DEAL LAWYERS Vol. 10, No. 3 May-June 2016 Structuring Considerations for Minority Investments By Ari Blaut, Neal McKnight, Richard Pollack and Daniel Loeser of Sullivan & Cromwell LLP1 In its recent decision in Wilmington Savings Fund Society v. Foresight Energy2 interpreting a typical “change of control” provision in an indenture for high-yield notes, the Delaware Chancery Court held that, based on the indenture’s reference to the definition of “beneficial ownership” contained in Rule 13d-3 of the Securities Exchange Act, (1) the acquisition of a minority ownership stake in a company, when coupled with a veto right over the sale of shares by the majority shareholder, caused the acquiror to obtain beneficial ownership over the shares in the company not being purchased by the acquiror and, as a result, led to a “change of control” under the company’s indenture, and (2) a change of control had also occurred due to the parties’ deliberate efforts to “evade” the change of control provision.

The occurrence of a change of control triggered a requirement for the company to offer to repurchase outstanding notes within a specific time frame, and because the company had not made that offer it was in default under the indenture. The Delaware Chancery Court held that despite the parties’ efforts to structure the minority investment in a manner so as not to trigger the change of control provision, the “anti-evasion” provision of Rule 13d‑3 required the court to look beyond the literal terms of the change of control provision to whether the parties transferred de facto control of the company in a manner designed to circumvent the provision.3 While certain aspects of the decision, particularly with respect to anti-evasion, are not consistent with prevailing interpretations of Rule 13d-3 and may not be widely followed by other courts, the uncertainty the case casts over the interpretation of these provisions heightens the risk that debt holders may claim a “change of control” has occurred in a minority investment transaction. 1 Ari Blaut, Neal McKnight and Richard Pollack are partners, and Daniel Loeser is an associate, of Sullivan & Cromwell LLP. Mr. Blaut maintains a broad corporate practice with a focus on leveraged finance and acquisition finance transactions, capital markets issuances, bank financings, special situations and private equity investments.

Mr. McKnight, who co-heads the Firm’s Credit and Leveraged Finance Practice, advises financial institution, sponsor and corporate clients on a broad range of corporate financing transactions, including capital markets offerings, revolver and term loan facilities, receivables and asset-based facilities, and securitizations, and has particular expertise in acquisition financings. Mr.

Pollack co-heads the Firm’s Private Equity Group and has extensive experience in cross-border mergers and acquisitions in a wide range of industries, as well as in public and private offerings of equity and debt securities on behalf of U.S. and non-U.S. issuers. 2 Case No.

11059 (Dec. 4, 2015) (Laster, V.C.). 3 Id. at *19. TABLE OF CONTENTS – Structuring Considerations for Minority Investments .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

1 – Insurance Due Diligence: Three Practical Tips . . .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

. . 5 – Basics: Drafting & Negotiating Disclosure Schedules .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

. . 8 – Talent Retention: A Toolkit for M&A .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

. . 12 – Which Investors Like Which Risks? .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

. . .

16 © 2016 Executive Press, Inc. DealLawyers.com • P.O. Box 1549 • Austin, TX 78767 • (925) 685-5111 • Fax (925) 930-9284 • info@DealLawyers.com ISSN 1944-7590 . This risk is particularly acute as a result of recent turbulence in the sub-investment grade debt markets, which has resulted in a number of recent private equity transactions being structured as minority investments so as not to trigger a “change of control” under the debt. Below is a brief summary of the facts and legal conclusions behind the court’s decision, followed by a discussion of key considerations for structuring minority investments that sponsors and other parties should take into account in light of the decision. The Decision In early 2015, Murray Energy Corporation (“Murray”) began negotiations with the owners of Foresight Energy LLC (“Foresight”) regarding a potential acquisition by Murray of an indirect controlling stake in Foresight. A major obstacle to the deal was the change of control provision in the indenture governing Foresight’s $600 million of outstanding high-yield notes (the “Notes”). The provision required Foresight to offer to repurchase the Notes at 101% of face value upon a “change of control,” which was defined to include any transaction that would result in any person or group (other than certain specified persons)4 acquiring beneficial ownership of 35% or more of the voting equity interests of the general partner of Foresight’s direct parent (the “General Partner”). The parties initially agreed to a transaction in which Murray would acquire an 80% voting interest and 77.5% economic interest in the General Partner,5 conditioned on the noteholders agreeing to waive their contractual redemption rights arising from a change of control in exchange for an 8% consent fee. However, the parties were not able to obtain the consent or alternative debt financing for the transaction on agreeable terms (likely due in part to deepening concerns in the debt markets about the financial prospects of the U.S.

oil and gas sector). The parties renegotiated the transaction so as not to trigger the change in control provisions in Foresight’s indenture. Under the revised terms, Murray would acquire a 77.5% economic interest and a 34% voting interest in the General Partner. In addition, the General Partner entered into a management services agreement under which an affiliate of Murray would take over responsibility for the day-to-day management, and a relative of Murray’s Chief Executive Officer was appointed Chief Executive Officer of the General Partner and Foresight’s direct parent.

