The decline in Canadian equity financings and rising interest rates have prompted strategic changes among Canadian public companies. Faced with funding challenges and escalating borrowing costs, more reporting issuers are considering going-private transactions. This shift offers opportunities for foreign strategic buyers interested in acquiring depressed-valued Canadian public company targets.

This article provides an overview of Canadian going-private transactions and outlines key considerations for foreign strategic buyers and target companies.

Private Equity Considerations

Declining markets prompt foreign strategic buyers, like private-equity (PE) funds, to seek acquisition opportunities where a target’s market value misaligns with its perceived value. PE funds view going private as an opportunity to lower costs, enhance operational strategies, shield from market pressures, and reduce regulatory obligations. Enhanced operational flexibility and the freedom to enact changes without immediate market scrutiny increase the perceived value of going private. PE funds typically structure transactions as a leveraged buy-out (LBO) with debt backed by the target’s assets to maximize returns, securing control with minimal capital investment.

In some cases, insiders initiate going-private transactions. Target management (a Management Buyout) or existing security holders may seek to take the company private. For Management Buyouts, often backed by a PE fund, the board must manage potential conflicts.

A. Structuring the Transaction

Structuring a going-private transaction requires diligent planning and analysis. The three common structures are take-over bids followed by second-step transactions, amalgamations, or court-sanctioned arrangements. Each approach has benefits, challenges, and regulatory requirements.

1. Take-Over Bids

A take-over bid refers to an offer aimed at acquiring a target company’s outstanding voting or equity securities within a Canadian jurisdiction. This offer is directed at one or more security holders. If the securities involved, combined with those already owned or controlled by the offeror, equal 20 percent or more of the class, it qualifies as a take-over bid. The rules and disclosure obligations are primarily outlined in Part 2 of National Instrument 62-104 – Take-Over Bids and Issuer Bids (NI 62-104).

For a take-over bid, NI 62-104 mandates creating and distributing a written offer to purchase and a take-over bid circular to all eligible security holders of the target company. In response, the directors of the target company are required to produce their own circular, endorsing or opposing the bid. The nature of this recommendation depends on whether the bid is negotiated or unsolicited. A negotiated take-over bid (a friendly bid) garners endorsement of the target company and often is facilitated through a definitive acquisition agreement adhering to relevant securities laws. Unsolicited bids (hostile bids) involve direct offers to security holders, potentially circumventing the target company’s board.

The conclusion of a take-over bid occurs upon the bid’s expiration and the successful acquisition and payment for the securities tendered by security holders. Considering the possibility of incomplete tendering, a second-step transaction (statutory squeeze-out or business combination) is often necessary to secure the remaining securities. The structure of the second step will depend on the percentage of controlled securities by the offeror after the bid expires. If over 90% of the class’s outstanding securities are tendered in the bid, the offeror can effect the acquisition of the remaining securities through a statutory squeeze-out. If the threshold is not met, a business combination may be used to force out the remaining security holders of the target company at the same price and under the same terms that were offered under the initial bid.

2. Amalgamation

Another option is through an amalgamation. The foreign buyer establishes a wholly owned Canadian subsidiary that amalgamates with the target. Following the amalgamation, security holders of the target company typically receive redeemable securities in the newly formed entity, which are swiftly redeemed for cash. The buyer then has control over the amalgamated entity, which then continues the operations of the former publicly traded company.

Corporate regulations require a shareholder meeting to approve the amalgamation. Approval from security holders who own a minimum of two-thirds of the outstanding voting securities must be secured, either in person or via proxy. Moreover, the applicability of MI 61-101 – Protection of Minority Security Holders in Special Transactions (NI 61-101) could necessitate majority approval from minority security holders, unless an exemption is applicable.

3. Plan of Arrangement

A plan of arrangement is commonly used for going-private transactions in Canada. This court-approved process involves negotiations between the foreign buyer and the target company’s board or special committee. The parties will negotiate an arrangement agreement to outline terms, followed by two court appearances.

The initial appearance includes the target company’s application for an interim order, which governs procedural aspects such as convening and notifying the special meeting of security holders, as well as stipulating approval thresholds for each class. The subsequent appearance, which follows the special meeting approval, seeks a final order confirming the arrangement’s equity and rationality.

Distinguishing itself from a take-over bid, a plan of arrangement allows the buyer to secure all outstanding voting securities of the target within a single transaction, sidestepping the need for a second-step acquisition or a business combination. This structure offers agility in managing distinct security classes as compared to other methods, providing the potential to encompass asset divestitures, spinouts, or other restructuring matters, facilitating efficient structuring and strategic tax planning.

B. Key Considerations

1. Exclusivity

As the strategic buyer will need to expend significant resources to negotiate the transaction, it will seek exclusive engagement with the target company for a predetermined period to conduct comprehensive due diligence, secure financing commitments, and finalize terms while shielding from competing offers.

Negotiating exclusivity involves balancing the buyer’s needs and target board’s fiduciary duties. The most buyer-friendly approach is a no-shop provision restraining the target from exploring alternatives. Public company directors must consider how this affects their fiduciary duties. No-shop provisions usually include a fiduciary out, allowing the board to consider superior unsolicited bids. A window-shop provision is more balanced and allows the target to consider any unsolicited bids, even if they are not superior to the existing bid.

Go-shop provisions allow the target to actively seek third-party offers for limited periods. Go-shop provisions are used less frequently in Canada and are limited to transactions involving PE funds or where a limited market assessment has been conducted upfront. While favoring the target, foreign buyers may accept these clauses to reduce litigation risk. In cases of third-party offers, a potential foreign buyer may seek a matching right to counter preferred bids. Crafting these provisions requires balance considering fiduciary obligations and each party’s negotiating position.

2. Conflicts of Interest and Fiduciary Duties

In a going-private transaction, the directors, officers, and affiliates of the target company may be the acquirer of the target company. This scenario poses numerous potential conflicts of interest due to the fiduciary responsibilities of these parties. Where a conflict exists, MI 61-101 mandates an independent special committee be formed for oversight, enhanced disclosure, and minority shareholder consent. An impartial valuation may also be required and summary of the report provided in the disclosure documentation to verify the value of the target.

While not mandatory under Canadian law, the target company should consider whether it/the special committee requires its own impartial financial and legal advisor to assist with a fairness opinion to assess transaction terms. This assists in demonstrating the board met its fiduciary duties when approving the transaction.

3. Litigation Risk

Litigation risks in going-private deals, especially from minority holders challenging fairness or fiduciary breaches, underscore the need for transparent processes and conflict prevention. An independent director special committee, even if not mandated, offers protection against conflicts of interest and threats from minority security holders for misrepresentations or inadequate disclosure.

4. Enhanced Disclosure Obligations

Depending on the transaction, MI 61-101 may impose additional disclosure obligations. For instance, related-party take-over bids must include: (i) prior two-year valuations of the target company, (ii) relevant past offers in the two years before the deal, (iii) target board and special committee review process, (iv) relied-upon exemptions from MI 61-101 valuation rules, (v) any material disagreement between the target company’s board and the special committee, (vi) the number of votes that will be excluded to determine whether minority approval is obtained, and (vii) the identity of security holders who are excluded from the minority approval vote and their individual holdings.

5. Regulatory Matters

Foreign strategic buyers must navigate the Investment Canada Act (ICA) and its regulations on foreign investments. The ICA aims to ensure that non-Canadian investments contribute to Canadian economic growth and employment. When a foreign buyer gains control of a Canadian target, it may trigger an ICA notification or review. Notifications, simpler and less costly than reviews, require the foreign buyer to submit basic transaction details within thirty days of closing. If a foreign buyer’s acquisition meets financial thresholds and faces ICA review, they must prove to the Minister of Innovation, Science, and Economic Development that the investment benefits Canada. This assessment considers: (i) the impact on economic activity; (ii) the degree of Canadian involvement; (iii) the effects on productivity, technology, and innovation; (iv) the influence on industry competition; (v) policy alignment; and (vi) enhancement of Canada’s global competitiveness.

