisrequires a takeover offer to be made by Bidcounder the provisions of the City Code onTakeovers and Mergers (the “Code”) which isadministered by the Takeover Panel.

Certain Funds. Under the Code, Bidcocannot announce an intention to bid for aUK-listed company without having everyreason to believe that it can and will continueto be able to implement the offer. Bidco isalso required to appoint a financial adviser to

the offer which in turn must provide a cashconfirmation in the offer document to theeffect that sufficient funds are available toBidco to consummate the offer if the offer isaccepted by all shareholders. In order to givethe cash confirmation, the financial adviser(generally an investment bank) will requirethat Bidco has committed financing (“certainfunds”) available to it before it launches thebid. Therefore, Bidco must enter into a fullynegotiated credit facility and other financingdocuments which are subject to theminimum conditionality possible. Thismeans there is no MAC out in the financingdocumentation and the lenders are obliged tolend for the purposes of the bid in allcircumstances (other than, generally, in thecase of insolvency and deliberate breach ofcontract on the part of Bidco).

By virtue of the requirement for “certainfunds,” there is minimal conditionality onthe financing side of the public offer andabsolutely no financing “out.” (It has beensuggested that U.S. private equity firmsbecame comfortable with removing financingconditions in U.S. deals due to their forcedacceptance of that approach in the UK. See“Are Private Equity and Strategic Deal TermsConverging,” in the Summer 2005 issue ofThe Private Equity Report.) There are,though, certain customary conditionsincluded in the offer document which is sentto all share-holders of the target (for their“acceptance”) following the launch of the bid.These conditions typically do include a MACclause as well as an “acceptance” condition,and antitrust/competition clearances inrelevant jurisdictions.

The effectiveness of the MAC clause in apublic offer document was tested in 2001 asa result of the economic turmoil triggered bythe events of 9/11. WPP, the advertisingcompany, attempted to pull its plannedtakeover of Tempus, another listed advertising

company, by arguing that the events of 9/11had caused a material adverse change in theprospects of Tempus, which was of materialsignificance to WPP in the context of its offerto Tempus. The MAC clause was broadlydrafted and referred to “no material adversechange or deterioration having occurred inthe business, assets, financial or tradingposition or profits or prospects of anymember of the wider Tempus Group.”

The Takeover Panel dismissed WPP’sclaim, saying that the “material significanceto the offer” test (which a MAC would haveto meet under the Takeover Code) was notmet. To be met, it required “an adversechange of very considerable significancestriking at the heart of the purpose of thetransaction in question, analogous … tosomething that would justify frustration of alegal contract.” The Takeover Panel alsostated that the effect of the adverse changehad to be long-lasting and a mere temporaryeffect on profitability was not enough. TheTakeover Panel did eventually clarify therequirement of being “analogous to …something which would justify frustration ofa legal contract” by saying that the effect didnot actually have to be a legal frustration ofthe contract. However, in essence, somethingvery serious will have to have happened to

Material Adverse Change (MAC) Clauses from a UK Perspective


The MAC clause is an

unlikely refuge for an

acquirer or its financing

sources in a UK public

transaction, but may be

of greater relevance in a

private deal.


the target to justify triggering a MAC out ina UK public to private transaction and achange in general economic conditions isgenerally not enough.

In view of this tough stance taken bythe Takeover Panel under the Code, to theextent a public to private bid is aborted, it istypically pulled on the basis that theacceptance condition has not been met on aclosing date for the takeover offer, not theexistence of a MAC. The acceptancecondition is normally set at 90% (ofshareholders accepting the offer) (but can bewaived down to 51% by the offeror at itsdiscretion). Therefore, if a MAC occursbefore 90% is reached at a closing date, theoffer can be allowed to lapse without anyreason needing to be given. A MAC islikely to be tested, therefore, only incircumstances where the 90% threshold hasbeen attained and the MAC then occurs (aswas the case in WPP/Tempus).

