I. Conflicts of Interest within M&A Transactions
Whatever a manager does, whether he abstains from an action, or tolerates certain measures, he must exercise due care. Managers must identify and weigh pros and cons and balance conflicting interests. In this area, German law differs from general Anglo-American legal principles and practice in a distinct way. Shareholder primacy does not exist as a rule-of-law the manager of a company may not take only the interests of the company’s shareholders into account. Rather, as the target’s manager is responsible to the target itself, he must consider the legitimate interests of the target and of all its shareholders (i.e. not only the interests of the shareholders) – that is employees, creditors and the general public. Even in public tender offer situations (see B.V.), the managers of the target company are arguably not strictly obliged to act like auctioneers to achieve the highest price possible for the shareholders. Managers have broad discretion and this discretion is protected by the business judgment rule. As long as the managers decide on an entrepreneurial issue and can reasonably assume that, based on an appropriate basis of information, they are acting in the best interests of the company, the judge will not second-guess the managerial conclusion. However, a judge would consider whether a manager has lawfully determined the best interests of the company, i.e. whether the interests of all corporate constituencies were taken into account and that the manager was not erroneously driven only by shareholder interests (or worse, by his or her own interests as a present or future participation holder).
From the perspective of the managers, M&A transactions often entail the loss of a lucrative position, either by being laid off or by being forced to work under worse conditions. This end game situation induces managers to evaluate alternative employment scenarios and give up some of their loyalty to the target company. Eventually, this shift of loyalty may even result in an obstruction of the entire transaction. For this reason, members of management can often be regarded as the third party of the transaction. From the perspective of the remaining parties, it seems reasonable to contract for the management’s loyalty.
II. Management Incentives
1. Transaction Bonuses by Target Company
In an M&A transaction, the management of the target company is typically granted a bonus upon exit. The amount of the bonus is between one and two annual gross salaries; on occasion it might increase depending on the achieved purchase price. The bonus is generally paid upon closing. The bonus payment might be granted on a fully discretionary basis or may be dependent on the achievement of certain steps in an M&A transaction, e.g. establishment of an info memorandum and data room, preparation of due diligence or management presentations. In return, the management is often asked to deliver a directors certificate or warranty deed. In such declaration, management has to guarantee to the seller that the management is not aware of any facts which are incorrectly stated in the vendor due diligence reports or which would lead to a breach of representation in the share purchase agreement with the potential purchaser. The liability under such certificate might be limited to the anticipated bonus payment.
In general, transaction bonuses paid by the employing company must be in appropriate proportion to the duties of such manager and the target company’s condition. Moreover, these bonuses only have a sound legal basis if they are stipulated in the employment agreement in advance. Without such contractual basis, the bonus payments are only justified if they are paid in the interest of the company. This is deemed to be the case if, by receiving the bonus, the manager is bound to the company or if the recipient or other employees are incentivized to work for the company to achieve similar bonus payments.
2. Transaction Bonuses by Seller
Under German law, the supervisory board of a company is responsible for the appointment, revocation and compensation of members of the management board. Nevertheless, there are situations in which a shareholder intends to grant financial benefits to members of the management board in accordance with milestones to be achieved by the managers with respect to the company’s conduct of business. Due to the fact that such benefits are not directly granted by the employing company, they are generally called third party bonuses. The performance- related milestones of these bonuses enable the alignment of the manager’s conduct of business with the objectives of the third party providing the benefits. Therefore, from an economic point of view, bonuses granted by a shareholder within an M&A transaction coincide with the manager’s interest, as well as the interest of the relevant shareholder, to achieve a high enterprise value for the company. However, it is disputed whether it is permissible under German law for a third party to grant transaction bonuses to the management instead of the company. It seems reasonable to demand approval by the supervisory board or at least require that it be informed.
3. Incentives within Public Tender Offers
In public tender offer situations (see B.V.) a manager’s remuneration shall also be in an appropriate relationship to the duties of such manager and the target company’s condition. Transaction bonuses by the seller to the management arguably require approval by the AGs supervisory board or that the board must be informed of such measures. A bidder might be inclined to offer or grant benefits to managers, only for the purpose of winning the management’s favor in order to gain ground in competitions among several bidders. Without good reason, the acceptance of these benefits is a violation of the manager’s fiduciary duty owed to the target company and is therefore invalid pursuant to the German Takeover Act. Certain benefits, however, are allowed, provided they are "justified". While the exact meaning of "justification" in this context remains rather vague, it is acknowledged that benefits allowing for the continuation of the management’s services can be permissible.
In public tender offer situations, the management is obliged to make a statement on the offer to the target company’s shareholders. If an incentive causes a conflict of interest for the management, it seems reasonable to ask this manager either not to join the management’s statement or to explain the nature of the conflict and to hire an expert witness. Moreover, the bidder has to state in his bidding documents details of any monetary or cash equivalent benefits for the management or the supervisory board, even if the benefits might be justified under the aforementioned terms.
4. Taxation and Social Security Contribution of Transaction Bonuses
Bonus payments are fully taxable as ordinary income at the manager’s individual tax rate (the maximum tax rate amounts to 45 % plus church taxes and solidarity surcharge). Provided that managers are above the maximum limits by virtue of their ordinary income, no social security contributions should arise with respect to these arrangements (maximum limits are currently EUR 69,600 (West Germany) and EUR 58,800 (East Germany)).