Conclusion

Going-private transactions restore operational flexibility by minimizing exposure to market volatility and regulatory constraints, but challenges persist. Foreign buyers, including PE funds, must select optimal structures carefully and manage many aspects of the transaction, including exclusivity concerns, conflicts of interest, litigation risk, disclosure, and regulatory considerations. The parties must weigh potential value creation against the complexities of transitioning to a private entity. Optimal planning and execution are crucial to harnessing the full potential of these transactions.

Following the publication of a draft multicurrency facility term sheet including a sustainability-linked loan appendix by the Asia Pacific Loan Market Association (APLMA) in the last quarter of 2022, on February 17, 2023, the Loan Syndications and Trading Association (LSTA) issued drafting guidance for sustainability-linked loans, to provide drafting examples of provisions related to sustainability-linked loans for a U.S.-style syndicated credit agreement.^[1]

On February 22, 2023, the LSTA, the APLMA, and the Loan Market Association (LMA) jointly issued updated versions of the Guidance on Sustainability-Linked Loan Principles (SLLP),^[2] Guidance on Green Loan Principles (GLP),^[3] and Guidance on Social Loan Principles (SLP).^[4] Each of the Guidances should be read alongside the respective updated principles SLLP,^[5] GLP,^[6] and SLP.^[7] Although these are suggested market-standard frameworks, it is recommended by the loan bodies that loan transactions completed prior to March 9, 2023, should continue to follow the original positions under the relevant guidelines and principles relating to SLLP, GLP, and SLP and that all loans originated, extended, or refinanced after March 9, 2023, should fully align with the relevant guidelines and principles of SLLP, GLP, and SLP as amended by the 2023 updates.

The LSTA, APLMA, and LMA had previously jointly issued the latest version of Guidance for Green, Social and Sustainability-Linked Loans External Reviews in March 2022,^[8] which is a voluntary guidance on professional and ethical standards for external reviewers for circumstances where external review providers are appointed to undertake external reviews in connection with entering into and executing green loans, social loans, or sustainability-linked loans. The purpose of that update was to align with the guideline on the same topic issued by the International Capital Market Association (ICMA) in the previous year.

These regular updates by loan industry bodies covering Europe, Asia Pacific, and the United States show a growing trend toward standardizing loan terms with respect to green loans, social loans, or sustainability-linked loans by providing a harmonized recommended framework for credit market players to encourage borrowers to contribute to sustainability from an environmental, social, and governance (ESG) perspective. Alignments made with ICMA guidelines also show the intention to promote consistency across debt (bond and loan) markets.

Green Loans and Social Loans: Key Changes in 2023

The amended 2023 GLP, SLP, and SLLP and their respective guidances provide more articulation of the characteristics of green loans, social loans, and sustainability-linked loans. To distinguish between a green loan and a social loan, the fundamental determinant is the utilization of the loan proceeds for green projects or social projects. Besides the key determinant of use of proceeds, the other core criteria set out in the respective GLP or SLP principles must also be met; these criteria are generally related to project evaluation and selection, management of proceeds, and reporting.

Green loans are any type of loan instruments and/or contingent facilities (such as bonding lines, guarantee lines, or letters of credit) made available exclusively to finance, refinance, or guarantee, in whole or in part, new and/or existing eligible green projects. The key changes to the 2023 GLP include the following:

• The loan industry bodies provided a list of examples of eligible green project categories to capture common types of projects supported by the green loan market, such as (but not limited to) renewable energy (including production, transmission, appliances, and products); energy efficiency (such as in new and refurbished buildings, energy storage, district heating, smart grids, appliances, and products); pollution prevention and control; climate change adaptation; green buildings; and clean transportation projects.
• With respect to the process for project evaluation and selection, borrowers are encouraged to have a process in place to identify mitigants to known or potential material risks of negative project impacts.
• With respect to management of proceeds, the borrower should attest to that in a formal internal process linked to the borrower’s lending and investment operations for green projects, and the borrower should let lenders know of any intended types of temporary placement for the balance of unallocated proceeds.

Social loans are categorized as any type of loan instruments and/or contingent facilities that are made available exclusively to finance, refinance, or guarantee, in whole or in part, new and/or existing eligible social projects and that are aligned to the core components of the SLP with respect to the use of proceeds, the process for project evaluation, and selection and reporting. It is recommended that borrowers explain the alignment of their social loan with the SLP in their legal documentation. The key changes to the 2023 SLP include the following:

• The SLP provides nonexhaustive categories for eligible social projects and explicitly recognizes several broad categories of eligibility for social loans with the objective of addressing key social purposes, such as affordable basic infrastructure, access to essential services, and affordable housing.
• There is emphasis on the requirement for transparency, accuracy, and integrity of disclosure of information reported by borrowers to stakeholders through the core components of the SLP.
• Similar to project evaluation and selection of green project loans, borrowers are encouraged to have a process in place to identify mitigants to known or potential material risks of negative project impacts with respect to the process for project evaluation and selection.
• Similar to the management of proceeds of green project loans, the borrower should attest to the management of proceeds in a formal internal process linked to the borrower’s lending and investment operations for green projects, and the borrower should let lenders know of any intended types of temporary placement for the balance of unallocated proceeds.

Sustainability-Linked Loans: Key Changes in 2023

In terms of sustainability-linked loans, one should not make a determination based on the use of proceeds to determine the sustainability-linked loan’s categorization but should rather focus on whether the loan supports a borrower in improving its sustainability performance, through meeting (or not meeting) predetermined sustainability performance targets. The amended SLLP guide provides that sustainability-linked loans are any types of loan instruments and/or contingent facilities for which the economic characteristics can vary depending on whether the borrower achieves ambitious, material, and quantifiable predetermined sustainability performance objectives. Therefore, proceeds under a sustainability-linked loan could be used to finance any kind of business activities that the borrower is pursuing—for example, it could finance a project that overlaps under a green/social loan or an acquisition transaction.

The table below summarizes examples of recommendations in the SLLP as amended in 2023:

Recent Leading Market Example

In Canada, FortisBC Energy Inc. (FortisBC) recently announced on its company website that it incorporated SPTs to establish a market-leading sustainability-linked credit facility with the Canadian Imperial Bank of Commerce (CIBC) as administrative agent, sole book runner, sole lead arranger, and sole sustainability structuring agent. ^[9] The Canadian market welcomed this news, which was shared by various media platforms on the internet, because this is reputedly the first time that a natural gas Canadian utility incorporated a customer emissions target into its credit facility with financial institutions—and, moreover, such credit facility included SPTs related to Indigenous participation on a project basis, which we understand is still highly uncommon in Canada.

According to publicly available disclosures, fees under FortisBC’s sustainability-linked credit facility were tied to and may be adjusted based upon two SPTs relating to the environment and Indigenous participation:

• annual greenhouse gas (GHG) emissions reduced through renewable and low carbon gas displacing conventional natural gas volumes, lowering customers’ GHG emissions; and
• increased focus on projects with meaningful and equitable Indigenous participation.

FortisBC will be able to obtain favorable pricing adjustments on its credit facility if it makes progress in these SPTs, and we look forward to following the journey of FortisBC and CIBC in their respective ESG contributing roles.

Conclusion

With the recent 2023 updates on green loans, social loans, and sustainability-linked loans by various loan bodies, there is an expectation in the market about the importance of leading financial institutions and their key role of encouraging borrowers to join the sustainability movement. Money is not the only metric in the funding market, and if environmental and social impact metrics are done right to allow lenders to support their clients in achieving their sustainability/ESG goals, the sustainable future that both sides are committed to pursuing may provide a longer-lasting positive impact internationally.

