The Law of Corporate Finance

The Law of Corporate Finance:

General Principles and EU Law

Petri Mantysaari ¨

The Law of Corporate

Finance: General Principles

and EU Law

Volume III: Funding, Exit, Takeovers

123

Professor Petri Mantysaari ¨

Hanken School of Economics

Handelsesplanaden 2

65100 Vaasa

Finland

[email protected]

This title is part of a three volume set with ISBN 978-3-642-03105-2

ISBN 978-3-642-03057-4 e-ISBN 978-3-642-03058-1

DOI 10.1007/978-3-642-03058-1

Springer Heidelberg Dordrecht London New York

Library of Congress Control Number: 2009938577

c Springer-Verlag Berlin Heidelberg 2010

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Table of Contents

1 Introduction......................................................................................................1

1.1 Cash Flow, Risk, Agency, Information, Investments ..............................1

1.2 Funding, Exit, Acquisitions .....................................................................1

1.3 Financial Crisis........................................................................................2

2 Funding: Introduction.....................................................................................3

2.1 General Remarks .....................................................................................3

2.2 Separation of Investment and Funding Decisions?..................................3

2.3 Forms of Funding, Funding Mix, Ancillary Services ..............................5

2.4 Legal Risks Inherent in Funding Transactions ......................................13

2.5 Particular Remarks on the Subprime Mortgage Crisis...........................17

2.6 Funding Transactions and Community Law..........................................19

3 Reduction of External Funding Needs .........................................................21

3.1 Introduction ...........................................................................................21

3.2 Retained Earnings..................................................................................22

3.3 Management of Capital Invested in Assets............................................22

3.3.1 Introduction ................................................................................22

3.3.2 Excursion: IFRS and Derecognition...........................................23

3.3.3 Leasing .......................................................................................25

3.3.4 Sale and Lease-back ...................................................................35

3.3.5 Repos and Securities Lending ....................................................39

3.4 Management of Working Capital ..........................................................39

3.4.1 General Remarks ........................................................................39

3.4.2 Management of Accounts Payable .............................................40

3.4.3 Management of Accounts Receivable ........................................44

3.4.4 Particular Aspects of Securitisation............................................57

3.4.5 Cash Management ......................................................................70

3.5 Excursion: Basel II ................................................................................81

4 Debt.................................................................................................................83

