“Change of Control” through Acquisition by Private Equity Fund and Management Team:

“Going Private” Transactions by a Publicly Traded Outsourcing Service Provider

© 2007 William B. Bierce.  All rights reserved.

Affiliated Computer Services, Inc. (“ACS”) is an American-based leading provider of business process outsourcing services to industry and government.   On March 20, 2007, ACS received a proposal from its CEO, Darwin Deason, and Cerberus Capital Management, L.P. to acquire for cash all of the outstanding shares of the ACS (not including certain shares and options held by Mr. Deason and members of ACS’s management team).  Aside from the Sungard acquisition by a consortium of private equity funds, the ACS proposal would be perhaps the first case of a “going private” transaction for a U.S.-based major service provider of IT and business process services with a global services delivery model, in the form of a management buyout financed by a private equity fund (with a promise of future debt funding from the financial markets). 

 The proposed transaction highlights complex legal issues and business considerations in how a change of control of a BPO service provider can impact an entire BPO ecosystem.   Looking at a possible change of control of a service provider, the event could trigger changes that improve or impair a variety of relationships.

·        MSA.  For the provider’s customers, there could be a change in customer relations under master services agreements. 

·        Employment.  A change could affect employment relations under employment agreements, stock options and deferred compensation plans.

·        Capital Markets.  In the capital markets, a change of control could affect corporate finance and the provider’s credit rating and access to, and cost of, capital and the availability of new investment.

·        Supply Chain.  In the back office, a change of control may create strange bedfellows bringing new views on supply chain integration

·        Risk Profile.  In short, a change of control could be accompanied by a change in the leadership, corporate culture and general risk profile for the service provider. 

As a result, enterprise customers, service providers, key employees, banks, lenders, strategic alliance partners, private equity investors, hedge fund managers and public investors, and outsourcing lawyers, need to understand these implications and take appropriate actions.

            I.            Change of Corporate Control: A Commercial Perspective

The change of control may have several consequences.  Each of them depends on the particular facts and circumstances.

Changes of Long-term Strategies.   New management installed by new owners will have the power to change corporate strategies.   The risk of a change of control may be a consideration in the business judgment whether to enter into a commercial or investment relationship with the particular.

Concerns.  Psychologically, the strategies could cast fear, uncertainty and doubt (“FUD”) about the worst-case scenario, without any clear outcome until the lapse of substantial time.  For example, before the new strategy can yield fruit, the customer might fear the worst when the service provider sets new targets in new lines of business that require substantial lead times and financial investment before yielding a reward.   Any change of control represents a surprise requiring further investigation by all affected parties.  Whatever the nature of the change, there will be some turmoil, temporary distractions and other substantive risks. 

·        Intuitus Personae: The Personal Character of the Business Relationship.  Outsourcing contracts typically permit the customer to terminate the contract upon a change of control of the service provider, and sometimes in case of a change of control of the enterprise customer.   Such a termination is a no-fault event that does not necessarily cause harm, damage or increased risk to the enterprise customer.   But such a change goes to the concept of personal relationship with a critical supplier of services.  In Civil Law, this personal character is reflected in the concept of intuitus personae, the personal character of the contractual relationship.  

·        Role of Corporate Culture.  Does this intuitus personae concept fit into outsourcing contracts?   After all, under the outsourcing contract, and the RFP bidding process, all service providers are considered fungible, and they compete on price and performance.   The business relationship is based on an ability to perform services under statements of work, service level agreements, key performance metrics, restrictions on reassignment of key personnel and defined business process methods.  The answer lies in the variable known as corporate culture.  Cultural fit is an important element in the trust bond.

 What’s Happening – A Customer’s View.  New strategies could harm the customer relationship in the short term. 

• Distractions and Redirection of “Mindshare” at the Top.  Senior management might be distracted from maintaining the highest quality in the customer’s business services.  Each senior manager will likely have new personal incentives for achievement that are dictated by a new overall compensation structure mandated (or negotiated) by the new owners. 

• Attrition of Human Capital.  Incumbent project executives might be transferred to new customers or new lines of business.  Attrition may likewise occur by departures from the service provider by executives who see little opportunity for personal growth under the new owners.  In a public company, many executives may be well compensated. In a newly private entity, the incentives may be redirected to key individuals with specific missions, which may take away incentives from those responsible for maintaining high quality “status quo” operations.

