Monday, February 8, 2010

Liability Clauses in Outsourcing Agreements

One of the clauses that is frequently negotiated in Master Service Agreements is the liability clause – that is, the clause that stipulates who is responsible for paying if certain events occur, and the amount up to which a party shall be liable in such event. Such amount is referred to as the “liability cap”, and certain events tend to fall within the cap while others are excluded from the cap. For events that are excluded from the cap, the compensating party will have unlimited liability if such events occur. The liability clause is also closely related to the indemnification clause, which specifies which party is responsible for indemnifying the other in the event of a third party suit, or sometimes even for direct claims from the other party.

As these clauses are heavily-negotiated, it is important to know as to what the current trends are with respect to liability/indemnification clauses, and what items tend to be subject to the cap on liability or not subject to the cap. In assessing current trends, reliance has been placed on provisions from Master Service Agreements disclosed in Indian outsourcing companies’ public U.S. filings and other lawyers’ published comments as to what they typically see in outsourcing transactions.

The trends show that the following are generally excluded from the cap on liability:

• Bodily injury;
• Damage to tangible personal property;
• Breach of confidentiality or obligations to keep customers’ data confidential and secure;
• Failure to comply with laws;
• Infringement of intellectual property;
• Wrongful termination of the outsourcing agreement or supplier’s refusal to provide termination services;
• Fraudulent or criminal acts;
• Willful misconduct;
• Gross negligence;
• Government claims; and
• Taxes.

Keep in mind that many of the above are generally limited to third-party claims, and not claims directly from the customer against the outsource provider.

The following are generally included in the cap on liability:

• Breaches of representations, warranties or covenants under the Master Services Agreement or Statements of Work; and
• Other events giving rise to indemnification claims.

Although many outsourcer providers are currently taking over more and more of the core of customers’ businesses, outsourcer providers still generally do not take on liability for financial or economic losses suffered by the customers or the clients of customers.

Monday, April 27, 2009

Importance of Anti-Dilution Provisions in Venture Financing Deals

The primary purpose of anti-dilution provisions is to protect investors from the adverse impact experienced when a company issues new securities (whether it be shares of preference stock, common stock or securities convertible, exercisable or exchangeable for shares of preferred or common stock) at a price that is lower than that paid by such investors. Anti-dilution protection and the liquidation preference are two important provisions that distinguish preferred stock from common stock.


There are two principle formulae to grant protection against anti-dilution: full ratchet and weighted average formulae. In each case, the anti-dilution protection can be effected by an adjustment to the conversion ratio of the investor’s share of preferred stock into shares of common stock (or sometime by the issuance of additional shares of capital stock to the investors).

The full ratchet formula is a more aggressive form of anti-dilution protection than weighted average formula and provides the most protection to the investors, but has the greatest adverse impact on the company, founders and management. The purpose of a full ratchet formula is simple – to place the investor in the same position it would have been had it originally invested in the company at the lower price per share being paid by the new investors in the subsequent round of financing, that is, the new conversion price for converting the investor’s share of preferred stock into shares of common stock would equal the lower price per share being paid by the new investors.

Weighted average formula is considered more equitable and takes into account the number of shares already issued plus the number of new shares being issued at the lower price. The weighted average formula determines the adjustment to be made to an existing investor’s stockholding based on the size of new offering and the lower price at which the new shares are to be issued to the new investors. Under the weighted average formula, the new conversion price of the investor’s share of preferred stock into shares of common stock can be calculated using the following formula:

new conversion Price = old conversion price x common stock equivalents prior to issuance + old conversion price (new consideration)/ common stock equivalents prior to issuance + new common stock equivalents


There are two main variations of the weighted average formula, namely, broad based and narrow based. Broad based weighted average includes a wider range of shares and other securities (such as warrants, options and other convertible securities) in the calculation and therefore the adjustment required to the existing investors’ stockholding is lower. Accordingly, it is less onerous on the company and not as dilutive on the founders, management and existing investors. Narrow based weighted average formula, includes a less number of shares and securities (generally may not include warrants, options and other convertible securities) in the calculation and therefore the adjustment required to the existing investors stockholding is higher and is therefore more burdensome on the company, founders and management.

