debevoise & plimpton private equity report/media/files/insights...with "pik toggle"...

W H AT ’ S I N S I D E

3 Mission Possible:

PE Investments in the

Defense Industry

5 Thinking About an IPO?

The Road to Market Is

Paved with New

Disclosure Requirements

7 UPDATE

How Green Is Your

Portfolio? — Update II

9 EU Alternative Investment

Fund Managers Directive:

A Tale of Two (or Three)

Proposals

11 UPDATE

Bridging the Gap —

Implied Obligations in

Earnout Contracts

13 UPDATE

Climate Change Issues

Are Turning Up the Heat

on Businesses in the U.S.

15 New UK Tax Hurdles

for Debt Buy Backs and

Leverage

Winter 2010 Volume 10 Number 2

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Many private equity portfolio companiesthat issued PIK Toggle debt during thecredit boom are beginning to wrestle withthe problem of how to calculatemandatory partial redemption paymentsthat were intended to avoid adverse taxconsequences. These payments,affectionately known as AHYDO savers,will come due for many issuers over thecourse of the next two years.During the middle of the decade just

past, when the leveraged finance marketwas awash in easy credit, corporateborrowers issued large sums of high-yieldjunior debt bearing original issue discount(“OID”). In some cases, issuers built in“PIK or pay” features, which allowedthem to conserve cash if business

conditions required. Under these “PIKToggle” instruments, borrowers werepermitted during the first few years of theinstrument’s term (and sometimes longer)either to pay cash interest currently,capitalize interest into the principal of thedebt, or elect a combination of currentpayment and capitalization. Althoughthese instruments would in many casesotherwise be Applicable High YieldDiscount Obligations (“AHYDOs”), manyborrowers avoided classification of theinstruments as AHYDOs by providing forone or more special mandatory partialredemption payments to be made morethan five years after issuance. Under normal credit market

AHYDO Savers: Not Life Savers After All for PIK Toggle Issuers?

CONTINUED ON PAGE 18

After a very long winter, the private equity industry is poised fora period of renewal. Deal activity is clearly on the uptick, thefinancing markets are showing signs of activity, the IPO marketis no longer in the doldrums and asset allocations to privateequity are no longer just a memory.The challenges facing the private equity industry are too

numerous to list. In this issue, we suggest ways in which to tacklemany of them.On our cover, we remind those who financed transactions

with "PIK toggle" instruments that, while cash interest paymentscan certainly be avoided, mandatory partial redemptionpayments may soon be due. These partial redemption paymentswere designed to avoid adverse tax consequences, but willcertainly now give rise to thorny calculation issues which wereunanticipated when it was expected that the debt could easily berefinanced well in advance of its due date.The legislative scene seems like no friend of private equity these

days. We report on the recent changes to UK tax law, which willlimit to some degree both the leverage available to UK companiesand the advantages of repurchasing portfolio company debt. Wealso report on the state of the EU's Alternative Investment FundManagers Directive, which is poised for passage in some form inthe near term. Whether it will threaten the ability of London tocontinue as a private equity hub remains to be seen.Climate change and other "green" legislation is on the

legislative agenda in both the U.S. and Europe. From ourLondon office, we herald some good news for private equity

sponsors with UK portfolio companies because the final CarbonReduction Commitment legislation due to become effective thisspring offers more options for compliance than initiallyproposed. It is expected that climate change legislation in theU.S. is also forthcoming, and we offer a primer on its manysources as well as why private equity players should stay abreast ofits progress.As the IPO market improves, we offer some guidance to those

private equity sponsors who have been away from the market fora while by reviewing the new SEC disclosure requirementsrelating to compensation, corporate governance and climatechange. We have previously highlighted the use of earnouts to bridge

valuation gaps in unsettled markets. In this issue, we remind youthat earnouts are no panacea. Two recent decisions in two U.S.circuits suggest that in order to avoid an affirmative duty to helpa seller realize the earnout payments, buyers may need tonegotiate a complete set of rules for the operation of a businessduring the earnout period.We also report on the challenges and opportunities of private

equity investment in the U.S. defense industry.As always, we look forward to your comments and your

suggestions on what aspects of the private equity industry youwould like to see featured in future issues of the Debevoise &Plimpton Private Equity Report.

The Debevoise & PlimptonPrivate Equity Report is apublication of

Debevoise & Plimpton LLP919 Third AvenueNew York, New York 100221 212 909 6000

www.debevoise.com

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Private Equity Partner /Counsel Practice Group MembersFranci J. Blassberg Editor-in-Chief

Stephen R. Hertz Andrew L. Sommer Associate Editors

Ann Heilman MurphyManaging Editor

David H. Schnabel Cartoon Editor

Please address inquiriesregarding topics covered in thispublication to the authors orany other member of thePractice Group.

All contents ©2010 Debevoise& Plimpton LLP. All rightsreserved.

The Private Equity Practice GroupAll lawyers based in New York, except where noted.

Private Equity FundsMarwan Al-Turki – LondonKenneth J. Berman– Washington,D.C.Erica BerthouJennifer J. BurleighWoodrow W. Campbell, Jr.Sherri G. CaplanJane EngelhardtMichael P. HarrellGeoffrey Kittredge – London Anthony McWhirter – LondonMarcia L. MacHarg – Frankfurt Jordan C. Murray Andrew M. Ostrognai – Hong Kong Gerard C. Saviola – LondonDavid J. SchwartzRebecca F. Silberstein

Hedge FundsByungkwon LimGary E. Murphy

Mergers & AcquisitionsAndrew L. BabE. Raman Bet-Mansour – ParisPaul S. BirdFranci J. BlassbergRichard D. BohmThomas M. Britt III – Hong KongGeoffrey P. Burgess – LondonMarc Castagnède – ParisNeil I. Chang – Hong KongMargaret A. DavenportE. Drew Dutton – Paris Michael J. GillespieGregory V. GoodingStephen R. HertzDavid F. Hickok – LondonJames A. Kiernan III – LondonAntoine F. Kirry – ParisJonathan E. LevitskyGuy Lewin-Smith – London

Li Li – ShanghaiDmitri V. Nikiforov – MoscowRobert F. Quaintance, Jr.William D. RegnerKevin A. RinkerJeffrey J. RosenJeffrey E. RossKevin M. SchmidtThomas Schürrle – FrankfurtWendy A. Semel – LondonAndrew L. SommerStefan P. Stauder James C. Swank – ParisJohn M. Vasily Peter Wand – Frankfurt

Leveraged FinanceKatherine Ashton – LondonWilliam B. BeekmanDavid A. BrittenhamPaul D. BrusiloffPierre Clermontel – Paris Alan J. Davies – LondonPeter Hockless – London

Letter from the Editor

Franci J. Blassberg

Editor-in-Chief

Despite a host of unusual deal challenges,private equity firms have in the past madea number of significant investments indefense, aerospace and other companieswith military operational elements.Significant examples include KKR andGeneral Atlantic’s acquisition of TASCInc. in 2009, Carlyle’s acquisitions of

Booz Allen’s government consulting armin 2008 and Sequa in 2006, Goldman andOnex’s acquisition of Hawker Beechcraftin 2007 and the 2006 acquisition by aconsortium of private equity firms of aminority stake in EADS. While M&Aactivity in the aerospace and defensesector slowed in 2009 and PresidentObama’s recently announced defensebudget shows a slight decrease in defensespending for 2010, many analysts arecautiously optimistic about growth andrelated merger activity in the space in thecoming year. Some positive factorsinclude the surge in Afghanistan, thecontinued U.S. presence in Iraq, lowleverage at many defense-relatedcompanies and growth in foreign militarysales. More generally, rampant and

continuing worldwide security concernsseem to make for a bullish environmentfor investment in this sector.Given the potential opportunities in

this space, we think it is a good time tohighlight some of the legal and regulatoryissues which raise special challenges forinvestments in this arena, particularly for

private equity buyers. There are manysuch challenges, but don’t be dismayed!For the determined sponsor, it is not asbad as it may seem at first blush.

Security ClearancesUnlike many strategic buyers of defensecompanies, most sponsors are unlikely tohave on staff anyone with active securityclearances. This poses significantchallenges to the diligence process becausethe sponsor will not only be denied accessto important contracts and facilitiesrelating to any classified projects of thetarget, but also may not be entitled evento be told of the existence or nature of theproject. While a target may alwaysdisclose to an uncleared buyer that it is

involved in one or more “black box”projects, it cannot provide anyadditional color as to what theprojects are, who the customer is(what branch of the governmentor military) or the nature andscope of the contracts. This canforce private equity and otherbuyers to fly blind on importantoperational aspects of the target,thereby greatly complicatingvaluation and other riskallocation judgments.

The process for obtaining asecurity clearance can be time-consuming and intrusive. It mayeven include always welcomequestions like “Have you paid allof your ‘nanny taxes’?” or “Did

you smoke pot in college?” It is not forthe faint of heart, and can often take upto a year to complete. But it is doable.One approach for private equity firmswith a particular focus in this sectorwould be for the firm to hire aninvestment professional who already hassecurity clearance, such as an individual

with the requisite military experience.Still, if that is not feasible, and if noinvestment professional at the privateequity firm is willing to endure theaggravation of obtaining the neededclearances, the sponsor can of course moveforward with the transaction withoutdiligencing the classified projects. Thereare many public companies with classifiedprojects whose stockholders makeinvestment decisions on the basis oflimited disclosure made in the companies’public reports. In addition, the privateequity buyer may attempt to shift the riskof what it doesn’t know about the generalsize, duration and reliability of theprojects to the seller via representationsand indemnities. Still, it is difficult tonegotiate appropriate contractualprotections in a vacuum, and in anyevent, they do not afford a buyer the sameperspective as reading the contracts anddiscussing the actual projects withmanagement.Another possible alternative is to retain

a third party, ideally one whose businessjudgment is strong and well-known to thesponsor, with the necessary clearance toperform diligence on the classifiedprojects. Of course, that person (who willalso need to get approval from therelevant agency before being grantedaccess) would be unable to disclose any ofits findings or conclusions to the buyer.Still, the buyer may be at least able to take

