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Commercial Awareness: The Fortnightly Round-Up (w/b 27th February)

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About The Author

Jack Turner (Commercial Awareness Guru)

Jack is a law graduate from the University of Manchester and is currently working for as an analyst for a 'Big 4' accountancy firm. He has an interest in current affairs, business and commercial law, while also being a talented and passionate musician.

This article is part of the 'Commercial Awareness Fortnightly Round-Up' series, edited by Jack Turner.

Every two weeks, Keep Calm Talk Law will bring you an overview of main commercial stories that have occurred. Detailing the main players involved, the interesting and salient facts, and the main points of discussion that arise from each story, this round-up is intended to be vital tool for developing that commercial knowledge and awareness demanded by the country’s top law firms.

Other articles from this series are listed at the end of this article.

Kraft Heinz Walks Away From Unilever Deal

Early last week Kraft Heinz announced that it would be giving up its plans to takeover Unilever. The announcement came just two days after Kraft Heinz made an initial bid of $143bn for the company. The fast moving nature of this story is partly due to the financial press getting wind of this deal earlier than the parties would have liked; such revelations push deadlines as the parties involved seek to agree on terms before the markets, politicians and the public can react.

Kraft Heinz knew it faced an uphill battle in getting this deal through as very quickly UK politicians began to express their concerns. Kraft Heinz is still in the UK governments’ bad books after going back on promises to keep open UK factories and protect UK jobs when it acquired Cadbury in 2011. Politicians were also wary of permitting another UK company to be acquired by an overseas rival following the referendum result. As such, this deal would have been subject to intense scrutiny from politicians and regulators.

Further, Kraft Heinz would have faced a difficult job winning over Unilever shareholders. Payment to Unilever shareholders would have been partly cash and partly shares in the newly merged company. Given that Kraft would have assumed enormous amounts of debt to finance this transaction, the sustainability of these shares and their long-term value would have been questionable. Even at the huge figure of $143bn, the bid undervalued Unilever. This means even greater debt would have been taken on to finance a winning bid.

Ultimately the decision to pull the plug on the deal came from Kraft-Heinz’s two biggest backers – Warren Buffet and Jorge Paulo Lemann (founder of Brazilian private equity group - 3G Capital). Knowing the difficulties and scrutiny this deal would face they decided to avoid a dirty takeover battle that could damage the company’s reputation.

Talking Points

This story is a good illustration of some of the factors that can make a deal fall apart. Political and regulatory obstacles, clear disinterest from the target, and the prospect of assuming potentially unsustainable levels of debt helped bring this deal to its knees. As a commercial advisor, lawyers need to be able to judge a client’s needs against the reality of success and tell them when to walk away. In Kraft Heinz’s case, this was one of those moments.

Although this deal did not reach a point where it was subject to formal investigation by the government, the noise it created amongst politicians suggests that they are becoming increasingly wary of foreign takeovers of UK companies. Indeed, Theresa May made a commitment to a new industrial policy designed to protect UK assets and jobs when she succeeded David Cameron as Prime Minister. This should send a message to overseas bargain hunters seeking to acquire UK companies for a reduced price while the pound remains weak and may make M&A less attractive in Britain in the future.  

Linklaters advised Unilever on the bid, while US firm Paul Weiss advised Kraft Heinz.

Banking Results

Banks dominated the financial press last week as they released their full year results for 2016. There is an overlap between banks and commercial law firms which is especially pronounced during the M&A process where they will work together to help a client finance and structure a transaction. Banks can also take pride of place on a commercial law firm’s client roster. It is therefore of interest for law firms to keep track of banks’ financial performance. Breaking these annual results down and understanding the underlying reasons behind them can help you demonstrate commercial awareness. Last week HSBC, Barclays, and RBS were among those announcing their results.

HSBC

HSBC announced a 62% fall in profits to $7.1bn for 2016. The bank attributes this partly to a $3.2bn impairment of goodwill to its European private bank. Goodwill is an intangible asset taking into account factors that would increase the value of a company e.g. a company’s brand, customer base, and customer relations. An impairment of goodwill therefore simply means a reduction in the value of goodwill. The uncertainty surrounding UK banks operating in Europe following the Brexit vote and the alleged facilitating of tax avoidance by the Swiss private bank are likely causes of this impairment of goodwill.