1. Drafting Guidance for Sustainability Linked-Loans, Loan Syndications and Trading Association (Feb. 17, 2023). ↑

2. Guidance on Sustainability Linked Loan Principles (SLLP), Loan Syndications and Trading Association (Feb. 2023). ↑

3. Guidance on Green Loan Principles (GLP), Loan Syndications and Trading Association (Feb. 2023). ↑

4. Guidance on Social Loan Principles (SLP), Loan Syndications and Trading Association (Feb. 2023). ↑

5. Sustainability Linked Loan Principles (SLLP), Loan Syndications and Trading Association (Feb. 2023). ↑

6. Green Loan Principles, Loan Syndications and Trading Association (Feb. 2023). ↑

7. Social Loan Principles, Loan Syndications and Trading Association (Feb. 2023). ↑

8. Guidance for Green, Social, and Sustainability-Linked Loans External Reviews, Loan Syndications and Trading Association (Mar. 2022). ↑

9. FortisBC Puts Its Money on Sustainability Through Sustainability Linked Loan, FortisBC (Jan. 13, 2023). ↑

Last updated on September 1, 2024.

This is a summary of the Hotshot course “Sandbagging: Market Trends,” which features ABA M&A Committee members Lisa Hedrick from Hirschler Fleischer PC and Nate Cartmell from Pillsbury LLP discussing market trends for sandbagging provisions, drawing on data from the ABA’s Private Target M&A Deal Points Study. Lisa and Nate talk about why so many deals are silent on sandbagging, the risk of being silent, and where they think the trend is heading. View the course here.

Sandbagging: Market Trends

• The majority of deals covered by the ABA M&A Committee’s Private Target Deal Points Study are silent on the issue of sandbagging, thereby defaulting to state law.
  • 76% of the deals in 2022 and the first quarter of 2023 were silent.
    • Up from 68% in the 2020 and 2021 deals.
  • 12% of the deals included pro-sandbagging provisions.
    • Down from 29% in 2020 and 2021.
  • Only 5% of them included anti-sandbagging provisions.
    • Up from 2% in 2020 and 2021.
• These numbers represent the general trend in this area since these figures were first tracked in the 2006 study.
  • The number of deals that are silent on the issue has generally been increasing.
  • The number of deals that include sandbagging provisions has correspondingly decreased.
• Several developments account for this trend.
  • As a result of several Delaware Court of Chancery decisions since 2006, more lawyers consider Delaware a pro-sandbagging default jurisdiction.
    • This means that when acting as buyer’s counsel, lawyers were increasingly willing to choose Delaware as the governing law for their agreements and be silent on the issue.
    • However, the 2018 Delaware Supreme Court decision in Eagle Force Holdings v. Campbell has cast some doubt on the assumption.
  • The use of representation and warranty insurance in M&A deals has been increasing.
    • These policies generally exclude from coverage any loss resulting from a breach of a representation or warranty known to the buyer at closing.
    • So, if a buyer’s recourse post-closing is against the insurance policy and not the sellers, pro- or anti-sandbagging provisions become irrelevant.
    • Particularly in a sellers’ market where a buyer may have limited or no recourse beyond a rep and warranty insurance policy, bargaining for a pro-sandbagging provision may provide little or no value.
  • As lawyers have become more focused on these issues, they’re relying not on the representations themselves but on separate line-item indemnities (which are unaffected by knowledge) to protect buyers from losses associated with breaches of representations they suspect (or know) may not be true.

The rest of the course includes interviews with ABA M&A Committee members Nate Cartmell from Pillsbury LLP and Lisa Hedrick from Hirschler Fleischer LLP.

Download a copy of this summary here.

This is a summary of the Hotshot course “Sandbagging: Buyer and Seller Perspectives,” a discussion on buyer and seller perspectives regarding the issue of sandbagging featuring insights from ABA M&A Committee members. View the course here.

Buyer and Seller Perspectives

• In this section we’ll look at the buyer’s motivation to include a pro-sandbagging provision in an acquisition agreement and the seller’s point of view.
• Under most acquisition agreements, inaccuracies in the seller’s reps and warranties don’t excuse the buyer from its obligation to close, unless the inaccuracies rise to a certain level of materiality.
• For the buyers, that becomes challenging if:
  • The buyer learns about an inaccuracy in the reps before closing; and
  • The inaccuracy isn’t so material that it gives the buyer the right to walk away.
• The buyer might feel that the company it’s about to acquire isn’t what the seller had represented.
• And, because it couldn’t claim that it had “relied” on the inaccurate representation in proceeding to close, it would have waived any right to damages.
  • Note — a buyer might have a claim if the rep was inaccurate at signing as well as at closing, but the buyer only had knowledge of the inaccuracy at closing.
    • The buyer could argue that while it may be deemed to have waived the inaccuracy in the rep made at closing because it was aware of the inaccuracy and closed over it, it could not have waived the inaccuracy of the rep made at signing if it was unaware of the breach at the time.
  • However, to date, anti-sandbagging jurisdictions appear not to have drawn such a distinction.
    • By proceeding to close with knowledge of the breach, a buyer waives both claims.
• Sellers stress the injustice of:
• A buyer learning of inaccuracies in the seller’s proposed reps before the acquisition agreement is signed or between signing and closing; and
• “Lying in wait” to recover damages post-closing.
  • Rather than bringing the inaccuracies to the seller’s attention and perhaps renegotiating the purchase price.
• There is another reason buyers want pro-sandbagging provisions in their agreements.
  • Let’s say that after closing:
    • A buyer discovers an inaccuracy in a rep and tries to recover under the indemnification provision for the breach.
    • The seller acknowledges that there was a breach.
  • Without a pro-sandbagging provision, the seller can challenge the claim by alleging that the buyer did in fact have knowledge of the breach as a result of the buyer’s due diligence review.
    • The buyer would then be subject to the cost and delay of an evidentiary hearing before being able to recover, and the result of that hearing would be uncertain.
  • The pro-sandbagging provision takes the knowledge issue off the table, both in terms of:
    • Making a claim; and
    • Getting paid quickly.
• For the large (and growing) number of transactions in which the buyer obtains rep & warranty insurance, the debate over sandbagging is usually moot.
  • This is because under the terms of the insurance, the buyer is required to deliver a “no claims” certificate and can’t make a claim for breaches that:
    • It was aware of pre-signing; or
    • Came up between signing and closing.
  • A buyer may still seek inclusion of pro-sandbagging language when the seller is “backstopping” the insurance.
    • This means that the seller is responsible for claims not covered by the insurance.
    • A seller backstopping the insurance may seek a representation in the acquisition agreement saying that the buyer knows of no breaches other than those disclosed to the insurer in the no-claims certificate.
• Sandbagging provisions only address a buyer’s ability to seek damages in contract for inaccuracies in the reps and warranties in the agreement.
  • Pro-sandbagging provisions do not eliminate reliance as a required element for a tort claim:
    • Brought by the buyer under the so-called “fraud exception” found in the exclusive remedy provisions of most acquisition agreements; or
    • Brought for misrepresentations or omissions made by a seller to a buyer beyond those contained in the agreement itself (e.g., during buyer’s due diligence)

This course also includes interviews with ABA M&A Committee members Nate Cartmell from Pillsbury LLP and Lisa Hedrick from Hirschler Fleischer LLP.

Download a copy of this summary here.

This is a summary of the Hotshot course “Sandbagging: Sample Provisions,” a look at typical sandbagging provisions, including pro-sandbagging and anti-sandbagging provisions, that also includes drafting tips and perspectives from ABA M&A Committee members. View the course here.

Sample Provisions

Sample Pro-Sandbagging Provision

The right to indemnification, payment, reimbursement, or other remedy based upon any such representation, warranty, covenant, or obligation will not be affected by any investigation conducted or any Knowledge acquired at any time, whether before or after the execution and delivery of this Agreement or the Closing Date, with respect to the accuracy or inaccuracy of, or compliance with, such representation, warranty, covenant or obligation.