Winter 2010 l Debevoise & Plimpton Private Equity Report l page 3

Li Li – ShanghaiDmitri V. Nikiforov – MoscowRobert F. Quaintance, Jr.William D. RegnerKevin A. RinkerJeffrey J. RosenJeffrey E. RossKevin M. SchmidtThomas Schürrle – FrankfurtWendy A. Semel – LondonAndrew L. SommerStefan P. Stauder James C. Swank – ParisJohn M. Vasily Peter Wand – Frankfurt

Leveraged FinanceKatherine Ashton – LondonWilliam B. BeekmanDavid A. BrittenhamPaul D. BrusiloffPierre Clermontel – Paris Alan J. Davies – LondonPeter Hockless – London

Alan V. Kartashkin – Moscow Pierre Maugüé Margaret M. O’NeillNathan Parker – LondonA. David ReynoldsPhilipp von Holst – Frankfurt

TaxJohn Forbes Anderson – LondonEric Bérengier – ParisAndrew N. BergPierre-Pascal Bruneau – ParisGary M. FriedmanPeter A. FurciFriedrich Hey – FrankfurtAdele M. KarigRafael KariyevVadim MahmoudovMatthew D. Saronson – LondonDavid H. SchnabelPeter F. G. SchuurRichard Ward – London

Trust & Estate PlanningJonathan J. RikoonCristine M. Sapers

Employee Compensation & BenefitsLawrence K. CagneyJonathan F. Lewis Alicia C. McCarthyElizabeth Pagel SerebranskyCharles E. Wachsstock

The articles appearing in thispublication provide summaryinformation only and are notintended as legal advice. Readersshould seek specific legal advicebefore taking any action withrespect to the matters discussedherein. Any discussion of U.S.Federal tax law contained in thesearticles was not intended orwritten to be used, and it cannotbe used by any taxpayer, for thepurpose of avoiding penalties thatmay be imposed on the taxpayerunder U.S. Federal tax law.

CONTINUED ON PAGE 4

Mission Possible:PE Investments in the Defense Industry

l Debevoise & Plimpton Private Equity Report l Winter 2010

some cold comfort from the fact thatone of its representatives has reviewedthe classified projects and has had anopportunity to raise a red flag.Unfortunately, none of this changes

when the sponsor wins control of thetarget. Unless and until someoneobtains the required security clearance,the sponsor will have to rely on thetarget’s management and will be left inthe dark as to its black box projects.

Exon-FlorioUnder the Exon-Florio Act, private equityfirms constituting “foreign persons” mayneed to obtain clearance with theCommittee on Foreign Investment in theUnited States (CFIUS) prior to acquiringcontrol of a U.S. defense-related business.Moreover, as we noted in our article“Final Exon-Florio Regulations: What

They Mean for Private Equity” in theWinter 2009 Debevoise & Plimpton PrivateEquity Report, under new final regulationsadopted in 2008 with respect to Exon-Florio, under certain circumstances, aprivate equity fund that views itself as aU.S. person may nonetheless be deemedto be a “foreign person” for purposes ofExon-Florio.Exon-Florio authorizes the President

of the United States to “suspend,prohibit or require the unwinding of anytransaction by or with a foreign personthat could result in foreign control of aU.S. business, if the President concludesthat (1) the foreign interest exercisingcontrol might take action that threatensto impair U.S. national security and (2) other laws do not provide adequateprotection.”An acquirer who believes it is subject

to Exon-Florio may voluntarily make afiling with CFIUS, which will trigger areview and waiting period of theproposed transaction. If CFIUS clearsthe transaction without further review,the parties can close without fear ofsubsequent Presidential interference,unless the parties submit false ormisleading material to CFIUS ormaterially breach their mitigationagreement, described below. Bycontrast, if no filing is made, thePresident has the power to unwind thetransaction after it has closed. It is,therefore, almost always prudent in thiscontext for a foreign buyer, including aprivate equity buyer who is a “foreignperson” under Exon-Florio, voluntarilyto make the appropriate filing withCFIUS.Exon-Florio was amended in 2007 by

the Foreign Investment and NationalSecurity Act of 2007 (FINSA). One ofthe changes implemented by FINSAinvolves so-called “mitigation

agreements.” Prior to FINSA, theseagreements were informally entered intofrom time to time between a foreignperson exercising foreign ownership,control or influence (FOCI) over acompany with a U.S. national securityinterest and the relevant federal agency.The purpose of such agreements was tomitigate the effect of FOCI by, forinstance, limiting involvement by foreignpersonnel on the company’s board ofdirectors and in certain sensitive tasks,requiring audits and the oversight ofelectronic communications to and fromthe foreign shareholder, establishing asecurity plan and a designated securityofficer and guaranteeing the right of thegovernment to site visits and access tobooks and records. Each agreementwould be individually tailored to theparticular circumstances.FINSA now specifically authorizes

CFIUS to enter into mitigationagreements with buyers as a means ofenabling them to receive clearance ofparticular transactions. Unlike theinformal pre-FINSA process, however,the entire committee must approve boththe appropriateness of mitigation andthe proposed mitigation measuresthemselves before a mitigationagreement may be negotiated orexecuted. Executive Order 13456 alsoprevents CFIUS in most cases fromcoercing a company into complying withauthority to which it would otherwisenot be subject. Although theseprovisions may delay somewhat theprocess of entering into a mitigationagreement and thus clearing atransaction through CFIUS, they willhave the beneficial effect ofcircumscribing the conditions that aforeign buyer will need to comply within order to complete a transaction. On

PE Investments in the Defense Industry (cont. from page 3)


[M]ost sponsors are

unlikely to have on staff

anyone with active security

clearances. This poses

significant challenges to

the diligence process

because the sponsor will

not only be denied access

to important contracts and

facilities relating to any

classified projects of the

target, but also may not be

entitled even to be told of

the existence or nature of

the project.

The long awaited flurry of private equitybacked IPOs is edging closer to reality,providing private equity firms with apotential opportunity to rationalize thebalance sheets of portfolio companies,generate welcome returns on investment andbegin the process of exiting legacyinvestments. Private equity sponsors who are reentering

the market after the long drought stoked bythe financial crisis will face not only uncertainmarkets, but also a panoply of new disclosurerequirements. Here’s a “Cliff Notes” versionof these new requirements, which relate tocompensation, corporate governance andclimate change:

Compensation and CorporateGovernance DisclosureConcern about the impact of compensationpractices on corporate risk-taking promptedthe SEC to adopt amendments in late 2009to rules governing compensation and othercorporate governance disclosure. The ruleamendments apply to registration statementswith an initial filing date on or afterDecember 20, 2009 and that are declaredeffective on or after February 28, 2010.

Compensation policies and riskmanagement. Registrants (other than smallbusiness issuers) must now discuss theircompensation policies and practices foremployees generally, including non-executiveofficers, as they relate to risk managementpractices and risk-taking incentives, if thesecompensation policies and practices createrisks that are reasonably likely to have amaterial adverse effect on the company. Indetermining whether risks are reasonablylikely to have a material adverse effect,companies may consider policies andpractices that mitigate or balance incentivesto offset the risks involved. While situations requiring disclosure will

vary depending on the particular registrantand compensation policies and practices, therule amendments provide a non-exclusive listof situations where compensation programshave the potential to trigger a requirement fordisclosure, including policies and practices:(1) at a business unit that carries a significantportion of the company’s risk profile; (2) at abusiness unit with compensation structuredsignificantly differently than other unitswithin the company; (3) at a business unitthat is significantly more profitable thanothers within the company; (4) at a businessunit where compensation expense is asignificant percentage of the unit’s revenues;and (5) that vary significantly from theoverall risk and reward structure of thecompany. The rule amendments also provide the

following examples of issues that a companymay need to discuss if it determines that anysuch disclosure is required: (1) the generaldesign philosophy of the compensationpolicies and practices for employees whosebehavior would be most affected by theincentives established by the policies andpractices and the manner of theirimplementation; (2) the company’s riskassessment or incentive considerations, if any,in structuring its compensation policies andpractices or awarding and payingcompensation; (3) how the compensationpolicies and practices relate to the realizationof risks resulting from the actions ofemployees in both the short term and thelong term; (4) the company’s policiesregarding adjustments to its compensationpolicies and practices to address changes in itsrisk profile; (5) material adjustments thecompany has made to its compensationpolicies and practices as a result of changes inits risk profile; and (6) the extent to whichthe company monitors its compensationpolicies and practices to determine whether

its risk management objectives are being metwith respect to incentivizing its employees.Although disclosure that is responsive to therule amendments is not generally required tobe included in the company’s CompensationDiscussion & Analysis (“CD&A”), therelevant risk considerations must be discussedin the CD&A if they are a material aspect ofthe compensation decisions for namedexecutive officers.

Equity compensation. Registrants mustnow report the full grant date fair value ofoptions and other equity awards in the nowall-too-familiar Summary CompensationTable and the Directors Compensation Tablefor the year in which they are awarded toexecutives, rather than the amount recognizedfor financial statement purposes for therelevant fiscal year. For performance awards,the value reported should be computed basedupon the probable outcome of theperformance condition (or conditions) as ofthe grant date, consistent with the estimate

Thinking About an IPO? —The Road to Market Is Paved With New Disclosure Requirements

CONTINUED ON PAGE 6


Private equity sponsors

who are reentering the

market after the long

drought ... will face not

only uncertain markets,

but also a panoply of

new disclosure

requirements..., which

relate to compensation,

corporate governance

and climate change. ...


used for accounting purposes, and footnotedisclosure of the maximum value of theawards assuming the highest level ofperformance conditions is achieved is nowalso required. For an equity award grantedin a certain fiscal year to an executive officerthat is forfeited due to the executive officer’sseparation from the company, the grantdate fair value for such award is required tobe included for the purpose of determiningthat year’s total compensation. The grantdate value of an award subject to time-basedvesting should exclude the effect ofestimated forfeitures. Being responsive to these new disclosure

rules could easily impact the determinationof which executive officers, other than theCEO and CFO, are the highest paidofficers and therefore required to beincluded in the Summary CompensationTable as named executive officers. Wherecompany compensation decisions, includingdecisions to grant “new hire” or “retention”awards, do cause the named executiveofficers to change, the rule amendmentspermit companies to include supplementalcompensation disclosure for executiveofficers who otherwise would have beensubject to reporting (allowing disclosure formore than five officers, but not relieving acompany of the obligation to disclose thenew hire or retention award recipients inthe table).

