After deliberations over more than a year’s time, the Standing Committee of the National People’s Congress (“NPC Standing Committee”) finally adopted the Cyber Security Law (“CSL”) on November 7, 2016. The CSL is the first omnibus law in China governing cyber security issues and has incorporated a number of new legal concepts and requirements that may impact companies with business operations in China.
Below we will briefly introduce the CLS in terms of its background, applicable scope and legislative purpose, major requirements, and potential practical impact.
This legislation includes provisions relating to information and technology security. Meanwhile, as China has not enacted a unified data protection law, the CSL also incorporates several provisions related to the protection of personal information, which is also an issue of wide concern.
Application Scope and Purpose
The CSL applies to the construction, operation, maintenance and use of networks as well as the supervision and administration of cyber security within the territory of the PRC. “Networks” include networks and systems that are composed of computers and other information terminals and the relevant facilities and used for purposes of collecting, storing, transmitting, exchanging and processing information in accordance with certain rules and procedures (Article 76). “Network operators”, an important subject of legal obligations under the CSL, is broadly defined as “owners and administrator of networks and network service providers (Article 76)”.
The CSL provides for “safeguarding the national cyberspace sovereignty” as a fundamental principle, and, for that purpose, includes provisions on, inter alia, the strategy, plan and promotion of cyber security, network operation security, network information security, and alarm and emergency response systems.
The national cyberspace administration authority, namely the Cyberspace Administration of China (“CAC”), is responsible for the coordination of cyber security protection activities and the relevant supervision and administration activities on a national level. It further provides that the Ministry of Industry and Information Technology, the Ministry of Public Security and other relevant government departments shall be responsible for the protection and supervision of cyber security within their respective authorities.
The CSL will become effective on June 1, 2017. Therefore, nearly a half year is provided as a transition period before its implementation.
Major Legal Requirements
Strengthened Network Operation Security Obligations
The CSL provides various security protection obligations for network operators, including, inter alia:
- the compliance with a series of requirements of tiered cyber protection systems (Article 21);
- the verification of users’ real identity (an obligation for certain network operators) (Article 24);
- the formulation of cyber security emergency response plans (Article 25); and
- the assistance and support necessary to investigative authorities where necessary for protecting national security and investigating crimes (Article 28).
In addition, network products and service providers shall inform users about and report to the relevant authorities any known security defects and bugs, and furthermore shall provide constant security maintenance services for their products and services, not install malware with their products, and clearly inform users and obtain their consent if their products or services collect users’ information (Article 22).
Key network facilities and special products used for protecting network security shall comply with the relevant national standards and compulsory certification requirements, and may only be offered for sale after being certified by the qualified security certification organization or passing the relevant security tests (Article 23).
It is notable that some requirements for network operators, such as retention of user logs for at least six months (Article 21) and regulations on the publication of cyber security information regarding system loopholes, computer viruses, cyber-attacks, cyber invasions, etc. (Article 26), are prescribed for the first time under PRC laws.
Heightened Protection of Critical Information Infrastructure
The CSL, for the first time under PRC law, clearly imposes a series of heighted security obligations for operators of critical information infrastructure (“CII”), including:
- internal organization, training, data backup and emergency response requirements (Article 34);
- storage of personal information and other important data must in principle be secured within the PRC territory (Article 37);
- procurement of network products and services which may affect national security shall pass the security inspection of the relevant authorities (Article 35); and
- conducting annual assessments of cyber security risks and reporting the result of those assessments and improvement measures to the relevant authority (Article 38).
Protection of Personal Information
The CSL reiterates the obligations of network operators regarding the protection of personal information which appear across existing laws and regulations, including the mandate to observe the principle of lawfulness, necessity and appropriateness in the collection and use of personal information and to observe “the notification and consent requirements” (Article 41), to use personal information only for the purpose agreed upon by the relevant individual (Article 41), to adopt security protection measures for personal information (Article 42), and to protect the individual’s right to access and correct personal information (Article 43). In addition, the CSL also incorporates some new rules on personal information protection, including data breach notification requirements (Article 42), and data anonymization as an exception for notification and consent requirements (Article 42), and the individual’s right to request the network operators make corrections to or delete their personal information in case the information is wrong or used beyond the agreed purpose (Article 43).