• This provision says that a party’s right to indemnification (and other costs and remedies) based on a “representation, warranty, covenant, or obligation” won’t be affected by “any investigation conducted or any Knowledge acquired at any time” regarding the accuracy or compliance with those provisions.
  • It applies whether it’s before or after signing or closing.
• This language expressly disclaims investigation and knowledge as a basis for challenging a right to indemnification.
  • Because of this, it allows the buyer who is aware (or should have been aware) of the inaccuracy of seller’s reps and warranties to close the deal and then recover damages even when the breaches were sufficiently material that the buyer could have refused to close.

Sample Anti-Sandbagging Provision

No party shall be liable under this Article for any Losses resulting from or relating to any inaccuracy in or breach of any representation or warranty in this Agreement if the party seeking indemnification for such Losses had Knowledge of such Breach before closing.

• This provision says that a party will not be liable under the indemnification section for losses that relate to “any inaccuracy in or breach of any representation or warranty” in the agreement if the other party had knowledge of the breach before closing.
• This language expressly disclaims a party’s ability to seek indemnification for damages resulting from a breach of which it had “Knowledge” (note this is a defined term) before closing.
  • Because of this, it precludes the buyer from making a claim if it:
    • Knew of the inaccuracy; and
    • Depending on the definition of Knowledge, possibly even when the buyer didn’t have actual knowledge but only “should have known” of the breach. (This is often called “constructive knowledge.”)

Definition of Knowledge

• This is an area where the agreement’s definition of knowledge can have a major impact.
• Sellers will want to define the term broadly, both in terms of:
  • Whose knowledge is imputed to the buyer; and
  • What qualifies as knowledge.
    • They’ll want constructive as well as actual knowledge to count.
• Buyers will want the term to be as narrow as possible, wanting:
  • A limited knowledge group; and
  • Actual knowledge only.

Impact of Rep & Warranty Insurance

• Even when agreements are silent on sandbagging, there’s another provision that sellers sometimes try to include: a rep by the buyer that at the time of signing it had no actual knowledge of any inaccuracy in the seller’s representations and warranties.
  • This rep won’t restrict a buyer with knowledge from bringing a claim post- closing in a pro-sandbagging jurisdiction.
  • But it will allow the seller to assert a competing claim of breach of buyer’s rep.
• This rep is especially likely to be found in deals with rep & warranty insurance, where the buyer has to give the insurer a “no claims” certificate (which says that the buyer isn’t aware of any breaches other than those disclosed in the certificate).
  • If the seller is responsible for claims that go beyond the policy limit or are excluded from the policy (referred to as “backstopping” the insurance), the seller may insist that the buyer make that same rep in the acquisition agreement.
  • If the seller isn’t backstopping the insurance there’s no need for this protection.

This course also includes interviews with ABA M&A Committee members Nate Cartmell from Pillsbury LLP and Lisa Hedrick from Hirschler Fleischer LLP.

Download a copy of this summary here.

This is a summary of the Hotshot course “Sandbagging,” an explanation of sandbagging in private M&A deals, including a discussion on pro- and anti-sandbagging provisions and how different courts and jurisdictions handle the issue. View the course here.

What Are Sandbagging Claims and Provisions?

• “Sandbagging” refers to when the buyer in a private M&A deal tries to enforce an indemnification claim that the seller breached a representation or warranty in the acquisition agreement, even though the buyer knew that the rep or warranty was false when it closed the deal.
• Whether or not sandbagging claims are allowed is handled in one of two ways:
  • The acquisition agreement addresses the issue by including a sandbagging provision in the indemnification section of the agreement; or
  • The agreement is silent on the issue, in which case the governing law of the relevant jurisdiction will apply.
• There are two types of sandbagging provisions:
  • Pro-sandbagging provisions.
    • Also known as “savings clauses.”
    • They allow the claims and are favored by buyers.
  • Anti-sandbagging provisions.
    • They prohibit the claims and are favored by sellers.
• There are also pro-sandbagging jurisdictions and anti-sandbagging jurisdictions.
• Parties often include sandbagging provisions in their acquisition agreements to clarify whether these claims are allowed, particularly since jurisdictions differ on that question.
• Even in jurisdictions that are “pro-sandbagging,” there can be differences in the degree to which they allow sandbagging claims, so putting a provision in the agreement clarifies things.

The Courts and Sandbagging Claims

• Understanding why jurisdictions have different default rules on sandbagging involves a little history.
• Courts have followed one of two competing approaches:
  • One based in tort law.
  • The other based in contract law.
• These approaches relate to the historical treatment of representations and warranties.
  • Historically, courts regarded warranties as promises that the buyer purchased as part of the purchase price, much like buying insurance.
    • A wronged buyer needed only to show that the seller’s promise was breached and that the buyer suffered damages in order to recover under contract law.
    • The buyer didn’t have to show any reliance on the warranties to recover.
  • In contrast, courts historically considered representations as mere statements of fact made separate from the contract (even if they were contained in it) and made only to induce the other party to enter into the contract.
    • A misrepresentation was not considered a breach of contract, but a wrongful act that caused harm to the other party.
    • So the buyer’s remedy for a misrepresentation was based on tort law, and the buyer needed to prove that the untrue statement actually induced it to enter into the contract (that is, the buyer had to show reliance).
    • If a buyer had knowledge of the misrepresentation prior to signing, it would be hard for the buyer to argue that it had relied on the representation when signing or closing the deal.
• U.S. case law no longer treats “representations” and “warranties” differently in the contractual setting.
• However, the distinction between the tort-based remedy and the contract-based remedy is still found in how different jurisdictions approach a buyer’s right to recover damages for breach of a rep or warranty.
• Jurisdictions that take the contract-based approach (where reliance isn’t necessary to recover damages) effectively permit sandbagging claims and are “pro-sandbagging jurisdictions.”
  • This is the “modern” – and majority – “default” rule.
  • Even among states adopting the modern approach, there are meaningful differences in how it’s applied, including:
    • Different outcomes hinging on whether the buyer learned of the inaccuracy from the seller or independently; and
    • Whether the outcome should differ depending on whether the buyer had knowledge at signing that the representation or warranty was false.
• The states that take a tort-based approach, requiring proof of “justifiable” or “reasonable” reliance before awarding damages, are the “anti-sandbagging jurisdictions.”
  • Even if the buyer didn’t have actual knowledge of the inaccuracy, courts may inquire into the “reasonableness” of the effort made by the buyer to investigate the seller before signing – its “due diligence.”
  • Courts may deny recovery in situations where even a modicum of effort would have uncovered the inaccuracy.
• If lawyers are comfortable with a state’s default rule, they may choose to have the contract governed by that state’s law.
  • This means they achieve the desired “pro-” or “anti-sandbagging” result without needing to argue to include a sandbagging provision in the agreement.
• However, many lawyers either:
  • Aren’t comfortable with the default rules of the states that would be logical choices for governing law; or
  • Would prefer not to leave a determination up to the courts, which might interpret the default rule differently depending on specific circumstances.
• As a result, those lawyers include the contractual language explicitly permitting or disallowing sandbagging.
  • The enforceability of these contractual provisions hasn’t been widely addressed by the courts.
  • But the decisions that have addressed the issue have favored enforceability even when the provision was the opposite of the jurisdiction’s default rule.

This course also includes interviews with ABA M&A Committee members Nate Cartmell from Pillsbury LLP and Lisa Hedrick from Hirschler Fleischer LLP.

Download a copy of this summary here.