Board and executive officer disclosurerequirements. Disclosure regarding eachdirector’s and director nominee’s particularexperience, qualifications, attributes or skillsthat led the board of the company toconclude that the person should serve as adirector or be nominated to so serve is nowrequired to be disclosed. The SEC has notspecified the particular information thatmust be included with the disclosure,providing flexibility to include informationmost relevant to the company. However,disclosure of criteria or attributes as a group

is insufficient, and a company must includean explanation as to why each individualdirector was chosen. The rule amendments require disclosure

of directorships at public companies andregistered investment companies held byeach director during the past five years.Previously, only current directorships wererequired to be disclosed. The ruleamendments also lengthen the time duringwhich disclosure of legal proceedingsinvolving directors, director nominees andexecutive officers is required from five to tenyears and expand the list of legalproceedings required to be disclosed in theregistration statement to include: (1) judicial or administrative proceedingsresulting from involvement in mail or wirefraud or fraud in connection with anybusiness entity; (2) judicial oradministrative proceedings based onviolations of federal or state securities,commodities, banking or insurance lawsand regulations, or any settlement to suchactions (not including settlements of privatecivil litigation); and (3) disciplinarysanctions or orders imposed by a stock,commodities or derivatives exchange orother self-regulatory organization.

Disclosure Related to Climate Change MattersOn January 27, 2010, the SEC issuedinterpretative guidance regarding disclosurerelated to climate change. Existing SECdisclosure rules require “material” effects ona company’s business to be disclosed in aregistration statement, including in the RiskFactors, Business, Legal Proceedings andManagement’s Discussion and Analysis ofFinancial Condition and Results ofOperations sections. The SEC’s interpretive guidance clarifies

the disclosure obligations of a companyregarding the impact of climate change inthese sections, and provides examples where

climate change may trigger disclosure that acompany may need to consider. Theseexamples include: (1) the impact of certainexisting laws and regulations regardingclimate change and the potential impact ofpending legislation and regulation, and thedifficulties involved in assessing the timingand effect of the pending legislation orregulation; (2) the risks or effects on acompany’s business of international accordsand treaties and other internationalactivities in connection with climate changeremediation; (3) legal, technological,political and scientific developmentsregarding climate change which may createnew opportunities or risks for companiesand the actual or potential indirectconsequences they may face due to climatechange-related regulatory or business trends;and (4) actual and potential physicalimpacts of climate change on a company’sbusiness. For IPO candidates that operatein an industry that is regarded asenvironmentally “challenged” or isotherwise affected by climate-relateddevelopments, the SEC’s guidance is a“must read.”

* * *While the devil in any SEC rules andinterpretive guidance is always in the details,IPO candidates will need to ensurecompliance with and adherence to the ruleamendments and guidance summarizedabove in order to avoid potential delays inhaving their registration statements declaredeffective.

Matthew E. [email protected]

Thinking About an IPO? (cont. from page 5)


How Green Is Your Portfolio?—Update IIU P D AT E

Private equity firms with UK portfoliocompanies can no longer delay focusingon the implications of the final CarbonReduction Commitment (“CRC”)legislation which is expected to becomeeffective on 1 April 2010The draft CRC Energy Efficiency

Scheme Order 2010 (the “CRC Order”)was submitted to the House of Commonsand House of Lords in England and therelevant legislative bodies in Scotland,Wales and Northern Ireland for approvalin January 2010, and it appears that suchapproval has now been received inEngland and Northern Ireland. On thewhole, the updated draft reflects the UKgovernment’s final policy position set outin its response to the third and finalconsultation on the scheme issued on 7 October 2009.Readers of our prior articles will

remember that the CRC legislation asoriginally proposed presented severedifficulties for private equity fundsbecause UK organizations controlled by acommon parent were to be groupedtogether with their parent entities andtreated as a single parent. Corporategroups were (and indeed still are) to bedetermined based on their structure as of31 December 2008, applying thedefinitions of “parent undertaking” and“subsidiary undertaking” in the UKCompanies Act 2006. The ultimateparent of the combined organization,including parent entities based outside ofthe UK, were to bear primaryresponsibility for compliance with thelegislation by their qualifying UKportfolio companies. Although this is still the default

position, there is good news for theprivate equity industry: the updated CRCOrder permits the ultimate parent of a

CRC group to select any “SignificantGroup Undertaking” (an “SGU”) withinits group to participate separately in thescheme, as promised in the October 7response. Once an SGU is split from itsCRC group, it will participate as aseparate entity (with no joint and severalliability with its parent) for the whole ofthe relevant phase of the scheme, even if itsubsequently reduces in size.It is apparent from the CRC Order

that, although the ultimate parent of alarge corporate group may be able todecrease the size of its participant groupby using this so-called “disaggregation”procedure, the ultimate parent must stillparticipate with one or more of itssubsidiaries and will be jointly andseverally liable with those subsidiaries forcompliance with the scheme, asdisaggregation is not permitted if it wouldresult in the rest of the group fallingbelow the 6,000MWh participationthreshold.If the ultimate parent of the group is

based outside the UK, it will be requiredto nominate a group company based inthe UK to act as “Primary Member” onbehalf of the whole group. The UKEnvironment Agency (the Governmentbody responsible for implementing andmonitoring the CRC) has indicated thatalthough it intends primarily to pursuethe Primary Member to enforcecompliance with the CRC Order andrecover any unpaid fines or other sums, itdid not discount pursuing other groupmembers if this was not successful, usingthe principle of joint and several liability.In order for an SGU to be eligible for

disaggregation, the ultimate parent musthave applied for registration in the schemeat least three months before theregistration deadline, being 30 September

2010 for the first phase. A group musttherefore have applied for registration by30 June 2010 in order to disaggregate anyof its SGUs for the first phase of thescheme.There are special rules dealing with the

transfer of SGUs during the periodbetween the end of a qualification yearand the end of the registration period fora particular phase (from 1 January 2009until 30 September 2010 for the firstphase). In short, the SGU will becomepart of the purchaser’s group formonitoring and compliance purposes, andif the purchaser’s ultimate parent was notoriginally obliged to register as aparticipant (because its group emissions inthe qualification year fell below theparticipation threshold), it will need toregister as a participant, but will only berequired to participate in respect of theemissions of that SGU and will not berequired to include emissions of any otherUK subsidiaries held during thequalification year.Accordingly, funds will not only need

to identify their participant group as of 31 December 2008, if any, but alsoconsider whether any subsequentlyacquired portfolio company would havebeen classified as an SGU of the seller asat that date. This potentially complicatedexercise will need to be undertaken byprivate equity investors as soon as possibleso that they can assess and potentiallylimit their exposure to the scheme beforethe June 30 registration deadline.

Geoffrey P. [email protected]

Russell D. [email protected]

February 22, 2010Geoffrey P. Burgess“Private Equity: Its Role in India’s Growth Story”

Thomas M. Britt, III“M&A Opportunities in the Indian Market”

IBA Presents: Globalisation of Mergers andAcquisitions – An Indian PerspectiveInternational Bar AssociationMumbai, India

March 8-9, 2010Rebecca F. Silberstein“US Regulatory Initiatives”

Jennifer J. Burleigh“Issues in Refinancing, Restructuring and Endof Fund Life”

11th Annual International Conference onPrivate Investment FundsInternational Bar AssociationLondon

March 15, 2010Kenneth J. Berman“Understanding the Impact of Legislative andRegulatory Changes on Mutual Funds”2010 Mutual Funds and InvestmentManagement Conference Investment Company InstitutePhoenix

March 26-27, 2010Lorna G. Schofield“The Financial Crisis, the Rise of Asia, and theRole of Anti-Bribery Enforcement Compliance”Twenty-eighth Annual Symposium 2010Queensland Law SocietyBrisbane, Australia

April 23, 2010Gregory J. Lyons“Private Equity and Institutional Investmentsin the Banking Industry”ABA’s Business Law Section Spring Meeting 2010American Bar AssociationDenver

May 13, 2010Kevin M. Schmidt“Special Issues Involved in AcquiringDivisions or Subsidiaries of LargerCompanies”Acquiring or Selling the Privately HeldCompany 2010Practicing Law InstituteNew York

May 13, 2010W. Neil Eggleston“The Role of Directors in a ChallengingEconomic Environment”Chicago Chapter of the NationalAssociation of Corporate DirectorsChicago

page 8 l Debevoise & Plimpton Private Equity Report l Winter 2010

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A cynical observer of the tortured path of

financial reform legislation in the

European Union might argue that EU

policymakers are almost as determined as

their American counterparts to violate

Rahm Emanuel’s first rule of governing by

letting a good crisis go to waste. But the

legislation that most directly affects the

private equity industry — the draft

directive on alternative investment fund

managers — remains very much alive,

even if attempts to reach early agreement

between Member States on the

outstanding issues have been put on hold

following some heavy lobbying. Whether

this bolsters or disproves the cynic’s

argument may be both a matter of

perspective and the final shaping of the

directive as it enters a critical stage in the

legislative process.

European CommissionProposalIt is hard to put all the recent chatter in

context without a little history. The

directive was first proposed by the

European Commission (the

“Commission”)1 in April 2009, as part of

the Commission’s response to the

worldwide financial crisis. Intended to

create a comprehensive and effective

regulatory and supervisory framework for

alternative investment fund managers in

the EU, and also to help develop a single

European market for alternative

investment funds,2 the draft directive

augured a dramatic change in the EU

regulatory landscape for private equity

managers. See the Spring 2009 edition of

the Debevoise & Plimpton Private Equity

Report, “What You Need to Know About

the Proposed EU Directive on Alternative

Investment Fund Managers.”

The proposal put forward by the

Commission (the “Commission

Proposal”) did not follow the usual

lengthy consultation process for EU

financial services legislation. Instead, it

was produced in haste and with limited

scope for prior comment. As a result,

some of the provisions are vague and do

not fit easily into the EU’s existing

financial services framework. In part

because of these drafting problems, but

also because the proposed legislation

would impose significant new capital,

disclosure, valuation and other regulatory

burdens on private equity and hedge fund

managers, the Commission Proposal set

off a firestorm of criticism from the

industry.

The Commission Proposal requires

that fund managers based in the EU be

authorized in order to provide

‘management services’ (the activities of

managing and administering one or more

funds on behalf of investors). In one of

the more controversial aspects of the

legislation, after a three-year transition

period, authorization would also be

required for managers based outside the

EU which market their funds to investors

within the EU.