4.1 Introduction ...........................................................................................83

4.2 Management of Risk: General Remarks................................................87

4.3 Particular Clauses in Loan Facility Agreements....................................98

4.4 Prospectus............................................................................................111

4.5 Particular Remarks on Corporate Bonds..............................................112

VI Table of Contents

4.6 Particular Remarks on Securities in the Money Market ...................... 119

4.7 Particular Remarks on Syndicated Loans ............................................ 125

5 Equity and Shareholders’ Capital.............................................................. 131

5.1 The Equity Technique, Different Perspectives .................................... 131

5.2 Share-based Equity and Equity That Is Not Share-based .................... 138

5.3 The Legal Capital Regime................................................................... 140

5.4 The Legal Capital Regime Under EU Company Law ......................... 145

5.5 Strategic Choices................................................................................. 158

5.6 Legal Aspects of Equity Provided by Shareholders ............................ 163

5.6.1 General Remarks...................................................................... 163

5.6.2 General Legal Aspects of Shares in Legal Entities .................. 163

5.6.3 Shares in Partnerships .............................................................. 171

5.6.4 Shares in Limited Partnerships................................................. 172

5.6.5 Shares in Private Limited-liability Companies......................... 173

5.7 Private Placements............................................................................... 180

5.8 Shares Admitted to Trading on a Regulated Market ........................... 183

5.9 Listing and the Information Management Regime .............................. 185

5.9.1 Introduction.............................................................................. 185

5.9.2 Listing Conditions.................................................................... 193

5.9.3 Prospectus ................................................................................ 199

5.9.4 Periodic and Ongoing Disclosure Obligations ......................... 205

5.9.5 Disclosure of Risk .................................................................... 207

5.9.6 Disclosure of Corporate Governance Matters .......................... 208

5.9.7 Prohibition of Market Abuse.................................................... 209

5.9.8 Enforcement ............................................................................. 215

5.9.9 Delisting ................................................................................... 218

5.10 Shares as a Source of Cash.................................................................. 222

5.10.1 General Remarks...................................................................... 222

5.10.2 Management of Risk ................................................................ 224

5.10.3 Internal Corporate Action......................................................... 234

5.11 Shares as a Means of Payment............................................................. 236

5.11.1 Introduction.............................................................................. 236

5.11.2 Community Law: General Remarks......................................... 237

5.11.3 Mergers and Share Exchanges ................................................. 239

5.11.4 Mergers and Company Law ..................................................... 244

5.11.5 Share Exchanges and Company Law ....................................... 256

5.11.6 Share Exchanges and Securities Markets Law ......................... 260

5.11.7 Fairness, Price, Existence of a Market ..................................... 268

5.12 Shares as a Means to Purchase Other Goods....................................... 278

5.13 Share-based Executive Incentive Programmes.................................... 281

6 Mezzanine..................................................................................................... 283

6.1 Introduction ......................................................................................... 283

6.2 Example: Venture Capital Transactions .............................................. 289

6.3 Loan-based Mezzanine Instruments .................................................... 292

Table of Contents VII

6.3.1 General Remarks ......................................................................292

6.3.2 Structural Subordination of Debts ............................................293

6.3.3 Repayment Schedules as a Form of Subordination ..................293

6.3.4 Statutory Subordination............................................................294

6.3.5 Contractual Subordination of Debts .........................................294

6.3.6 Contractual Subordination of Collateral...................................298

6.3.7 Structural Subordination of Collateral......................................300

6.3.8 Participation in Profits..............................................................300

6.4 Share-based Mezzanine Instruments....................................................302

6.5 Profit-sharing Arrangements................................................................306

7 Chain Structures and Control ....................................................................309

7.1 General Remarks .................................................................................309

7.2 Examples of Cases...............................................................................309

7.3 Legal Risks ..........................................................................................311

7.3.1 Parent........................................................................................311

7.3.2 Companies Lower Down in the Chain .....................................312

8 Exit: Introduction ........................................................................................315

8.1 General Remarks .................................................................................315

8.2 Exit from the Perspective of the Investor ............................................316

8.3 General Remarks on the Management of Risk ....................................318

8.3.1 Introduction ..............................................................................318

8.3.2 Replacement Risk and Refinancing Risk .................................318

8.3.3 Risks Relating to Ownership Structure and Control.................320

8.3.4 Counterparty Risks (Agency) in General .................................321

8.3.5 Information and Reputational Risk...........................................321

9 Exit of Different Classes of Investors .........................................................325

9.1 General Remarks .................................................................................325

9.2 Exit of Asset Investors.........................................................................325

9.3 Exit of Debt Investors..........................................................................327

9.4 Exit of Shareholders ............................................................................328

