Mergers

Mergers in the United States differ from those in all other jurisdictions that I am familiar with by being statutory mergers: State laws define how a merger has to be effected, and it becomes effective through the filing of the requisite documentation with the relevant authorities, such as the Secretary of State's Corporation Office in the case of a Delaware corporation. In contrast, in all non-U.S. jurisdictions, mergers become effective by court order. In these countries, a judge has the final say in approving a merger. In the United Kingdom, for example, at least two court meetings are required before a scheme of arrangement can be completed, whereby the last court meeting sanctions the scheme

In a direct merger (see Figure 6.1), the target firm merges directly into the acquirer. Shareholders of the target receive the merger consideration. To the extent that they receive stock of the acquirer, they become shareholders of the buyer. Direct mergers are not very popular because they require the approval of the shareholders of both target and acquirer. Therefore, a more common merger structure is an indirect merger in which the acquirer forms a wholly owned subsidiary that merges with the target. These structures involve three firms and are known as triangular mergers. The merger subsidiary (or merger sub) is a corporation that is created only for the purpose of effecting the merger.

Two types of triangular mergers are possible. In a forward triangular merger, the merger sub merges with the target, and the merger sub is the surviving entity, as shown in Figure 6.2(a). In a reverse triangular merger shown in Figure 6.2(b), the target is the surviving corporation. Reverse triangular mergers are by far the most favored transaction structures.

The choice between direct mergers or the two types of triangular mergers is driven by tax and legal considerations. In a direct merger, the buyer acquires all assets and also all liabilities of the target.

When the target is the surviving corporation, all its contracts and licenses are maintained. This can be particularly important when complex licensing applications have to be maintained in heavily regulated industries, such as financial services, air transportation, or casinos. If the target company is merged out of existence through a direct or forward triangular merger, all contracts and licenses must be assigned to the surviving corporation. Similarly, debt may not have to be refinanced when the borrower continues to exist. Assignment of contracts and refinancing of debt can take a considerable amount of time for larger firms. A recent case in Delaware¹ confirmed the long-held view that a reverse triangular merger does not constitute an assignment of contract, so that this deal structure will remain the structure of choice for the future.

As a general principle in all countries known to the author, stock-for-stock mergers are tax free. In mixed cash and stock mergers, the stock portion is tax free. The cash portion of the merger is referred to as boot. When shareholders receive new shares for their old shares they have continuity of ownership and it would not make sense to impose a tax. However, when shareholders receive cash and no longer have economic exposure to the business, taxation as a sale is reasonable. As with all tax matters, the devil is in the detail, and mergers can become taxable under circumstances that would appear to make them nontaxable.

In the United States, the tax treatment of mergers is governed by Section 368 of the Internal Revenue Code. For reverse triangular mergers, the stock portion is tax free only if it represents not less than 80 percent of the consideration received. In a forward triangular merger, only 50 percent of the consideration needs to be stock. In a direct merger, any combination of stock and cash or other property can be used to maintain the tax-free status of the stock portion. The relevant date for the determination is the closing date of the merger.

Even if merging companies chose a triangular merger structure, they can combine later into a single firm. Such later combinations, known as upstream mergers, are subjected to the tax treatment as if they were completed at the time of the original transaction. Therefore, it is possible to perform a reverse triangular merger with a cash consideration of more than 20 percent if it is followed shortly by an upstream merger. The two transactions will be collapsed into one by the Internal Revenue Service and considered a direct merger for tax purposes.

Arbitrageurs can identify the type of merger from the disclosures in the Securities and Exchange Commission (SEC) filings. Exhibit 6.1 is an excerpt from the merger agreement between priceline.com and KAYAK Software Corporation, which was acquired for $40 in cash through a forward triangular merger.

Other than in the merger agreement, descriptions of the type of merger of a given transaction can be found also in the proxy statement. Exhibit 6.2 shows excerpts of the proxy statement of the acquisition of H. J. Heinz Company by Berkshire Hathaway and private equity firm 3G Capital. This merger was structured as a reverse triangular merger. H. J. Heinz Company was acquired for $40 in cash.