Jonathan Kanter, Assistant Attorney General for the Department of Justice’s Antitrust Division, has been openly and repeatedly skeptical of merger remedies and settlements, making comments such as “merger remedies short of blocking a transaction too often miss the mark.” He has made clear that an injunction blocking a transaction “is the surest way to preserve competition.” Similarly, Chair of the Federal Trade Commission (“FTC”) Lina Khan made plain in a 2022 interview that “[the agency is] going to be focusing our resources on litigating, rather than on settling.”

This summer, however, the federal antitrust enforcers and, in one transaction, the state agencies have negotiated and agreed to settlements in three separate merger matters. While this might appear to be a sea change, merging parties should not assume that it is. The facts and circumstances of each matter are different, but the settlements provide insights into remedies and strategies merging parties should consider.

Amgen/Horizon

Most recently, the FTC announced a settlement of its challenge to Amgen Inc.’s $27.8 billion acquisition of Horizon Therapeutics plc. In May 2023, the FTC and six states—California, Illinois, Minnesota, New York, Washington, and Wisconsin—filed a complaint to block the proposed transaction. Although both are pharmaceutical companies, Amgen and Horizon do not have any competing drugs in their portfolios or development pipelines. According to the complaint, Amgen’s rationale for acquiring Horizon was to control certain high-revenue-generating pharmaceuticals in anticipation of the loss of revenues caused by the 2030 expiration of one of Amgen’s “blockbuster” drugs and the potential downward price pressure from Medicare and Medicaid negotiations under the Inflation Reduction Act. Specifically, the FTC alleged that Amgen was most interested in two Horizon “orphan drugs” for treating certain rare diseases: thyroid eye disease and chronic refractory gout. Orphan drugs are medicines developed to help treat or prevent rare diseases, which are defined in the Orphan Drug Act as conditions that each affect fewer than 200,000 people in the United States or for which there is no reasonable expectation of recovering the cost of developing and making available a drug for the condition.

Because product development and other costs are high and the number of people requiring the orphan drugs is low, the Food and Drug Administration awards the inventor a seven-year exclusivity period. Allegedly, Amgen was willing to pay a premium for Horizon because of the dependable profitability of these two drugs, which accounted for 72% of Horizon’s sales. The FTC claimed that other companies are in the process of developing drugs to compete with Horizon’s orphan drugs when exclusivity expires and that Amgen could use its blockbuster drugs to secure preferential treatment or exclusionary access from pharmacy benefit managers for its non-blockbuster drugs.

Despite Amgen’s pre-litigation offer to commit that it would not bundle other products with Horizon’s orphan drugs, the FTC and six states filed a lawsuit claiming that the acquisition would give Amgen the ability and incentive to engage in cross-product bundling that would exclude Horizon’s rivals and maintain its monopolies, harming patients in the long run.

First and foremost, the settlement accepted by the FTC prohibits Amgen from engaging in any cross-product bundling or exclusionary rebating schemes involving Horizon’s monopoly orphan drugs. The consent order will also prohibit Amgen from entering into an agreement to acquire any pipeline and post-clinical trial products, commercialized products, or interests in any business engaged in the development, manufacturing, or sale of any such products, biosimilars, or therapeutic equivalents that treat either orphan illness, without prior approval. A monitor will be appointed to oversee Amgen’s compliance, and the monitor’s reports will be submitted to the Commission and to the states.

Black Knight

In late August, the FTC also announced the settlement of its challenge to the $13.1 billion acquisition of Black Knight, Inc. (“Black Knight”) by Intercontinental Exchange, Inc. (“ICE”). Black Knight and ICE are direct competitors with their loan origination system software (“LOS”) and a number of ancillary services, including product pricing and eligibility engines (“PPE”). PPE is software that allows a lender to identify potential loan rates for a borrower, determine the borrower’s eligibility for a given loan, and lock in the loan’s terms for the borrower.

According to the FTC, ICE offers the dominant LOS in the United States, processing nearly half of all residential mortgages originated each year, and Black Knight has the second-largest LOS in the United States. Black Knight’s PPE is the industry leader, serving lenders that originate as much as 40% of the residential mortgages in the U.S. each year. ICE’s PPE is currently available only to lenders who use ICE’s LOS. The FTC alleged that because of ICE’s dominant LOS market share and the dependency of PPEs and other ancillary service providers on LOS integration, ICE will have the ability to disadvantage existing and potential ancillary service competitors, including competing PPE providers, by foreclosing or impeding LOS access.

In an effort to resolve the FTC’s concerns, Black Knight proposed divesting its LOS and certain ancillary products but not its PPE. The divestiture buyer, Constellation Web Solutions, Inc. (“Constellation”), would also act as a reseller for certain ancillary services acquired by ICE from Black Knight. The FTC rejected the proposed remedy because it allegedly failed to provide Constellation with the ability, resources, and incentive to replace the intensity of the competition between ICE and Black Knight.

As part of the FTC settlement, Black Knight and Constellation agreed that Black Knight will finance a portion of Constellation’s purchase price of Black Knight’s PPE via a promissory note, but within ten days of a trustee’s appointment, the promissory note will be transferred to the trustee. The trustee will sell the note to a third party within six months of the divestiture.

Assa Abloy

In a rare departure, the Antitrust Division of the U.S. Department of Justice (“DOJ”) agreed to settle its court challenge to Sweden’s Assa Abloy AB’s $4.3 billion proposed deal to buy Spectrum Brands Holdings, Inc.’s hardware and home improvement division in May.

The DOJ’s complaint alleged that Assa Abloy and Spectrum are two of the three largest producers of residential door hardware in an already concentrated US industry. The agency alleged that the proposed transaction would harm competition in two relevant markets: (1) premium mechanical door hardware and (2) smart locks. The DOJ rejected Assa Abloy’s pre-ligation offer to settle because the proposed divestiture package did not include sufficient smart lock assets and contemplated continuing entanglements between the company and potential divestiture buyer. Consistent with its past statements, the DOJ argued that only completely blocking the transaction would eliminate its risk to competition.

The settlement accepted by the DOJ included Assa Abloy’s EMTEK and Schaub premium mechanical door hardware businesses, its Yale and August residential smart lock businesses in the United States and Canada, and other assets for multifamily smart lock applications in the United States and Canada. The settlement also included expanded intellectual property and commercialization rights in smart locks, additional residential mechanical lock assets, and the ability for the DOJ to seek additional relief later under certain circumstances.

Conclusions

Amgen is the first FTC conduct remedy settlement under current leadership, and Assa Abloy is the first merger settlement under the DOJ’s current leadership. It is too early, however, to determine whether the recent settlements reflect a significant shift in either agency’s approach to merger enforcement.

In Amgen, the FTC explained that a settlement likely would not have been sufficient if the deal gave a company control over products or services that its rivals use to compete or increased the risk of information exchange. Because such conduct can be achieved through “subtle and varied” means that are “difficult to detect,” the FTC would have been more reluctant to accept a conduct remedy in lieu of blocking the transaction.

The Commissioners’ statement about the settlement noted that there are “features” specific to the Amgen matter that suggest that the settlement’s bundling prohibition was sufficient to effectively prevent it, making it unnecessary to block the transaction. The FTC seemed comforted by the fact that Amgen’s conduct would be monitored not only by a settlement monitor and agency but also by the states and that the prohibited bundling should be readily detectable by reviewing Amgen’s future agreements. Accordingly, the consent order will require Amgen to submit all contracts with payers related to the formulary and placement of Horizon’s orphan drugs within thirty days of entering into each contract, and the states will have the individual right to enforce the order.

The Black Knight and Assa Abloy settlements reflect the importance of addressing the potential lessening of competition in all the markets about which the agencies are concerned and, to the extent possible, the complete disentanglement of the divested business from the merging parties. In this and past administrations, the agencies would be very skeptical of a remedy that includes a resale agreement involving the products or services of the merged firm. Parties should be aware that the goal is for the divestiture buyer to compete vigorously against the post-merger company; this includes ensuring that the divestiture buyer has access to all the elements needed to compete and that the merged parties do not have the ready ability to interfere with that access.