The CSL is the first law in the PRC specially focused on cyber security matters. When the CSL takes effect on June 1, 2017, internet companies and other industries in China will be subject to stricter and more comprehensive obligations and face more severe punishments for violations. As an omnibus law on cyber security issues, many provisions of the CSL are still very general and abstract, and the detailed requirements for implementation and enforcement depend on subsequent and more specific implementation regulations as well as the opinion of the relevant authorities. We may expect that the relevant regulatory authorities may promulgate a series of implementation regulations to clarify certain requirements under the CSL, such as the regulations on tiered cyber security protection systems, the specific scope and protection measures of CII, the protection of minors on networks, the mandatory security certification and the test requirements for key network devices and special cyber security products, national security review on the network products and services procured by CII operators, etc. For example, as for the protection of minors on the internet, the CAC published a draft of Regulations on Protection of Minors Online for public comment last month.
Nearly half a year remains before the formal implementation of the CSL and companies may use this transition period to improve their understanding of the potential impacts of the CSL on their business. In particular, if companies are deemed operators of CII, the CSL may have a significant impact on its network security framework, procurement of security products, and data storage. Companies may consider whether they need to adjust their business and operation practices in these aforementioned aspects and enhance their cyber security protections so as to ensure fully compliance with the CSL. Given the specific implementation of the requirements in the CSL are not entirely clear, companies will also need to closely follow any subsequently released regulations and opinions of the relevant governmental authorities.
- Global M&A volume in 2016 continued to be robust, reaching $3.7 trillion, approximately 40% of which involved cross-border deals, as compared to one-third in 2015. Five out of the ten largest deals of the year were cross-border transactions. The pace of deals grew during the second half of the year, especially in the U.S., and there are many signals pointing to a continued strong pace of transactions. The big wild card, of course, is the extent to which recent political upheaval both in the U.S. and around the world will translate into increased protectionism or other upheaval in taxation, regulation or finance. So far, the deal market is largely unfazed, and rising U.S. equity valuations provide plenty of dry powder for stock deals.
- U.S. targets accounted for approximately $1.7 trillion of last year’s deal volume, with approximately 30% of U.S. deals involving non-U.S. acquirors.
- We would be surprised, even in the face of significant change and uncertainty, were robust levels of cross-border M&A not to continue to be a prominent feature of the international business landscape. Both U.S. sellers and non-U.S. buyers will remain interested in the opportunities presented by investment in the U.S., and perhaps more so in a world where economic nationalism is on the rise.
- This post updates our checklist of issues that should be carefully considered in advance of an acquisition or strategic investment in the U.S.
Global M&A volume in 2016 continued to be robust, reaching $3.7 trillion, approximately 40% of which involved cross-border deals, as compared to one-third in 2015. Five out of the ten largest deals of the year were cross-border transactions. The pace of deals grew during the second half of the year, especially in the U.S., and there are many signals pointing to a continued strong pace of transactions. The big wild card, of course, is the extent to which recent political upheaval both in the U.S. and around the world will translate into increased protectionism or other upheaval in taxation, regulation or finance. So far, the deal market is largely unfazed, and rising U.S. equity valuations provide plenty of dry powder for stock deals.
U.S. targets accounted for approximately $1.7 trillion of last year’s deal volume, with approximately 30% of U.S. deals involving non-U.S. acquirors. German, French, Canadian, Japanese and U.K. buyers accounted for approximately 65% of the volume of cross-border acquisitions into the U.S., and acquirors from China, India and other emerging economies accounted for approximately 15%. Cross-border deals involving U.S. target companies included a number of noteworthy transactions, including Bayer AG’s $66 billion acquisition of Monsanto, the $28 billion merger between Enbridge and Spectra Energy, Danone S.A.’s $12.5 billion acquisition of Whitewave Foods, and Samsung’s $8 billion acquisition of Harman International.
Predictions – as has been famously and variously attributed to Niels Bohr, Yogi Berra and others – are tough, especially about the future. What we can expect in 2017, as a Trump administration takes up the reins of power in the U.S., the U.K. inches and lurches toward Brexit, Italy regroups, France and Germany hold elections, and Chinese signals on outbound investment (which surged more than 350% for 2016 U.S. deals as compared to 2015 levels) and outbound capital movement are both mixed and opaque, is beyond our powers of prediction, however ex-cited the U.S. equity markets may currently be.
That said, we would be surprised, even in the face of significant change and uncertainty, were robust levels of cross-border M&A not to continue to be a prominent feature of the international business landscape. Both U.S. sellers and non-U.S. buyers will remain interested in the opportunities presented by investment in the U.S., and perhaps more so in a world where economic nationalism is on the rise.
What won’t change is that advance preparation, strategic implementation and sophisticated deal structures that anticipate likely concerns will continue to be critical to successful acquisitions in the U.S. It will remain the case that cross-border deals involving investment into the U.S. are more likely to fail because of poor analysis, planning and execution than fundamental legal or political restrictions.