An amalgamation is the Canadian equivalent of a statutory merger. Amalgamations are used mostly by private companies and small public companies. One such rare occurrence was the 2011 acquisition of Distinction Group, Inc. by private equity firm Birch Hill. Even though to date this is the largest Canadian public company to have been acquired through an amalgamation, the equity value was only C$130 million. This illustrates that this transaction type is rare and used mostly by smaller companies.

As an aside the term amalgamation is also used in Indian mergers. However, these transactions are subject to court supervision and hence are more akin to a scheme of arrangement than a Canadian amalgamation. Terminology can be confusing when the true meaning is lost in translation.

Scheme of Arrangement

A scheme of arrangement, or plan of arrangement in Canada, is an intermediary structure between a merger and a tender offer that is in widespread use in countries that have adopted a U.K.-style corporate law. In a scheme the share ownership is transferred to the buyer by court order and shareholders receive the agreed upon merger consideration, which can be stock or cash. For the court to authorize the transfer of ownership, most jurisdictions require the approval by more than a majority of shareholders. In Canada, the support of two-thirds of shareholders is required, whereas in the United Kingdom and Australia that number is three-quarters.

Unlike in a merger described in the previous section, the target company does not cease to exist. Its ownership is merely transferred by court order. Exhibit 6.3 illustrates this in an Australian scheme of arrangement through which Dai-ichi Life Insurance acquired Tower Australia.

In the United Kingdom, schemes of arrangement have a tax advantage over takeovers because no stamp tax is due if the scheme is structured so that shares are canceled rather than transferred. At a current rate of 0.5 percent it is clear that tax considerations favor schemes over takeover offers. In order to avoid incurring the stamp tax U.K. schemes reduce the outstanding capital of the target firm. Exhibit 6.4 illustrates this mechanism in the acquisition of soft drink company Britvic plc by A.G. Barr p.l.c. Note that in a Scheme of Arrangement under English law shares of the target company are canceled, whereas in the Australian example above they were transferred to the buyer. For this reason, English schemes of arrangement are sometimes referred to as capital reduction schemes. In fact, a scheme of arrangement is an instrument that can be used beyond corporate mergers. Capital reductions through schemes are also frequently employed in credit restructurings.

Tender Offers

In a tender offer, the buyer purchases the target indirectly. The buyer asks the shareholders of the target company to tender their shares into the offer. Most tender offers are friendly and are done after an agreement has been negotiated between the target and the acquirer. However, because no agreement between the target and the acquirer is necessary, a tender offer is the vehicle used in hostile acquisitions. The acquirer simply asks the shareholders to tender their shares directly to the acquirer. The transaction takes place between shareholders and the acquirer, so that it can occur even when the target firm is opposed to the acquisition. In such a hostile transaction, the acquirer replaces the board of the target once it has sufficient shares and then acquires control.

The advantage of a tender offer is the speed with which it can be executed and the absence of a shareholder vote with the associated proxy solicitation. Shareholders vote with their feet in that they can tender their shares or not.

It is impossible to obtain full control of a public company with a shareholder base of thousands, possibly millions, of small holders through a tender offer. There will always be some shareholders who do not tender. This is why tender offers are structured as two-step transactions:

1. Step 1. The acquirer seeks to get as many shares as possible in the tender offer.
2. Step 2. Once a certain threshold is reached, the acquirer squeezes out the remaining shareholders through a short-form merger.

A short-form merger allows the acquirer to cash out remaining shareholders if it holds more than a threshold percentage of a firm. The level of the threshold depends on the state of incorporation and lies between 85 and 95 percent. In Delaware, it is 90 percent.

