Canon/Toshiba: the death of the Two-Step?

The European Commission has published the full text of its decision to impose a €28 million fine (actually two €14 million fines) on Canon for breaching the standstill and notification obligations under EU merger control rules. The EC found that Canon partially implemented the transaction to acquire Toshiba’s medical equipment business (TMSC) before obtaining EC clearance. The decision has been eagerly awaited by practitioners for insights on the elements of the transaction structure used, which were considered objectionable, in particular as concerns two-step deals and pre-payment of consideration.

Quick recap

Canon’s acquisition of TMSC involved an aggressive warehousing structure. The parties’ internal documents showed this was specifically devised in order to address Toshiba’s financial difficulties and its consequent desire to avoid reporting negative shareholder equity before its financial year end. As part of a number of actions to address its financial issues, Toshiba invited outside majority shareholders into its medical equipment subsidiary, TMSC, in exchange for cash. The desire to obtain cash swiftly meant that it was unlikely all necessary competition clearances (EU, U.S., Japan and China) could be obtained in time.

We have previously covered the details of the case. But to recap, the structure involved the following:

  • Step 1: An SPV created by three individuals paid Toshiba €800 for 20 Class-A shares (representing 95% of the shares) of TMSC. Canon paid Toshiba €5.28 billion for one Class-B share (representing 5% of the shares) of TMSC plus 100 share options to acquire the SPV’s stake. This step took effect when the three parties signed the transaction agreements and before any antitrust clearances had been obtained. In effect, Canon paid Toshiba the full purchase price prior to obtaining control via a majority voting stake.
  • Step 2: Canon acquired full ownership of TMSC by converting the 100 share options into shares. This step took effect after EU and other suspensory antitrust clearances were obtained.

Although the decision spans some 51 pages, the crux of the EC’s reasoning is that:

  • The relevant law governing the standstill obligation is set out in the European Court of Justice’s judgment in Ernst & Young. Namely, in order to determine if there has been early implementation, transactions carried out in the context of a concentration must be “necessary to achieve a change of control” over the target. This will be the case if they “present a direct functional link with the implementation of the concentration”.
  • This includes partial and not just full implementation - i.e. the acquisition of control. It is contrary to Editions Odile Jacob (also a warehousing arrangement) where the same Court stated that “a violation of the standstill obligation is excluded if the acts in question have not yet led to a transfer of control”.
  • In Canon, the transfer of voting shares to the SPV and the final acquisition of control by Canon were together a single concentration because they were inherently connected (a direct functional link). Step 1 contributed, at least in part, to the change of control of TMSC within the meaning of Ernst & Young. In the EC’s view, this was shown by the following factors:
  • The parties’ internal documents showed, amongst other things, that the structure was deliberately designed to avoid merger control and as a result “could attract attention”. And that the transfer of voting shares to Canon was “reasonably expected to be completed with certainty”.
  • From Step 1, Canon “inevitably acquired the possibility of exercising decisive influence over TMSC’s future”. From that point it had the “sole power” to determine the identity of TMSC’s ultimate acquirer (whether it was Canon itself or a third party) as a result of veto rights which prevented the SPV owners from obtaining a majority in TMSC.
  • Finally, and crucially, that Canon bore the economic risks in TMSC from the start by paying the full purchase price when it bought share options.
No more dancing the Two-Step?

If there was any remaining doubt, it is clear as a result of Canon that warehouse arrangements will be treated with hostility by the EC. The EC emphasised that Union Courts in Editions Odile had not opined on the legality of warehousing structures. And since 2007, para 35 of the EC’s Consolidated Jurisdictional Notice (CJN) has made clear the EC’s attitude to warehousing structures is to consider an acquisition by an interim warehouser to be part of an overarching single concentration (unless it is a bank qualifying for the narrow exception). This means that if Step 1 is done prior to clearance, it will breach the notification and suspension obligations.

However, Canon does not mean, as some have interpreted it to, the death of two-step structures (specifically, the purchase of a minority stake with an option to acquire a majority). The EC makes this plain at paragraphs 139-141. Provided the option is not certain to be exercised, and the full value of the majority stake is not paid for when the option rights are acquired, then options will continue to be treated as relevant to control only when exercised and not when the right is acquired. This is consistent with para 60 CJN and previous case law, for example, Air France v Commission.

Other notable features

The reasons for the EC’s decision reveal some interesting new facts.

First, Toshiba had proposed that bidders for TMSC implement a less aggressive structure. Ironically, this stood a better chance of being compatible with EU merger rules than the structure proposed and ultimately implemented by Canon.

Secondly, shortly after the transaction was announced, the EC received an anonymous complaint that the parties had breached the EU suspension and notification obligations. It seems likely that the complainant was an unsuccessful bidder in the auction for TMSC. The complainant, coupled with the fact authorities in China, Japan and the U.S. had already concluded gun jumping proceedings, gave the EC little choice but to levy fines (although they were low, representing only 0.5% of turnover).

Finally, despite Toshiba benefiting from the structure, Canon was the only party fined for it. Although in practice both buyer and seller “implement” a concentration, the only party responsible for notifying it is the acquirer (and no seller has to our knowledge been fined for breaching the standstill obligation). The EC pointed out that given Toshiba’s financial difficulties, Canon could have approached the EC for a derogation from the standstill obligation but did not do so. A true case of buyer beware.