Sunday, January 25, 2009

M&A- Relevance of Legal Structures

The number of overseas mergers and acquisitions pursued by India Inc. has grown remarkably in the recent years and is likely to further grow in the future. The current global meltdown in the world economy has considerably brought down the valuation of various reputable and viable companies around the globe, thereby facilitating and incentivising the companies with reserves to make expansions. However, it is imperative to structure a transaction in a way that yields and caters to the objective of the Company which is dispensing away with its reserves during these hard times.

There are a number of legal structures that can be pursued to consummate a transaction, wherein the Indian Company (sometime referred to herein as “Acquiror”) acquires a publicly listed corporation (the “Target”) in the US. For the purposes of this writing, I have focused on three alternative structures for the acquisition of the Target by the Acquiror in the US, which are noted below:

a. Tender Offer- In a tender offer, an Acquiror makes an offer directly to the Target’s shareholders to sell their shares to the Acquiror at a specified price, which is generally at a premium to the existing share price quoted on a stock exchange of the Target shares.

b. Statutory Merger- In a statutory merger, the foreign Acquiror would form a wholly owned subsidiary for the purposes of consummating the merger and depending on the structure of the merger either the Target would be merged with the newly formed acquisition subsidiary with the newly formed subsidiary surviving the merger or the newly formed subsidiary would be merged with and into the Target with the Target surviving the merger. The shareholders of the Target would receive the merger consideration for their shares. After the closing of the merger, the Target would be a wholly owned subsidiary of the Acquiror.

c. Asset Purchase- Depending on the intent of the Acquiror and the assets it intends to acquire in the acquisition, the transaction can be structured as an asset purchase.

The above mentioned structures are described briefly below:

A. TENDER OFFERS

The term "tender offer" is not defined in the Exchange Act or any of the rules promulgated there under, but it has been described generally as: publicly made invitation, usually announced in a newspaper advertisement, to all stockholders of a corporation, to tender their shares for sale at a specified price. To induce the stockholders to sell, the price usually includes a premium over the current market price of the Target company's shares. Cash or other securities may be offered to the stockholders as consideration. An offer is made for a limited period of time only. The Acquiror may offer to buy all tendered shares, or it may offer to buy only a stated number. In general, the Acquiror also sets a minimum number of shares that must be tendered before the Acquiror will buy any shares. The rules and regulation promulgated under the Securities Exchange Act of 1934, as amended, contained detailed provisions relating to tender offers.

The applicable provisions of the regulations provide that it is unlawful for a person to make a tender offer for an Exchange Act-registered equity security if, after consummation of the offer, the Acquiror would beneficially own more than 5% of a class of securities unless, at the time such offer is first published or given to stockholders, certain required filings are made with the Securities and Exchange Commission (SEC), including a Tender Offer Statement on Schedule TO. A tender offer may not only be conditioned on the receipt of a minimum number of securities, but may also place a cap on the number of securities that the Acquiror desires to purchase. There exist detailed regulations and provisions which have to be complied with prior to as well as during the tender offer process, such as Pre-Commencement Communications, Commencement of Tender Offer, Filing Schedule TO, Dissemination of Tender Offer Materials, Withdrawal Rights, Pro Rata Purchase, Pricing and Best Price Requirement, Recommendation of Target Company, Tender Offer Period, Filings with SEC, etc.

One of the features that makes tender offer more lucrative over a merger is speed of closing. In a statutory merger, the Acquiror can not circulate the materials to the shareholders of the Target unless and until the SEC has completed its review of or has decided not to review the initial material to be circulated. However, the SEC does review the material circulated to the shareholders during the pendency of the offer, which allows the tender offers to close several weeks earlier than a statutory merger transaction. Also, the target is more protected from market risk, material adverse change risk and the risk of a third party matching a bid due to quicker speed of Tender Offer over a statutory merger.
Another fact that needs to be weighed in is that in a cash tender offer, the initial antitrust review is quicker as the waiting period under the Hart-Scott-Rodino Act for a cash tender offer is 15 days whereas in a merger, it is 30 days. Furthermore, there are some securities laws benefits in a Tender Offer as the Company that is not in compliance with its financial reporting obligations can initiate a tender offer by circulating the proxy material, whereas in a merger transaction such a company cannot issue a merger proxy and thus, cannot hold a proper shareholder vote on the merger.