However, not all tender offers are followed by an immediate squeeze-out of minority shareholders. In the United States, an immediate squeeze-out is standard procedure but in Germany, for example, a domination and profit sharing agreement is signed after the acquirer gains control, and a squeeze-out may not occur until years later, if ever. This is discussed in Chapter 8.

Even in the United States, there can be exceptions from an immediate squeeze-out. In the acquisition of broker/dealer GFI Group by BGC Partners, GFI acquired a 56 percent stake in GFI through a tender offer that completed on February 27, 2015. Management, which owned 39 percent of the shares, had committed to tendering its shares to BGC at a later time after completion of the tender offer. In a highly unusual step, BGC started taking control of GFI Group and implementing synergies, such as the combination of the two firms' back-office operations, right after the completion of the tender offer and prior to squeezing out the minority shareholders.

Tender offers often are extended to allow shareholders who have not yet tendered to do so when an acquirer does not reach the requisite ownership level for the short-form merger. As the offer is extended, the shareholder base turns over, and more arbitrageurs will hold stock in the target. Arbitrageurs are more likely to tender their shares than other investors.

In the United States, if several tender offer extensions still cannot get the acquirer to the desired percentage, it is possible to use a top-up option. However, this option must be included in the tender offer documentation and cannot be adopted retroactively: The target agrees to issue sufficient shares to the buyer to bring the ownership to the level where a short-form merger can be completed. The number of shares that must be issued can be calculated in the following manner:

6.1

where

A problem with the top-up option is that a large number of shares must be issued to increase the ownership of the acquirer. This is possible only if sufficient shares have been authorized. In addition, if more than 20 percent of the shares are issued, most exchanges require shareholder approval. Arbitrageurs can estimate the probability of completion of the deal from the number of shares that must be issued. Top-up options are relatively new instruments that have become common in the last decade only. They have not yet been tested extensively in court. An example of the top-up option from a merger agreement is shown in Exhibit 6.5.

More recently, the use of top-up options has declined after the Delaware legislature changed DGCL to expedite the closing of tender offers. The merger agreement can now specify that section 251(h) applies, and in that case, the acquirer only need 50 percent plus one share in order to close a merger following a tender offer. The parties are at liberty to negotiate a threshold that is higher than 50 percent. The result is that while in the year 2008 almost all tender offers had a top-up option, this has now become practically disused in agreements governed by Delaware law.

Comparison of Mergers and Tender Offers

The speed of completion works in favor of tender offers, which are much faster to complete than mergers. The SEC reviews tender offer documents while the offer is open; in a merger, the SEC must approve the merger's proxy materials before they can be distributed to shareholders. A tender offer must be open for as little as 20 days, whereas the advance-notice period for the shareholder meeting to approve a merger is at least 30 days. Further time may be required if the buyer must register new shares. Moreover, the waiting period under the Hart-Scott-Rodino Act (see Chapter 12) for a cash tender offer is shortened to 15 days compared to 30 days in a merger, which makes it possible to close the transaction earlier. All these facts suggest that the default acquisition method should be a tender offer.

The difference in speed at which mergers and tender offers can be completed can be seen in statistics of actual transactions. Table 6.2 shows the timing of mergers and tender offers in the years from 1980 to 2005. It can be seen that for public targets, tender offers always close faster than mergers. For private targets, however, mergers are faster. This difference reflects the delay that public companies experience due to the filing of proxy statements. Private companies do no have to go through an SEC review of proxy statements and therefore can close their transactions faster.

^* “Effective date” is defined here as the day of the shareholder vote approving the transaction, not the closing date, which is the relevant date used in this book for the most part.

Source: S. Betton and K. S. Thorburn, “Corporate Takeovers,” in B. E. Eckbo, ed., Handbook of Empirical Corporate Finance, vol. 2 (Amsterdam: Elsevier, 2008), 304. Reprinted with permission of Elsevier.