Murray also received certain minority shareholder protection and governance rights, including: – a call option to acquire an additional 46% voting interest in the General Partner for a set price, which could only be exercised if Foresight successfully refinanced the Notes on reasonably acceptable terms; – the right to appoint approximately one third of the directors on the board of the General Partner; – the right to block certain corporate actions and transactions, including changes to senior management; and – the right to veto any transfer of equity interests by the majority owner. Following the deal’s announcement, the trustee for the Notes brought an action in the Delaware Chancery Court asserting that the transaction constituted a “change of control” under the indenture and the company was required to make a repurchase offer for its outstanding notes.6 The court held for the trustee on two separate grounds, each of which rested on an expansive interpretation of what constitutes “beneficial ownership” under Rule 13d-3. First, the court held that Murray’s right to block any transfer of the majority owner’s equity interests provided Murray with the “power to . .

. direct the disposition of” those equity interests. As a result, Murray possessed “shared investment power”, and hence beneficial ownership of the majority owner’s shares under Rule 13d-3, bringing Murray’s beneficial ownership of the General Partner’s voting equity interests to well in excess of 35%. 4 The specified persons included certain equity owners and their related persons at the time the bonds were issued. In addition to acquiring voting and economic interests in the General Partner, in both the original and revised versions of the transaction, Murray would also acquire a mix of common units and subordinated units in Foresight’s direct parent representing not more than 51% of the parent’s limited partnership interests. 5 6 On April 13, 2015, days after the renegotiated deal was announced and noteholders learned that there would be no change of control offer or consent fee, the Notes were trading at around 96% of par (the Notes had been trading at slightly above par in the prior weeks). Over the course of the litigation, the Notes traded down to around 70% of par in mid-November 2015 amid a general decline in bond prices throughout the sector, before climbing to around 85% in late November 2015 after Foresight’s parent restated its third-quarter financials to reflect higher income than previously reported.

Trading prices for the Notes remained relatively stable following the announcement of the Chancery Court’s ruling, with only a slight uptick. Deal Lawyers May-June 2016 2 . Second, and perhaps most importantly, the court held that the parties’ efforts to structure the minority investment in a way that circumvented the change of control provision while simultaneously vesting Murray with practical control of the company violated the anti-evasion provisions of Rule 13d-3(b),7 resulting in Murray being considered the “beneficial owner” of a majority of the General Partner’s voting power. The court pointed to the fact that Murray’s call option could only be exercised upon 61 days’ notice; a clear effort, in the court’s view, to contract around the fact that under Rule 13d-3, the holder of an option to purchase a security is generally deemed to beneficially own the security if the option is exercisable in 60 days or less. The court also pointed to evidence suggesting that the consideration paid by Murray included a control premium. By applying the anti-evasion provision, the court effectively read out of Rule 13d-3 (without providing any justification for doing so) the reference to evasion being for the purpose of evading reporting requirements. Key Considerations for Structuring Minority Investments In the face of challenging conditions in the sub-investment grade debt markets, some private equity sponsors are opting to acquire minority stakes in portfolio companies. A minority investment enables a sponsor to acquire an equity stake in a leveraged portfolio company, without needing to obtain the new debt financing that would be required for a leveraged buyout.

Historically, these minority investments have been coupled with call options and broad governance rights. A key premise of such transactions is that the minority investment will not trigger any change of control provisions in the target company’s existing debt.8 Often the party acquiring a minority stake aims to exercise the call option to buy out the selling party once the debt markets have improved and the company’s existing debt can be refinanced on favorable terms. If transactions are not structured in a manner to address the issues identified in the Foresight case, the decision may encourage debt holders to bring actions asserting that a change of control has occurred, particularly in the case of issuers and borrowers whose debt is trading below par. Even if the debt holders may not ultimately be successful in their claim, the potential damage to the company from bringing an action may give the debt holders sufficient leverage to negotiate a repurchase of some of their debt at a price above where the debt is trading or to exact a significant consent fee. In order to avoid triggering a change of control in a minority investment, it is critical that sponsors carefully consider the structure of minority investments in light of the Foresight decision.

Key considerations include: • Careful Analysis of Change of Control Provisions: Does the indenture or credit agreement define “beneficial ownership” by reference to Rule 13d-3 under the Exchange Act, or Section 13(d) of the Exchange Act? If so, sponsors should be aware that there is a risk that a court may interpret “beneficial ownership” expansively. Following the Foresight decision, efforts to avoid change of control provisions through careful legal structuring may be dismissed by courts under the antievasion rule of Rule 13d-3(b), with the focus turning to whether a de facto change in control has actually occurred. While many commentators consider the Chancery Court’s “anti-evasion” holding in the case aggressive and unlikely to be widely followed by other courts, parties to a minority investment should pay particular attention to the considerations set forth below. 7 Rule 13d-3(b), the “anti-evasion” provision, provides that “any person who uses .