As with the above matters and others, such as Microsoft/Activision and UnitedHealthcare/Change Healthcare, litigating the fix may be a successful strategy that allows the parties to shift some risk onto the agencies—they may either seriously consider accepting the parties’ proposed remedy in advance of litigation or be forced to shift their positions and accept a remedy package to avoid the risk of loss at trial and establishment of bad precedent. All reports suggest that the Assa Abloy judge was settlement-minded and that if the DOJ refused to consider any divestiture proposal, it was a risky tactic, and that if the merging parties refused to address the deficiencies the DOJ identified in the pre-trial proposed divestiture package, it was similarly risky. Accordingly, parties should not assume that the DOJ will significantly change its skepticism toward divestiture. Also, even if the DOJ accepts future settlements, it is likely that such settlements will, as the Assa Abloy settlement does, allow the agency to seek additional relief later if the divestiture fails to maintain the intensity of competition that existed before the merger in one or more areas or for one or more products.

September 17 is Constitution Day and Citizenship Day, and it is customary that the President of the United States proclaims the week of September 17 as Constitution Week.

The origins of Constitution Day and Citizenship Day are interesting because they illustrate how individuals or a small group of people can come up with and cause to be implemented ideas that contribute to strengthening the Rule of Law. This is worth noting because community commitment is an essential component of the Rule of Law.^[1]

The origins of Citizenship Day date back to 1939, when William Randolph Hearst suggested creation of a holiday to celebrate American citizenship. As a result of his influence, in 1940 Congress designated the third Sunday in May as “I Am an American Day.” In 1952, a Louisville, Ohio, resident named Olga T. Weber petitioned the leaders of her municipality to change the day of the holiday to correspond with the anniversary of the signing of the United States Constitution in Philadelphia on September 17, 1787. They agreed. Weber then made the same request at the state level, and that too was approved. In 1953 Weber made a similar request to the United States Congress, and both the Senate and the House of Representatives approved the change. Consequently, President Dwight D. Eisenhower renamed the day “Citizenship Day” and moved it to September 17.

In 1997, Louise Leigh, a retired medical technologist from El Monte, California, founded a nonprofit organization called Constitution Day, Inc. with the goal of having a federally recognized Constitution Day. She had been inspired to do so after taking a course in Constitutional history sponsored by the National Center for Constitutional Studies. As a result of Leigh’s efforts, and with critical support from Senator Robert Byrd, Constitution Day became an official holiday in 2004, alongside Citizenship Day. (Senator Byrd added the “Constitution Day” amendment to an omnibus spending bill.)

You need not make any commitment of time and energy as significant as the efforts by Olga T. Weber and Louise Leigh in order to make a difference in terms of helping spread the word about Constitution Week. I have two suggestions for things you can do that would be “an easy lift.”

First, you can remind people that September 17 is Constitution Day and Citizenship Day and that the week following is Constitution Week. If they look at you and ask something along the lines of “So what?” you can share with them a few thoughts that were expressed in last year’s Presidential proclamation:

America is founded on the most powerful idea in history—that we are all created equal. That idea sparked our revolution, ignited a wave of change of across the world, and beats in the hearts of Americans today. It is central to our Constitution, and citizenship embodies a true faith and allegiance to give it full meaning in our everyday lives. . . .

When our Founding Fathers came together nearly 250 years ago, they set in motion an experiment that changed the world. They disagreed and debated but ultimately came together to forge a new system of self-government—a system balanced between a strong Federal Government and the States, held together by co-equal branches and a separation of powers. America would not be a land of kings or dictators; it would be a Nation of laws . . . .

As we have seen throughout our history, though, nothing about our democracy is guaranteed. America is an idea—one that requires constant stewardship.

A Proclamation on Constitution Day and Citizenship Day, and Constitution Week, 2022 (Sep. 16, 2022).^[2]

Second, you can tell them about the annual “Civics Challenge” created by the Federal Judges Association (FJA). The FJA offers this annual challenge to high school students across the country as part of an effort to increase civic engagement, knowledge of United States history and government, and appreciation for our country’s citizenship process.

High school students, grades 9 through 12, can participate in this challenge if they have a teacher who is willing to participate. The students take the Civics Test that is given to individuals seeking United States citizenship. Any high school teacher can agree to administer and grade the Civics Test. The Civics Test must given, graded, and the results submitted by the participating high school teacher to the FJA by no later than December 31, 2023.

A student who achieves a perfect score on the Civics Test, as determined by the participating high school teacher, will receive an “Excellent Citizen” certificate, which will be mailed to the participating high school teacher. Such students will also have a potential opportunity to be invited to attend a federal court naturalization ceremony in their home judicial district presided over by a federal judge.

If you know a high school teacher, or know someone who knows a high school teacher, please mention this to that individual and let them know that they can contact the FJA coordinator, Susan DeCourcey, at the following email address: [email protected].

In case you are intrigued, the following is a sample of typical questions that appear on the Civics Test:

• What does the Constitution do?
• The idea of self-government is in the first three words of the Constitution. What are these words?
• What are two rights in the Declaration of Independence?
• What is the “rule of law”?
• If both the President and the Vice President can no longer serve, who becomes President?
• What does the judicial branch do?
• Under the Constitution, some powers belong to the states. What is one power of the states?
• What is one responsibility that is only for United States citizens?
• The Federalist Papers supported the passage of the U.S. Constitution. Name one of the writers.
• Name one American Indian tribe in the United States.
• Name one U.S. territory.

Perhaps we should set up a testing booth at one of the American Bar Association Business Law Section meetings and see how we as a Section do?

1. World Justice Project, “What is the Rule of Law?,” https://worldjusticeproject.org/about-us/overview/what-rule-law (“The Rule of Law is ‘a durable system of laws, institutions, norms, and community commitment’ based on ‘four universal principles’: ‘just law’; ‘open government’; ‘accessible and impartial justice’; and ‘the government as well as private actors are accountable under the law.’”) (emphasis added) (last visited 9/7/23). ↑

2. See https://www.whitehouse.gov/briefing-room/presidential-actions/2022/09/16/a-proclamation-on-constitution-day-and-citizenship-day-and-constitution-week-2022/. ↑

The Governor of Delaware has signed into law amendments to the General Corporation Law of the State of Delaware (the “DGCL”) proposed by the Delaware State Bar Association and subsequently approved by the Delaware legislature. A number of provisions of the DGCL are affected, and the legislation addresses several significant topics, including simplifying the procedures required to ratify a defective corporate act because of a failure of authorization and simplifying the required contents of a certificate of validation under Section 204 of the DGCL; clarifying the record date for identifying which stockholders are entitled to notice of stockholder action via written consent; modifying the need for or reducing the minimum stockholder vote required for charter amendments effecting forward stock splits, reverse stock splits, and changes in the number of authorized shares of a class of stock; providing appraisal rights in connection with a transfer; continuance or domestication of a Delaware corporation to a non-U.S. entity; and creating a safe harbor in which stockholder approval would not be required for a mortgage or pledge of assets.

Authority to Sell Treasury Shares (Sections 152, 153, 157, and 160(b))

The amendments to Sections 152, 153, and 157 of the DGCL build on amendments adopted in August 2022 that expanded a board’s ability to delegate authority to an individual or entity to issue stock or options in the corporation, and also harmonized the procedures to authorize rights and options to purchase stock with existing procedural requirements to issue stock.

The amendments to Sections 152 and 153 of the DGCL, which govern the approval and issuance of stock, clarify that treasury shares may be sold for less than the minimum consideration required to issue stock, which is typically par value. In addition, Section 153 was amended to provide that (i) the consideration received for treasury shares may be greater than, less than, or equal to the par value of the shares, and (ii) the consideration a corporation may receive for treasury shares may consist of cash, any tangible or intangible property, or any benefit to the corporation, harmonizing Section 153 with language already contained in Section 152.