The following is our updated checklist of issues that should be carefully considered in advance of an acquisition or strategic investment in the U.S. Because each cross-border deal is unique, the relative significance of the issues discussed below will depend upon the specific facts, circumstances and dynamics of each particular situation.
- Political and Regulatory Considerations. Even if investment into the U.S. remains mostly well-received and generally not politicized or made a pawn in broader global economic and other confrontations (an assumption that will be monitored very closely in M&A circles and more broadly), prospective non-U.S. acquirors of U.S. businesses or assets should undertake a thoughtful analysis of U.S. political and regulatory implications well in advance of any acquisition proposal or program, particularly if the target company operates in a sensitive industry, if post-transaction business plans contemplate major changes in investment, employment or business strategy, or if the acquiror is sponsored or financed by a foreign government, or organized in a jurisdiction where a high level of government involvement in business is generally understood to exist. It is imperative that the likely concerns of federal, state and local government agencies, employees, customers, suppliers, communities and other interested parties be thoroughly considered and, if possible, addressed prior to any acquisition or investment proposal becoming public. It is also essential that a comprehensive communications plan, focusing not only on public investors but also on all these core constituencies, be in place prior to the announcement of a transaction so that all of the relevant constituencies can be addressed with the appropriate messages. It will often be useful, if not essential, to involve experienced public relations firms at an early stage in the planning process. Similarly, potential regulatory hurdles require sophisticated advance planning. In addition to securities and antitrust regulations, acquisitions may be subject to CFIUS review (discussed below), and acquisitions in regulated industries (e.g., energy, public utilities, gaming, insurance, telecommunications and media, financial institutions, transportation and defense contracting) may be subject to an additional layer of regulatory approvals. Regulation in these areas is often complex, and political opponents, reluctant targets and competitors may seize on perceived weaknesses in an acquiror’s ability to clear regulatory obstacles. High-profile transactions may also result in political scrutiny by Congress, state and local officials.
Finally, depending on the industry involved and the geographic distribution of the work-force, labor unions will continue to play an active role during the review process. Pre-announcement communications plans must take account of all of these interests.
- Transaction Structures. Non-U.S. acquirors should be willing to consider a variety of potential transaction structures, especially in strategically or politically sensitive transactions. Structures that may be helpful in sensitive situations include no-governance and low-governance investments, minority positions or joint ventures, possibly with the right to increase ownership or governance over time; partnering with a U.S. company or management team or collaborating with a U.S. source of financing or co-investor (such as a private equity firm); utilizing a controlled or partly controlled U.S. acquisition vehicle, possibly with a board of directors having a substantial number of U.S. citizens and prominent U.S. citizens in high-profile roles; or implementing bespoke governance structures (such as a U.S. proxy board) with respect to specific sensitive subsidiaries or businesses of the target company. Use of debt or preferred securities (rather than ordinary common stock) should also be considered. Even more modest social issues, such as the name of the continuing enterprise and its corporate location or headquarters, or the choice of the nominal legal acquiror in a merger, can affect the perspective of government and labor officials.
- CFIUS. Under current U.S. federal law, the Committee on Foreign Investment in the United States (CFIUS) – a multi-agency governmental body chaired by the Secretary of the Treasury, the recommendations of which the President of the United States has personal authority to accept or reject – has discretion to review transactions in which non-U.S. acquirors could obtain “control” of a U.S. business or in which a non-U.S. acquiror invests in U.S. infrastructure, technology or energy assets. That authority was notably used in 2016 to block the Aixtron and Lumileds transactions. Although filings with CFIUS are voluntary, CFIUS also has the ability to investigate transactions at its discretion, including after the transaction has closed. While it is not clear if and how CFIUS’s review of cross-border transactions will change in a Trump administration, we believe three useful rules of thumb in dealing with CFIUS will continue to be useful:
- first, in general it is prudent to make a voluntary filing with CFIUS if the likelihood of an investigation is reasonably high or if competing bidders are likely to take advantage of the uncertainty of a potential investigation;
- second, it is often best to take the initiative and suggest methods of mitigation early in the review process in order to help shape any remedial measures and avoid delay or potential disapproval; and
- third, it is often a mistake to make a CFIUS filing prior to initiating discussions with the U.S. Department of the Treasury and other officials and relevant parties. In some cases, it may even be prudent to make the initial contact prior to the pub-lic announcement of the transaction. CFIUS is not as mysterious or unpredictable as some fear – consultation with Treasury and other officials (who – to date – have generally been supportive of investment in the U.S. economy) and CFIUS specialists will generally provide a good sense of what it will take to clear the process. Retaining advisors with significant CFIUS expertise and experience is often crucial to successful navigation of the CFIUS process. Transactions that may require a CFIUS filing should have a carefully crafted communications plan in place prior to any public announcement or disclosure. In addition, given that CFIUS will require a draft filing in advance of the official filing, building in sufficient lead time is essential.