Private AcquisitionsMost private company acquisitions by PEsponsors in recent years have tended to bemade by way of an auction organised by theseller. In competitive auctions, acquirorshave not had the luxury of being able toinsert a MAC clause in the Share PurchaseAgreement (SPA) and, as a result such

clauses are rare in recent UK transactions.However, MAC clauses are more customaryin US style transactions which have animportant European element and in mid-market deals. If there is no MAC clause inthe SPA, the financing documentation(which is entered immediately prior tosigning the SPA) has tended not to haveany MAC out for the lenders. Therefore, asa result of the robust market, banks havegenerally been pushed to accepting aposition analogous to “certain funds” inprivate transactions, which was unheard ofuntil recent times). There has, therefore,been very limited conditionality in private

acquisitions by way of auction and MACclauses have not played a part. By way ofexample, in some recent auctiontransactions, the only condition to closingwas the anti-trust/competition clearances.

MAC clauses as closing conditions inprivate acquisitions and related financingarrangements could become more commonagain in different deal environments. If aMAC is included in a private acquisitionSPA, it is likely to be construed inaccordance with normal contractualprinciples and will be given the meaningwhich it conveys to a reasonable person,having all the background knowledge whichwould reasonably have been available to theparties at the time of entry into thecontract. In other words, even if MACclauses return on large private deals, well-negotiated clauses should not be expansivelyinterpreted.

Recent ExampleOne recent example of an interpretativedispute under English law regarding a MACclause arose in a different context. In 2005,a syndicate of international banks invoked aMAC as a basis to call a default under theirUK law-governed credit facility with YukosOil Company. The banks were reacting toan entry of a judgment against Yukos for

several billion dollars of tax liabilities, whichin turn had led to the freezing of Yuko’sassets and its issuance of a press releasestating that it was at risk of an insolvency.Under the credit facility, a MAC event ofdefault was defined essentially as theoccurrence of any event or circumstancewhich (in the reasonable opinion of thelenders) had or might reasonably beexpected to have a material adverse effect).Yukos challenged the lenders right to invokethis MAC clause but the court held that theMAC event of default had occurred in linewith the wording of the contract and theloan could be accelerated.

Note though that because this case arose“after the fact” in the context of a creditfacility, it is not necessarily predictive ofhow a similar case might play out in anacquisition context. In addition, the valueof the case for an M&A deal in terms oflegal precedent could be limited by theextreme facts in the case and theformulation of the MAC clause itself, whichincluded a subjective element—i.e., thereasonable opinion of the lender.

Failure to Lend/Measure of DamagesOf course an equally, if not moreinteresting, question as to what constitutes aMAC under English law is what would bethe measure of a PE firms’ damages if aMAC clause were wrongly invoked by itslenders? Put differently, what would be aprivate equity firm’s measure of damages ifits lenders blocked an acquisition byrefusing to fund on the basis of an allegedMAC, but a court later concluded that theMAC clause had not been triggered andthat the banks were therefore in default? Asstated above, we believe this would occur inthe UK only in a private deal. But if alender pulled its financing in breach ofcontract, the measure of damages wouldlikely be (1) reasonably foreseeable losses

e.g., extra interest and other costs and feesincurred in arranging alternative financingand (2) specially contemplated losses e.g.,losses arising out of the failure of theborrower to complete the acquisition to befinanced by the loan. This would includeany termination fee payable for notcompleting the deal plus any other wastedexpenditure or costs incurred. Thealternative to claiming wasted expenditure isto claim loss of profit suffered as a result ofthe termination (under English law youhave to choose between claiming wastedexpenditure of loss of profit—you cannot

Material Adverse Change (MAC) Clauses from a UK Perspective (cont. from page 17)



claim both). Loss of profit may be hard toquantify but could be significant enough toincentivize the lender to reach anaccommodation rather than litigate. Itshould be noted that a borrower willgenerally not able to obtain specificperformance of a loan obligation from alender, in which case its only remedy underEnglish law will be in damages, with anobligation to mitigate its loss e.g., by seekingalternative financing.

