Courtesy of CEB, we are bringing you selected legal developments in areas of California business law that are covered by CEB’s publications. This month’s feature is from the September 2020 update to Sales and Mergers of California Businesses. References are to the book’s section numbers. The most significant legal developments since the last update include developments in such important topic areas as federal and state taxation, securities law, the CARES Act, and matters relating to the COVID-19 pandemic.
Sales and Mergers of California Businesses
September 2020 Update
Key aspects of M&A transactions merit special consideration in view of the COVID-19 pandemic and its aftermath. To remove potential uncertainty and to allocate risks clearly, the parties should consider addressing the impact of COVID-19 expressly in negotiating and drafting their agreement. See §1.69.
- Due diligence. Diligence investigations in the COVID-19 world have become entirely virtual, with in-person meetings and presentations replaced by videoconferencing and document disclosure taking place in virtual data rooms. Buyers must now consider, and include in diligence protocols, a new series of questions, e.g., (1) what changes have occurred in the normal operations of the seller’s or merger target’s business as a result of the COVID-19 pandemic; (2) to what extent is the seller or target still able to operate its facilities; (3) how has the seller’s or target’s workforce been affected; (4) what privacy and cybersecurity measures have been implemented; (5) to what extent has the seller’s or target’s supply chain and distribution network been disrupted; (6) has any major customer or supplier given notice of a force majeure or taken any other action that could have a material adverse effect on the seller or target; (7) have any COVID-19-related claims or litigation matters arisen; and (8) what is the scope of the seller’s or target’s insurance coverage.
- Continued eligibility for government relief. In 2020, the federal government implemented several programs intended to provide relief for U.S. businesses adversely affected by the COVID-19 pandemic. If either or both parties to the proposed transaction obtained a benefit under one of these programs, both parties should consider whether and how the transaction will affect their continued eligibility for program benefits.
- Representations and warranties. Specific representations and warranties addressing COVID-19-related matters should reflect the results of the diligence investigation.
- Interim operating covenants. The seller or target may wish to clarify that it may change its operations in response to COVID-19. For greater certainty, the buyer may wish to include specific COVID-19-related operating covenants, including covenants relating to the seller’s or target’s employees.
- Purchase price, purchase price adjustments, earn-outs. In calculating purchase price adjustments or earn-out formulas, the buyer and seller normally begin with a reference to historical financial information. Now, however, historical information may not be the best reference point if the seller’s financial condition has been adversely impacted by COVID-19.
- Material adverse change (MAC) clauses. The key question is whether the impact of COVID-19 on a seller or target would constitute a MAC, but courts have consistently held that the burden of proof that a MAC has occurred is very high. Akorn, Inc. v Fresenius Kabi AG (Del Ch, Oct. 1, 2018, No. 2018-0300-JTL) 2018 Del Ch Lexis 325, aff’d (Del 2018) 198 A3d 724, is the first case in which a Delaware court found that a MAC had occurred.
- MAC clause exceptions. The seller or target may wish to negotiate specific exceptions to the MAC clause, e.g., changes that generally affect the U.S. economy, changes that generally apply to the industry or market in which the seller or target operates, or changes in applicable law. Express exceptions could also include COVID-19 effects or the effects of pandemics or epidemics. The buyer in turn may wish to carve out a “disproportionate effect” exception to the specified exceptions, which would allow termination if the MAC has a disproportionate impact on the seller or target as compared with other industry participants.
- Third-party and regulatory approvals; other closing conditions. The parties should note that COVID-19-related closures may delay or impede the parties’ ability to obtain any needed third-party or regulatory consents or approvals. A longer time frame or outside “drop dead” date may be appropriate. In addition, the buyer may wish to add closing conditions that address specific COVID-19 issues.
- Indemnification provisions. The buyer may wish to negotiate an express indemnification provision to cover potential liabilities arising on account of COVID-19, possibly including an escrow of a portion of the purchase price to cover any liability that arises.
In Techno Lite, Inc. v Emcod, LLC (2020) 44 CA5th 462, 471, the court held that Bus & P C §§16601–16602.5 do not affect limitations on an employee’s conduct or duties while employed. In addition, a covenant not to compete with an employee’s employer is enforceable against the employee while that employee is employed. Although California law permits an employee to seek other employment and even to make some preparations to compete before leaving, an employer is entitled to its employees’ undivided loyalty during the term of employment. See §§2.12, 2A.2.
The tax brackets for long-term capital gains and dividends have changed for 2020. See §3.3.
In late 2019, the IRS proposed regulations under IRC §382(h) that, if finalized, would eliminate the availability of §338 to calculate built-in gain and loss, and instead require that the approach set forth in IRC §1374 (with certain modifications) be used. See §§3.25, 3.47A.
Given the numerous changes in federal tax law brought on by the Tax Cuts and Jobs Act (TCJA) (Pub L 115–97, 131 Stat 2054), California Governor Gavin Newsom in 2019 signed AB 91 (Stats 2019, ch 39) (the Loophole Closure and Small Business and Working Families Tax Relief Act of 2019) into law in order to bring California law into alignment with certain provisions of the TCJA, such as the elimination of net operating loss (NOL) carrybacks with indefinite carryforwards. See §3.41.