Specifically, authorization under the

Commission Proposal would mean that

fund managers:

l must have minimum capital of

€125,000, plus 0.02% of the value of

assets under management in excess of

€250 million (subject to an overriding

‘own funds’ requirement of 25% of

annual fixed overhead);

l must ensure that an independent valuer

is appointed to value the assets of each

fund they manage;

l must ensure that an independent EU

authorized credit institution is

appointed as a depositary (custodian)

to hold the assets of each fund they

manage;

EU Alternative Investment Fund Managers Directive: A Tale of Two (or Three) Proposals

1 The Commission is the EU institution withresponsibility, among other things, for proposing newlegislation that applies throughout the EU. TheCommission has the sole right to propose new laws,but the laws must be adopted by the EuropeanParliament and the EU Council before becomingbinding on Member States.

The proposal put forward

by the Commission ...

did not follow the usual

lengthy consultation

process for EU financial

services legislation.

Instead, it was produced

in haste ... [and] set off a

firestorm of criticism

from the industry.


2 Investment funds that are not subject to theUCITS Directive, Directive 2009/65/EC on thecoordination of laws, regulations and administrativeprovisions relating to undertakings for collectiveinvestment in transferable securities, which permitsopen-ended funds that comply with certain criteria tobe marketed to retail investors across the EU under anEU passport.


l may delegate their functions to

appropriately qualified third parties,

but must first obtain prior

authorization from their regulator;

l must comply with extensive disclosure

and reporting requirements, including

(in the case of fund managers

managing leveraged funds)

information on the levels of leverage

they employ;

l must make additional disclosures to

their regulators and their portfolio

companies and the companies’

shareholders and employee

representatives, when acquiring voting

interests in portfolio companies of

30% or more (except for acquisitions

of interests in small and medium

enterprises);

l may market EU-based funds that they

manage to ‘professional investors’

throughout the EU, under an EU

‘passport’ (i.e., without requiring

marketing authorization from each

Member State);

l may market non-EU-based funds to

professional investors in their home

Member State, provided that, after

the expiry of a three-year transitional

period following the Directive’s

implementation, an OECD

compliant tax agreement has been

signed between their home Member

State and the country where the fund

is based; and

l may market non-EU-based funds to

professional investors in other

Member States under an EU passport,

after the expiry of a three-year

transitional period following the

directive’s implementation, provided

an OECD compliant tax agreement

has been signed between the Member

State where the marketing is carried

out and the country where the fund is

based.

EU Council’s Proposal —Some Relief, But AdditionalRequirementsThe directive is being legislated under

the EU’s ‘codecision procedure’, which

means it has to be approved by both the

EU Council (the “Council”)3 and the

European Parliament. In response to the

heavy criticism and vociferous lobbying

from the alternative investment fund

industry, the EU Council has issued a

series of compromise proposals for the

directive. The latest version, published

on March 11 (the “Council Proposal”)

differs from the Commission Proposal in

a number of respects that are beneficial

to fund managers.

For the purposes of the directive, the

definition of ‘marketing’ is narrowed, to

exclude cases where the initial approach

comes from the investor rather than the

fund manager; the minimum capital

requirement for fund managers is capped

at €10 million (but still subject to the

overriding ‘own funds’ requirement of

25% of annual fixed overhead); the

valuer is no longer required to be

independent; individual Member States

(rather than the Commission) will have

the power to set leverage limits; and the

threshold for making additional

disclosures on the acquisition of interests

in non-listed portfolio companies is

increased to 50%.

The Council Proposal added some

new obligations, however, that raised the

hackles of the private equity industry

and the City of London. Most

prominent of these, the Council

Proposal contains new provisions which

require fund managers to have in place

remuneration policies and practices that

meet specific criteria, including the

deferral of at least 40% of variable

remuneration paid by both the fund

manager and the fund itself (such as

carried interest). The deferral would be

“over a period which is appropriate in

view of the life cycle and redemption

policy of the fund concerned.” In the

case of variable remuneration of a

“particularly high amount” at least 60%

would be deferred.

In addition, the Council Proposal

dropped the provisions allowing fund

managers not based in the EU to obtain

authorization to market funds across the

EU under an EU passport. Instead,

Member States are to be permitted to

EU Alternative Investment Fund Managers Directive (cont. from page 9)

3 The Council is made up of one member fromeach Member State. The Presidency of the Councilrotates every six months to ensure that no MemberState has too great an influence in the developmentof any single policy. Spain currently holds thePresidency of the Council.


In response to the heavy

criticism and vociferous

lobbying from the

alternative investment

fund industry, the EU

Council has issued a

series of compromise

proposals for the

directive.



Bridging the Gap— Implied Obligations in Earnout Contracts

U P D AT E

Caveat Emptor, or buyer beware, istaking on an important new dimensionin the context of M&A deals featuringearnout provisions. Two recent decisionsreflecting courts’ willingness to imposeaffirmative obligations to meet earnouttargets deserve serious attention fromany private equity buyer consideringentering into such a provision.In our article entitled “Bridging the

Gap,” published in the Winter 2009edition of the Debevoise & PlimptonPrivate Equity Report, we noted thatprivate equity deal professionals werefinding earnouts to be an increasinglyeffective tool in bridging valuation gapsin today’s unsettled markets. We alsonoted that while earnouts could make iteasier for parties to come to terms onprice, they often led to complexnegotiations calibrating a seller’s desireto protect its earnout opportunitythrough restrictive covenants, veto rightsand other protective provisions and abuyer’s desire to be able to run theacquired business autonomously.For these reasons, many buyers have

historically approached earnoutnegotiations with the goal of limitingthe number and scope of a seller’sprotective provisions to the greatestextent possible. We cautioned in ourearlier article, however, that incircumstances where a definitiveagreement sets forth incomplete groundrules for the operation of an acquiredbusiness during an earnout period,buyers have been held to have animplied covenant of good faith and fairdealing, precluding them from takingactions in bad faith to interfere with a

seller’s ability to achieve an earnout eventhough such actions were not prohibitedby the express terms of the applicablepurchase agreement. A recent decision of the Court of

Appeals for the First Circuit goes evenfurther in this regard by holding that incircumstances where a definitiveagreement contains such incompleteground rules, a buyer may have animplied affirmative obligation underMassachusetts law to use reasonableefforts to operate an acquired business soas to support a seller’s earnoutopportunity. Another recent decision ofa U.S. District Court found a similaraffirmative obligation under Ohio law.These cases, coupled with the impliedcovenant of good faith and fair dealing,are noteworthy to deal professionalsbecause they demonstrate the willingnessof certain courts to impose importantduties on buyers to help sellers realizeearnouts, even (and, indeed, particularly)where the parties’ respective rights andobligations with respect to the earnoutare not set forth with clarity in the fourcorners of the purchase agreement.

Sonoran Scanners(Massachusetts Law)FactsSonoran Scanners v. PerkinElmer, Inc. (1stCir. Oct. 29, 2009) arose out of the2001 purchase by PerkinElmer, Inc.from Sonoran Scanners, Inc. of itscomputer-to-plate (CTP) business,which involved developing andmarketing high-speed digital printingtechnology for the newspaper industry.Under the asset purchase agreement,

PerkinElmer paid Sonoran $3.5 millionat the closing and agreed to makeadditional payments (up to $3.5 million)if certain product sale targets forSonoran’s CTP products were met eachyear between 2001 and 2006. Thepurchased business turned out to be afailure. PerkinElmer made a single saleof the CTP products and, before theexpiration of the earnout period, soldthe acquired assets and laid off affiliatedstaff. No additional amounts were paidby PerkinElmer to Sonoran under theearnout. Sonoran sued, alleging, among other

things, that PerkinElmer breached theasset purchase agreement by failing tomake good faith and reasonablycompetent and diligent efforts todevelop, market and sell Sonoran’sproducts. The district court grantedsummary judgment to PerkinElmer, butthe First Circuit reversed.

Implied Covenant to Use Reasonable EffortsThe First Circuit stated thatMassachusetts courts follow the principleformulated by Justice Cardozo in Woodv. Lucy, Lady Duff-Gordon (N.Y. 1917)that “[the] promise to pay … profits andrevenues resulting from [an] exclusiveagency … was a promise to usereasonable efforts to bring profits andrevenues into existence.” In Eno Sys.,Inc. v. Eno (Mass. 1942), the SupremeCourt of Massachusetts held that aperson that obtains an exclusive licenseto manufacture a product under a patenthas an implied obligation to use


reasonable efforts to promote sales of theproduct and maximize revenue.Although PerkinElmer argued that theimplied duty to use reasonable effortsrecognized by the Supreme Court ofMassachusetts in Eno was limited toexclusive licensing arrangements, theFirst Circuit rejected that argument andheld that the implied obligation couldexist in other situations, including anearnout. PerkinElmer also argued, citing cases

from some other jurisdictions, that theimplied obligation to use reasonableefforts to support an earnout is limitedto contracts where there is noconsideration supporting the existence ofa contract other than the earnout. SincePerkinElmer paid $3.5 million for theacquired business at the closing, itcontended that the implied obligation touse reasonable efforts did not apply to itsdeal with Sonoran. The First Circuitdisagreed. The key inquiry underMassachusetts law, the court stated, iswhether the acquisition agreement as awhole supports an inference of areasonable efforts obligation. Applying this standard to the terms of

the asset purchase agreement, the FirstCircuit held that there were severalfactors that supported Sonoran’sargument that the reasonable effortsobligation was implicit. The courtpointed out that the earnout wassubstantial in relation to the up-frontclosing payment, that a significantportion of the closing payment went toSonoran’s creditors and did not benefitits shareholders directly, and that theagreement contemplated a campaign tomarket Sonoran’s products over the nextfive years (although, the court noted,that did not mean that it would not bereasonable to abandon those efforts

sooner). Importantly, the First Circuitalso noted that there were no expressprovisions in the agreement negating anobligation by PerkinElmer to usereasonable efforts or giving it absolutediscretion to operate the purchasedbusiness.Under these circumstances, the First

Circuit concluded that PerkinElmer hadan implied obligation to use reasonableefforts to develop and promote Sonoran’stechnology in order to make the earnoutpayments under the asset purchaseagreement. The court remanded thecase to the district court to determinethe separate question of whether or notPerkinElmer had breached thatobligation.