ConclusionUnlike the U.S., where MAC clauses haveentered the lexicon of the general press inthe wake of the credit crunch, MAC clauseshave not come into play very often in theUK context owing to the UK publictakeover regime and the recent negotiatingstrength of sellers on the private acquisitionside. But although MAC clauses mayalways be of little import on the public offerside in the UK, under current market

conditions there may well be somemovement back to including MAC clausesin private acquisition agreements andrelated financings in the UK.

Peter [email protected]

Material Adverse Change (MAC) Clauses from a UK Perspective (cont. from page 18)

intent rather than rewriting a contract intosomething that they think is reasonable.UK judges also focus on issues of causationand loss — all of which are basic commonlaw concepts. Although EU law has someimpact on English law contracts, Englishlaw is still very familiar to those accustomedto U.S. law contracts — much more sothan contracts which are governed byFrench or German law or the laws of othercontinental European jurisdictions.

As I understand it, the national law of EUmember countries like the UK is required tocomply with EU directives. To what extenthas the EU forced the UK to change itshistorical approach in certain areas such asemployment and product liability?

I think there are two points here. The firstis that in every country, including theUnited States, traditional common lawconcepts have been fashioned by legislativeenactments or local laws. In the UnitedKingdom, both parliamentary laws and EUlaw have imposed new regulations relatingto employment, product liability and thelike. That does not erase the core conceptsof commercial contracts. What it does

mean is that those doing business in anyEuropean country need to be well aware ofthe local law and be advised about itsimpact.

The second point is that EU law isalways subject to negotiation and in manyareas has to be a subject of unanimousagreement among the member states,including the United Kingdom. Havingbeen very closely involved in negotiatingsome aspects of EU law on behalf of theUnited Kingdom, I can say that the UnitedKingdom has always advocated that someof the solutions which work for ourcontinental colleagues don’t work for us andcannot be reconciled with our common law.Actually, there is now more of a voice forthe common law countries because there arenow three other common law countries—Ireland, Cyprus and Malta—in the EU. Ican assure U.S. investors that the UnitedKingdom government has always believedthat the legacy of common law has beenimportant for British business and has beenat pains to keep alive the core conceptsunderlying our common law.

At a time when London is clearly the center ofEuropean business, are there areas that concernyou about the impact that the EU will haveon English business and on others doingbusiness in the UK?

One aspect that has been of great concernto British industry is the industrial relationssettlement, which governs the relationshipthat employers have with unions, and isdifferent in the United Kingdom from therest of Europe. The UK government hasbeen very keen to preserve those rights. Atthe moment, we are going through the finalstages of a new EU treaty, following failedattempts at a full European UnionConstitution. It will contain a specificprotocol which is designed to protect theUnited Kingdom settlement in relation tosocial and economic rights. One of the verylast things I did in government before Istepped down was to draft that protocol tobe satisfactory to both Tony Blair andGordon Brown, the outgoing and the in-coming Prime Ministers. Another area ofconcern that should be followed carefully isthe increase in responsibilities and duties of

An Interview with Lord Peter Goldsmith (cont. from page 1)



directors, although it is not specific to theUnited Kingdom.

Can you help those of our readers based inAmerica to understand the difference betweenwhat it means to be a director of, say, aDelaware company and the director of a UKcompany?

In the past, very similar concepts haveapplied—the concept of loyalty and theconcept of reasonable business care. In theUnited Kingdom, the basic Companies’legislation has just been rewritten. I wasvery closely involved in formulating the newapproach to directors’ duties and the newapproach to derivatives claims. The newlegislation seeks to strike a balance betweenthe importance of duties to shareholders, onthe one hand, and the interests of suppliers,employees, and the local community inwhich businesses may be located, on theother hand.