A corollary of the increased speed of the tender offer is the lower likelihood of the emergence of a competing bid from another buyer. A potential acquirer needs a certain amount of time to conduct due diligence, and the time frame of a tender offer is simply too short for thorough research. In addition, if the competing bidder needs to raise additional capital to make the acquisition, it is unlikely to find sources of capital quickly enough to beat the original tender offer's deadline. This is definitely a plus from the acquirer's point of view; for investors and arbitrageurs, however, it reduces the probability of getting a higher value for their shares.

Shareholder acceptance is easier to obtain in a tender offer than in a merger. In a merger, shareholders can vote if they owned shares on the record date. The record date is four to eight weeks before the vote takes place. Many shareholders sell their holdings after the record date and before the date of the shareholder meeting. They have the right to vote at the shareholder meeting but no longer have an interest in voting shares of a company that they do not own. The new owners of the shares, who would have an interest in voting, do not have the right to vote because they did not own the shares on the record date. The result is that these shares are not voted at all. Shares that do not vote in favor are counted as voting against the merger. Therefore, a large turnover in the investor base after the announcement of a merger makes it more difficult for the target company to obtain shareholder approval. One way to improve the odds is to set the record date at a longer interval after the announcement of the merger. This gives shareholders time to sell and arbitrageurs time to accumulate shares. Arbitrageurs naturally have an interest in the closing of the merger and will vote their holdings in favor. If a large premium is paid in a merger, then long-term holders are more likely to sell to arbitrageurs than when the premium is modest. Therefore, the period between the announcement of a merger and the record date should be longer for mergers with larger premia than for those with smaller premia.

Tender offers have one major drawback that limits their use: the best price Rule 14d-10. This rule means that all shareholders must receive the same merger consideration no matter when they tender their shares. The price paid to all must be the highest that is paid to any shareholder. Courts interpreted this rule in a very broad sense. Until November 2006, some courts interpreted consideration received in a merger to include also bonuses paid to management, noncompete payments, and golden parachutes and other executive compensation if it became due as a result of the acquisition. A tender offer had to pass an “integral part of the tender offer” test² in order to avoid violating the best price rule. Under this test, if a payment is connected with the transaction, such as a change of control payment that is triggered by the transaction, then it is part of the price paid and violates Rule 14d-10. As a result, transactions in which large golden parachutes are made, or where executives continue to own shares—for example, as part of a co-investment with a private equity fund—had to be structured as mergers rather than tender offers. Other courts used a more lenient standard, the bright line test. Under this test, the best price rule applied only to transactions that occurred while the tender offer was pending. The legal uncertainty created by these divergent interpretations limited the use of tender offers.

In November 2006, the SEC issued a clarification to Rule 14d-10 that made tender offers more attractive. Under the new and current standards, compensation paid to employees is no longer considered “integral part of the tender offer” if two conditions are met:

1. The compensation is related to services rendered in the past or future, or related to noncompete agreements (i.e., services that are not rendered).
2. This compensation cannot be based on the number of shares tendered by the employee.

This change was done through the addition of only a few words to one sentence in the rule. The original Rule 14-d10 read:

The consideration paid to any security holder pursuant to the tender offer is the highest consideration paid to any other security holder during such tender offer. [Italics added.]

The amended Rule 14-d10 reads:

The consideration paid to any security holder for securities tendered in the tender offer is the highest consideration paid to any other security holder for securities tendered in the tender offer. [Italics added.]

A direct consequence of the update of Rule 14d-10 has been an expanded use of tender offers, including by private equity firms. The incentive structure of private equity firms previously prevented them from using tender offers. During the first six months of 2007 at least 29 tender offers for U.S. targets with a market cap in excess of $200 million were announced, compared with just 5 for the same period in 2006. This trend is expected to continue.

A remaining problem with tender offers is the financing of the shares that are acquired in the tender. Because the company remains public between the completion of the first step, the tender offer, and the second step, the short-form merger, the investment bank financing a tender offer is subject to the margin requirements of Regulation T (Reg T). Under Reg T, customers must have at least 50 percent equity in their account at the time of the purchase of a security on credit.