The amendments to Section 157 of the DGCL further modernize the statute by providing that, in addition to granting board authority to a person or body, including a committee of the board, to issue rights and options, the board may also delegate authority to determine the terms upon which shares may be acquired by the corporation upon the exercise of rights or options. As a practical matter, the amendments expand the delegation of authority permitted under Section 157 to include vesting terms, acceleration, and other typical features of equity awards.

In connection with the amendments to Section 152, 153, and 157, Section 160(b) of the DGCL was amended to clarify that a corporation may resell treasury shares resulting from the corporation’s redemption or repurchase of treasury shares out of surplus, in accordance with Section 153, so long as the shares have not been retired, and the corporation’s certificate of incorporation does not require the shares to be retired.

Ratification of Defective Corporate Acts (Section 204)

Section 204(c)(2) of the DGCL was amended to clarify that the determination as to whether any shares of valid stock are outstanding and entitled to vote on the ratification must be made at the time the board adopts the resolutions approving the defective corporate act. Similarly, Section 204(d) was amended to fix the board’s adoption of the resolutions ratifying a defective corporate act as the time for determining which shares constitute valid stock and which shares constitute putative stock entitled to vote on the adoption of the ratification of a defective corporate act, in circumstances requiring a vote of the holders of valid stock.

Streamlining the process to ratify a defective corporate act, a corporation is now required to file a certificate of validation only in circumstances where any section of the DGCL would have required the filing of a certificate in connection with the defective corporate act and such certificate was either (i) never filed or (ii) was filed, but to give effect to the underlying corporate act, the certificate must be amended. When a certificate of validation must be filed, Section 204(e), as amended, simplifies the required contents, including by eliminating the need to describe the underlying defective corporate acts and the nature of the failure of authorization relating to those acts.

Record Date for Stockholders Entitled to Notice of Stockholder Action by Written Consent (Section 228(e))

Section 228(e) of the DGCL has been amended to conform the determination of the record date to be used for purposes of identifying the stockholders entitled to notice of stockholder action taken by written consent with Section 213(b) of the DGCL. As amended, Section 228(e) now provides that the persons entitled to receive notice of action by written consent are persons who (i) were stockholders as of the record date for the action by written consent, (ii) would have been entitled to notice of the meeting if the action had been taken at a meeting and the record date for the notice of the meeting was the record date for the action by written consent, and (iii) have not consented to the action by written consent. The amendments further modernize the statute by permitting the notice required under Section 228(e) to be disseminated through a notice of internet availability of proxy materials, in accordance with current SEC rules.

Forward and Reverse Stock Splits (Section 242)

Amendments to Section 242 of the DGCL, which governs the requirements to amend the certificate of incorporation of a Delaware corporation, were implemented to address, in part, recent issues encountered by public corporations in securing the stockholder vote required to approve a reverse or forward stock split.

New Section 242(d)(1) of the DGCL provides that no stockholder approval is necessary for an amendment to the corporation’s certificate of incorporation for a forward stock split, provided that such class is the only class of such corporation’s capital stock then outstanding and is not divided into series. Further, the amendment may increase the number of authorized shares of such class of stock up to an amount proportionate to the subdivision.

The amendments to Section 242(d)(2) of the DGCL modify the voting requirement to a majority of votes cast rather than a majority of the shares outstanding for reverse stock splits and for amendments to certificates of incorporation to increase or decrease to the number of shares of a class of stock. The new voting standard applies if, (i) the shares are listed on a national exchange immediately before the amendment becomes effective and the corporation meets the listing requirements relating to the minimum number of holders immediately after the amendment becomes effective, and (ii) if the amendment increases or decreases the number of shares of a class of stock that has not opted out of the class vote pursuant to Section 242(b)(2), the votes cast for the amendment by the holders of such class exceed the votes cast against the amendment by the holders of such class. Abstentions have no effect on whether the required approval is obtained.

Section 242(d) of the DGCL continues to permit a corporation to opt in to the required stockholder votes under Section 242(b). Thus, a corporation must affirmatively opt out of the new Section 242(d). A general recitation of the vote generally required under Section 242(b) in the certification of incorporation will not be sufficient to opt out of Section 242(d).

Appraisal Rights (Section 262)

Subject to the “market out” exception, Section 262 of the DGCL has been amended to provide appraisal rights to stockholders in connection with a transfer, domestication, or continuance of the corporation in a foreign jurisdiction pursuant to Section 390 of the DGCL. In addition, appraisal rights have been eliminated for an entity that has converted to a Delaware corporation in connection with a merger, consolidation, conversion, transfer, or domestication authorized in accordance with Section 265 for an entity that has converted or domesticated into a Delaware corporation.

Section 262(k) of the DGCL was also amended to permit the withdrawal of an appraisal demand either within sixty days after the effective date of the transaction, or thereafter, if the withdrawal is approved by the corporation.

Conversions, Transfers, Domestications, and Continuances (Sections 265, 266, and 390)

Section 265 of the DGCL as amended adds subsection (k), which, in connection with a conversion pursuant to Section 265, permits the converting entity to adopt a plan of conversion setting forth the terms and conditions of the conversion. Newly added Section 265(c)(4) also requires the converting entity’s approval before the effective date of the conversion for any corporate action included in the plan of conversion. Similarly, the newly added Section 265(l) clarifies that any corporate actions included in the plan of conversion will be deemed to be authorized, adopted, and approved, as applicable, by the converted Delaware corporation, and do not require further action by the converted corporation’s board or stockholders.

Section 266(b) of the DGCL, governing the conversion of a Delaware corporation to another entity, has been amended to provide that a plan of conversion may be adopted setting forth: (i) the terms and conditions of the conversion; (ii) the terms of the instrument governing the internal affairs of the entity included as an attachment to the plan of conversion; (iii) the manner of exchanging or converting the shares of the converting corporation; (iv) any other provisions deemed desirable; and (v) such other provisions or facts as required by the laws applicable to the entity into which the entity is being converted. Section 390(b) of the DGCL was also amended to add a similar requirement pursuant to a transfer, domestication, or continuance to be adopted in accordance with Section 390(j) of the DGCL.

Section 390(b) of the DGCL was also amended to modify the voting requirement to approve a transfer, domestication, or continuance from all of the outstanding shares of stock of the corporation (voting or non-voting) to a majority of the voting power of the outstanding shares of stock of the corporation entitled to vote on the transfer, domestication, or continuance.

Safe Harbor—Mortgage or Pledge of Assets (Section 272)

Section 271 requires stockholder approval of a sale, lease, or exchange of all or substantially all of a corporation’s assets, subject to certain exceptions, while Section 272 of the DGCL governs the mortgage or pledge of the corporation’s assets. In response to Stream TV Networks, Inc. v. SeeCubic, Inc., 279 A.3d 323 (Del. 2022), new Section 272(b) of the DGCL provides a safe harbor clarifying that stockholder approval is not required under Section 271 with respect to the sale, lease, or exchange of property or assets securing a mortgage or pledged to a third party under certain circumstances. Importantly, the intent of the new Section 272(b) was not to preclude further development of the quantitative and qualitative analyses utilized by the Delaware courts to interpret Section 271.

Under Section 272(b), no stockholder approval is required if the secured party (i) exercises its rights to sell, exchange, or lease the property or assets without the corporation’s consent under applicable law, or (ii) in lieu of the secured party exercising its rights, the board of directors agrees to an alternative transaction and the value of the property or assets is less than or equal to the amount of the liability or obligation being reduced or eliminated as a result of the transaction (the “asset value test”). Section 272(b) provides further that the consideration paid to the corporation or its stockholders will not create a presumption that the value of such property or assets is greater than the total amount of such liability or obligation being reduced.