Eggert Agency (Ohio Law)The existence of an implied obligationto use reasonable efforts to generaterevenues to support an earnout was alsorecognized recently under Ohio law inEggert Agency Inc. v. NA ManagementCorp. (S.D. Ohio 2009). In that case,NA Management purchased from EggertAgency the stock of a subsidiary. Thepurchase price included payments basedon revenues generated by the subsidiary’sbusiness during the three-year periodafter the closing. When the earnoutpayments did not meet the seller’sexpectations, the seller sued, allegingthat the buyer had reduced the numberof employees, closed a key office andconverted clients to its own technologyplatform. The U.S. District Court forthe Southern District of Ohio held that,because payouts to the seller werecontingent on the buyer’s revenues fromthe acquired business, the buyer had anobligation to use reasonable efforts togenerate such revenues. The court alsonoted that the implied duty to usereasonable efforts was not modified or

eliminated by the express terms of thepurchase agreement, which did notspecifically describe the buyer’sobligations with respect to the earnout.

Other JurisdictionsWhile Sonoran and Eggert Agency arelimited to Massachusetts and Ohio law,respectively, it is possible that othercourts, applying the laws of other states,could reach similar conclusions. Forinstance, although we are unaware of anycase specifically recognizing an impliedduty of reasonable efforts in an earnoutcase under New York law, New Yorkcourts generally follow the Wood case inrecognizing the implied reasonableefforts obligation in the context ofexclusive licensing agreements.

ImplicationsSonoran and Eggert Agency are significantbecause they demonstrate the willingnessof certain courts to impose importantaffirmative duties on buyers to helpsellers realize earnouts, particularly incircumstances where the parties fail toset forth clear and comprehensivestandards governing the operations ofthe acquired business during the earnoutperiod.Accordingly, one way for parties to

avoid or at least limit the application ofSonoran and Eggert Agency could be forthem to negotiate a comprehensive set ofground rules for the operation of thebusiness during the earnout period.This has long been a prudent way toapproach earnouts, but it is also likely tolead to protracted and painfulnegotiations, which in practice clientsare often tempted to truncate byagreeing to a less developed earnoutprovision.Alternatively, the parties to an

earnout could agree on some generalized

Update: Bridging the Gap (cont. from page 11)



Climate Change Issues Are Turning Upthe Heat on Businesses in the U.S.

U P D AT E

Federal, state and regional climate change

initiatives are already having an impact

on private equity acquisitions, and M&A

deals more generally, and passage of a

climate change bill by the U.S. Congress

would likely have an even greater effect on

the market. Below is a brief update to our

Spring 2008 article on the status of

climate change legislation and regulation

and the effect on private equity deals.

Despite the introduction of a number

of bills and some high-profile debate in

recent years, the U.S. Congress has not

passed comprehensive climate change

legislation. The protracted legislative

process and related uncertainties

concerning the eventual regulatory

landscape has created both an

opportunity and a burden for private

equity sponsors.

Private equity firms, particularly

those contemplating acquisitions of

carbon-intensive businesses, are

analyzing issues associated with pending

climate change legislation and

regulation. They are investigating the

potential costs of complying with

proposed federal legislation, including

expenditures necessary to upgrade plant

equipment (to reduce greenhouse gas

emissions) or purchase emissions

allowances. Similarly, purchasers are

investigating whether target businesses

are subject to the U.S. Environmental

Protection Agency’s (“EPA”) greenhouse

gas (“GHG”) reporting obligations and

proposed climate change regulations.

Purchasers are also assessing the costs

necessary to comply with state and

regional climate change initiatives.

Additionally, private equity firms are

finding new opportunities in businesses

that are well-positioned to prosper if the

regulatory landscape favors renewable

energy sources, a price is put on GHG

emissions, and a robust carbon-trading

market emerges in the U.S.

With the U.S. House of

Representatives’ passage of a climate

change and clean energy bill last

summer and the Senate expected to

debate a climate change bill this spring,

some observers believe 2010 could be

the year. In the meantime, state and

regional initiatives have moved forward,

and the EPA has been taking steps to

regulate greenhouse gas emissions under

existing laws.

Federal LegislationBeginning with the introduction of

legislation in the U.S. Senate in the fall

of 2007, the adoption of some form of

comprehensive federal legislation

addressing climate change and

regulating GHG emissions has seemed

increasingly likely. Most recently, in

June 2009, the U.S. House of

Representatives passed the American

Clean Energy and Security Act of 2009,

also known as the Waxman-Markey bill,

which introduced a nationwide federal

renewable energy standard and created a

nationwide cap-and-trade program

designed to curb emissions of carbon

dioxide and other GHGs.

The Waxman-Markey bill’s renewable

energy standard requires utilities to

obtain a certain percentage of their

electricity from renewable sources,

including wind, solar and geothermal

energy, biomass or landfill gas,

hydropower, and marine and

hydrokinetic renewable energy. The bill

creates federal renewable energy credits

(“RECs”) which could be traded in a

federal REC market.

With respect to cap-and-trade, the

bill caps GHG emissions by certain



With the U.S. House of

Representatives’ passage

of a climate change and

clean energy bill last

summer and the Senate

expected to debate a

climate change bill this

spring, some observers

believe 2010 could be

the year. In the

meantime, state and

regional initiatives have

moved forward, and the

EPA has been taking

steps to regulate

greenhouse gas emissions

under existing laws.

heavy emitters, such as facilities

emitting more than 25,000 tons of

GHGs annually, which collectively

account for approximately 85% of the

nation’s total GHG emissions. Total

U.S. emissions are capped at 17% below

2005 levels by 2020 and 83% below

2005 levels by 2050. To comply with

the cap, covered sources could reduce

actual emissions by implementing

technological or other changes, or

purchase emissions allowances on the

open market. The bill allows companies

to trade and “bank” allowances for

future use, and, in certain

circumstances, borrow against future

allowances.

In September, a climate change bill

was introduced in the U.S. Senate by

Senators Barbara Boxer (D-Calif.) and

John Kerry (D-Mass.). The bill, the

Clean Energy Jobs and American Power

Act, is similar in many respects to the

Waxman-Markey bill. The Senate bill,

though, calls for deeper cuts in GHG

emissions than the House bill.

However, because of the Senate’s focus

on healthcare reform legislation, debate

on the proposed Senate legislation

stalled.

Senator Kerry and Senators Joseph

Lieberman (I-Conn.) and Lindsey

Graham (R-S.C.) have been trying to

drum up bipartisan support for a new

climate change bill that will be less

costly to electric utilities, manufacturers

and others. Their climate change bill is

expected to be introduced this spring.

However, it is not clear whether they

will have the 60 votes necessary for the

bill’s passage. President Obama

supports comprehensive climate change

legislation and is expected to sign any

climate change bill that Congress passes.

EPA Regulation In 2009, the EPA took several steps to

regulate GHG emissions under existing

laws in the absence of Congressional

passage of a comprehensive climate

change bill. In December, the EPA

issued its “endangerment finding,”

which concluded that GHG emissions

endanger public health and welfare and

are subject to regulation. This finding

opened the door for the EPA to regulate

GHG emissions under the existing

federal Clean Air Act. However,

legislation has been introduced in

Congress to delay or stop the EPA from

regulating GHG emissions.

In addition, in September, the EPA

finalized a rule requiring certain large

emitters of GHGs to report their annual

GHG emissions to the EPA. That rule

is already effective and requires many

facilities to collect data on their GHG

emissions. The EPA estimates the rule

will require reporting from

approximately 10,000 facilities.

State and RegionalInitiativesIn the absence of federal climate change

legislation, various state and regional

initiatives are regulating GHG

emissions and promoting renewable

energy by requiring emissions reporting,

setting emissions reduction targets,

implementing state renewable portfolio

standards and launching energy

efficiency campaigns. In November, for

example, California released draft rules

regulating GHG emissions from

electricity generators, oil refineries and

other industrial facilities and creating a

statewide cap-and-trade program in

2012. The Regional Greenhouse Gas

Initiative, a regional cap-and-trade

system for carbon dioxide emissions

from power plants involving 10 states in

the northeastern U.S., is already up and

running. Currently, more than half of

the states have implemented mandatory

renewable portfolio standards and a

number of states have similar voluntary

initiatives.

ConclusionOver the next few months, the spotlight

on climate change legislation will shine

brightly as the U.S. Senate debates

passage of a comprehensive climate

change bill. The private equity

community should monitor these

developments as the proposed climate

change laws could affect private equity

investments. We will provide a full

update on climate change legislation if

the U.S. Senate passes a climate change

bill.

Stuart Hammer

[email protected]

Lauren Boccardi

[email protected]

Update: Climate Change Issues Are Turning Up the Heat (cont. from page 13)



Among the challenges facing the private

equity community, the UK’s regime forthe taxation of corporate debt – longconsidered taxpayer friendly – recentlybecame a little less hospitable. Changes toUK tax law have added additionalcomplexity and potentially tax costs toacquisition financings and to debtrepurchases by private equity sponsors.As a result of new rules adopted by

HM Revenue & Customs (“HMRC”),UK members of a group of companiesface additional restrictions on the amountof tax relief for interest costs on intra-group financing which generally apply ifthe UK group companies are moreleveraged (taking into account bothexternal and intra-group financing) thanthe group as a whole (taking into accountexternal financing only). The good newsfor private equity sponsors is that therestrictions on interest costs under thenew Worldwide Debt Cap (“WDC”) rulesgenerally should not apply to shareholderloans that private equity funds typicallyuse to finance UK acquisition vehicles.However, interest costs on intra-grouploans from a non-UK parent company toa UK group company may be subject tolimitation if the group as a whole is lessleveraged than the UK group. In additionto the WDC rules, HMRC has imposed asignificant new hurdle to tax efficientrepurchases of portfolio company debtthat trades at a discount, which generallywill have the effect of narrowingconsiderably the circumstances in whichdebt can be repurchased at a discountwithout triggering income from therelease of debt.

Worldwide Debt Cap: LimitingTax Relief for Finance CostsOn January 1, 2010, the new WorldwideDebt Cap (“WDC”) rules came intoforce. The rules limit the tax reliefavailable to the UK members of a group

of companies in respect of financing costs.