III. Management Participation
A private equity investor aims at aligning its own and concurrent interests of the management with the interests of the target company. For this reason, the implementation of an up-to-date Management Equity Program (MEP) is of utmost importance in management buyouts and became a conditio sine qua non. For this reason, the following principles address investments of private equity investors in particular. Nevertheless, if strategic investors implement management participation programs, these participations follow similar rules in general and, to a certain extent, the following policies can be applied accordingly.
a) Participation Ratios and Amounts
Management will typically invest alongside the investor by way of an interposed trust vehicle or partnership in the acquisition vehicle. The quote depends upon the type and size of the deal and might vary from 3 % to 25 %. 1st line managers are requested to invest one to two gross annual salaries in addition to any potential transaction bonuses. 2nd line managers are allowed but not requested to invest between EUR 10,000 and EUR 100,000, also depending on the size of the deal and on the investment amount available to the management. In a secondary transaction, management is asked to reinvest at least 50 % net of taxes of their sales proceeds.
In a typical investment scenario, management could expect a money multiple of 10 and an envy ratio of 3. Money multiple means that management is able to receive 10 times their invested money if the business plan for the next 5 years is met and the company is sold on the same multiple as the entry multiple. Envy ratio is the ratio between the money multiple anticipated for the management and the one for the investor.
The envy ratio is accomplished by leveraging the acquisition of those shares that are acquired by the management. This leverage effect can either be achieved by a disproportionate subscription of shareholder loans or preference shares or a non-recourse loan for the managers.
b) Shareholder Agreement
The rights and obligations of the managers and the investor are stipulated in a shareholders or co-investment agreement. Such agreement includes – inter alia – provisions on the exit and the so-called leaver scheme. In case of an exit, management is obliged to co-sell its shares with the investor (drag-along right) and vice versa: Management is entitled to request to co-sell its shares if the financial sponsor partially or in total sells its shares (tag-along right). In case of corporate actions, the rights of the management (subscription rights, retention of the capital structure, etc.) can be protected by anti-dilution clauses. The allocation of any exit proceeds follows the allocation of the shareholding in the acquisition vehicle. However, the parties can agree upon alternative liquidation preferences.
c) Leaver Scenarios
Upon termination of the manager’s employment contract or upon the manager’s cessation as managing director with the target company, as well as under other specifically stipulated circumstances, the private equity investor can request the respective manager to sell and transfer his shares (call option). The manager, respectively his heirs, might request the acquisition of his shares upon the occurrence of certain events (e.g. death, disability, retirement) (put option). In both cases, the repurchase price depends on the specific termination event. Parties distinguish between good leaver cases (e.g. death, invalidity, occupational disability, manager’s termination for good cause) and bad leaver cases (e.g. manager’s breach of duty, termination of manager’s contract by the employing company for good cause). In good leaver cases, the repurchase price is equal to current fair market value of his shares, subject to vesting schedules. In bad leaver cases the manager is only entitled to the lower of the fair market value and his acquisition costs for his shares. Vesting of the shares might be subject to time (e.g. 25 % p.a.) or performance of the target company (e.g. achievement of certain EBITDA/free cash flow targets). Payment of the repurchase price might be made upon exercise of the respective option or deferred until the occurrence of an exit.
In addition, the management’s participation might be subject to money-multiple hurdles (e.g. 2.5 times the invested money) or internal rate-of-return hurdles (e.g. 25 % p.a.) set by the financial sponsors (ratchet).
2. Tax Aspects
Structuring of management incentives in Germany is, to a considerable extent, tax-driven: stock option schemes are taxed like bonus schemes, i.e. the gain recognized by management upon exit is fully taxable as ordinary income. In contrast, MEPs can be structured in order to generate favorable capital gains for managers.
For shares acquired prior to January 1, 2009, the former tax regime applies. If a manager holds less than 1 % of the stated share capital of the company, the shares can be sold free of taxes after a holding period of at least 12 months. For shares acquired after January 1, 2009, the new capital gains flat tax of 25 % (plus church taxes and solidarity surcharge) applies if the shareholding is less than 1 %. If the shareholding is above 1 %, the capital gain is subject to the partial income procedure (Teileinkünfteverfahren), i.e. only 60 % of the gain is subject to the personal tax rate (plus church taxes and solidarity surcharge).
The acquisition of shares below fair market value will trigger fully taxable ordinary income. The same applies to the whole MEP gain, if the beneficial ownership in the acquired shares is denied by the tax authorities due to intensive restrictions of shareholder rights of managers, e.g. vesting, claw backs, transfer restrictions.
IV. Personal Obligations and Liability Risks of Managers in M&A-Scenarios
Managers in M&A transactions have personal obligations, the breach of which creates personal liability. This is relevant not only in private equity situations (with management participations on either one or both sides), but also between the target and its managers. Seller’s or purchaser’s managers and their advisors might have their own obligations and liabilities if they, for example, cause or induce a breach by the target company’s managers, or if they otherwise participate in ￼that violation (which might constitute fraud or another tort or criminal offence) or because they fail to detect or disclose the breach.
A manager may breach his obligations by making disclosures. Any disclosure of a company’s data or secrets to another person might constitute a breach of confidentiality. Disclosure to a competitor is certainly a breach and even a financial sponsor might be, or become, a competitor through another investee company. Releasing information may be a breach of third party rights, such as express or implied confidentiality obligations to customers, suppliers or employees. Disclosure can also constitute a breach of data protection laws – either industry-specific ones such as those in the financial and telecommunication industries, or general ones such as the Federal Data Protection Act.
Non-disclosure can also constitute a breach of a manager’s obligations and expose the manager to liability. Generally speaking, conflicts of interest must be disclosed. For instance, direct contact between management and bidders (or contact in the absence of the seller’s representatives) is forbidden, even without a special agreement to this effect, unless it is disclosed to the target and the seller.