10 Exit of Shareholders ....................................................................................329

10.1 Introduction .........................................................................................329

10.2 Cash Payments by the Company .........................................................329

10.2.1 General Remarks ......................................................................329

10.2.2 Dividends and Other Distributions...........................................331

10.2.3 Redemption of the Subscribed Capital .....................................334

10.2.4 Share Buy-backs.......................................................................335

10.2.5 Redeemable Shares...................................................................340

10.2.6 Withdrawal of Shares Otherwise..............................................342

10.3 Third Party as a Source of Remuneration............................................342

10.3.1 Introduction ..............................................................................342

10.3.2 Clean Exit, Private Sale, Auction, IPO, Bids ...........................343

VIII Table of Contents

10.3.3 Termination of a Joint-Venture ................................................ 362

10.3.4 Privatisation.............................................................................. 365

10.4 Mergers and Divisions......................................................................... 370

10.4.1 General Remarks...................................................................... 370

10.4.2 Mergers .................................................................................... 370

10.4.3 Formation of a Holding SE ...................................................... 377

10.4.4 Divisions .................................................................................. 378

10.5 Private Equity and Refinancing........................................................... 383

10.6 Walking Away..................................................................................... 388

10.7 Liquidation .......................................................................................... 389

11 Takeovers: Introduction ............................................................................. 391

11.1 General Remarks, Parties .................................................................... 391

11.2 Structures............................................................................................. 392

11.3 Consideration and Funding.................................................................. 398

11.4 Process................................................................................................. 399

11.5 Contents of the Sales Contract............................................................. 401

11.6 Summary ............................................................................................. 403

12 Acquisition of Shares in a Privately-owned Company for Cash.............. 405

12.1 Introduction ......................................................................................... 405

12.2 Confidentiality..................................................................................... 407

12.3 Preliminary Understanding.................................................................. 408

12.4 Ensuring Exclusivity, Deal Protection Devices................................... 410

12.4.1 General Remarks...................................................................... 410

12.4.2 Exclusivity Clauses .................................................................. 411

12.4.3 Ensuring Exclusivity v Company Law..................................... 414

12.5 Signing, Conditions Precedent to Closing ........................................... 417

12.6 Employee Issues .................................................................................. 421

13 Due Diligence and Disclosures.................................................................... 427

13.1 General Remarks ................................................................................. 427

13.2 Due Diligence in Practice.................................................................... 428

13.3 Legal Requirements and Legal Constraints......................................... 432

13.3.1 General Remarks...................................................................... 432

13.3.2 Vendor Due Diligence, Vendor’s Perspective.......................... 433

13.3.3 Buyer Due Diligence, Vendor’s Perspective............................ 433

13.3.4 Buyer Due Diligence, Target’s Board...................................... 436

13.3.5 Buyer Due Diligence, Buyer’s Perspective .............................. 440

13.3.6 Buyer Due Diligence, Buyer’s Board....................................... 442

13.4 Particular Remarks on External Fairness Opinions ............................. 443

14 Excursion: Merger Control ........................................................................ 447

14.1 General Remarks ................................................................................. 447

14.2 Jurisdiction .......................................................................................... 449

14.3 Complying with Community Law....................................................... 452

14.4 National Merger Control ..................................................................... 458

Table of Contents IX

15 Excursion: Sovereign Wealth Funds..........................................................459

15.1 General Remarks .................................................................................459

15.2 Community Law..................................................................................460

16 Key Provisions of the Acquisition Agreement...........................................463

16.1 General Remarks .................................................................................463

16.2 The Specifications of the Object..........................................................463

16.3 Excursion: Non-Competition Clauses..................................................470

16.4 Remedies (Indemnities).......................................................................472

16.5 Purchase Price and the Payment Method.............................................478

16.5.1 General Remarks ......................................................................478

16.5.2 Choice of the Payment Method ................................................479

16.5.3 Adjustment of Consideration....................................................481

16.6 Buyer Due Diligence After Closing, Claims .......................................486

16.7 Excursion: Auction Sale ......................................................................487

17 Duties of the Board in the Context of Takeovers ......................................491

17.1 General Remarks .................................................................................491

17.2 In Whose Interests Shall Board Members Act?...................................491

17.3 Duty to Obtain Advice or to Give Advice ...........................................496

17.4 Takeover Defences and the Interests of the Firm ................................498

18 Takeover Defences .......................................................................................503