B. STATUTORY MERGER

As noted above, in a statutory merger, the Acquiror would form a wholly owned subsidiary for the purposes of consummating the merger and depending on the structure of the merger either the Target would be merged with and into the newly formed acquisition subsidiary with the newly formed subsidiary surviving the merger or the newly formed subsidiary would be merged with and into the Target with the Target surviving the merger. The existing shareholders of the Target would receive the merger consideration for their shares. After the merger, the Target would be a wholly owned subsidiary of the Acquiror.
In a merger, the Acquiror and the Target would negotiate and execute a merger agreement. Among other conditions to closing, one of the conditions would be that the requisite number of stockholders of the Target approved the merger. To obtain the stockholder consent the Target company sends its stockholders a proxy statement soliciting votes on the merger. Assuming the Board of the Target is in favor of the merger, the Board would recommend to the stockholder of the Target to vote in favor of the merger. Delaware General Corporation Law provides that, unless otherwise set forth in the charter documents of the Target company, the consent of stockholders holding at least a majority of the shares of capital stock is necessary to approve a merger. If all conditions to the merger are satisfied as set forth in the merger agreement (including obtaining the necessary stockholder consent), the parties would file the certificate of merger with the relevant states, and the Target would be merged with the newly formed acquisition subsidiary formed by the Acquiror and the Target would become a wholly owned subsidiary of the Acquiror on the closing of the merger. Section 262 of the Delaware General Corporation Law provides for appraisal rights to stockholder who disapprove of the merger. However, the stockholders of the Target would not be entitled to appraisal rights. Pursuant to Section 262 (b) (1) of the Delaware General Corporation Law, no appraisal rights are available to the stockholders of a company whose shares are listed on a national stock exchange.

Target’s Board of Directors Responsibility and Special Committees:
The board of directors of the Target must carefully consider their fiduciary duties while approving or disapproving the acquisition transaction. The Board of the Target will frequently form a special committee of disinterested independent directors to consider the merger transaction. To be disinterested, a director must not be an affiliate or designee of the controlling shareholder or the acquiring management team or otherwise be "related" to the proposed acquirer. To be independent, a director must not be "beholden" to the controlling shareholder. This committee must have real bargaining and negotiating power on an arms length basis. The committee also has the duty to approve transactions only if it finds the transactions to be in the best interests of the shareholders. The use of a special committee of disinterested and independent directors will not be conclusive that the transaction is fair, but courts will view it as strong evidence of fairness. It is still highly recommended that the Target’s Board form a special committee composed entirely of independent, disinterested directors to consider the proposed acquisition transaction. It is also necessary to obtain a fairness opinion from an investment bank in connection with the merger.

C. ASSET PURCHASE

Another alternative is structuring the transaction as an asset purchase. If the Acquiror is interested in acquiring only certain, all or substantially all the assets of the Target, then the transaction could be structured as an asset purchase transaction. However, one of the disadvantages of an asset purchase transaction is that all assets, contracts, intellectual property, etc. need to be individually assigned to the Acquiror. Other considerations include the possible transfer of the corporate name, and the rehiring of employees by the Acquiror entity.
The Target may be less inclined to structure the transaction as an asset purchase often because of negative tax consequences to the Target and its stockholders – essentially the purchase price for the assets is paid to the Target, which would trigger an income to the Target attracting corporate taxes and then when the Target makes a distribution of the purchase consideration to its stockholders the stockholder would again be subject to income taxes. However, depending on the financials of the Target (i.e., Target having past losses) the tax consequences may not be adverse to the Target and its stockholders. From an accounting perspective, the Acquiror records the assets and liabilities at the fair market value assigned to them as part of the transaction. This may increase or decrease the carrying value and/or amount of annual depreciation with respect to individual assets and liabilities.

Tuesday, November 25, 2008

Tumbling Insurance Industry- Jurisdiction & Domicile Issues for Specialty Insurers

In the United States, the insurance industry is primarily regulated by the regulations of the various states in which the insurer operates. Each state has its own rules, regulations and requirements that need to be complied with in order for the specialty insurers to operate and write policies in such state. The insurance laws of each state of the United States expressly prohibits the sale of insurance policies within their jurisdictions by insurers that are not admitted to do business within such state. The regulatory framework varies from state to state, but generally relates to the standards of solvency that must be met and maintained, including risk-based capital standards, licensing approvals and related matters, restrictions on insurance policy terminations, the nature of and limitations on the amount of investments made with the insurer’s capital and periodic examinations of the financial condition and market conduct of insurance companies. Regulations pertaining to specialty insurance companies may be less onerous than those required of insurance companies engaged in property, casualty, life and health insurance. None the less, this is not to say that specialty insurance companies are not subject to relatively rigid and potentially burdensome regulatory frameworks.