While still an evolving product, in the past year some insurers have begun offering insurance coverage for CFIUS-related non-consummation risk, covering payment of the re-verse break fee in the event a transaction does not close due to CFIUS review, at a cost of approximately 10-15% of the reverse break fee.
- Acquisition Currency. While cash remains a common form of consideration in cross-border deals into the U.S., non-U.S. acquirors should think creatively about potential avenues for offering U.S. target shareholders a security that allows them to participate in the resulting global enterprise. For example, publicly listed acquirors may consider offering existing common stock or depositary receipts (e.g., ADRs) or special securities (e.g., contingent value rights). When U.S. target shareholders obtain a continuing interest in a surviving corporation that had not already been publicly listed in the U.S., expect heightened focus on the corporate governance and other ownership and structural arrangements of the non-U.S. acquiror, including as to the presence of any controlling or large shareholders, and heightened scrutiny placed on any de facto controllers or promoters. Creative structures, such as the issuance of non-voting stock or other special securities of a non-U.S. acquiror, may minimize or mitigate the issues raised by U.S. corporate governance concerns. As we have said previously, the world’s equity markets have never been more globalized, and the interest of investors in major capital markets to invest in non-local business never greater; equity consideration, or equity issuance to support a transaction, should be considered in appropriate circumstances.
- M&A Practice. It is essential to understand the custom and practice of U.S. M&A trans-actions. For instance, understanding when to respect – and when to challenge – a target’s sale “process” may be critical. Knowing how and at what price level to enter the discussions will often determine the success or failure of a proposal; in some situations it is prudent to start with an offer on the low side, while in other situations offering a full price at the outset may be essential to achieving a negotiated deal and discouraging competitors, including those who might raise political or regulatory issues. In strategically or politically sensitive transactions, hostile maneuvers may be imprudent; in other cases, unsolicited pressure might be the only way to force a transaction. Takeover regulations in the U.S. differ in many significant respects from those in non-U.S. jurisdictions; for example, the mandatory bid concept common in Europe, India and other countries is not present in U.S. practice. Permissible deal protection structures, pricing requirements and defensive measures available to U.S. targets will also likely differ in meaningful ways from what non-U.S. acquirors are accustomed to in deals in their home countries. Sensitivity must also be given to the distinct contours of the target board’s fiduciary duties and decision-making obligations under state law. Finally, often overlooked in cross-border situations is how subtle differences in language, communication expectations and the role of different transaction participants can impact transactions and discussions; advance preparation and ongoing engagement during a transaction must take this into account.
- U.S. Board Practice and Custom. Where the target is a U.S. public company, the customs and formalities surrounding board of director participation in the M&A process, including the participation of legal and financial advisors, the provision of customary fairness opinions and the inquiry and analysis surrounding the activities of the board and the financial advisors, can be unfamiliar and potentially confusing to non-U.S. transaction participants and can lead to misunderstandings that threaten to upset delicate transaction negotiations. Non-U.S. participants need to be well-advised as to the role of U.S. public company boards and the legal, regulatory and litigation framework and risks that can constrain or prescribe board action. These factors can impact both tactics and timing of M&A processes and the nature of communications with the target company.
- Distressed Acquisitions. Distressed M&A is a well-developed specialty in the U.S., with its own subculture of sophisticated investors, lawyers and financial advisors. The U.S. continues to be a popular destination for restructurings of multinational corporations, including those with few assets or operations in the country, because of its debtor-friendly reorganization laws. Recently, this trend has been most evident in the bankruptcy filings of non-U.S. based companies in the energy and shipping sectors. Among other ad-vantages, the U.S. bankruptcy system has expansive jurisdiction (such as a world-wide stay of actions against a debtor’s property and liberal filing requirements), provides relative predictability in outcomes and allows for the imposition of debt restructurings on non-consenting creditors, making reorganizations more feasible. In recent years, court-supervised “Section 363” auctions of a debtor’s assets (as opposed to the more traditional Chapter 11 plan of reorganization) have become more common, in part because they can be completed comparatively quickly, efficiently and cheaply. Additionally, large foreign companies have increasingly turned to Chapter 15 of the U.S. Bankruptcy Code, which accords debtors that are already in foreign insolvency proceedings key protections from creditors in the U.S. and has facilitated restructurings and asset sales approved abroad. Firms evaluating a potential acquisition of a distressed target based in the U.S. should consider the full array of tools that the U.S. bankruptcy process makes available, including acquisition of the target’s fulcrum debt securities that are expected to be converted in-to equity through an out-of-court restructuring or plan of reorganization, acting as a plan investor or sponsor in connection with a plan of reorganization, backstopping a plan-related rights offering or participating as a bidder in a “Section 363” auction. Transaction certainty is of critical importance to success in a transaction in bankruptcy, and non-U.S. participants accordingly need to plan carefully (especially with respect to transactions that might be subject to CFIUS review, as discussed above) to ensure that they will be on a relatively level playing field with U.S. bidders. Acquirors also need to be aware that they will likely need to address the numerous constituencies involved in a bankruptcy case, each with its own interests and often conflicting agendas, including bank lenders, bondholders, distressed-focused hedge funds and holders of structured debt securities and credit default protection, as well as landlords and trade creditors.