• Resource Reallocation.  The service provider’s financial resources might be reallocated to increase or reduce the future levels of investment in the service provider’s continuous process improvement for incumbent customers.  Every change of control will have its own unique resulting reallocation.   Thus, new acquisitions could be targeted in new arenas, but generally private equity investors are not driven to such changes for successful companies.  Conversely, if the change of control represents a takeover, the post-merger integration could result in cuts or orphaning of certain operations that are considered redundant or not worth further commercialization.  Such changes may work in the software arena (such as in ERP software). 

What’s Happening – A Service Provider View.   From the service provider’s view, the typical change of control serves to improve quality and benefit the customer in many ways.  New management might improve the responsiveness of customers, implement a new growth strategy to put new investment capital to effective use, enhance cultural identity and improved fit with its target clientele and refocus attention on core programs.   Each case presents a different profile.

            II.            Impact of Change of Control on Employment

A change of corporate control affects employees across the board.

Senior Executives.    Many senior executives in publicly traded BPO service providers enter into employment agreements.   Under such agreements, a change of control may trigger:

·        Termination for “Good Reason,” entitling the employee to

o       terminate the agreement,

o       negotiate a sweeter compensation package with the new owner,

o       concomitant severance payments such as “parachute payments” (three or more times prior annual compensation) that are not deductible for U.S. federal income tax purposes and vesting of deferred compensation.  See Internal Revenue Code, Sections 83(b) and 409A.

·        Vesting of unvested stock options.

Middle Level Employees.   A broad range of mid-level employees may also be affected by a change of corporate control.  While they might not enjoy the rights of senior executives, they could enjoy special negotiated incentive compensation to retain them.  The negotiation of such incentives could distract human resources executives from the key tasks of defining key performance requirements and other human capital management strategies.  Similarly, a change of control affects middle-level employees who may have to make an election to be taxed in the current tax year on the value of stock options that do not vest until some future date.  See 26 U.S.C. 83(b).

            III.            Impact of Change of Control on Capital Markets

Disclosure.  Changes in control will affect investor perceptions of the future value of the service provider.  Publicly traded service providers must thus disclose all such changes under applicable securities laws.  Privately held providers do not.  Accordingly, the outsourcing contract should address the means of disclosure.  Private financial information of a private company, for example, should normally be covered by a non-disclosure agreement.

Access to Capital.  A change of control may alter a company’s access to capital at favorable terms. 

Being “Put in Play.”   In the field of proxy fights, hostile takeovers and tender offers, once a company is “put in play” by someone’s offer to purchase control, the company’s stock market price may be bid up artificially by arbitrageurs, and fall precipitously if the proposed “takeover” changes.  Company defenses against such measures may result in shareholder class action lawsuits.  

IV.             Risk Management through Shark Repellent: Shareholders’ Rights Plans. 

One strategy to reduce the risk of an unwanted change of control is to give existing shareholders certain rights that would spring into effect upon the occurrence of a hostile takeover bid not approved by the Board of Directors.  Shark repellent may be “good” for enterprise customers by enabling the service provider to maintain stability, but “bad” because it does not promote potentially beneficial mergers or capital infusions.

Perot Systems has a “Stockholders’ Rights Plan” that does just that.   It explains the impact of a “change of control” on shareholders’ rights, which is a form of “shark repellent.”

In addition, we have adopted a stockholders’ rights plan. Under this plan, after the occurrence of specified events that may result in a change of control, our stockholders will be able to buy stock from us or our successor at half the then current market price. These rights will not extend, however, to persons participating in takeover attempts without the consent of our Board of Directors or that our Board of Directors determines to be adverse to the interests of the stockholders. Accordingly, this plan could deter takeover attempts.

Source: Securities and Exchange Commission, Perot Systems Corp., Annual Report for the fiscal year ended December 31, 2006.  

V.            Impact of Change of Control on Supply Chain Relationships

Every BPO service provider, like its global enterprise customers, constitutes a web of strategic and temporary alliances with third parties in a supply chain.   A change of corporate control can normally be expected to trigger a re-assessment by supply chain partners of the BPO provider’s new mission.  The change of control and commercial mission might generate a newly competitive attitude in supply chain alliances.  

VI.            Impact of Change of Control on Quality of Customer Relations and Affected Master Services Agreements

A change in control of a service provider can have a major impact on the quality of the relationship between the service provider and its clients.  In exploring the multifarious components, enterprise customers think first about the particular consequences of a change of control   From this, they can deduce the terms required in their contracting to trigger remedial rights – notably, termination – that could serve to restructure the relationship without having to pay termination fees.  From the provider’s side, a grant of termination rights should bear a cost since the change of control does not automatically result in loss of any contractual rights or benefits, and does not necessarily impair the financial or technical capacity of the service provider to meet all service level agreements and deliver all agreed services.     