Overall, tender offers remove many of the protections for investors that mergers provide. For a start, appraisal rights are not available in a tender offer. Only in the subsequent short-form merger can shareholders exercise their appraisal rights. Appraisal rights are discussed in Chapter 13.

For investors, another big disadvantage of tender offers over mergers is the lower fiduciary standard to which boards of directors are held in a tender offer. As we discuss in Chapter 8, courts apply a high standard of entire fairness in a merger. In a tender offer, however, courts only evaluate whether the tender offer was coercive. As long as there is no coercion, a tender offer will pass legal muster. In addition, there is no obligation for the board of the target to seek a maximum price for shareholders. We discuss this in more detail in Chapter 11, when we look at the use of tender offers to squeeze out minority shareholders.

The absence of a shareholder vote is also a drawback, in particular for institutional investors. Many institutions rely in their voting on the advice of the major proxy advisory services. These services do not provide recommendations on tender offers because no shareholder vote is involved. As a result, many institutions simply go with the default decision of tendering their shares. Institutional investors might not have as sound a basis for tendering their shares as they would if they were voting on a merger.

Courts take a somewhat naive position when they assume that tender offers are voluntary and that shareholders have a choice whether to tender or not. Most institutional investors will not make a careful evaluation of a tender offer but simply follow the management recommendation to tender. It takes the initiative of an aggressive activist investor to stop institutions from tendering their shares. It is easier for shareholders opposed to a buyout to solicit proxies against the transaction in a merger than to convince investors not to tender their shares.

Moreover, extension risk introduces a strong incentive to tender rather than withhold shares. An investor who does not tender shares eventually will be cashed out at the same price in the second step when the short-form merger closes. This delay can last anywhere from a few days to several months. The investor loses the time value of money in this period, because the ultimate payment after the short-form merger must be the same as that in the tender and cannot pay interest for the forgone period of time. Therefore, it is always optimal to tender unless opposition to the transaction is so strong that the probability of the deal not closing, or the price being increased, is very high.

Even companies that are not current on their financial statements can be acquired through a tender offer. If the company were to be acquired through a merger, it would have to update its financial statements to become current on its SEC filings before it could solicit proxies for a merger. In a tender offer, however, an acquirer can purchase a target company even if shareholders have no basis to evaluate the offer or determine whether the price paid is reasonable. A company that is delinquent on its SEC filings usually trades at a distressed price; it may even be delisted from an exchange and be relegated to the pink sheets if it cannot update its filings promptly. This uncertainty about the company's financial condition leads to significant selling pressure and a steep drop in its share price. Such a firm can be bought at a price that is much lower than what shareholders would have accepted if they were informed fully about the company's value and prospects. Shareholders will accept cash, even if they think it is less than the value of the firm, rather than hold a pink sheet company that is delinquent in its filings.

Finally, an interesting difference between mergers and tender offers can be seen in the returns earned by shareholders of target and acquirer before and after the announcement of the transaction. Table 6.3 shows the cumulative abnormal returns (CARs) earned in the run-up to an announcement of a transaction between days 41 and 2 prior to the announcement, as well as from the day prior to the announcement until the day after. It can be seen that the abnormal returns are higher in tender offers than mergers. This is true for both the target and the acquirer. Abnormal returns are defined by the authors of this study as the excess return over the expected return . This is a standard method for estimating excess returns used widely in the financial literature.

Source: S. Betton, and K. S. Thorburn, “Corporate Takeovers,” in B. E. Eckbo, ed., Handbook of Empirical Corporate Finance, Vol. 2 (Amsterdam: Elsevier, 2008), 363–364. Reprinted with permission of Elsevier.

The conclusions that can be drawn from these results are not only that abnormal returns are higher for tenders than mergers but also, just as interestingly, that both transaction structures generate positive abnormal returns for the combination of target and acquirer. In layman's term, on average, mergers are win-win situations for investors in all firms involved.