- Financing. Heading into 2017, recent trends that have influenced acquisition financing may be reversing. Rising interest rates deserve a moment of reflection, including in terms of the still-available opportunity to lock in long-term fixed rates to finance acquisitions, and in the challenges to de-lever post-acquisition so as to best position the company for future refinancings that may be in a higher-rate environment. On the other hand, the U.S. regulatory oversight of banks that led to leveraged lending constraints may be relaxed by the new administration, allowing banks more flexibility to finance acquisitions at higher leverage levels. Moreover, acquisition financing commitments that had been constrained, particularly for acquisitions requiring long regulatory approval periods be-tween signing and closing, may become less so. Additionally, if tax-related costs to repatriate offshore cash of U.S. corporations are reduced, the result may be new tax-efficient structures for financing deals. None of this is assured, of course, and therefore careful consideration of financing-related market trends and developments is more important than ever in planning acquisitions.
Important questions to ask when considering a transaction that requires debt financing include: what is the appropriate leverage level for the resulting business; where financing with the most favorable costs, terms and conditions is available; what currencies the financing should be raised in; and how fluctuations in currency exchange rates can affect costs, repayment and covenant compliance; how committed the financing is or should be; which lenders have the best understanding of the acquiror’s and target’s businesses; whether there are transaction structures that can minimize financing and refinancing requirements; and how comfortable a target will feel with the terms and conditions of the financing.
- Litigation. Stockholder litigation accompanies many transactions involving a U.S. public company but generally is not a cause for concern. Excluding situations involving competing bids – where litigation may play a direct role in the contest – and going-private or other “conflict” transactions initiated by controlling shareholders or management – which form a separate category requiring special care and planning – there are very few examples of major acquisitions of U.S. public companies being blocked or prevented due to shareholder litigation or of materially increased costs being imposed on arm’s-length acquirors. In most cases, where a transaction has been properly planned and implemented with the benefit of appropriate legal and investment banking advice on both sides, such litigation can be dismissed or settled for relatively small amounts or other concessions. Moreover, the rate of such litigation (and the average number of lawsuits per deal) declined in 2015 and 2016, due in part to a seminal case in a key jurisdiction for such litigation (Delaware) that reduced the incentives for the stockholder plaintiffs’ attorneys to bring such suits by signaling that disclosure-only settlements (and the attorneys’ fees they generated) would face significantly more scrutiny. Some, but not all, other courts have followed Delaware’s lead in this regard. In any event, sophisticated counsel can usually predict the likely range of litigation outcomes or settlement costs, which should be viewed as a cost of the deal.
While well-advised parties can substantially reduce the risk of U.S. stockholder litigation, the reverse is also true – the conduct of the parties during negotiations can create “bad facts” that in turn may both encourage stockholder litigation and provoke judicial rebuke, including significant monetary judgments. Sophisticated litigation counsel should be included in key stages of the deal negotiation process. In all cases, the acquiror, its directors, shareholders and offshore reporters and regulators should be conditioned in advance (to the extent possible) to expect litigation and not to view it as a sign of trouble. In addition, it is important to understand the U.S. discovery process in litigation is significantly different than the process in other jurisdictions and, even in the context of a settlement, will require the acquiror to provide responsive information and documents (including emails) to the plaintiffs.
- Tax Considerations. With Republicans in control of the White House, the Senate and the House of Representatives, comprehensive tax reform is likely to be enacted in 2017. It is anticipated that such reform will be based on the House GOP plan and the Trump plan which, despite their differences, are aligned on a number of key issues, including significant reduction in tax rates, deduction of capital expenditures, potential limitations on the deductibility of interest expense, and repatriation relief. While the specific outcome of this process remains to be seen, such tax reform is anticipated to increase the attractiveness of investing in the U.S.