Let me make sure I understand. UnderDelaware law, a director is supposed to put theinterests of shareholders above all else unless thecompany is insolvent. In some states, thedirectors are permitted to consider the interests

of the relevant communities and the interestsof other stakeholders, but they are not requiredto do so. Are you saying that, in the UK, thedirectors are, in fact, required to take intoaccount those considerations?

The new legislation does require directors tohave regard to these considerations. But,the precise language is very important.These matters are to be given regard by thedirectors, in good faith, as part of anoverriding obligation to promote the successof the company for the benefit of itsmembers as a whole. There is nothing thatrequires these other concerns to bedeterminative, but directors of companiesmust give a fair consideration to theseissues. In the discussions I’ve had withdirectors of public companies in the UK,even though they weren’t happy about theseconsiderations being raised to legalobligations, they didn’t think this wouldactually change the way they did business,because those were the things for whichthey traditionally had regard—on thetheory that building long-term shareholdervalue is dependent on having theseconsiderations in mind.

Many private equity firms still control theirportfolio companies even after an IPO. Inmany of these cases, there are also significantminority shareholders. How have theobligations of directors and majoritystockholders in public UK companies changedas a result of the new UK Companies Act, andis this something that our private equityinvestors should be particularly concernedabout?

Concern is not necessary, but knowledge is.What has really changed is a codification oflaws which always existed in the UnitedKingdom. Minority shareholders could incertain circumstances bring claims on behalfof the company which were not beingpursued by the majority shareholders, or

directors. As in the U.S., these wereshareholders’ derivative actions. The newlegislation was actually designed to avoid asituation in which shareholders of thecompany find themselves faced withvexatious, frivolous claims of the sort thatwe know from time to time are brought bylitigious shareholders. The new legislationprovides protection by mandating that thesetypes of claims cannot be brought withoutjudicial consent. In this regard, the judge isrequired to consider a number ofcircumstances including whether theconduct is likely to be ratified byshareholders.

The private equity community breathed acollective sigh of relief earlier this Fall whenthe proposed tax changes announced byGordon Brown’s government maintained thebasic premise that carried interest would betaxed as capital gains and revised the capitalgains rate applicable to that carried interestfrom 10% to 18%. Do you think that’s ashortsighted sigh of relief?

No. This must have been underconsideration for some time. This questionhas been quite a hot political potato. Ithink it’s a good overall solution. It hashelped a lot of investors by reducing therate of capital gains tax. It also produced aresulting tax for private equity carry that isnot out of line with the rate of tax thatapplies in a number of other importantjurisdictions. The UK’s tax rate of 10% onprivate equity carry and other businessassets held for two years was particularlygenerous. From private conversations I’vehad with people in the market, I think theproposed tax is exactly where they thoughtit would be a comfortable place to end up.Interestingly, the initial complaints aboutthis change were not from our privateequity community, but from small business



The UK’s tax rate of

10% on private equity

carry and other business

assets held for two years

was particularly

generous .... [T]he

proposed tax is exactly

where they thought it ...

a comfortable place to

end up.


owners who thought this new proposalcreated an unexpected tax hardship forthem. In response to these complaints,Gordon Brown’s government looks likely toconcede extra capital gains tax reliefintended especially to benefit retiring smallbusiness owners. One other effect of theproposed change is to remove someuncertainties and complications about thepresent regime. But having said that, it isright to point out that the government hassaid it will continue to monitor theoperation of some of the rules relating tothe taxation of private equity.

UK investors in the stock market, as Iunderstand it, also benefit from this taxproposal because their tax rate for capital gainson sales of securities would be reduced frompotentially up to 40% to 18%.

Absolutely. This is welcomed as a result bysmall investors who would have beenpaying the high rate of tax on capital gainsand will now simply pay this flat 18%.

Is this almost a match to what the U.S. hasbeen doing for a number of years with its15% capital gains rate?

