In the post-merger period, the merging companies may face legal issues that stem from pre-merger agreements made with the US government concerning antitrust effects of the merger or that may revolve around plant closings and reduction of staff that result from many mergers. Let’s examine these issues more closely.
Formation of New Legal Entity
A statutory merger, where two companies merge to form a new company, requires the formation of a new corporate entity. It is likely that the new corporation will be incorporated under the laws of the state in which one of the merged companies had its corporate headquarters. Or it can simply incorporate in another state acceptable to both pre-merger corporations. Typically, the selection of the state of incorporation for the new entity will be included in the merger agreement. The filing of new incorporation cannot be done until the consummation of the agreement.
In some merger situations, one of the firms will be accorded “survivor” status, meaning that the firm’s top management will operate the new firm. This can happen even if the transaction is a merger and not an acquisition and can occur regardless of the name used post-merger. For example, when Continental and United Airlines merged, the Continental hierarchy took control of the organization, but the airline continued to operate under the name “United.” Similarly, when US Airways merged with American Airlines, US Air’s management took control, but the airline continued to operate under the name “American Airlines.” In a corporate acquisition transaction, the acquiring firm’s corporate shell will usually be used to consolidate the assets and liabilities of the acquired company.
Continuing Reporting Requirements under Antitrust Laws
Federal antitrust laws may require continuing reporting by the newly merged company. Such reporting requirements may be mandatory under agreements entered into by the pre-merger companies and government officials. The Department of Justice retains monitoring powers over the merged companies under the Hart-Scott-Rodino Act to identify potential antitrust violations after the merger is completed. Similarly, the Federal Trade Commission uses its internal investigative powers to monitor previously approved mergers that may raise questions concerning new potential violations. If the FTC staff investigators and attorneys suspect new violations, they can recommend to the FTC board to reopen the investigation for further review and action. The FTC board may decide to levy a fine for each violation found, authorize litigation where the possible penalty may be significant or decide not to reopen the matter.
A consent decree is derived from the settlement of a pre-merger litigation with the Department of Justice. In a consent decree, the corporate party does not have to admit to any specific violations, but agrees to engage in the prescribed behaviors to settle pending litigation with the DOJ and move forward with the planned merger. Under the provisions of a typical consent decree, the Justice Department will closely monitor the competitive actions and policies of the merged company during the period designated in the consent decree. Failure to comply with the requirements may result in the DOJ reopening the litigation and seeking penalties for the violation of the consent decree and possibly other criminal or civil sanctions.
Post-Transaction Liability Potential
Corporate mergers or acquisitions often result in the creation of redundant labor and management positions. For companies engaged in manufacturing, a merger also may force plant closings to eliminate or reduce overcapacity created as a result of the merger. Thus, layoffs and terminations of employees are all but inevitable. Management may seek to soften the blow by offering employees retraining opportunities and/or severance pay. To address the impact of plant and factory closings after a corporate merger or acquisition, Congress enacted the Worker Adjustment and Retraining Notification Act.[1] This Act protects workers and their communities by requiring employers with 100 or more full-time employees to provide at least 60 calendar days’ advance written notice of a plant closing or mass layoff affecting 50 or more employees at a single site.
An employer who violates this Act may be liable to each employee for back pay and benefits for the period of the violation, up to 60 days. Furthermore, the Act requires employers to separately notify the state dislocated workers unit and the chief elected official of the unit of local government in the jurisdiction where the plant is located. In terminating or laying off employees as a result of a reduction of labor force stemming from a merger, employers must comply with the requirements of Title VII of the Civil Rights Act of 1964.[2] Specifically, Title VII bans discrimination in employment based on color, national origin, race, religion or sex in the areas of employment recruitment, hiring, promotion or termination. Therefore, in the reduction planning and implementation, the human resources personnel of the merged companies must carefully tailor their actions to comply with the requirements of Title VII.
Another set of post-merger legal issues may develop when one or both of the merged companies’ existing loan agreements are in default. Usually, prior to the closing of the merger, the representatives of both companies will re-negotiate all outstanding loan agreements. Most of these renegotiations revolve around replacing the existing borrower with the new borrower who will take over the loan after the transaction is completed. However, post-merger issues may arise when the newly formed company identifies unaccounted-for liabilities or there is an unexpected shortfall of revenue after the merger has been completed. Also, unexpected higher costs from plant closings or employees’ severance packages can hit the bottom-line triggering a violation of a loan agreement. The new company may be forced to try to amend, modify or replace outstanding loan agreements.
The Foreign Investment Risk Review Modernization Act
During the first half of 2018, the total value of cross-border mergers and acquisitions topped $2.5 trillion dollars worldwide.[3] The United States had the most companies acquired with total values of over $1 trillion dollars. However, 2018 federal legislation makes foreign companies targeting certain American companies more challenging. This legislation is the Foreign Investment Risk Review Modernization Act of 2018.[4] The Act was adopted to provide the US Committee of Foreign Investments in the United States additional powers. The Committee is responsible for reviewing certain transactions involving foreign investment. The Committee is empowered to determine the effect of covered transactions on the national security of the United States.