U.S. tax issues affecting target shareholders or the combined group may be critical to structuring a cross-border transaction. In transactions involving the receipt by U.S. target shareholders of non-U.S. acquiror stock, the potential application of so-called “anti-inversion” rules, which could render an otherwise tax-free transaction taxable to exchanging U.S. target shareholders and also result in potentially significant adverse U.S. tax consequences to the combined group, must be carefully evaluated. Non-U.S. acquirors frequently will need to consider whether to invest directly from their home jurisdiction or through U.S. or non-U.S. subsidiaries, the impact of the transaction on tax at-tributes of the U.S. target (e.g., loss carryforwards), the deductibility of interest expense incurred on acquisition indebtedness and eligibility for reduced rates of withholding on cross-border payments of interest, dividends and royalties under applicable U.S. tax treaties. In particular, non-U.S. acquirors should carefully review the impact of recently finalized debt/equity regulations on related-party financing transactions. Because the U.S. presently does not have a “participation exemption” regime that exempts dividend in-come from non-U.S. subsidiaries, a non-U.S. acquiror of a U.S. target with non-U.S. sub-sidiaries should analyze the tax cost of extracting such subsidiaries from the U.S. group. Parties to a potential transaction should carefully monitor how their transaction may be affected by U.S. tax reform.
- Disclosure Obligations. How and when an acquiror’s interest in the target is publicly disclosed should be carefully controlled and considered, keeping in mind the various ownership thresholds that trigger mandatory disclosure on a Schedule 13D under the federal securities laws and under regulatory agency rules such as those of the Federal Re-serve Board, the Federal Energy Regulatory Commission (FERC) and the Federal Communications Commission (FCC). While the Hart-Scott-Rodino Antitrust Improvements Act (HSR) does not require disclosure to the general public, the HSR rules do require disclosure to the target before relatively low ownership thresholds can be crossed. Non-U.S. acquirors have to be mindful of disclosure norms and timing requirements relating to home country requirements with respect to cross-border investment and acquisition activity. In many cases, the U.S. disclosure regime is subject to greater judgment and analysis than the strict requirements of other jurisdictions. Treatment of derivative securities and other pecuniary interests in a target other than common stock holdings can also vary by jurisdiction.
- Shareholder Approval. Because few U.S. public companies have one or more controlling shareholders, obtaining public shareholder approval is typically a key consideration in U.S. transactions. Understanding in advance the roles of arbitrageurs, hedge funds, institutional investors, private equity funds, proxy voting advisors and other market players – and their likely views of the anticipated acquisition attempt as well as when they appear and disappear from the scene – can be pivotal to the success or failure of the transaction. It is advisable to retain an experienced proxy solicitation firm well in advance of the shareholder meeting to vote on the transaction (and sometimes prior to the announcement of a deal) to implement an effective strategy to obtain shareholder approval.
- Integration Planning. One of the reasons deals sometimes fail is poor post-acquisition integration, particularly in cross-border deals where multiple cultures, languages and historic business methods may create friction. If possible, the executives and consultants who will be responsible for integration should be involved in the early stages of the deal so that they can help formulate and “own” the plans that they will be expected to execute. Too often, a separation between the deal team and the integration/execution teams invites slippage in execution of a plan that in hindsight is labeled by the new team as unrealistic or overly ambitious. However, integration planning needs to be carefully phased in as implementation cannot occur prior to the receipt of certain regulatory approvals.
- Corporate Governance and Securities Law. Current U.S. securities and corporate governance rules can be troublesome for non-U.S. acquirors who will be issuing securities that will become publicly traded in the U.S. as a result of an acquisition. SEC rules, the Sarbanes-Oxley and Dodd-Frank Acts and stock exchange requirements should be evaluated to ensure compatibility with home country rules and to be certain that the non-U.S. acquiror will be able to comply. Rules relating to director independence, internal control reports and loans to officers and directors, among others, can frequently raise issues for non-U.S. companies listing in the U.S. Non-U.S. acquirors should also be mindful that U.S. securities regulations may apply to acquisitions and other business combination activities involving non-U.S. target companies with U.S. security holders. Whether the Trump administration, Congress and a new chairman of the U.S. Securities and Exchange Commission will significantly alter the regulatory landscape for public companies and transactions will be a subject of keen interest not only to non-U.S. acquirors, but to all public companies, acquirors and investors. Sweeping change has been promised and may be delivered.