I cannot believe that my former colleaguewould not have looked hard at what othermarkets were doing when they decided onthe tax rate. That private equitycommunity is very important to the City ofLondon and the government would nothave wanted to drive people away bymaking it uncompetitive.

Some of my private equity friends in the U.S.have remarked from time to time that thereare more non-domiciliaries in the privateequity business in London than there aredomiciliaries. Can you explain why that hasbeen of concern to U.S. business and what thenew tax proposal suggests will happen?

This is another issue that has been around

for quite a long time. Non-domiciliaries inthe United Kingdom, who usually “live” inLondon, have been entitled to veryfavorable tax treatment especially ascompared to those residents who are UKdomiciliaries. The dilemma for governmenthas been: Do you then bring these peopleinto the tax regime even though they arenot domiciled in the UK and perhaps riskdriving them away from the Londonmarket, together with all the benefits thatthey provide with respect to the creation ofwealth in the United Kingdom. Or do youleave what appears to be a huge inequalitywith bosses who are paying no tax,employing ordinary and dutiful people whoare paying a lot of tax. This issue has beenbubbling away in the political world forsome time. What brought it to a headappears to have been a proposal launchedby the Conservative party to raise a flat rateon non-domiciliaries. Labour’s Chancellorhas now announced changes which aredifferent, but which also propose a flat ratelevy. That may well satisfy the politicaldemand to make a big change in relation tonon-domicilaries and yet not jeopardize thebusiness climate. The government has saidit will continue to review this area,including whether people who have beenresident in the UK for over ten years shouldmake a great contribution.

You have assured us that English law remainsvery suitable for many business transactionsand that the UK remains a prime player inthe private equity community, but I haveheard concern that Britain is moving towardsa U.S.-style transaction culture which wouldsuggest that litigation risk and the potential fordisastrous recoveries may soon be coming toLondon.

My judgment is that the litigation risk inthe UK remains and will remainsignificantly less than in the U.S. It is true

that there have been a number of highprofile actions which could, because of thenumber of plaintiffs involved, be thought ofas akin to class actions. It is also true thatthese claims are a bit easier to bring thanthey were historically because of changes tothe procedural law. But there remain very,very significant and quite deliberatedifferences between the UK law in this areaand U.S. law. First of all, lawyers can’t getenough lift of their fees if they succeed inthe action; they cannot go for a straightcontingency agreement irrespective of theamount of work that they do. The rewardsfor lawyers therefore are significantly less.Secondly, you cannot get general punitive



... [L]itigation risk in

the UK remains and

will remain significantly

less than in the U.S.

.... [T]here have been a

number of high profile

actions which could,

because of the number of

plaintiffs involved, be

thought of as akin to class

actions .... But there

remain very, very

significant and quite

deliberate differences

between the UK law in

this area and U.S. law.


damages as a plaintiff in a UK class action.Each claimant has got to prove his or heractual loss. Thirdly, claimants come intothe UK litigation group as a result of adeliberate decision to “opt-in”—a claimantsays he wants to be part of an action andhas the opportunity of doing so. It is not asituation where one person can bring a classaction on behalf of a broad class ofunidentified people who then have to opt-out if they don’t want to be bound by theresult. These vast differences have,unfortunately, not convinced some U.S.plaintiff-oriented law firms that it is notlucrative for them to set up shop inLondon. But the general consensus of theUK legal profession remains that the cultureand legal structure of U.S.-style class actionsdoes not exist, thereby creating a morebenign business environment.

Are there other types of regulatory changes thatmay have a major business impact in Europethat the PE community should be aware of?

There are two aspects that I wouldmention. The first is merger control andthe second is the responsibility of directorsand corporate supervision. My perspectiveon merger control is as a result of the Sony-BMG merger being declared void by alower European court after the EC hadcleared the merger. The bottom line is thata decision of the European Commissionclearing a merger is not final. Even after themerger takes place, and indeed when thebusinesses are merged, a court can comealong and void it. That decision has causeda lot of consternation about the future ofmerger control in Europe.