18.1 General Remarks .................................................................................503

18.2 Pre-Bid Defences Well in Advance.....................................................506

18.3 Structural Takeover Defences, Control................................................506

18.4 Price-increasing Defences ...................................................................507

18.5 Keeping Assets Away from the Acquirer ............................................508

18.6 Securities Lending ...............................................................................509

18.7 The White Knight Defence..................................................................510

18.8 Poison Pills, Shareholder Rights Plans ................................................511

18.9 Greenmail and Other Targeted Repurchase Actions............................512

18.10 Tactical Litigation, Administrative Constraints...................................513

18.11 Example: Arcelor and Mittal ...............................................................514

19 A Listed Company as the Target................................................................519

19.1 General Remarks .................................................................................519

19.2 Information Management: Secrecy v Disclosure.................................521

19.3 Toehold, Creeping Takeover, Major Holdings ....................................524

19.4 Selective Disclosure Internally ............................................................531

19.5 Selective Disclosure to Lenders...........................................................533

19.6 Selective Disclosure to Outsiders by the Acquirer ..............................533

19.7 Selective Disclosure to Outsiders by the Target ..................................535

19.8 Disclosure to the Public.......................................................................539

19.9 Acting in Concert, Acting in a Certain Capacity .................................541

19.10 Public Takeover Offers........................................................................543

X Table of Contents

20 Acquisition Finance ..................................................................................... 549

20.1 Introduction ......................................................................................... 549

20.2 Funding Mix ........................................................................................ 552

20.3 Particular Remarks on Securities Lending........................................... 555

20.4 Financial Assistance ............................................................................ 556

20.5 Debt ..................................................................................................... 564

20.5.1 General Remarks...................................................................... 564

20.5.2 Commitment of Banks ............................................................. 567

20.5.3 Many Legal Entities on the Side of the Borrower .................... 570

20.5.4 Internal Coherence of Contracts............................................... 576

20.6 Shareholders’ Capital .......................................................................... 579

20.7 Mezzanine ........................................................................................... 580

References .......................................................................................................... 583

1 Introduction

1.1 Cash Flow, Risk, Agency, Information, Investments

The first volume dealt with the management of: cash flow (and the exchange of

goods and services); risk; agency relationships; and information. The firm man￾ages these aspects by legal tools and practices in the context of all commercial

transactions.

The second volume discussed investments. As voluntary contracts belong to the

most important legal tools available to the firm, the second volume provided an in￾troduction to the general legal aspects of generic investment contracts and pay￾ment obligations.

This volume discusses funding transactions, exit, and a particular category of

decisions raising existential questions (business acquisitions). Transactions which

can be regarded as funding transactions from the perspective of a firm raising the

funding can be regarded as investment transactions from the perspective of an in￾vestor that provides the funding. Although the perspective chosen in this volume

is that of a firm raising funding, this volume will simultaneously provide informa￾tion about the legal aspects of many investment transactions.

1.2 Funding, Exit, Acquisitions

Funding transactions are obviously an important way to manage cash flow. All in￾vestments will have to be funded in some way or another. The firm’s funding mix

will also influence risk in many ways.

Funding. The most important way to raise funding is through retained profits

and by using existing assets more efficiently. The firm can also borrow money

from a bank, or issue debt, equity, or mezzanine securities to a small group of in￾vestors.

Securities can also be issued to the public. In this case, the management of in￾formation will play a central role. For example, the marketing of securities to the

public is constrained by the mandatory provisions of securities markets laws, and

there can be ongoing disclosure and other obligations for issuers.

Exit. The firm must manage exit-related questions in two contexts. First, the

firm’s own investors will want an exit at some point of time. There is a very wide

range of exit forms depending on the investment. For example, an investor can sell

his claims to another investor, the company can make payments to an investor

P. Mäntysaari, The Law of Corporate Finance: General Principles and EU Law,

DOI 10.1007/ 978-3-642-03058-1_1, © Springer-Verlag Berlin Heidelberg 2010

2 1 Introduction

who wants out, the company can merge with another company, or there can be an

IPO. Exit can influence the firm’s cash flow and create risks. Second, the firm will

act as an investor itself. In this case, it must manage its own exit.

Business acquisitions (existential decisions). Business acquisitions belong to

the largest investments that the firm will make. The acquisition must also be

funded in some way or another. For example, the buyer might issue securities to

the public, a small number of investors, or the sellers. Alternatively, it might bor￾row money from a bank.

For the target firm, business acquisitions can raise existential questions. For ex￾ample, the target’s board may have to decide whether the target should remain in￾dependent or accept a takeover proposal. In addition to business acquisitions, exis￾tential questions are normally raised by corporate insolvency (which will fall

outside the scope of this book).

Business acquisitions are legally complicated, and they involve the use of most

legal instruments discussed in Volumes I–II. Typically, there is a contract between

the buyer and the seller. The management of information plays a major role in this

context.

1.3 Financial Crisis

The financial market crisis that began in mid-2007 affected the funding of firms

on a very large scale. There was a “Minsky moment”. The legal aspects of funding

and exit transactions nevertheless remain unchanged. The same legal tools and

practices that were available before the crisis will be available even after the crisis.