If the UK group members have, in theaggregate, higher net finance costs thanthe gross external finance costs of thegroup, for example, because of loans madeby a non-UK parent to a UK groupmember, HMRC now infer that the UKmembers’ finance costs are notcommercial and should be partiallydisallowed. The rules apply to large groups which

contain at least one company that isresident in the UK or carrying on a tradein the UK through a permanentestablishment, subject to a “gateway” testand certain exemptions. Existingtransactions and loans are not to begrandfathered and groups of companieswill now need to determine each yearwhether they are subject to the WDCrules.

The GatewayDetermining whether a group is subject tothe new WDC rules is made easier by agateway test. Under the test, a groupgenerally will be subject to the WDCregime only if the net debt of the UKgroup members (financing-related debtnet of financing-related assets) exceeds75% of the gross external debt of theentire group. For this purpose, a groupincludes the parent company and its 75%subsidiaries. The group must determineeach year whether the gateway test issatisfied.

How Do the Rules Work?If a group satisfies the gateway test andthe WDC rules apply, the interest on thegroup’s external debt sets a cap on theamount of intra-group interest costs ofUK group members for which tax reliefmay be claimed. The amount disallowedis determined by comparing the aggregatenet finance expense of the UK groupmembers (the “tested amount”) with the

gross external finance expense of the

group (the “available amount”). If theaggregate net finance expense of the UKgroup members (the excess of financingcosts over financing income, calculatedseparately for each UK group memberthat has an excess amount, and thenaggregated) exceeds the gross externalfinance expense of the group, the WDCrules disallow an amount of intra-groupinterest costs equal to the excess. Toprevent a doubling up of the disallowance,UK group members with net financingincome may be entitled to exemptionfrom tax in an equivalent amount.Certain types of business are excluded

from the new WDC rules, includingfinancial services businesses, and anycompany whose net finance expense is lessthan £500,000 is also disregarded. Anelection may be made to ignore any grouptreasury company, and similar electionsare available for short-term financing

New UK Tax Hurdles for Debt Buy Backs and Leverage

... [There is] a significant

new hurdle to tax

efficient repurchases of

portfolio company debt

that trades at a discount,

which generally will have

the effect of narrowing ...

the circumstances in

which debt can be

repurchased at a

discount without

triggering income from

the release of debt.


arrangements within the group and forfinance expenses that are “stranded” forUK corporation tax purposes.The WDC regime is subject to so-

called “targeted anti-avoidance rules”(“TAARs”). Each of these deals withattempted manipulation of differentparts of the WDC code.

Interaction with Existing LawThe new rules add to UK tax law ratherthan replace any of it. HMRC haveindicated, for example, that the transferpricing rules, which control tax relief onfinancing costs incurred by thinlycapitalized companies, will be appliedbefore the application of the WDCrules.

Impact on Private EquityThe application of the WDC rules toexisting and future structures will vary

depending on the facts, but the news isnot all bad. Shareholder loans thatprivate equity funds typically use to fundUK acquisition companies generallyshould not be caught by the WDC rules.That is because shareholder loans from afund that is structured as a limitedpartnership are likely to qualify asexternal financing, which carries with itan increase in the group’s availableamount. For example, if a private equityfund capitalizes a UK holding companywith £10 million of equity and £90million of shareholder loans (with 10%interest), and the UK holding companyfinances its subsidiary UK acquisitioncompany with £10 million of equity,£90 million of shareholder loans fromthe UK holding company (with 10%interest) and £200 million of bank loans(with 8% interest), the gross externalfinance expense of the group is £25million (£9 million attributable to theshareholder loans from the fund plus£16 million attributable to the bankloans) and the aggregate net financeexpense of the UK group is also £25million (£0 of holding company netfinance expense (the excess of £9 millionover £9 million) plus £25 million ofacquisition company net finance expense(the excess of £9 million plus £16million over £0)). Since the aggregatenet finance expense of the UK groupdoes not exceed the gross externalfinance expense of the group, the WDClimitation does not apply. In contrast, a shareholder loan from

an upper-tier non-UK company to itsUK subsidiary may result in restrictedtax relief for borrowing costs if theupper-tier company is less leveraged thanthe UK subsidiary, because the intra-group loan does not increase the group’savailable amount. For example, if a

Dutch company is financed with theEuro equivalent of £50 million of bankloans (with 10% interest) and £50million of equity, and the Dutchcompany finances a UK subsidiary with£50 million of shareholder loans (with10.50% interest), £40 million of bankloans (with 10% interest) and £5 millionof equity, a portion of the UKsubsidiary’s interest costs on theshareholder loans will be disallowed: thegross external finance expense of thegroup is £9 million (the Euro equivalentof £5 million at the Dutch companylevel and £4 million at the UK companylevel), whereas the net financing expenseof the UK group is £9.25 million (£4million plus £5.25 million). In this case,the aggregate net finance expense of theUK group exceeds the total externalfinance expense of the group by£250,000, resulting in £250,000 ofdisallowance of intra-group interest forUK tax purposes.Any attempt to restructure existing

arrangements purely in order to mitigatethe effects of the new rules is likely totrigger one or more of the TAARs and sobe ineffective.

Debt Buy-Backs: UK Tax ChargeDuring the credit crunch, a number ofprivate equity fund sponsors tookadvantage of the heavily discountedpricing of their portfolio companies’external debt and bought back some ofthat debt. If structured properly, theacquisition could be effected withoutcausing UK portfolio companies torecognize income from the release ofdebt. Since October 14, 2009, it hasbecome much more difficult to buy backdebt at a discount unless the portfoliocompany is distressed.

Worldwide Debt Cap and Debt Buy-Backs (cont. from page 15)


During the credit

crunch, a number of

private equity fund

sponsors took advantage

of the heavily discounted

pricing of their portfolio

companies’ external debt

and bought back some of

that debt. ... Since

October 14, 2009, it has

become much more

difficult to buy back

debt at a discount unless

the portfolio company is

distressed.




Background: Debt Buy-Backs Can Be Tax-exemptCompanies that are subject to UKcorporation tax generally are taxed onincome or obtain relief from lossesarising from indebtedness in a mannerthat follows the accounting treatment ofthe income and losses. As a result, if adebt is released in whole or in part, thegeneral rule is that the debtor hasincome from the release of the debt andthe creditor obtains relief for its loss, onthe basis of the accounting treatment ofthe transaction. Under an exception tothe general rule, if the debtor and thecreditor are considered to be“connected” entities (which generally isthe case if one of them controls theother, or the two entities are undercommon control), the debtor is nottaxed on its accounting income and thecreditor will not obtain relief for itsaccounting loss.If the holder of debt that is trading at

a discount sells the debt to an entity thatis not connected to the debtor, thegeneral rule is again that the seller andthe debtor are taxed or obtain relief inaccordance with their accounting

treatment of the transaction. As a result,the seller generally would obtain relieffor its loss but the debtor generallywould not recognize any income.However, if the buyer is connected tothe debtor, the UK tax rules provide thatthe acquisition triggers a “deemedrelease” of the impaired part of the debtfor UK corporation tax purposes,thereby causing the debtor to recognizeincome.It was recognized that the deemed

release rule might obstruct corporaterescues. Therefore, the rule was relaxedso that there is no deemed release if the

buyer acquires the debt pursuant to anarm’s length transaction and was notconnected with the borrower at any timein the period beginning four yearsbefore, and ending (a little curiously) 12months before, the date of theacquisition. This relaxation provided afairly simple means by which a debt buy-back could be structured withoutincurring any immediate tax charge forthe debtor company under the deemedrelease rule. The debtor group wouldform a new subsidiary to buy the debt.Since the subsidiary would be newlyformed, it would not be connected withthe borrower in the three-year window,and therefore could acquire the debt at adiscount without triggering a deemedrelease.

Restriction on the ExemptionFrom October 14, 2009, thecircumstances in which there is nodeemed release on the sale of impaireddebt to a company that is connected tothe debtor are limited considerably. Inbroad terms, the effect of the new rulesis that a deemed release will arise inrelation to an acquisition of impaireddebt by a company connected with thedebtor unless: (1) the acquisition occursin the context of a restructuring whichavoids an insolvency situation thatwould otherwise arise or (2) the buyerpays for the debt with its own debt (withthe same nominal value and substantiallythe same market value) or its own equity.In addition, if there is no deemed releaseat the time of acquisition, any futurecancellation of the debt by the buyermay result in the borrower being taxedon the amount of the previously untaxedimpairment.The new rules, although in force with

effect from October 14, 2009, will not

be formally introduced until later thisyear in the Finance Act 2010. The newregime is currently contained in draftlegislation, which may change before itfinds its way onto the statute book.Until the new rules are enacted,however, it would be dangerous toassume that they can be circumvented,and a deemed release avoided, outside aninsolvency situation.

* * *These new rules pose additional

challenges, and potentially tax costs, forprivate equity sponsors in structuringacquisition and debt repurchases and ontheir ability to obtain tax relief forfinancing costs with respect to existingdeals. Sponsors are well-advised toconsult early with their tax advisors toassess the impact of the new regime ontheir deals, both those in place and incontemplation.

Richard [email protected]

Lawrence [email protected]


These new rules pose

additional challenges,

and potentially tax costs,

for private equity

sponsors in structuring

acquisition and debt

repurchases and on their

ability to obtain tax

relief for financing costs

with respect to existing

deals.

conditions, many issuers would haverefinanced the relatively expensive PIKToggle instruments before these specialpayments came due. The currenteconomic crisis, however, has maderefinancing difficult, and many issuerswill soon be forced to confront the issueof how to calculate these specialpayments. Because of ambiguities in thetax law, the amount of these specialpayments will be highly uncertain.Absent guidance from the IRS, the resultwill be a high-stakes dilemma for manyissuers that will unfold over the next fewyears.

What Is an AHYDO?An AHYDO is a debt instrument thathas a term longer than 5 years, a yield tomaturity greater than the Governmentborrowing rate plus 5 percentage pointsand OID that is not mostly paid off bythe close of the first accrual period

ending after the fifth anniversary ofissuance. For tax purposes, aninstrument bears OID unless interest isunconditionally payable in cash at leastannually. PIK Toggle debt instrumentsbear OID, even if they are issued at par,because the issuer is not unconditionallyobligated to pay cash interest at leastannually. If an instrument is anAHYDO, some interest deductions arepermanently disallowed and theremaining deductions are deferred untilinterest is paid in cash. Congress enacted the AHYDO

legislation in 1989 against the backdropof the highly leveraged acquisitions ofBeatrice Companies, RJR Nabisco andRH Macy & Co. Congress’s intent wasto curtail the use of deep discountobligations in leveraged takeovers. Italso sought to disallow and defer interestdeductions on instruments that itbelieved had many characteristics ofequity (e.g., high yield and long term).