There is also a series of events, includingEuropean Union Directives, which makecorporate financial supervision all the moreimportant. These will increase the risk ofpersonal responsibility of directors,including audit committee members. For

example, if there is a whistle-blower or someallegations of illegal conduct, such asbribery within a subsidiary company, therisk of personal liability means that directorsmust be cautious not to sanction onlylimited investigations.

U.S. directors have always been concerned thatserving on the boards of European companiesor even European subsidiaries of U.S.companies creates more of a risk of personalliability than serving on U.S. corporateboards. Do you think that perception is noweven more justified?

There is some truth in it. If I look atEnglish corporate law going back less than100 years ago, a director was a gentlemanwho was expected simply to act in goodfaith and wasn’t expected to have anyparticular degree of business judgment, letalone skill. That has changed. Thelegislation alone has not changed it, butrather the evolution of the common law inlight of a number of corporate disasters.

Do you anticipate, for example, AuditCommittees having their own counsel on aregular basis, as opposed to just when there issome provider concern about the financialstatements or about management’s activities?

It is not going to be necessary for an AuditCommittee to have counsel on alloccasions. It may be prudent for AuditCommittees to take good independentadvice when they see a problem, in order tomake sure that the solution is the rightsolution and to give themselves protection.

So now that you’re a month or so into yournew position, tell me about your dreamprivate equity assignment?

Before I went into public service, I spentmy time solving problems after they’darisen—trying to pick up the pieces afterdeals had gone wrong. That is, of course,

what litigators do. In public service, I spenta lot of time trying to make sure thingshappened right from the start. I am veryexcited about the prospect of being moreinvolved in the transaction side, but I verymuch want to do a lot on the litigationdispute resolution side as well. Theproblems are global, there are jurisdictionissues arising in a number of differentplaces, and you want to plan from the starthow you are going to resolve your disputes.I can envision a situation in which it wouldbe very good to be involved in the earlystages, hoping to anticipate problems sothat actual disputes don’t arise, but if theydo, then having in place a good disputeresolution mechanism so as to sort themout in the most advantageous way.

In a multi-jurisdictional transaction, wouldyou recommend using litigation or arbitrationas the best dispute resolution method?

If you’re going across a number of countries,I think it is likely to be most effective to usearbitration. Where a contract is enteredinto by parties from multiple States, theyoften choose arbitration over litigation inone of those States in order to avoid givingan actual or apparent advantage to one side.Certainly you don’t want to have a situationwhere, frankly, your choice of forum isgoing to be in a country which doesn’t havea long experience in dealing withcommercial disputes. You can decide thingsin Delaware; you can decide things inLondon, but it is not desirable to go tocourts in places without a long history ofsuccessful commercial dispute resolution.That state of facts creates an internationalarbitration lawyer’s dream assignment.

Lord Peter [email protected]

Franci J. [email protected]



less appealing for private equity firms. Priorto the flurry of deal-making that began in2004, it was not uncommon for an MAEto be defined in a private equity firm’sacquisition agreement without exceptionsthat were standard in strategic transactions;that is, without carving out particularoccurrences that the parties agreed wouldnot be taken into account for purposes ofdetermining whether an MAE hadoccurred. This meant that adverse changesin the target business’s industry, thefinancial markets or the economy generally,applicable law, accounting rules and otherbackground events not specific to the targetalone could be invoked by a private equitybuyer as a reason not to close the purchase.Unlike strategic buyers, who could bedeemed to be already exposed to such risksin their own business and for that reasonbetter able to weather such adverse changesand consummate a purchase, private equityfirms, with a three to five year investmenthorizon and no current exposure to thetarget business, considered themselves, andwere able to persuade sellers that they were,in need of such protection.