On the other hand, the financial crisis increased risk-awareness. One can there￾fore assume that risks will be managed more carefully immediately after the crisis

(before firms again become less risk averse and start reacting to the fear of nega￾tive things occurring rather than risk as such).

Before the crisis, there was a trend towards higher and higher leverage. During

the crisis, it became more difficult for non-financial firms to raise debt funding.

As a result, it became vital for firms to have enough equity on the balance sheet

and to ensure liquidity by hoarding cash. After the crisis, firms may again have

better access to debt funding.

One of the things that could change the funding mix of firms after the financial

crisis is the choice of principal. The trend towards higher leverage was partly

caused by the choice of shareholders as the most important principal in corporate

governance. However, firms whose managers choose to further the long-term in￾terests of the firm rather than the short-term interests of its shareholders are more

likely to survive in the long term.

2 Funding: Introduction

2.1 General Remarks

The purpose of Chapters 2–7 is to discuss the legal aspects of the most important

forms of funding from the perspective of a non-financial firm. There are various

forms of external funding ranging from traditional debt and shareholders’ capital

to mezzanine capital. The firm can also release capital and retain earnings. The

purpose of this chapter is to provide an overview.

2.2 Separation of Investment and Funding Decisions?

There can be different views in financial economics and corporate finance law (as

well as business practice) about whether investment and funding decisions are

separate decisions.

Financial economics. In financial economics, funding and investment decisions

are separate decisions. When the firm considers the acquisition of an asset, it

should estimate the cash flows that are expected to arise from the ownership of the

asset. These should then be discounted at a rate that reflects the risk associated

with those cash flows. The asset should be acquired if the net present value (NPV)

is positive. How the acquisition should be financed is another matter.1

According to the separation theorem, investment and financing decisions can be separated

if there is an opportunity to borrow and lend money (the Fisher-Hirshleifer separation theo￾rem first identified by Irving Fisher). Investment decisions and financing decisions should

thus be made independently of one another.

The separation theorem has three important implications: First, the firm should invest in

projects that make it wealthier. Second, the personal investment preferences of individual

“owners” are irrelevant in making corporate investment decisions, because individual

“owners” can maximise their personal preferences for themselves Third, the financing

method does not affect the “owners’” wealth.

The separation theorem is complemented by the unanimity proposition according to

which firms need not worry about making decisions which reconcile conflicting share￾holder interests, because all shareholders are thought to share the same interests and should

therefore support the same decisions.

1 See, for example, McLaney E, Business Finance. Sixth edition. Pearson Education, Har￾low (2003) p 237.

P. Mäntysaari, The Law of Corporate Finance: General Principles and EU Law,

DOI 10.1007/ 978-3-642-03058-1_2, © Springer-Verlag Berlin Heidelberg 2010

4 2 Funding: Introduction

However, the unanimity proposition does not describe corporate reality very well. For

example, because of private benefits of control, company decisions affect the interests of

the controlling shareholder in ways other than through the decision’s impact on the value of

the company. In company groups, the business interests of the parent or the group as a

whole normally affect decision-making in companies belonging to the group.2

In Volume I, it was argued that shareholders cannot be regarded as the firm’s “owners”

in the first place and that they do not share the same interests.

Corporate finance law. In corporate finance law, questions of funding and invest￾ment are, for four reasons, very often connected.

First, the providers of funding also provide ancillary services (section 2.3 be￾low). Who holds the claim in general matters.3 Some investments are not possible

without the ancillary services of certain finance providers.

Second, the firm cannot acquire any asset without funding. (a) Very often the

acquisition and funding are part of the same contractual framework. Such cases

range from simple purchases of supplies or equipment (section 3.4.2) and simple

financial leasing transactions (section 3.3.3) to asset-backed or structured finance

(section 3.4.4), and generally to large transactions in which the availability of

funding is a typical condition precedent to closing (Chapter 20). (b) Even where

the acquisition and funding are not part of the same contract framework, the avail￾ability of external funding can influence the amount that the firm can invest or the

price that it can pay. For example, the availability of debt funding can depend on

whether potential lenders believe that the cash flows from the asset enable those

debts to be repaid or whether the asset can be used as collateral. The structuring of

the acquisition can therefore be influenced by the interests of the lenders and other

investors and depend on the structuring of the funding transaction.