New Section 272(d) of the DGCL provides further that a corporation’s certificate of incorporation must expressly state that stockholder approval is required for a sale, lease, or exchange permitted by Section 272(b). Merely stating in the certificate of incorporation that stockholder approval is required for a sale, lease, or exchange of assets will not apply to such sale, lease, or exchange pursuant to Section 272(b). Section 272(d) only applies to certificate of incorporation provisions that first become effective after August 1, 2023.

Newly added Section 272(c) of the DGCL also provides that, following the consummation of a transaction, the transaction cannot be invalidated for failure to satisfy the asset value test above if the transferee provided appropriate value for the assets and acted in good faith.

The term “Artificial Intelligence” is not helpful to our public discourse. Artificial Intelligence (AI) is not intelligent. The term encompasses too much, is poorly defined, and therefore can’t be discussed precisely.

But it is important for policymakers to understand what they are encouraging or prohibiting. Passing a law to “restrict artificial intelligence” is a dangerous exercise under current definitions.

Different functions of artificial intelligence create different problems for law and society. Generative AI creates not only new text, code, audio, or video, but problems with deepfakes, plagiarism, and falsehoods presented as convincing facts. AI that predicts whether a prisoner is likely to commit future crimes raises issues of bias, fairness, and transparency. AI operating multi-ton vehicles on the road creates physical risks to human bodies. AI that masters the game of chess may not raise any societal issues at all. So why would politicians and courts treat them the same?

They shouldn’t, but if people don’t understand the distinctions between functional types of artificial intelligence, then they won’t be able to make sensible rules. Our language is holding us back. We need to think differently about AI before determining how to treat it.

There can be useful arguments for defining artificial intelligence by the process used to create it. Large language models or other models built by shoveling tons of data into the maw of a machine-learning algorithm may be the purest form of AI. Politicians don’t understand the distinction between these models and other functioning forms of code, however, and they shouldn’t need to. Politicians don’t care how to build an AI model; they only care what it does to (or for) their constituents.

Some of what we think of as AI is nothing more than complex versions of traditional computational algorithms. Standard big-data mining can seem miraculous, but no machine-learning modules are needed to elicit the desired results. And yet, when regulators discuss strapping restrictive rules onto AI, they would include standard algorithms.

Science fiction writer Ted Chiang has defined artificial intelligence as “a poor choice of words in 1954,” preferring instead to call our current technologies “applied statistics.” He also observed that humanized language for computer activities misleads our thinking about amazing, but deeply limited tools, like effective weather predictors and art generators. There is sorting, excluding, selecting, and predicting in these applied statistical processes, but not context, thinking, or intelligence in the human sense.

Whether our problem is understandable-but-unfortunate humanization of these models, whether it is imprecise thinking about what types of technology constitute AI, or whether it is lumping together of disparate functionalities into a single unmanageable term, we are harming the discourse—and our ability to diagnose and treat dysfunction—by using the term “artificial intelligence” in the present manner.

If we wish to police AI, our society needs to define and discuss AI precisely.

In the explosion of commentary surrounding generative AI, hand-wringing about singularities devolved into an oft-expressed desire to regulate and otherwise “build guardrails” for AI. Society’s protectors, elected and otherwise, believe that we must stop AI before AI stops us, or at least before our use of AI foments foreseeable harm to populations of innocents.

What we casually call AI right now is a set of computerized and database-driven functionalities that should not be considered—and certainly should not be regulated—as a single unit with a single rule. AI consists of too many tools raising too many separate and unrelated societal problems. Instead, if we wish to effectively legislate AI, we should break the definition into functional categories that raise similar issues for the people affected by the technology in that category.

I propose a modest organizational scheme below to assist lawyers, judges, legislators, and regulators to 1) grasp the present state of AI and 2) design rules to regulate the functions of machine learning modules. Some of these lines blur, and certain technical or social problems are shared across classifications, but thinking of current AI solutions in legally significant functional categories will simplify effective rulemaking.

Each of these categories provides a unique set of problems. Legislators and regulators should be thinking of AI in the following functions.

Automating AI: Certain AI models automate processes within business or government without making decisions about the opportunities of specific people. Automating AI may streamline an accounting system, research the case law on burglary, or provide a system of forms for running a company. It can replace human workers in some tasks, and therefore has a social impact.

Generative AI: By predicting the output requested from a series of prompts, certain AI tools build a word-by-word or pixel-by-pixel product that can mimic (or copy) human-looking creations. This can lead to working software code and functioning websites, art in the vernacular of Jan van Eyck, papers discussing the use of symbolism in The Scarlet Letter, or legal arguments in a contract litigation. These products raise intellectual property and plagiarism questions, and they can be trained on improperly obtained material. This technology can produce deep-fakes that are indistinguishable from actionable proof. When Generative AI works poorly, it can generate absolute nonsense presented as true fact.

Physical Action AI: Driverless vehicles operate on the interplay between sensors and predictive algorithms, and so do many industrial and consumer technologies. These are systems that use AI to function in the physical world. This category of AI can include running a single machine, like a taxi, or managing traffic systems for millions of vehicles or Internet of Things devices. Legal concerns not only involve safe product design and manufacture, but tort law, insurance issues, and blame-shifting contracts that affect all activity where the laws of physics and moving bodies apply.

Strategizing AI: We all know about predictive machine-learning programs that mastered human strategy games like chess by playing millions of games. Strategizing AI makes predictions based on running simulations, and humans use it to choose effective strategies related to those simulations. Strategizing AI raises concerns regarding accuracy and reliability of the predictions.

Decisioning AI: This category is not defined by technology but by the technology’s effect on people. Algorithmic tools are used to limit or expand the options available to people. AI ranks resumes for human resource managers, highlights who should be interviewed for jobs, and evaluates the reactions of applicants in those interviews. For years algorithms have made prison parole recommendations, sorted loan applicants, and denied suspicious credit transactions. These decisions are subject to bias of various types, also raising issues of transparency, accuracy, and reliability. The EU and some US states have already regulated this category of AI. The Chinese government has elevated these tools into a societal scoring system that can affect every aspect of a citizen’s life and freedom.

Personal Identification AI: Also defined by its effects on humans, certain AI is being used to pick an individual out of a crowd and name them, to extrapolate whose fingerprint was pulled from a crime scene, or to identify a person carrying a specific phone over specific geography. Most Personal Identification AI uses biometric readings from face, voice, gait, or other traits tied to our bodies, but some is behavioral, including geolocation patterns, handwriting, and typing. This type of AI has been implicated in constitutional search and seizure issues, highlighted for findings that were biased against certain ethnic groups, and questioned for its trustworthiness.

Differentiating AI (Data Analytics): Some algorithms simply decide which items should be included or excluded from a specific group. While this sounds like a simple task, sheer numbers and/or complexity can make the work impossible for humans. Differentiating AI can spot a growing cancer from a shadow on an X-ray much more effectively than teams of trained radiologists. It can predict which cell in a storm may drop a tornado. It helps decide which picture shows a cat and which shows a dog. Both Decisioning AI and Personal Identification AI are legally significant subgroups of Differentiating AI, but I am proposing that this classification will not include tools designed to identify people or make subjective decisions about people, but instead be limited to those that suggest factual groupings that might lead to real-world consequences.

Military AI: An amalgam of each of the other functional types listed here, the military builds its own strategizing models, decisioning models, and physical action AI. These tools raise some of the same issues as civilian versions, but an overlay of special purposes and the law of war create a unique category of considerations for military AI. Like most military tools and strategy, the rules for military AI will appear in international treaties and informal agreements between nation-states. Civilian authorities are unlikely to develop effective limitations for the military’s utilization of AI and algorithmic tools.

AI exists in extensive forms and functionalities, so attempting to regulate the entire set of technologies would be overreaching and likely ineffective. The above categorizations provide a safer place to start if we wish to regulate a vast and shifting technology. By adopting this thinking, AI management becomes less daunting and more effective.