- Antitrust Issues. To the extent that a non-U.S. acquiror directly or indirectly competes or holds an interest in a company that competes in the same industry as the target company, antitrust concerns may arise either at the federal agency or state attorneys general level. Although less typical, concerns can also arise if the foreign acquiror competes either in an upstream or downstream market of the target. As noted above, pre-closing integration efforts should also be conducted with sensitivity to antitrust requirements that can be limiting. Home country or other foreign competition laws may raise their own sets of issues that should be carefully analyzed with counsel. The administration of the antitrust laws in the U.S. is carried out by highly professional agencies relying on well-established analytical frameworks. The outcomes of the vast majority of transactions can be easily predicted. In borderline cases, while the outcome of any particular proposed transaction cannot be known with certainty, the likelihood of a proposed transaction being viewed by the agencies as raising substantive antitrust concerns and the degree of difficulty in over-coming those concerns can be. In situations presenting actual or potential substantive is-sues, careful planning is imperative and a proactive approach to engagement with the agencies is generally advisable.
- Due Diligence. Wholesale application of the acquiror’s domestic due diligence standards to the target’s jurisdiction can cause delay, waste time and resources or result in missing a problem. Due diligence methods must take account of the target jurisdiction’s legal re-gime and, particularly important in a competitive auction situation, local norms. Many due diligence requests are best channeled through legal or financial intermediaries as op-posed to being made directly to the target company. Making due diligence requests that appear to the target as particularly unusual or unreasonable (not uncommon in cross-border deals) can easily create friction or cause a bidder to lose credibility. Similarly, missing a significant local issue for lack of local knowledge can be highly problematic and costly. Prospective acquirors should also be familiar with the legal and regulatory context in the U.S. for diligence areas of increasing focus, including cybersecurity, data privacy and protection, Foreign Corrupt Practices Act (FCPA) compliance and other matters. In some cases, a potential acquiror may wish to investigate obtaining representation and warranty insurance in connection with a potential transaction, which has been used with increasing frequency as a tool to offset losses resulting from certain breaches of representations and warranties.
- Collaboration. More so than ever in the face of the current U.S. and global uncertainties, most obstacles to a deal are best addressed in partnership with local players whose interests are aligned with those of the acquiror. If possible, relationships with the target company’s management and other local forces should be established well in advance so that political and other concerns can be addressed together, and so that all politicians, regulators and other stakeholders can be approached by the whole group in a consistent, collaborative and cooperative fashion.
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As always in global M&A, results, highpoints and lowpoints for 2017 are likely to include many surprises, and sophisticated market participants will need to continually refine their strategies and tactics as the global and local environment develops. However, the rules of the road for successful M&A transactions in the U.S. remain well understood and eminently capable of being mastered by well-prepared and well-advised acquirors from all parts of the globe.
CHINESE UPDATE – Limitations on Overseas Direct Investment, A First Step of Temporary Capital Controls?
During this sensitive time when capital control measures are about to come out, through an interview of officials of the State Administration of Foreign Exchange (“SAFE”), the Xinhua News Agency on December 8 revealed the details and direction of policy on the recent tightening of overseas direct investment (“ODI“). The effects on ODI from the tightening of policy restrictions, starting from several months past and up to present, are rapidly magnifying.
At the opening of the news interview, it was stated that cross-border capital flows were generally stable, and according to monitoring, there was no finding that desire for foreign exchange purchases by enterprises or individuals would surge sharply; however, it was pointed out that a large number of ODI projects have already been placed under scrutiny of various departments (i.e., NDRC, MOFCOM, PBOC, and SAFE). During the interview, SAFE officials pointed out that four categories are considered abnormal circumstances of ODI behavior: (1) newly established enterprises without substance of business carry out overseas investment; (2) the scale of overseas investment is far greater than the registered capital of the domestic parent company, and the operational status as reflected by financial statements of the parent company is not comparable to support the scale of overseas investment; (3) no correlation exists between the main business of the domestic parent company and the overseas investment project; (4) the RMB used for investment obtains from an abnormal source, being suspect of illegally transferring assets for Chinese individuals and illegal operation of underground money exchange. Having such a wide range for the definitional scope of abnormal behavior is really rare. From the perspective of SAFE, only enterprises with the capability and qualification can make overseas direct investment, while pooling of funds by individual investors for conducting overseas direct investment does not conform to the so-called “authenticity and compliance” principle.
In addition, this interview once again mentioned the ways of foreign exchange payment violations by individuals, that is by way of split where the annual remittance quotas of other individuals are used in performing fund remittances; as well as the possible consequences of such violations, that is these individuals might be put on an “Attention Name List,” and have their annual remittance quotas for the next two years canceled, and where circumstances are serious, be put on file for punishment.