HSBC also cited a $1.7bn loss from the sale of its operations in Brazil and slow economic growth in Hong Kong and the UK as factors contributing to this fall in profit. This announcement was also coupled with the news that HSBC is a subject of an investigation by the Financial Conduct Authority into money laundering controls.

Talking Points

HSBC’s strategy following the financial crisis has been to sell off its underperforming assets and focus on key markets in the UK and Hong Kong. The annual results for 2016 lay clear the downsides to such a strategy. The $1.7bn loss on the sale of its Brazilian operations is a clear cost of restructuring the bank and disposing of non-core assets. Further, the bank’s focus on markets in Hong Kong and the UK came at a time when China’s economic growth steadied and the UK economy was in a state of uncertainty following the Brexit referendum result.

However, this doesn’t necessarily mean that the strategy is wrong. Costs of restructuring are not unique to HSBC; incurring losses in order to dispose of underperforming assets is a common side effect of restructuring and in the long run, such a strategy can prove to be financially advantageous. Similarly, should China’s economy start to fire on all cylinders again, HSBC will be well positioned to benefit from the increased spending and investment which will need financing and the increased wealth in the region which will need managing.

HSBC’s legal panel includes Allen & Overy, Clifford Chance, Freshfields, Linklaters, Norton Rose Fulbright, and US firms Davis Polk and Wardwell, Cleary Gottlieb Steen & Hamilton, Latham & Watkins and Mayer Brown.

RBS

RBS announced a £7bn loss for 2016. The bank has now reported losses for the ninth consecutive year, taking total losses to around £58bn since 2008 and surpassing the government’s £45.5bn bailout of the bank. Charges and fines from the long list of scandals RBS have been involved in remains a contributing factor to their poor financial performance. The worst is still to come for RBS in this respect; it still needs to settle with US regulators for its role in the financial crisis selling mortgage-backed securities. Analysts predict that a settlement fee could be as high as £15bn.

RBS has also incurred significant restructuring charges in order to shrink its assets and comply with state aid provisions from the government bailout in 2009. These require RBS to offload assets in order to decrease its market share.

Talking Points

Particularly tough interviewers may ask candidates to give their opinions on contentious commercial dilemmas, designed to test their commercial awareness. In order to impress candidates must give an informed opinion and show resilience when their opinion is challenged. A popular dilemma posed by interviewers is: “should the government have bailed out banks following the financial crisis?” RBS’s bailout by the government and its struggle with profit is an example you can use to add substance to an answer and evidence an opinion.

Bailing out RBS cost the government £45.5bn in exchange for an 81% share in the bank. Given RBS’s continual loss making it is clear that, even after eight years, taxpayers are still going to have to wait a long time before they can recoup this cost. So far the bailout has not had the effect of returning RBS to a healthy position. Had the government let the bank go to the wall, this £45.5bn could have been used to prop up public services during a decade plagued by austerity.

However, closing a bank negatively impacts many parties other than the bank itself. Closing a bank freezes credit; the bank can no longer give out loans to fund business or personal activities. This has a wider effect on the economy and can lead to a depression as businesses cannot get the credit they need to make investments or meet liabilities and consumers cannot get the credit they need to purchase goods and services. RBS has such a large presence in the UK and is so important to the flow of capital that the knock-on effect of its closure would have been extremely damaging to the UK economy.

Further, the closure of a bank the size of RBS may have created a fear that other banks will also close. Acting upon this fear, investors and depositors may have started to withdraw their money from other banks. Banks may also have begun to distrust one another and refuse to lend money to one another. This would have further exacerbated the credit freeze.

An important question to ask yourself when forming your opinion on this issues is, has RBS, and the UK banking industry in general, learnt its lesson from the financial crisis? As these annual results illustrate, RBS is still aching from the wounds it inflicted on itself when the banking industry came crashing down in 2008. If RBS is now prepared to take fewer risks and put sustainability and customer interests first then the bailout has not been in vain. However, if the bailout sends a message to the UK banking industry that the government will be there with a blank cheque when things go wrong, encouraging them to be even more reckless and short sighted, then such a measure cannot be defended.

Whatever side of the argument you come down on, using a real example from the business press will allow you to demonstrate commercial awareness and make your opinion more convincing to the interviewer.

RBS’s legal panel includes, amongst others, Allen & Overy, Ashurst, Clifford Chance, Linklaters and Simmons & Simmons.