The Committee is chaired by the Secretary of the Treasury and is comprised of nine federal departments and offices plus an additional five that may participate depending on the investment issues raised by a particular covered transaction under review. The Act reflects Congressional concerns about the changing nature of foreign investments and national security threats. It amends timelines, enhances accountability, codifies certain existing Committee practices and expands others, including the role of Congress. Fundamentally, the Act makes clear that the U.S. will continue to review foreign investment transactions to protect our national security and underlines the importance of the effects of foreign investments on national security.
Pursuant to the powers granted under the Act, the Office of Investment Security of the Department of the Treasury issued regulations for review of foreign investments in American companies. In summary, these regulations:
- Define “U.S. business” as any person engaged in interstate commerce. This is a noteworthy expansion from previous law, as it includes businesses located outside the United States.
- Define “critical infrastructure” as systems and assets, whether physical or virtual, so vital that their incapacity or destruction would have a debilitating impact on national security. Foreign transactions in any US business involved in critical infrastructure are covered transactions under the Act. The broad definition of critical infrastructure may include power grids, telecommunications and switching technologies.
- Applied the rules to both equity-type and debt investments.
- Define “critical technologies” to cover a wide-ranging group of technologies including certain defense-related articles or services; export-controlled items; nuclear equipment, parts, components, materials, software and technologies and facilities; certain agents and toxins and some emerging and foundational technologies.[5] Any attempt by a foreign entity to invest in a US business doing business in critical technologies areas is a covered transaction.
One immediate impact of the Act is to discourage foreign investors from certain investment transactions involving US businesses knowing that such proposed investments may not be approved by the Committee and/or may require a lengthy review. Finally, some countries might retaliate by establishing their own versions of the Act to prevent merger activities by American companies.
Acquiring Privately Held Companies
The Securities Act of 1933 covers the registration of securities for sale to the public. As investment contracts are securities, a merger or acquisition transaction is an investment contract that falls under the regulation of the 1933 Act. To invoke the application of the federal securities laws and regulations in merger or acquisitions, at least one company must be publicly-held. However, if a private company acquisition requires private financing from investors and such funds are raised interstate by using the mail or Internet (which covers the financing for most transactions), for example, then such funds must be raised pursuant to the provisions of the 1933 Act. These types of private security fund raisings are referred to as private placement offerings. While it does not require registration in the same way that a public offering does, a private placement offering must be issued under one of the SEC exemptions. The SEC has created a series of such exemptions.
One example is Regulation D issued by the SEC to provide a safe harbor for raising funds from private investors.[6] Under Regulation D, a private offering may raise up to $5 million per year. Investors are protected under the Regulation’s anti-fraud provisions, which give investors the power to rescind the investment contract and full return of their funds where they can show that material facts were misrepresented or omitted from the offering documents. There are also several accounting and business distinctions between private and public acquisitions.
First, privately held companies are controlled by fewer shareholders than publicly held companies. Private companies tend to be family owned businesses and are typically structured as S corporations or LLCs, meaning that, for tax reporting purposes, they may operate as pass-through entities. Second, many small private companies (those with under $50 million annual revenues) don’t produce audited financial statements. While these smaller companies are sometimes targeted for acquisition by larger companies, it is the bigger private mid-sized enterprises that are more frequently targeted. A midsized enterprise is generally defined as a company with annual revenues of 50 million to 500 million dollars annually. These larger firm acquisitions usually require bank financing, forcing these companies to produce audited financial statements. Having a history of audited financial statements is a key ingredient to timely and efficiently completing a private company merger or acquisition. Third, the lack of accurate internal reporting controls common in private companies may produce inaccurate accounting and financial data. That often means long delays in completing desired merger transactions, as the parties often must recreate accounting and financial data going back 3 to 5 years. Finally, there is not the same consistent profit motivation in private companies as is found in publicly held companies. Private companies, unlike their public counterparts, do not have to show consistent profit growth to attract investors. These companies are closely held, usually by small groups of owner-operators, who may, in fact, want to reduce profits by investing in business infrastructure and operations to reduce taxes in a given year. Potential profits may also be reduced by excessive salaries and benefits for the owner-operators or by perks like company-paid travel and entertainment expenditures permitted under the Tax Code.
This may skew data by masking the potential profits of the company were it run at maximum efficiency. Thus, a potential acquirer may need to recreate financial statements that the company would have produced had it engaged in expenditure levels that are more common to publicly held companies.
Conclusion
The areas covered by this module introduce a minefield of legal and business issues during the post-merger period, or in mergers and acquisitions involving cross-border and private company transactions. There is an ever-changing landscape of laws affecting merger and acquisitions in the US and globally. As the world continues to become ever more connected, global economy mergers are likely to increase due to the importance of the efficiencies and technological leadership created by mergers and acquisitions. The laws are there to guide, not discourage, the value creation that flows from mergers and acquisitions.
Thank you for participating in LawShelf’s video-course on mergers and acquisitions. We hope that you now have a better understanding of the benefits and risks of these transactions, which can have such positive or such negative impacts on companies and on the American and global economies. Please contact us if you have any questions or feedback and best of luck!
[1]29 USC §2101 et seq.
[2] 42 USC §2000(e).
[3] Stephen Grocer, A Record $2.5 Trillion in Merger Were Announced in the First Half of 2018, N.Y. Times, July 3, 2018, https://www.nytimes.com/2018/07/03/business/dealbook/mergers-record-levels.html
[4] 50 U.S.C. §4565.
[5] 31 CFR §801.204.
[6] 17 CFR Sections 230.501 et seq.