Two developments combined to takethis protection away from private equityfirms. First, sellers simply became morefocused on removing all forms ofconditionality from acquisition agreements.Second, many sizeable transactions weresold through an auction process, in whichprivate equity buyers, competing withstrategics in the auction, faced substantialpressure to agree to the lowest commondenominator in contract terms. The resultwas that, in most recent transactions withvalues of greater than $1 billion, a privateequity buyer was typically required toaccept the laundry list of exceptions to theMAE definition described above. Inaddition, over time, both private equity andstrategic buyers were pressured to accept stillbroader carve-outs, such as changesresulting from war and terrorism, the

target’s failure to meet earnings forecastsand, in some cases, contingencies set forth(often without great specificity) in sellerdisclosure schedules. A parallel and keydevelopment was the acceptance by lendersthat the MAE definition in the acquisitionagreement would be the MAE standardapplicable to the debt financingcommitment letters. This meant, at leasttheoretically, that the lender would not beable to rely on an MAE condition not alsoavailable to the private equity buyer, andtherefore made the private equity buyer lesswary of proceeding without a financingcondition.

Although strategic buyers were, ofcourse, required to accept the same risks,the loosening of MAE terms has posed lessrisk for private equity buyers in light of theliability limitations discussed above.Whereas a strategic buyer might face bothan unlimited damages claim and an actionfor specific performance if it were to lose anMAE dispute arising from a failure to closean acquisition, the private equity buyer thathas bargained for the package of liabilitylimitation described above—liability limitedto a negotiated, reverse termination fee anda seller waiver of specific performance—isin a substantially stronger position, both asto its limited downside and its ability tonegotiate terms for a revised transaction.

Representations, Warranties and IndemnitiesUntil recently, a sponsor would haveexpected to receive detailed representationsand warranties about the target businessfrom the seller in private deals. Thoserepresentations and warranties serve twopurposes. Unless the representations andwarranties remain true and correct—or, atleast, true and correct with certainmateriality or MAE qualifications—thebuyer would be excused from closing thetransaction. In addition, the representationsand warranties supported the buyer’s duediligence review, and—if, post-closing, it

emerged that the statements were materiallyuntrue—were typically backed up in a non-public deal by an indemnity from the seller.

That general approach shifted under thepressure of recent market conditions.Particularly in the largest transactions,sponsors have increasingly been asked to dodeals with a “public M&A style” contract—containing representations and warrantiesheavily qualified by materiality, knowledgeor MAE, and either no indemnity or a verylimited one, with all claims confined to anescrow. The use of MAE qualifications inparticular has had a powerful effect inundermining the significance ofrepresentations and warranties since, asnoted above, the kinds of changes thatwould constitute an MAE as defined incurrent deals are very limited. For theprivate equity buyer that has bargained for acap on liability and specific performancewaiver, however, a looser and morefrequently used MAE standard in therepresentations and warranties has less bite,or balance, than for a strategic buyer whodoes not benefit from the companionlimitations such terms provide.

Tighter Financing CovenantsAs the focus of both PE buyers andcorporate targets and sellers on the need toensure that the debt financing for a buyoutwould be available at closing sharpened,both sides perceived the need for strongerfinancing covenants. The private equitybuyer required the seller to commit in greatdetail to facilitate the financing, includingproviding financial statements and otherinformation and making target companyexecutives available to participate in thepreparation of debt offering memorandaand in road shows to sell the debt. For itspart, the seller required the private equitybuyer to use reasonable best efforts toobtain the debt financing, to seekalternative financing if necessary and to




draw down on committed bridge financingif the permanent financing could not besold within a specified marketing period.