The selection of a domicile is a very fact specific determination based upon the individual circumstances and facts applicable to the particular insurer. A review of the jurisdiction of domicile for the various insurance companies operating in the United States demonstrates that no single state offers an overwhelming distinctive advantage to domicile in a particular state over another (i.e. there is no “Delaware” for insurers). Various factors that seem to come into play include: (i) the physical location of its business, (ii) location of policyholders, (iii) historical remnants and factors that may no longer apply (e.g. an insurer that began operating in only one state and later expanded its business elsewhere), and (iv) the solvency and minimal capital requirements of a particular state (which vary from state to state depending upon the kind of insurance being offered by the insurer). Further, if the proposed enterprise decides to initiate operation by acquiring a shell, the choice of domicile is likely already made and not worth the burden of changing.

An alternative to domiciling the enterprise in the United States would be to select an offshore jurisdiction like Bermuda, Cayman Islands, or the British Virgin Islands. Each of the foregoing are attractive jurisdictions to insurance companies due to favorable regulatory frameworks and advantageous tax policies. In recent years, Bermuda in particular has become a very attractive offshore jurisdiction for insurers. Among other advantages, Bermuda offers an established infrastructure, political stability, trained and educated workers, evolved regulation, and a convenient geographic location. In addition, Bermuda also offers the following specific advantages:

1. Taxation

The governments of Bermuda and the U.S. signed a convention in 1986 relating to the taxation of insurance enterprises, thereby allowing subsidiaries of U.S. Companies to be set up in Bermuda and be taxed as per Bermuda laws.

Bermuda’s taxation system is “consumption based” meaning there are no taxes on profits, dividends or income for companies or individuals, nor are there any capital gains or inheritance taxes. Companies pay a payroll tax rather than being taxed on profit, income or dividends. Companies tend to find a tax advantage by setting up a Parent company in the United States with operating subsidiaries in Bermuda and the United States. Under this structure, the risks and premiums can be shared between the United States subsidiary and the Bermudan subsidiary, allowing the insurer to take part in some of the offshore tax advantages while also maintaining the regulatory advantages of having a domestic domiciled operating company.

2. Speed and Cost

The regulatory framework in Bermuda is very streamlined and efficient and permits enterprises to form and domicile insurers in Bermuda very quickly. The efficiency in Bermuda offers a considerable edge over other jurisdictions. A company can secure capital, obtain a license and be up and running in as little as six weeks in Bermuda. The same process may take over a year in the United States. Also, compared to other jurisdictions, the set-up and formation cost is significantly less expensive. It should be noted however, a Bermudian domiciled insurer would still need to obtain regulatory approval as a foreign insurer in each of the various fifty states in order to operate and write policies in such states.

3. Business in offshore jurisdictions

By establishing an operating company in Bermuda, an insurer can offer and write policies to non United States policyholders without having to comply with potentially burdensome regulatory requirements applicable to United States domiciled insurers. In addition, as a non United States domiciled insurer, it may be possible in certain instances to conduct a totally offshore transaction with a United States policyholder which would not be subject to the regulatory frameworks of the fifty states. Whether any individual policy underwriting could be considered “offshore” is a very fact specific determination but usually involves ensuring that all activities (including solicitation and negotiation) be conducted offshore.

On a precautionary note, the tax benefits afforded by domiciling in Bermuda are only advantageous when the enterprise is making a profit. If the company is incurring losses, as has been the case for many entities affected by the current financial crises, there is a disadvantage because Bermuda, unlike the United States, does not permit the offsetting of losses against future profit. Moreover, it should be noted that in order to take advantage of any tax benefits, the company must meet a 'mind and management' test that includes holding board meetings in Bermuda and other requirements, which may be onerous for some insurers.

Wednesday, November 5, 2008

Ignored Piece of Legislation

Under the International Investment and Trade in Services Survey Act of 1976 (the “Act”), a U.S. enterprise in which a foreign entity directly or indirectly acquires a 10-percent or more voting interest must file reports with Bureau of Economic Analysis ("BEA"), an agency of the U.S. Department of Commerce. The regulations encompass a wide range of legal structures, such as mergers, acquisitions, asset purchase and stock acquisitions. Though the Act is in effect since 1976, the compliance with these filings has been made mandatory since 2003, whereby penalties were prescribed for non-compliance (ranging from US $2,500 to US$25,000) and imprisonment for up to one year in case of willful failure to file.