The connection between investment and funding decisions can be illustrated by the take￾overs of Chrysler, an American car manufacturer, and ABN Amro, a Dutch bank.

Chrysler. In 2007, the suddenly tightening market for corporate debt and the high vola￾litility of stock markets meant that many leveraged buyouts either collapsed or had to be re￾negotiated because the banks that had agreed to lend money began to press for better terms.

Cerberus Capital Management, which agreed to acquire the Chrysler Group from Daimler￾Chrysler, had to re-negotiate its deal just before closing. Cerberus had to provide more eq￾uity, and the seller had to lend some of the money to Cerberus.

ABN Amro. In the ABN Amro case, there were two competing bids in 2007. Barclays

Bank, an English bank, noticed that a consortium led by Royal Bank of Scotland, a Scottish

Bank, had submitted a higher bid for ABN Amro. Barclays Bank then brought on board

two strategic investors, China Development Bank, a state-owned bank, and Temasek, Sin￾gapore’s government investment vehicle. They agreed to subscribe for shares in Barclays

Bank. This enabled Barclays Bank to revise its offer.

2 See also Gilson RJ, Controlling Shareholders and Corporate Governance: Complicating

the Comparative Taxonomy, Harv L R 119 (2006) p 1665. 3 Tirole J, The Theory of Corporate Finance. Princeton U P, Princeton and Oxford (2006)

p 75.

2.3 Forms of Funding, Funding Mix, Ancillary Services 5

Third, when choosing the funding mix, part of the firm’s risk management is to

take into account the assets being financed. Firms that are safe, produce steady

cash flows, and have easily redeployable assets that they can pledge as collateral

can afford high debt-to-equity ratios. In contrast, risky firms, firms with little cur￾rent cash flows, and firms with intangible assets, tend to have low leverage. Com￾panies whose value consists largely of intangible growth options have signifi￾cantly lower leverage ratios than companies whose value is represented primarily

by tangible assets.4

The fate of Northern Rock, a British mortgage bank, is an example of the relationship be￾tween the assets being financed and funding. Northern Rock relied largely on short-term

borrowing from the capital market to fund its mortgage lending practices and to offer more

attractive mortgage rates than its conservative competitors. When the interbank market was

temporarily disrupted, Northern Rock faced a liquidity crisis and anxious customers queued

up wanting to take their money out. In 2007, Northern Rock became the first British lender

in 30 years to be granted a bailout by the Bank of England. The problems of Northern Rock

were largely caused by its business model.

Fourth, a funding transaction can be someone else’s investment transaction, and

the legal framework of the transaction must address the concerns of both parties.

2.3 Forms of Funding, Funding Mix, Ancillary Services

All investments must be funded in one way or another. In addition to other in￾vestments, the firm will need to hoard reserves as part of its overall liquidity and

risk management in order to mitigate the risk of liquidity shortages.5

Funding mix, ancillary services. From the firm’s perspective, the typical forms

of funding are: retained earnings; capital released by the firm; debt; shareholders’

capital (equity); and mezzanine. There can be even other forms of funding ranging

from the investments of asset investors (sections 3.3.1 and 9.2) to state aids (see

Volume II).

The firm will thus choose a funding mix by weighing up the financial, commer￾cial, and legal advantages and disadvantages of different sources of funding. The

funding mix depends on: the availability and cost of capital; corporate risk man￾agement and the management of agency relationships between the firm as princi￾pal and investors as agents (Volume I); the ancillary services provided by the in￾vestors; and other things.

Providers of external funding can provide ancillary services such as signalling

services, monitoring services, management services, access to markets, access to

technology, and so forth. For example, shareholders’ company law rights partly

4 Tirole J, op cit, pp 99–100. See also Ferran E, Principles of Corporate Finance Law.

OUP, Oxford (2008) p 63, citing Myers SC, Capital Structure, J Econ Persp 15 (2001)

pp 81–102 at pp 82–84. 5 Tirole J, op cit, pp 199–200. See also Desperately seeking a cash cure, The Economist,

November 2008.