Barclays

Barclays announced a net profit of £1.6bn for 2016, ending two years of loss making. Barclays attributes this to increased revenues from its investment banking arm and a fall in conduct and litigation charges which have plagued the bank in recent years. Jes Staley, who took over as CEO at the end of 2015, focussed on turning Barclays into a transatlantic bank with a focus on investment banking. This annual result would suggest that Jes Staley’s brave strategy appears to be paying off. 

Talking Points

While these results are encouraging, Barclays’ future might not be as bright as the profits suggest. Like HSBC, Barclays is likely to incur costs from selling off assets as part of its restructuring. The bank is expected to pay a fee of around $1bn as part of a deal to separate from its African subsidiary. Similarly, the bank is yet to settle with US authorities over a claim for mis-selling mortgage-backed securities in the lead-up to the financial crisis in 2008. Deutsche Bank and Credit Suisse settled for $7.2bn and $5.3bn respectively and the US is looking to claim a similar sum from Barclays. A fine of this proportion could significantly impact the banks’ balance sheet.

However, Barclays’ strong position in the US will allow it to offset some of the risks it faces going forward. The election of Donald Trump as US president is likely to produce lower taxes and higher interest rates which will help generate stronger revenues in the US. Similarly, the strong dollar has meant that Barclays’ dollar-based assets have accumulated value.

Barclays’ legal panel includes, amongst others, Clifford Chance, Ashurst, Eversheds Sutherland, Mayer Brown, Reed Smith, Simmons & Simmons, Hogan Lovells, Pinsent Masons, DWF, Bond Dickinson, and US firms Boies, Schiller & Flexner, Cadwalader Wickersham & Taft; Davis Polk & Wardwell, Latham & Watkins and Skadden Arps, Meagher & Flom.

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Insurers Hit by Changes to Personal Injury Claims

The government has revised the formula, known as the discount rate, used to determine how much compensation must be paid to successful personal injury claimants. When awarding compensation, the courts take into account how much interest the money awarded will accumulate when it is invested by the recipient. The more interest it will accumulate, the lower the compensation awarded and vice versa. The discount rate for this purpose was set at 2.5 per cent since 2001. In reality, central bank interest rates have fallen since 2001 (currently set at 0.25%) causing some to argue that the discount rate is too high and assumes recipients are able to generate greater returns than they are actually able to achieve. The discount rate has now been revised to -0.75%.

Insurance companies will be negatively affected by the revision of the discount rate as they will now be expected to pay out higher sums in compensation to claimants. Direct Line said the move would wipe £215m-£230m off its pre-tax profits – its share price dropped by over 7% on Monday after the announcement. Similarly, Aviva believes that it will take a £385m hit to its profits. It is likely that drivers and property owners will assume some of these costs in the form of higher insurance premiums – an increase in the amount of money that an individual or business must pay for an insurance policy.

Talking Points

The reduction in the discount rate will be welcome news to victims of personal injury, especially those suffering from long-term debilitating injuries who rely on the compensation they receive to support themselves while they are unable to work or need to make adjustments to their lifestyle. Similarly, personal injury lawyers will welcome this decision as they will be able secure higher rates of compensation for their clients.

On the other hand law firms with a focus on insurance will be concerned with how this decision will negatively affect their clients operating in the insurance industry. As this decision will cut profits for motor insurance companies it will also reduce the amount of capital that these companies have to make investments and fund M&A activity. This may have a knock-on effect for law firms as they can play a role in advising insurance companies on M&A and can generate significant revenue from fees.

EU legislation currently requires insurance companies to hold a minimum amount of capital in order to deal with unexpected losses. If the reduction in discount rates affect capital levels so greatly that insurance companies are unable to meet these minimum requirements then law firms could see an increase in work as they assist insurance companies in capital raising deals. However, it is unlikely that the change to the discount rate will require capital increases as costs will be transferred to customers in the form of higher premiums. Further, insurance companies tend to be well diversified by geography and business line and will be able to offset weaker performance in the personal injury market with strength in other areas.  

Law firms with a notable insurance practice include DWF, Clyde & Co, Kennedys, and RPC.

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Tagged: Banking & Finance, Brexit, Commercial Awareness, Commercial Law, Legal Business, Legal Careers, Personal Injury, Regulators

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