The imposition of strict timelines withinwhich the financing covenants played outhad the unintended, but predictable,consequence of making, at certain key timesduring the life of a deal, the relationshipsamong the various parties required toconsummate a successful high yield debtfinancing or a bank loan syndication (thatis, the buyer, seller and financing sources)adversarial. After all, each party wasjockeying to preserve its rights under eitherthe acquisition agreement or the debtfinancing commitments. Many sellersthought they would benefit from havingratcheted up the financing covenants. Inpractice, what sellers discovered was that thelimited flexibility afforded buyers in a tightcredit market only made those buyers morelikely to tap the contractual outs they hadbargained for in the acquisition agreement.

What’s Next?It is hard to predict at this stage how sellers,buyers and their traditional financingsources will recreate the deal marketplace.Each side has a wish list, and whose favoredapproach prevails will depend – as always –on changes in market leverage of buyers andsellers that will be affected by a host ofvariables. However this situation evolves,the battle lines are clearly drawn.

On the sponsor side, we expect to seepressure for tighter MAE provisions withfewer carve-outs. With regard to financingouts and reverse termination fees, we expectsponsors to hold the line on the status quo,by insisting on the kind of liabilitylimitations and waivers of specificperformance that were the natural result oflosing the financing condition that hadbeen part of their deals for so many years.Whether private equity buyers will continueto do deals without financing conditions

will depend on the willingness of the banksand other financing sources to limit theconditionality of their financingcommitments. Recent evidence shows anunderstandable reluctance on the part ofproviders of staple and other financing toaccept limited conditionality. There aremany negotiations now in process and yetto come between sponsors and lendersrelating to market MACs, limited duediligence outs, and many other harbingersof conditionality and old-style deal makingthat were once part of the leveraged financeplaybook. Of course, since the leverage innew deals is significantly lower than in dealsdone earlier this year, it is too soon to tellhow the market will develop.

At least once recently announced deal,the $2.65 billion acquisition of GoodmanInternational, has an express EBITDA-based closing condition requiring the targetto achieve a specified minimum EBITDAover the last six months of 2007. Thebenefit of such an express condition seemsfavorable from a buyer’s point of view;however, because debt financingcommitments typically do not permit abuyer to waive such a condition without thelenders’ consent, such a condition can comeback to bite a buyer who still desires tofund the acquisition even in the event of aminor EBITDA shortfall. The “take-away”here is that negotiated protection can betwo-edged and sometimes createunintended consequences. The acquisitionagreement in Goodman also contains anexpress seller waiver of specific performanceand a clear limitation on liability, using thetwo-tier structure, to a bit less than twicethe reverse termination fee amount.

Sellers have different priorities. Weexpect them to press for higher reversebreak-up fees in order to induce buyers toclose. Whether that will be successful ishard to predict, especially when auctionsbecome competitive again. In “going

private” deals, in which a public sellerrequires for fiduciary reasons the right toterminate before a stockholder voteapproving the transaction, it may be hardfor sellers to demand a reverse break-up feemuch greater than the amount theDelaware courts will permit sellers to pay tobuyers in case of such a fiduciarytermination—generally in the range of twoto four percent of transaction value—although the need for symmetry in the sizeof such fees can be debated.

Sellers may increasingly press for the“specific performance” right to force buyersto close where debt financing is available.We may also see sellers pressing for thirdparty beneficiary rights under debtcommitment letters in order to overcomethe sponsors’ natural disinclination to suetheir lenders, a demand that is certain to behotly contested by the banks and theircounsel. As an alternative, sellers mayrequest that sponsors agree in theacquisition agreement that their “reasonablebest efforts” to get a deal done will includebringing a claim against the lending banksin case of a failure to provide financingpursuant to a commitment letter.

These are challenging times for thedeal community. As the buyout marketrecovers from the events of the summer of2007, we expect that buyers, sellers andfinancing sources will each be findingtheir way until a new “market” in contractterms develops.

Paul S. [email protected]

Jonathan E. [email protected]


Documents

Debevoise & Plimpton Private Equity Report/media/files/insights/publications/2007... · reemerged as LBO targets, both sellers and private equity sponsors looked for ways to ... Hertz