Our Interpretation: Except for ODIs conducted by enterprises possessing ample financial strength and where the ODI is closely related with the main business of such enterprises, other types of ODI would basically be stopped. In addition, there is a large possibility that the next step of SAFE will be to take further steps in regulatory and enforcement measures regarding overseas investment by individuals.
The new Dutch Corporate Governance Code, issued December 8, 2016, provides an interesting analog to The New Paradigm, A Roadmap for an Implicit Corporate Governance Partnership Between Corporations and Investors to Achieve Sustainable Long-Term Investment and Growth, issued September 2, 2016, by the International Business Council of the World Economic Forum. The new Dutch Code is applicable to the typical two-tier Dutch company with a management board and a supervisory board. The similarities between the Dutch Code and the New Paradigm demonstrate that the principles of The New Paradigm, which are to a large extent based on the U.S. and U.K. corporate governance structure with single-tier boards, are relevant and readily adaptable to the European two-tier board structure.
Both the New Paradigm and the Dutch Code fundamentally envision a company as a long-term alliance between its shareholders and other stakeholders. They are both based on the notions that a company should and will be effectively managed for long-term growth and increased value, pursue thoughtful ESG and CSR policies, be transparent, be appropriately responsive to shareholder interests and engage with shareholders and other stakeholders.
Like The New Paradigm, the Dutch Code is fundamentally designed to promote long-term growth and value creation. The management board is tasked with achieving this goal and the supervisory board is tasked with monitoring the management board’s efforts to achieve it.
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The evolution of corporate governance over the last three decades has produced meaningful changes in the expectations of shareholders and the business policies adopted to meet those expectations. Decision-making power has shifted away from industrialists, entrepreneurs and builders of businesses, toward greater empowerment of institutional investors, hedge funds and other financial managers. As part of this shift, there has been an overriding emphasis on measures of shareholder value, with the success or failure of businesses judged based on earnings per share, total shareholder return and similar financial metrics. Only secondary importance is given to factors such as customer satisfaction, technological innovations and whether the business has cultivated a skilled and loyal workforce. In this environment, actions that boost short-term shareholder value—such as dividends, stock buybacks and reductions in employee headcount, capital expenditures and R&D—are rewarded. On the other hand, actions that are essential for strengthening the business in the long-term, but that may have a more attenuated impact on short-term shareholder value, are de-prioritized or even penalized.
This pervasive short-termism is eroding the overall economy and putting our nation at a major competitive disadvantage to countries, like China, that are not infected with short-termism. It is critical that corporations continuously adapt to developments in information technology, digitalization, artificial intelligence and other disruptive innovations that are creating new markets and transforming the business landscape. Dealing with these disruptions requires significant investments in research and development, capital assets and employee training, in addition to the normal investments required to maintain the business. All of these investments weigh on short-term earnings and are capable of being second-guessed by hedge fund activists and other investors who have a primarily financial rather than business perspective. Yet such investments are essential to the long-term viability of the business, and bending to pressure for short-term performance at the expense of such investments will doom the business to decline. We have already suffered this effect in a number of industries.
In this environment, a critical task for boards of directors in 2017 and beyond is to assist management in developing and implementing strategies to balance short-term and long-term objectives. It is clear that short-termism and its impact on economic growth is not only a broad-based economic issue, but also a governance issue that is becoming a key priority for boards and, increasingly, for large institutional investors. Much as risk management morphed after the financial crisis from being not just an operational issue but also a governance issue, so too are short-termism and related socioeconomic and sustainability issues becoming increasingly core challenges for boards of directors.
At the same time, however, the ability of boards by themselves to combat short-termism and a myopic focus on “maximizing” shareholder value is subject to limitations. While boards have a critical role to play in this effort, there is a growing recognition that a larger, systemic recalibration is also needed to turn the tide against short-termism and reinvigorate the willingness and ability of corporations to make long-term capital investments that benefit shareholders as well as other constituencies. It is beyond dispute that the surge in activism over the last several years has greatly exacerbated the challenges boards face in resisting short-termist pressures. The past decade has seen a remarkable increase in the amount of funds managed by activist hedge funds and a concomitant uptick in the prevalence and sophistication of their attacks on corporations. Today, even companies with credible strategies, innovative businesses and engaged boards face an uphill battle in defending against an activist attack and are under constant pressure to deliver short-term results. A recent McKinsey Quarterly survey of over a thousand C-level executives and board members indicates most believe short-term pressures are continuing to grow, with 87% feeling pressured to demonstrate financial results within two years or less, and 29% feeling pressured over a period of less than six months.
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