AHYDO Saver PaymentsRather than forgo valuable interestdeductions or see them deferred, manyissuers of PIK Toggle debt in the 2005-2008 period included a provisionrequiring that the issuer make a specialmandatory partial redemption paymentto the holders at the close of the firstaccrual period ending after the fifthanniversary of the issue date (an“AHYDO Saver Payment”). Theamount of the AHYDO Saver Paymentwas generally drafted as the minimumamount “necessary such that theinstrument would not be classified as anAHYDO.” Making an AHYDO Saver Payment

will not cause the issuer to pay morecash under the debt instrument. Itmerely accelerates the timing ofpayments that would be made in any

event. Some issuers that project excesscash may welcome the AHYDO SaverPayment because it allows them to payoff expensive debt at par rather than at amake-whole price or with a redemptionpremium. In the case of a PIK Toggle

instrument with semi-annual accrualperiods, the AHYDO Saver Paymentmust be made at the time of the firstsemi-annual payment due following thefifth anniversary of issuance. For manyissuers, this date may be just around thecorner. They will accordingly soon haveto figure out the amount of the AHYDOSaver Payment. Broadly speaking, it isan amount equal to all the OID that hasaccrued on the instrument less the yieldto maturity of the instrument multipliedby its issue price. The problem is thatthe term “yield to maturity” is notdefined in the AHYDO statute and theterm “issue price” is defined by anambiguous cross reference. Although“yield to maturity” is a familiar conceptunder the tax law, the AHYDO statutecontains a series of presumptions thatclash with the presumptions usedelsewhere in the tax law. Accordingly,many issuers will be uncertain as to thecorrect amount of the special payment. There are many parties with an

interest in the correct determination ofthe AHYDO Saver Payment, whichraises the stakes for getting thecalculation right. First, there is the IRS,which may scrutinize the payment tomake sure the issuer actually did what itpromised to do to make the instrumenta non-AHYDO. Second, there are theholders of the instruments on which thepayment is due, who have a contractualright to be paid the correct amount butno more than the correct amount, sinceany excess might properly be

AHYDO Savers (cont. from page 1)


... [M]any issuers ... will

soon have to figure out

the amount of the

AHYDO Saver Payment.

... [T]he AHYDO statute

contains a series of

presumptions that clash

with the presumptions

used elsewhere in the tax

law. Accordingly, many

issuers will be uncertain

as to the correct amount

of the special payment.



characterized as a redemption paymenton which a premium or make-whole isdue. Third, there are the senior lenders,whose own loan documents willgenerally prohibit the issuer from payingthe holders of the PIK Toggle debt morethan the required amount. If the issuer has enough cash and

decides to “play it safe” by making alarge AHYDO Saver Payment, the

holders of the PIK Toggle instrumentcould claim that the issuer, contrary tothe debt documents, paid more thannecessary. These holders would thenclaim they are owed a make-whole or aredemption premium on theoverpayment. Moreover, the seniorlenders may claim that the issuerviolated the debt prepayment orrestricted payment negative covenantsunder the senior debt documents,thereby causing an event of default.Alternatively, the issuer could pay alesser amount, but then it runs the riskthat the IRS will disagree, and moreimportantly, that the toggle debtholders, who may prefer to be paid cashsooner rather than later, even without amake-whole or redemption premium,will claim an event of payment default.This would likely cause the senior debtto cross default.One may ask whether the

professionals should have draftedAHYDO Saver Payment clauses in a waythat would have avoided this dilemma.For example, should the saver clauseshave included a provision allowing theissuer’s board to make the requiredAHYDO Saver Payment determinationin good faith, perhaps in consultationwith a nationally recognized accountingfirm? Here the answer, seen purely froma tax perspective, is likely “no.” Such a

clause may have failed from the outset toprevent the instrument from being anAHYDO. The correct amount of theAHYDO Saver Payment is a matter offederal tax law and is objective. The IRSmight argue that leaving thedetermination to the board’s discretion,whether exercised in good faith orotherwise, caused the AHYDO SaverPayment to be indeterminate and that

the instrument therefore was anAHYDO from inception.

The Need for GuidanceAs the above discussion demonstrates,the uncertainty regarding the propercomputation of the AHYDO SaverPayment combined with the large sumsinvolved creates a high-stakes dilemmain which issuers might not only lose taxbenefits but may also face events ofdefault on large amounts of junior andsenior debt. Since PIK Toggle debt onlybecame popular beginning in late 2005,there is still time before most issuers willface having to make the computation.Issuers seeking to avoid last-minuteuncertainty should consider requesting aprivate letter ruling or otheradministrative determination from theIRS. The IRS will not get involved inthe legal interpretation of PIK Toggledebt documents, but the IRS could beasked to rule whether the payment of $Xon date Y will cause the instrument inquestion not to be an AHYDO. Issuerscould also ask the IRS whether $X is theminimum amount necessary to cause theinstrument not to be an AHYDO. It ishard to see why the IRS would object toruling.Rather than address the issue in a

piecemeal fashion, the IRS would bestaddress the issue by publishing a revenueruling stating that it will accept any one

of several enumerated methods ofdetermining the AHYDO Saver Paymentin a typical situation. Issuers could thenmake the necessary calculation of theAHYDO Saver Payment by choosing themethod that results in the smallestpayment. Alternatively, the IRS couldchoose one specific method of makingthe AHYDO Saver Paymentdetermination. Although some methods

of computing the AHYDO SaverPayment are better than others, thebusiness community would probably becontent with the IRS’s selection of anyreasonable method. It is the currentuncertainty that produces the greatestconcern.

ConclusionThe AHYDO provisions containundefined or ambiguous terms such asyield to maturity and issue price.Although these terms have meanings inother areas of the tax law, conflictingpresumptions in the AHYDO and othertax code provisions make it unclear whatthese terms mean in the context ofAHYDO Saver Payments. As a result,the computation of an AHYDO SaverPayment, which should be a mechanical,arithmetic operation, becomes aconfusing exercise with an uncertainoutcome. Because issuers are answerableto senior and junior debtholders as wellas to the IRS, many issuers may soonfind themselves facing a high-stakesdilemma. There is a clear need forguidance from the IRS to avoidpotentially costly controversies.

Gary M. [email protected]




the other hand, while pre-FINSAmitigation agreements on occasionincluded so-called “evergreen”provisions, those provisions are nowformally built into the law, so thatCFIUS is now authorized to reopen anytransaction at any time if the partiesmaterially breach their mitigationagreement.

Government Contracts in GeneralContracting with the government can bea complex and frustrating affair. Allgovernment contracts between a targetin this sector and the government aresubject to the Federal AcquisitionRegulations System, which is comprisedof the dense and extensive FederalAcquisition Regulations (FAR), togetherwith hordes of additional regulations,promulgated by individual agencies, that

implement or supplement the FAR.Given the unique position of thegovernment, many legal principles thatgovern contracts between twocommercial parties in other contextsmay be inapplicable to governmentcontract. For instance, the principle of“apparent authority” does not apply — acontract negotiated or signed by agovernment official without actualauthority to do so will be rejected by thegovernment often without liabilityunless someone with actual authorityratifies the contract. A contract between a target in this

sector and the government may alsosimply be illegal, and thus void ab initio.An example is a “cost plus percentage ofcost” contract, where the contractor’sprofit is based on the costs incurred.Once a contract is found to be illegal, itis not always clear whether thecontractor can recover from thegovernment any of the costs thecontractor already incurred, even if thegovernment has received a benefit. It is therefore wise to include in your

acquisition agreement robustrepresentations regarding the target’sgovernment contracts. These mayinclude compliance with laws andregulations, accuracy of allrepresentations and certifications madeto the government, absence of fraudinvestigations, absence of withholding ofmoneys owed, validity and enforceabilityof the contracts, absence of suspensionsand debarments, absence of disputes orclaims, and so on. In many cases it maybe worthwhile having a governmentcontracts lawyer look at the contracts(subject to security restrictions), ask theright questions and help tailor therepresentations in the acquisitionagreement.

Assignment of Contracts Read literally, the Anti-Assignment Act,which prohibits the assignment ofgovernment contracts, is triggered byvirtually all deal structures involving theacquisition of a government contractor,including stock deals, reverse triangularmergers and other structures where thereis no actual assignment of thecontracting parties’ rights under thegovernment contract. Courts, however,have been practical in their applicationof the law, and have developed a “byoperation of law” exception that hasbeen interpreted to except an assignmentpursuant to an acquisition after whichthe contracting party survives intact(such as a reverse merger or a stockacquisition) and its rights andobligations are unaffected. However,asset purchases and some forwardmergers likely do not fall within theexception. If the Anti-Assignment Actapplies to a transaction, the parties tothe transaction and the government willtypically enter into a NovationAgreement, a standard form of whichcan be found in the FAR. The prospectof negotiating one or more NovationAgreements with different branches ofthe government may be daunting andmay involve a good deal of potentiallyintrusive diligence by the government onthe buyer. Accordingly, structuring adeal so as to avoid the application of theAnti-Assignment Act can play asignificant role in the formative stages ofnegotiating an acquisition.

Intellectual PropertyA contract in which the governmentfunds any “experimental, development orresearch work” may fall under the Bayh-Dole Act. Many agreements withdefense contractors may include



[I]t is critical to keep in

mind that the government

is like no other customer.

... A contract between a

target in this sector and

the government may also

simply be illegal, and thus

void ab initio. ... It is

therefore wise to include

in your acquisition

agreement robust

representations regarding

the target’s government

contracts.



provisions relating to expenditures forthe research and development of acomponent, a system, a newly designedweapon or vehicle, or the like. If so,Bayh-Dole in most cases allows thecontractor to retain title to an inventiondeveloped under the agreement. Inreturn, the government receives a world-wide non-transferable, irrevocable,royalty-free license to use the invention.

Perhaps more importantly, thegovernment also obtains “march-in”rights, allowing it to force the contractorto grant licenses in the invention tothird parties if the contractor fails toreduce the invention to practicalapplication in a reasonable amount oftime. Thus, if a contractor develops anew missile launcher at the government’sexpense but does not take steps to makeactual missile launchers available withina reasonable time period, thegovernment can require the contractorto license the invention to one of itscompetitors. While these sorts of issuesdo not often plague contractors, they areworth keeping in mind as a sponsordiligences its defense-related target.