In Loeffler v Target Corp. (2014) 58 C4th 1081, the California Supreme Court held that consumer protection statutes (unfair competition law and the Consumers Legal Remedies Act (CLRA) (CC §§1750–1784)) cannot be used to overturn a sales tax imposed on a retailer’s sale of hot coffee to go. In McClain v Sav-On Drugs (2019) 6 C5th 951, 960, the court applied Loeffler to foreclose a pharmacy customer’s claim for a refund of collections of sales tax errantly collected by pharmacies for diabetic blood testing strips and lancets. See §3.42.
The Coronavirus Aid, Relief, and Economic Security (CARES) Act (HR 748, 116th Cong (2019–2020)), which was enacted to provide economic relief to individuals and businesses adversely affected by the COVID-19 pandemic, temporarily changed the NOL rules for losses arising in tax years 2018, 2019, and 2020. Under the CARES Act, NOLs arising in those years can be carried back 5 years. In addition, for tax years before January 1, 2021, the 80 percent limitation described above has been eliminated, so that NOLs for those years may now be used to offset 100 percent of taxable income. IRC §172(b)(D). See Rev Proc 2020–24, 2020–18 Int Rev Bull 750. See §3.47.
The CARES Act temporarily increased the maximum amount of the interest expense deduction from 30 percent to 50 percent of a business’s adjusted taxable income for tax years 2019 and 2020. IRC §163(j)(10)(A)(i). In addition, business taxpayers are allowed to use their 2019 ATI as the basis for calculating the deduction rather than their 2020 ATI, which is likely to be lower. IRC §163(j)(10)(B). See §3.47B.
In Lorenzo v SEC (2019) 587 US ___, 139 S Ct 1094, 1104, the U.S. Supreme Court held that liability under SEC Rule 10b–5(a) and (c) can apply when a person disseminates false or misleading statements with intent to defraud, even though that person did not personally “make” those statements as required under SEC Rule 10b–5(b). See §4.33.
On March 24, 2020, in response to the COVID-19 pandemic, the Antitrust Division of the Department of Justice and the Federal Trade Commission’s Bureau of Competition issued a Joint Antitrust Statement Regarding COVID-19 (Joint Statement), available at https://www.justice.gov/atr/joint-antitrust-statement-regarding-covid-19. The Joint Statement clarifies that there are many ways for businesses, including competitors, to collaborate in ways that do not violate the antitrust laws, and includes a series of examples of collaborative activities designed to improve the health and safety response to the pandemic that are consistent with the antitrust laws. See §5.1.
A transaction may not be free from scrutiny merely because the Hart-Scott-Rodino thresholds do not apply. Rather, it is important that parties to a transaction be aware of its potential impact to their competitive environment. In 2019, the FTC ordered Otto Bock HealthCare North America, a supplier of microprocessor-equipped prosthetic knees, to unwind its 2017 acquisition of a “significant and disruptive” competitor, even though the transaction did not meet the Hart-Scott-Rodino Act reporting thresholds. See In re Otto Bock HealthCare N. Am., Inc., FTC Docket No. 9378 (May 6, 2019), available here. See §5.2.
On January 10, 2020, the DOJ and FTC released draft Vertical Merger Guidelines for public comment. The draft notes that the Guidelines are intended to be read with the Horizontal Merger Guidelines because certain items (such as the principles and frameworks used in horizontal merger assessments) are also applicable to vertical mergers. Although vertical mergers do not reduce the number of companies vying for market share in a given segment as horizontal mergers do, the Guidelines note that a vertical merger may nonetheless lessen competition. The draft Guidelines can be found on the FTC’s website at https://www.ftc.gov/system/files/documents/public_statements/1561715/p810034verticalmergerguidelinesdraft.pdf. See §5.5.
In Hernandez v Enterprise Rent-a-Car Co. (2019) 37 CA5th 187, the court found that when a car rental business continued to exist after an asset sale, the causation requirement was not met, and therefore the rule in Ray v Alad Corp. (1977) 19 C3d 22 for successor liability did not apply given that the plaintiff was not prevented from seeking recourse against the seller. See §6.9.
In September 2019, the IRS proposed regulations under IRC §382(h) that, if finalized, would eliminate the availability of §338 to calculate built-in gain and loss and instead require corporations to use the approach defined under IRC §1374. See 84 Fed Reg 47455 (2019), available here. See §7.6.
In Channel Medsystems, Inc. v Boston Scientific Corp. (Del Ch, Dec. 18, 2019, No. 2018-0673-AGB) 2019 Del Ch Lexis 1394, the Delaware Chancery Court applied the analysis in Akorn, Inc. v Fresenius Kabi AG (Del Ch, Oct. 1, 2018, No. 2018-0300-JTL) 2018 Del Ch Lexis 325, aff’d (Del 2018) 198 A3d 724, to find that certain misrepresentations were not proven to have, or be reasonably expected to have, a material adverse effect. See §§7A.13, 10.29, 10.79, 11.24, 11.80, 12.8, 12.44, 12.53.