VII.          Defining the Triggers: What is a “Change of Control”

The definition of a “Change of Control” needs to address several parameters.  Depending on the definition, the enterprise customer might have a broad right of termination upon the occurrence of a relatively minor event, or the enterprise customer could be prevented from exercising a termination right.

Minority Control.   In some cases, a minority shareholder might be able to take practical control of a corporation even though such control is not absolute.  If shareholdings are skewed, with one shareholder owning 40% and all other shareholders owning less than one percent, there will be a natural inclination for the other shareholders to let the 40% owner select the Board of Directors and dictate general corporate policy.   To logroll a majority needed to defeat the 40% owner, the other shareholders would need to form a coalition.   Absent egregious misconduct by the 40% owner, the other shareholders could reasonably be expected to accept the status quo and not engage in shareholder activism.  This constitutes de facto control.

Indirect Control.   Indirect control is exercised by the Wizard of Oz, who, from behind the corporate curtain of one or more holding companies, exercises control through holding companies.  Where the ultimate beneficial owner has a disguised identity, it may be impossible to verify whether or when actual indirect control might change hands. Indirect control exists when an “ultimate beneficial controller” has “control” through another person or entity.  In the U.S. tax law, control is attributed to the ultimate beneficial controller under a flow down where at least 50% of ownership is controlled by an “affiliated person” (the intermediate controlling party), such as a trust, estate, partnership or other corporation.  26 U.S.C. 318.   This issue needs to be addressed during due diligence and contract development.

Change of Nationality.  A change of corporate nationality of the ultimate beneficial owner constitutes a change of control.  The question is whether it is merely a change of form without a change of substance.   Accenture’s management discussion and analysis of this question is revealing, since it changed its jurisdiction of incorporation from the United States to Bermuda.

Negative publicity about Bermuda companies may lead to new tax or other legislation that could increase our tax burden and may affect our relationships with our clients.

Members of the U.S. Congress have introduced legislation relating to the tax treatment of U.S. companies that have undertaken certain types of expatriation transactions. It is possible that legislation enacted in this area could reduce the tax benefits of our structure and materially increase our future tax burden, or otherwise adversely affect our business. Other legislative proposals, if enacted, could limit or even prohibit our eligibility to be awarded U.S. government contracts in the future. In addition, similar state legislative proposals, if enacted, could adversely affect our eligibility to be awarded U.S. state government contracts in the future. We are unable to predict with any level of certainty the likelihood or final form in which any proposed legislation might become law or the nature of regulations that may be promulgated under any such future legislative enactments. As a result of these uncertainties, we are unable to assess the impact on us of any proposed legislation in this area. In addition, there have recently been negative comments regarding Bermuda companies in the media. This negative publicity could harm our reputation and impair our ability to generate new business if companies or government agencies decline to do business with us as a result of the negative public image of Bermuda companies or the possibility of our clients receiving negative media attention from doing business with a Bermuda company.

We are registered in Bermuda, and a significant portion of our assets are located outside the United States. As a result, it may not be possible for shareholders to enforce civil liability provisions of the federal or state securities laws of the United States.

We are organized under the laws of Bermuda, and a significant portion of our assets are located outside the United States. It may not be possible to enforce court judgments obtained in the United States against us in Bermuda or in countries, other than the United States, where we have assets based on the civil liability provisions of the federal or state securities laws of the United States. In addition, there is some doubt as to whether the courts of Bermuda and other countries would recognize or enforce judgments of U.S. courts obtained against us or our directors or officers based on the civil liabilities provisions of the federal or state securities laws of the United States or would hear actions against us or those persons based on those laws. We have been advised by our legal advisors in Bermuda that the United States and Bermuda do not currently have a treaty providing for the reciprocal recognition and enforcement of judgments in civil and commercial matters. Therefore, a final judgment for the payment of money rendered by any federal or state court in the United States based on civil liability, whether or not based solely on U.S. federal or state securities laws, would not automatically be enforceable in Bermuda. Similarly, those judgments may not be enforceable in countries, other than the United States, where we have assets.

Source: Securities and Exchange Commission; Accenture Ltd. Annual Report for the fiscal year ended August 31, 2003.     

