It's been a rough few years, but 2011 is already being celebrated as a landmark year for mergers and acquisitions. There were nearly $900 billion in transactions in the first quarter alone, and another $2 trillion in deals is expected to follow by the close of the fourth quarter. Fueling much of this buying spree is a device called a contingent value right, or CVR. While CVRs are a valuable tool for avoiding long disputes over valuation, unless handled carefully they may prove instead to be more trouble than they're worth.
CVRs are derivative securities or contract rights that pay holders when specified contingencies occur. There are two principal types of CVRs, distinguished by the nature of the event that triggers the payout of additional value.
Performance-driven CVRs, whose use peaked in the 1990s, are linked to corporate performance over a certain period of time. However, it is event-driven CVRs that have come to play an increasing role in transactions in recent years. These CVRs link payout to the occurrence of uncertain events, such as the settlement or final disposition of a lawsuit, the final resolution of a regulatory investigation (or achievement of a regulatory milestone), or the results of a drug trial.
Event-driven CVRs have been widely used in mergers involving pharmaceutical and biotech companies. There, they are well adapted to addressing the valuation uncertainties inherent in a product development pipeline. They do this by tying additional consideration to the achievement of regulatory or commercial milestones for specified products in a postclosing period. For example, Endo Pharmaceuticals Inc., in its 2009 acquisition of Indevus Pharmaceuticals, paid $4.50 a share in cash but also agreed to pay Indevus shareholders an additional $3 a share if the Food and Drug Administration approved two Indevus drugs in development at the time. In Forest Laboratories, Inc.'s bid for Clinical Data, Inc., earlier this year, Clinical Data shareholders were offered $30 per share, together with CVRs promising another $6 if certain product sales milestones were met.
The promise of future additional value through an event CVR is one useful way of handling the thorny disputes over value that have erupted in the wake of the financial crisis of 200708. While many companies have seen substantial recoveries, share prices are still low by historical measures, and buyers and target companies often do not see eye to eye about the prospect for share price increases. These differences are exacerbated by the volatility in current markets.
When gaps between valuations by sellers and buyers are simply too wide to bridge, CVRs can help get a deal struck. Instead of negotiating a mutually agreeable present cash value, the buyer promises target shareholders a base amount in cash or stock, and promises to pay more if certain milestones are reached.
This mechanism sounds promising in theory by smoothing over immediate valuation concerns, CVRs seem to provide the best of both worlds: Parties can close the deal today but also wait and see how possible events or synergies pan out. However, unless these instruments are carefully drafted, they may come back to haunt corporate counsel.
One critical point concerns the way that trigger events are defined in event CVRs. To avoid future disputes, CVRs should be tied to objectively verifiable outcomes over short measurement periods.
Even more importantly, holders of CVRs must have the means of determining whether milestones have been reached. Target corporation shareholders may have little or no access to information internal to the buying company that could help demonstrate that sales or revenue benchmarks have been met. Accordingly, target companies considering an offer including CVRs may want to consider requiring that CVR holders, or their representatives, receive information relevant to the milestone event.
Provisions ensuring access to information need not be complex. In Ligand Pharmaceutical Incorporated's 2010 acquisition of Metabasis Therapeutics, Inc., Metabasis shareholders received a mix of cash and CVRs tied to sales or partnerships arising from any of the Metabasis drug development programs. The CVR agreement called for the appointment of a stockholders' representative, who was to be regularly supplied with documentation sufficient to determine whether holders of CVRs were entitled to a milestone payment. This stockholders' representative was also empowered to forward this information to holders of the CVRs. Similarly, in the Forest Laboratories/Clinical Data deal, the CVR agreement called for the appointment of an independent accountant, who was given access to Forest Laboratories records in order to determine whether milestone payments were due.
Even with access to information, CVR holders may be putting their financial lives in the hands of buying companies. Many milestone events, such as drug development or sales efforts, are within the power and control of the buying company, forcing shareholders in target corporations to rely on good-faith efforts of the buyer to cause the milestone to be reached. In some circumstances, target shareholders will depend on the acquiring company's legal obligation to pursue, through "best efforts," something that might be of marginal or no economic value to the buyer.
Given the likelihood of disputes over compliance with such covenants, establishing an efficient mechanism to resolve disputes over CVR agreements is vitally important to target company stockholders. This is especially true because individual CVR holders are unlikely to have the ability or economic incentive to pursue potentially costly litigation or arbitration. In the Ligand/Metabasis transaction, the stockholders' representative was given the sole power to pursue legal proceedings to enforce the CVR agreement. In the Forest Laboratories/Clinical Data transaction, the power to enforce the CVR was put in the hands of a rights agent, who could sue Forest Laboratories in the event it breached the CVR agreement.
Because event CVRs have only recently come to be used in mergers, there is relatively little jurisprudence to provide guidance to counsel. However, at least one suit involving performance CVRs gives evidence of what can go wrong.
In Rossdeutscher v. Viacom, Inc. (2001) a class action was brought by CVR holders against the issuer of the instruments for breaches of implied covenants of good faith and fair dealing. Plaintiffs alleged that Viacom intentionally inflated its own stock price in an effort to improperly reduce the payout under performance CVRs intended to protect shareholders in a corporation that Viacom acquired. The allegations in Rossdeutscher illustrate that, even if CVR holders are given performance data, their ability to collect milestone payments can be heavily dependent on the good faith of the CVR issuer.
The jury is still out on whether or not, in the long term, event CVRs represent an improvement in the way deals are structured. Until a consensus builds, however, corporate counsel for both buyers and target companies should closely scrutinize these instruments to minimize future litigation risk. Any good craftsman will tell you to bring the right tools for the job at hand, but some tools are sharp at both ends. In approaching a pending M&A deal, you may want to consider pulling the CVR out of your toolbox. But handle with care.