. . any .

. . contract, arrangement, or device with the purpose of effect of divesting such person of beneficial ownership of a security or preventing the vesting of such beneficial ownership as part of a plan or scheme to evade the reporting requirements of section 13(d) or (g) of the [Exchange Act] shall be deemed for purposes of such sections to be the beneficial owner of such security.” 17 CFR § 240.13d-3.

While it is clear that in referring to Rule 13d-3 the parties intended to use the broad definition of beneficial ownership, it is less clear that the reference was intended to also include the anti-evasion provisions, especially given that Foresight was not a registrant under the Exchange Act and, therefore, none of the steps taken by the parties in structuring the minority investment in any way related to a party’s reporting obligations under Section 13(d) or Section 13(g) of the Exchange Act. 8 Under a typical change of control provision in an indenture, the issuer must offer to purchase the outstanding notes at a premium to face value (often 101% of par) upon the occurrence of a change of control. In credit agreements, the occurrence of a change of control typically results in an event of default, entitling the lenders to accelerate the maturity of the loans and to terminate any unfunded commitments. 3 Deal Lawyers May-June 2016 . • Transfer Restrictions: A right by the minority investor to control or limit the majority owner’s ability to sell or transfer its ownership stake may result in the minority investor being considered the “beneficial owner” of the majority’s shares, potentially triggering a change of control. Under the Foresight decision, an absolute right to block the sale or transfer of the majority owner’s shares will generally result in the minority investor being deemed to beneficially own the majority’s stake. The reason is that under Rule 13d-3, the power to control disposition confers investment control and, as a result, beneficial ownership. However, it remains unclear whether other provisions relating to transfers, such as rights of first refusal, would also be considered to confer beneficial ownership. Careful consideration needs to be given to any transfer restrictions. • Call Options: Under Rule 13d-3, the holder of an option to purchase a security that is exercisable within 60 days is deemed to beneficially own the security.

As a result, many market participants, in situations where being deemed a beneficial owner would be undesirable, have structured call options to be exercisable upon 61 days’ notice. The Foresight decision calls into question this bright-line rule, and courts following Foresight may view a 61-day option as part of a scheme to evade the beneficial ownership rules. In addition, under existing case law, an option that can only be exercised upon the fulfillment of conditions outside the option holder’s control does not confer beneficial ownership.9 In Foresight, the parties also included a condition that the call option could not be exercised until the company’s existing debt was refinanced.

While many disagree with the court’s holding, debt holders were successful in claiming that the refinancing condition was merely an effort by the parties to evade the change of control provision. The decision suggests that courts may scrutinize the parties’ motives for incorporating such conditions into a call option in situations where the option might otherwise trigger a change of control. • Governance Rights: Any governance rights granted to the minority investor, including rights to block significant corporate transactions or appoint key members of senior management, should be evaluated carefully. If a court determines that such rights have the effect of conferring “practical control” of the company on a minority investor, the court may conclude that the minority investor beneficially owns the majority of the company’s equity interests for purposes of a change of control provision. • Declaratory Judgment: Parties interpreting change of control provisions in connection with minority investments face a degree of uncertainty as a result of the “anti-evasion” holding in the Foresight case.

Under a typical indenture or credit agreement change of control provision, once a “change of control” is deemed to have occurred, the negative consequences for the company (e.g., the requirement to repurchase the notes at a premium or, in the case of a credit agreement, the right of the lenders to demand immediate payment of the loans) cannot be reversed, even if the minority investor resells its stake to the majority owner. One potential solution to this uncertainty is to obtain a declaratory judgment from a federal or state court before consummating a proposed transaction that the transaction would not constitute a change of control under the relevant indenture or credit agreement. While this process may be costly and could result in delaying a transaction, a declaratory judgment if achieved would enable the parties to determine with certainty in advance whether a transaction will be considered a change of control. Though, actually achieving a declaratory judgment in practice may be difficult. There undoubtedly will be a number of transactions where parties structure minority investments not to confer “practical control” to the minority investor, but instead to provide appropriate governance, approval and other rights consistent with the minority investment.

These rights will be designed to protect the interests of the minority investor as a significant investor in the business, but not as a controlling party. While many disagree with the Chancery Court’s decision in the Foresight case, in today’s distressed debt environment, private equity sponsors and other parties should pay close attention to the decision in structuring minority investments. 9 See, e.g., Transcon Lines v. A.G.

Becker, Inc., 470 F. Supp. 356, 370-371 (S.D.N.Y.

1979). Deal Lawyers May-June 2016 4 .