Gray Areas: Practical Problems.    Control might not arise solely from ownership of a majority of shares or a controlling minority stockholding.  It can arise from the complex corporate financial structures or corporate governance structures such as a staggered board of directors, conditional voting rights of certain special securities (such as debentures or preferred stock) that apply only to certain major corporate events, and conditions in loan agreements.  Delaware law permits a certificate of incorporation to authorize the board of directors to issue “blank check” stock where the board sets forth a statement of designations and the powers, preferences and rights, and qualifications, limitations or restrictions thereof.   Del. Gen. Corp. L., Sec. 102(4).   Adoption and issuance of a new class of stock might fit as a change of control.  These gray areas may be addressed aforethought in the outsourcing contract.

VIII.       Contractual Provisions on Change of Control of Service Provider: Know Your Supplier

Any change of corporate control sets in motion the rearrangement of the business, financial, employment and commercial profile of a company’s constituencies.   In the outsourcing arena, effective planning is required to anticipate the impact of such changes to manage and mitigate risks.   Since a change of control could occur to either the BPO service provider or its enterprise customer, a conversation around these issues, and the possibility of termination without cause, should facilitate development of a contract that can identify applicable implications and mitigate the risks and costs associated with any such change. 

IX.             Contractual Provisions on Change of Control of the Enterprise Customer:  “Know Your Customer”

Bankers and others understand the maxim “know your customer.”   A change of control of the enterprise customer could have a major impact on the service provider’s ability to obtain inputs from customer management on emerging operational and relationship issues.  More likely, a change of control of the customer will introduce new management strategies in the customer’s board room, which could result in “insourcing” or “captive” sourcing.  

For example, a change of control of the enterprise customer could put new managers in place, with new perspectives on outsourcing generally.  For example, when Jamie Dimon, CEO of BankOne, became CEO of JPMorganChase after a merger, he set upon a course of dismantling as much outsourcing as he could reasonably do.   At BankOne, it was an in-sourced shop.  At JPMorganChase, it was a highly outsourced operation, and the change of control reportedly resulted in the termination of hundreds of millions of dollars in outsourcing contracts.  

By granting the customer a right of termination upon a change of control of the customer, the service provider will be putting the entire relationship at risk, even if the service provider is doing no damage and fully complies with the outsourcing agreement.  At that point, the customer’s termination right for its own change of control becomes a potestative condition, where one’s own acts justify one’s own termination of a contract.  Changes such as these may give rise to a right of termination, but the question then becomes why the termination should (or should not) be free from any termination fees, not to mention termination service charges.  Contract negotiators should understand the impact of such contingencies and address them in mutually agreeable contract conditions.

X.                Conclusions

When a company’s control passes to a new control group, the impact on its customers, suppliers, investors and employees could run the gamut: favorable, unfavorable, or undecided.   The actual impact could depend on the character of the new control group, which could be a competitor or otherwise have interests antagonistic to the enterprise customer or another supplier. 

If every contract were terminable upon a change of control, no service provider could consider major restructuring, such as an IPO, going private or merger.  This risk poses a challenge for smaller service providers soliciting expansion capital.  Moreover, not every major restructuring will have a negative impact on the quality of customer service, customer satisfaction or future relationships.

The actual Master Service Agreement terms need individual attention for risk management and mitigation. 

• For example, a blunt grant of an automatic termination right for ending the relationship might be suitable because of the particular circumstances.  
• In other cases, the enterprise customer might use a “change of control” as an excuse for termination event, as a smokescreen, or “get out of jail free” card, to resolve other unresolved governance issues.  In such cases, a narrower approach, that identifies and specifically the particular risks that are of primary concern to each party, might protect the enterprise customer’s principal concerns without exposing the service provider to undue risks of termination.   The suitability of this limitation will depend on many factors to be considered in each case.

Avoiding Potential Abuses of Change of Control Provisions.   “Change of control” clauses serve a useful benchmark to review the strength of a business relationship when a service provider’s corporate culture, finances and direction are at stake.  Such clauses are potentially subject to abuse where the change is beneficial, increasing financial capacity, adding synergistic lines of business and strong management.  The problem lies in knowing when the change will be harmful and when beneficial, and establishing a rule of thumb that fairly reflects the potential risks to each party.   By focusing on the question of potential harms and benefits, the parties may have a dialogue on certain changes that will automatically trigger a termination right, and those that will not. 

Ultimately, this dialogue may include identification of competitors, conflicts of interest, financial resource allocations and other critical factors.  Throughout this debate, the question is not whether the provider is in breach of its service obligations, but whether the change in control is reasonably likely to cause it to become in breach.  

Further Reading:

Failed Deals

Sample Statutory Definitions of Control