Despite this law being in force for than half a decade, many foreign companies establishing a business in the U.S. or the existing U.S. companies having its voting interest held by a foreign entity are not filing these mandatory periodic filings with the BEA. It is disquieting to note that such a pivotal piece of legislation has been flagrantly ignored because many lawyers and other intermediaries in a transaction are not aware of such regulations and continue to believe the compliance is elective in nature. In fact, the Act casts an obligation simultaneously upon the intermediaries
[1] along with the Company to make filings under their own name. It is therefore imperative that lawyers are aware of these regulations and are able to advise their clients on the consequences for ignoring this piece of legislation.

For the sake of brevity, the report includes the following forms:

a. Initial reports (Form BE-13)- This report is filed for reporting on a foreign person's direct or indirect acquisition, of a U.S. business enterprise.
[2] This report must be filed within 45 days after the transaction is concluded. Such a report must be filed if, (1) “the total assets of the newly created or acquired entity are more than $3 million, (2) the cost of the transaction is more than $3 million, or (3) the transaction involves the acquisition of 200 or more acres of U.S. land.”[3]

However, if the above listed thresholds are not met in a given transaction, then Form BE- 13 Supplement C (exemption form), claiming exemption to file BE-13 should be filed by a U.S. enterprise.

This report requires the Company to provide information such as type of transaction, identification of U.S. business enterprise, financial and operating data of the U.S. enterprise, industry classification, identification of foreign parent and ultimate beneficial owner and the cost of investment.

b. Quarterly reports (Form BE-605) - U.S. business enterprise in which a foreign person had a direct and/or indirect voting ownership interest of at least 10 percent at any time during the quarter is required to file this report every quarter. However, the U.S. enterprise is not required to report if the total assets, annual sales or gross operating revenues, and annual net income of the U.S. enterprise/U.S. affiliate are $30 million or less.

A U.S. enterprise/affiliate that meets the exemption criteria stated above must file a Certification of Exemption. The quarterly reports require the Company to disclose the information about the U.S. Company, information of the foreign parent and foreign affiliates of the foreign parent company, foreign parent’s direct equity share in the U.S. Company, etc.

c. Annual reports (Form BE-15) - The U.S. company/affiliates is required to file this report if a foreign person owns or controls a ten-percent-or-more voting interest, as of the end of the fiscal year. Depending upon the total value of the assets, sales or gross operating revenues, or net income, the Company would have to file either form BE-15 (long form) or form BE-15 (short form). The annual report requires the Company to disclose information about its total revenues, total assets, income, liability, cost, expenses, details about its affiliation with foreign group, etc.

d. Quinquennial reports (Form BE-12) - The quinquennial BE-12 Benchmark Survey is a comprehensive survey which is conducted once every 5 years. Depending upon the total value of the assets, sales or gross operating revenues, or net income, the Company would have to file either file BE-12 (long form) or BE 12 (short form). However, if the threshold limits are not met as prescribed in the above forms, then the Company may file an exemption as provided in the Form BE- 12 Mini.

The Act lays down that reports filed with BEA are confidential and may be used for analytical and statistical purposes only. The reports cannot be used for purposes of taxation or investigation by the U.S. government.

Though the underlying objective of the Act is to collect information on foreign investment in the United States, a detailed and complicated filing may only deter the companies from filing as the compliance cost of such regulations may be more than the civil penalties prescribed by the Act. The law has its own shortcomings and redundant objectives (topic for the next entry on this blog). None the less, this is not to say that companies are not subject to rigid and potentially burdensome regulatory filings.
[1] Intermediary include an intermediary, a real estate broker, business broker, and a brokerage house- who assists or intervenes in the sale to, or purchase by, a foreign person or a U.S. affiliate of a foreign person, of a 10 percent or more voting interest in a U.S. business enterprises, including real estate.
[2] It also includes establishment of a new entity and/or purchase of the operating assets.
[3] Report published by the Bureau of Economic Analysis (April 2008), U.S. Department of Commerce, Economics and Statistics Administration.