Burger King Provision: The Best of Both Worlds

Recently, the distinction between tender offers and mergers has begun to be somewhat blurred in the United States. Pioneered in the acquisition of Burger King by Brazilian private investment group 3G Capital in the year 2010, this clause in a tender offer allows the buyer to convert a tender into a merger if the tender does not close within a specific time period. The merger agreement provides for two different thresholds: If after the tender offer 3G Capital holds less than 79.1 percent of Burger King's shares, then a shareholder meeting would be called that will approve a merger of the two firms. At that meeting only a simple 50 percent majority of shareholders are needed to approve the merger. The odd number of 79.1 percent for the tender offer is related to the top-up option and the number of shares that are authorized for Burger King to issue. If the 79.1 percent level is reached, then Burger King can issue sufficient shares in the top-up option to get 3G Capital's stake to 90 percent, which is the level at which the squeeze-out of the second step can be effected.

With the introduction of the aforementioned section 251(h) in Delaware's General Corporate Law the Burger King structure is no longer needed to expedite tender offers as the second step of a merger can now proceed without the Burger King option. It should be noted that it had been employed in a number of mergers.

SEC's Approach to Regulation

The review of a transaction by the Securities and Exchange Commission depends on whether the acquisition is structured as a merger or a tender offer. Tender offer filings apply to both cash tender offers and stock tender offers. The SEC reviews three types of documents:

1. Proxy statements.

   These are filings made on Schedule 14A. They are similar to proxy statements sent out with annual meetings. A merger that requires shareholder approval requires a special meeting that is convened for this purpose. Sometimes the timing of the special shareholder meeting overlaps with that of the regular annual meeting, and the two are combined. Target companies sometimes simply skip the regular annual meeting if they are going to be acquired shortly and have a special meeting only for the purpose of approving the merger. If the merger were not to be approved, they would have to reconvene the regular annual meeting later.

2. Tender offer statements.

   These are documents that describe the terms of a tender offer. As discussed on Chapter 6, no shareholder approval is needed in a tender offer because shareholders consent indirectly by tendering their shares. These filings are made on Schedule TO.

3. Information statements.

   These are statements on Schedule 14C that are similar to 14A filings except that no proxies are solicited. Minority squeeze-outs through short-form mergers, for example, do not require shareholder approval, and a Schedule 14C is provided to shareholders.

A number of other, related filings are made in a merger, many of which reproduce information that is filed in the three statements just described. These other filings include:

• Going-private transaction; Schedule 13E-3.
• Schedule 14D-1 and 14D-9.
• Schedule 14E-4.
• Form 15. Once the merger is completed, the company files a Form 15 to announce the termination of the listing of its shares. These filings are made after the completion of the merger and have no relevance to arbitrageurs.

Table 6.4 shows the principal filings made by targets and acquirer as a function of whether the transaction is structured as a merger or tender offer, and whether the consideration is cash or stock. When both cash and stock are offered, the filings required for stock-for-stock mergers are made.

Documents filed with the SEC are available to the public on its EDGAR system through the Internet. For arbitrageurs, EDGAR is the first stop in the collection of information.

As soon as a merger is announced, the press release is filed with the SEC under Form 8-K along with the merger agreement. An 8-K is required to be filed within four business days of a material event. When a merger agreement is signed, the press release and the agreement are filed under item 1.01 of Form 8-K. There is often a duplicate filing of the press release and the merger agreement because under byzantine securities laws, a merger agreement is reportable not only as a material event but also, in the event of a stock-for-stock merger, as an event related to an offer of securities, or as a tender offer. Therefore, the EDGAR system will also show a Rule 425 filing or a Schedule TO with the exact same information as the 8-K. It is one of the more annoying aspects of researching mergers that many filings are duplicative or empty shells. Unfortunately, there appears to be no interest on the side of securities lawyers to make the system more easily comprehensible for investors. The more complex the system, the more need for expensive services of securities attorneys.