CRAIN’S CLEVELAND – SIDESTEP PRIVATE EQUITY’S POTENTIAL LANDMINES
Buyers, sellers should consider these potential issues during deal phase
By David Kern and Jon Stefanik
At its core, an M&A transaction involving a private equity buyer or seller is no different than any other M&A transaction that involves all of the usual suspects: due diligence checklists, working capital adjustments, baskets, caps, survival periods, carve-outs … you name it. There are, however, several under-the-radar issues unique to deals involving private equity buyers or sellers which, without planning, can become potential problems.
1. Payment of finder’s fees
The Securities Exchange Act of 1934 (the “Exchange Act”) requires most brokers or dealers to register with the SEC and to join a self-regulatory organization such as FINRA. Section 3(4) of the Exchange Act broadly defines a broker as “any person engaged in the business of effecting transactions in securities for the account of others.” Section 3(5) of the Exchange Act defines a dealer as “any person engaged in the business of buying and selling securities for his own account through a broker or otherwise.”
Private equity firms are often approached by individuals or organizations who are not registered with a self-regulatory organization to source investments and raise capital in exchange for a “success fee” payable upon closing of the sourced investment. Per Section 15(a)(1) of the Exchange Act, it is unlawful for any person to “effect a transaction in securities” or to “induce the purchase or sale of” any security other than through a broker or dealer registered under an SRO. Section 29(b) of the Exchange Act renders voidable every contract entered into in violation of the above-referenced broker-dealer registration requirements and gives the investor the right to rescind its purchase of securities.
Private equity firms should be cautious when working with employees or other unregistered persons in connection with solicitations for investor capital.
2. Sharing of pricing information
Private equity firms often concentrate investment in a specific industry. In the M&A context, this industry-specific focus has the potential to implicate U.S. anti-trust laws, including Section 1 of the Sherman Act, which generally prohibits the exchange of competitively sensitive information (including pricing and cost information) among competitors.
A private equity firm must take documented precautions to avoid violating the Sherman Act when acquiring a competitor of one or more of its portfolio companies. Of course, any such precautions must be weighed against the need to conduct proper due diligence — a legitimate business concern for the buyer.
In order to reduce the risk of violating antitrust laws, a confidentiality agreement prohibiting use of any disclosed information must be in place prior to disclosure. Furthermore, such agreement should limit internal disclosure of pricing and cost information to individuals who are not involved in establishing pricing of competitive products or services. The information exchanged should be provided in summary format, or at least sanitized (to the extent possible) to remove commercially identifying information.
Additionally, a “clean team” agreement should be considered to permit disclosure of commercially sensitive information for confirmatory due diligence only to third-party consultants, including accountants and investment bankers. If absolutely necessary, the agreement may also apply to employees who do not provide any input on pricing or costing of competitive products or services, and in each case who agree to be bound by the restrictive terms of that agreement. Finally, disclosure of commercially sensitive information could be withheld and used as part of confirmatory due diligence immediately prior to the closing, while remaining subject to confidentiality.
In addition to criminal prosecution, a violation of the Sherman Act may result in treble damages.
3. Interlocking directors
When acquiring a competitive entity, private equity firms must be aware of potential violations of the Clayton Act that may arise from their power to appoint directors to the boards of competitors, or from having the same directors sitting on the boards of competitors. Subject to statutory exceptions related to industry, capital and sales, Section 8 of the Clayton Act provides that “[n]o person shall, at the same time, serve as a director or officer in any two corporations … that are (a) engaged in whole or in part in commerce; and (b) by virtue of their businesses and locates of operation, competitors, so that the elimination of competition by agreement between them would constitute a violation of the antitrust laws.”
Section 8 of the Clayton Act is interpreted as prohibiting any “firm” from appointing the same or different individuals to sit as its agents on the board of directors of two competitors. A violation of Section 8 of the Clayton Act is a strict liability offense, so a private equity firm’s intent in appointing directors is not relevant. A violation of Section 8 of the Clayton Act may result in treble damages.
While these issues do not arise in all M&A transactions involving private equity firms, they do arise frequently enough that they merit serious consideration.
David Kern and Jon Stefanik are partners in the Business Practice Group at Buckingham, Doolittle & Burroughs LLC. Contact David at 330-258-6489 or [email protected]. Contact Jon at 330-643-0209 or [email protected].
Click here to read the story in Crain’s Cleveland Business.