Export ControlsThere are three basic sets of exportcontrols that may affect the productsand services of a defense company.These controls, which are complex andoften confusingly interrelated, focusamong other things on licensing,registration and the imposition ofpenalties for violations, includingdebarments, suspensions and monetarypenalties. Understanding how a target isregulated under these regimes andwhether it is complying with theregulations or subject to non-monetarypenalties that can affect its ability tocontinue doing business with thegovernment in one or more areas is

critical to the diligence process, thevaluation of the company and thedrafting of the risk allocation provisionsin the acquisition agreement.First, the State Department, through

the Directorate of Defense TradeControls (DDTC) and under authorityprescribed by the Arms Export ControlAct, controls the export of “defensearticles” and “defense services.” Items

that have been so designated are set outin twenty-one categories in the UnitedStates Munitions List, which is part ofthe International Traffic in ArmsRegulations (ITAR). The ITAR containcertain licensing requirements, and alsomandate the registration not only ofpersons who import or export defensearticles but also of those whomanufacture or “broker” defense articlesor furnish defense services. Registrantsmust give advance notice to DDTC ofany proposed transfer to foreignownership or control, a process that maydovetail with the Exon-Florio filings.DDTC will often approve blanketlicenses for the export of defense articlespursuant to a particular contract. Suchapprovals are generally embodied inManufacturing License Agreements orTechnical Assistance Agreements, whichcan be extremely complex and detailedarrangements.The Bureau of Industry and Security

under the Commerce Departmentadministers a second set of exportcontrols found in the ExportAdministration Regulations (EAR).While most exports are subject to theEAR (although only a very smallproportion actually fall under itslicensing regime), these controls are lesslikely to affect a defense company’sbusiness, because in practice they aregenerally limited to “dual-use” items,

that is, items that may be adapted toeither military or nonmilitary use. If theitem has been expressly designed formilitary use or its export is exclusivelycontrolled by another agency (e.g., theDDTC), the EAR likely will not apply. Finally, the Office of Foreign Asset

Control under the Treasury Departmentadministers economic sanctionsprograms, including export or import

embargoes relating to designatedpersons, entities or countries. Therelevant regulations sometimes overlapor interrelate with the ITAR and EAR.

* * *Acquiring a defense company can bedaunting, but the mission is possible! Asnoted above, there have been manyexamples over the years of private equityfirms buying defense companies oraerospace or other companies with amilitary aspect to them. Foreignacquirers buy them regularly. Still, it iscritical to keep in mind that thegovernment is like no other customer.Alerting the government’s point personson the target’s important projects earlyin the process, keeping them up to speedand receiving their approval of thetransactions can often be what makes orbreaks a transaction. Teaming up with astrategic partner may also ease some ofthe challenges, but going solo is perfectlyfeasible when you know what questionsto ask and have assembled the right teamto ask them.

Andrew L. [email protected]


allow a non-EU-based fund manager to

market its funds to professional investors

on their territory, but only if the fund

manager complies with the directive’s

disclosure and transparency

requirements, and “appropriate

cooperation arrangements4” in line with

international standards are in place

between the fund manager’s regulator

and the authorities of the Member State

where the fund is marketed. In other

words, individual private placement

regimes, which currently allow non-EU-

based funds to be marketed in some

Member States, would in future have to

comply with rules set by the

Commission.

European Parliament’sProposalMeanwhile, parallel discussions on the

directive have been taking place in the

European Parliament’s Economic and

Monetary Affairs Committee

(“ECON”). In November last year,

Jean-Paul Gauzès, the directive’s

“rapporteur,” presented his draft report

(the “Gauzès Report”) to ECON. This

contained a series of amendments, some

of which (such as the provisions on

remuneration and the dropping of the

EU passport for non-EU-based fund

managers) mirror those in the Council

Proposal.

According to the Gauzès Report,

however, the directive would apply to all

fund managers based in the EU,

regardless of size, and would cover a

wide range of activities, including

investment management, administration

and marketing. On the positive side, an

independent valuer would no longer be

required for private equity funds, but

fund managers would only be able to

delegate portfolio management to other

authorized fund managers, and would be

required to set leverage limits for their

funds.

The Gauzès Report also contained a

strangely-worded provision which would

only allow professional investors in a

Member State to invest in a non-EU-

based fund if the fund is managed by an

authorised fund manager, or the country

where the fund is based has signed an

information-sharing cooperation

agreement in line with relevant

international standards. It is not clear

how this would be enforced in practice.

Some 1,700 amendments (a record

for EU legislation) have been proposed

to the Gauzès Report by members of the

European Parliament, and Jean-Paul

Gauzès now has the unenviable task of

collating these into an amended draft

and managing the forthcoming debate

within ECON, following which a vote

will be taken on the final text of the

directive at a plenary session of the

European Parliament, currently

scheduled for July 6.

Current State of Play — The Politics of PostponementAs previously mentioned, in order to

become law, the directive has to be

approved by the Council as well as the

European Parliament. The Spanish

Presidency of the Council has identified

three key issues where there is not a

sufficient majority in the Council (255

votes out of a total of 345, under the

Council’s complicated ‘qualified

majority’ voting system) to support an

overall compromise between Member

States. These are:

l the overall scope of the directive,

particularly the availability of the

exemption for fund managers whose

managed assets are below a €100

million threshold (€500 million for

fund managers managing unleveraged

funds with five year lock-up periods)

set forth in the Commission Proposal;

l whether the role of depositary should

be restricted to EU credit institutions

and authorised investment firms, or

whether other entities should be

eligible; and

l so-called ‘third country issues’,

particularly whether allowing fund

managers based outside the EU to

market funds to investors in the EU

should be subject to certain

minimum standards and requirements


Postponement of the

decision provides an

opportunity for more

measured debate ... [and]

the prospect of the

directive becoming law

by early July now looks

less likely.


4 Details of the “appropriate cooperationarrangements” are to be contained in implementingmeasures to be adopted by the Commission.

Lookingfor a past

article?

A complete article index, along with

all past issues of the Debevoise & Plimpton

Private Equity Report, is available in the

“publications” section of the firm’s website,

www.debevoise.com.



laid down by the Commission, or left

up to individual Member States.

It is the third country issues that are

giving rise to increasing concern, both

on the part of fund managers based

outside the EU, who are concerned that

their ability to raise funds from EU

investors would be heavily restricted,

and on the part of EU investors, whose

access to non-EU funds could be

similarly limited. Some high-level

lobbying has been carried out by UK

Treasury Financial Services Secretary

Paul Myners and by U.S. Treasury

Secretary Tim Geithner, who wrote to

Michel Barnier, the EU Commissioner

for the internal market, to warn that the

directive could cause a transatlantic rift

by discriminating against U.S. groups.

EMPEA, the Emerging Markets Private

Equity Association, ILPA, the

Institutional Limited Partners

Association, and Gordon Brown, the

British Prime Minister, have recently

added their voices to the debate.

In an effort to speed up the legislative

process, the Spanish Presidency of the

Council asked the Committee of

Permanent Representatives to the

Council (Coreper) to intervene. The

Spanish Presidency hoped that this

would have enabled agreement on the

outstanding issues to be reached at a

meeting of EU finance ministers in

Brussels on March 16. However,

discussion of the directive was dropped

from the agenda at the last minute,

either because a qualified majority for a

compromise agreement between Member

States was not achievable, or possibly in

response to the recent lobbying.

Postponement of the decision provides

an opportunity for more measured

debate, but the Spanish Presidency will

still hope to achieve a compromise

agreement on the directive before its

term ends on June 30. The prospect of

the directive becoming law by early July

now looks less likely. But it is clear that

a number of Member States are anxious

to see the directive become law some

time this year, while others, like the UK,

are intent on reshaping the legislation

along more industry-friendly lines before

this is permitted to occur.

Anthony McWhirter

[email protected]

Philip James [email protected]


Update: Bridging the Gap (cont. from page 12)

but clearly stated standard of conductthat would modify or replace the buyer’simplied duty to use reasonable efforts toenable a seller to achieve its earnout.For instance, the parties could acceptthat a buyer has an obligation to usereasonable efforts to facilitate a seller’sability to achieve an earnout, along thelines of the duties implied in Sonoranand Eggert Agency, but could alsoestablish monetary or other objectivelimits on that obligation. Or the partiescould specifically disclaim any obligationof the buyer to use reasonable efforts toenable a seller to achieve the earnout,either on an absolute basis or in lieu of adifferent clearly stated standard, such aspermitting a buyer to take, or fail totake, any action with respect to anearnout so long as the buyer wouldreasonably be expected to take, or fail to

take, such action independent of thebuyer’s obligation to make any earnoutpayments. In the wake of Sonoran and Eggert

Agency, parties to earnout arrangementsshould, in all circumstances, carefullyconsider the impact of their choice ofgoverning law on the interpretation oftheir earnout. Our earlier articlepointed out that parties to an earnoutmay also wish, as a general proposition,to agree to binding arbitration oranother alternative dispute resolutionmechanic in order to streamline theprocess of resolving any earnout relateddisputes. Given the inherent subjectivityof applying the reasonableness standardsimposed under Sonoran and EggertAgency, parties to an earnout now havean additional reason to consideralternative dispute resolution mechanics

in order to reduce the time and cost itcould otherwise take to resolve thatsubjective issue in a litigation.

Stephen R. [email protected]

Dmitriy A. [email protected]

Leonora R. [email protected]

Economic, industry and regulatory factors are combining tocreate a global environment conducive to M&A activity acrossthe financial services spectrum. Join us as we provide an in-depth overview of relevant international regulatory andindustry developments, as well as targeted sessions designed toassist M&A participants in the U.S. and abroad in the failedbank, investment advisory and insurance arenas.

For details please e-mail [email protected]

Wednesday, April 21, 2010 8:00 a.m. - 1:30 p.m.

Join us for the Debevoise & Plimpton LLPGlobal Financial Services M&A Conference

KEYNOTE SPEAKER

Edward M. LiddyPartner, Clayton, Dubilier & Rice; Former Interim Chairman and Chief Executive Officer of American International Group, Inc.

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