A wave of corporate breakups has swept through the United States over the last few years as investors have taken notice of the fact that smaller companies focused on a single business tend to outperform their more diversified peers. A primary vehicle for these breakups has been the spin-off transaction, in which a publicly traded parent company distributes the shares of the spin-off company (spinco) to its own shareholders, creating a new, independent publicly traded entity. The New York Times, citing Dealogic, reported that there were 93 spin-off transactions worth $128 billion in 2011, and that 2012 kept pace with 85 spin-off transactions worth $109 billion. The rationale for a spin-off often is to unlock the value in a business or division that is trapped in a larger corporate bureaucracy. Conglomerates tend to spread capital across all of their divisions rather than focusing on the individual opportunities within each business that are the most promising. Holding company structures also can make decision-making more cumbersome and equity incentives less incentivizing for division management who feel as though their hard work is being diluted by the underperformance of other divisions or businesses.
Spin-offs, however, are complicated transactions that require a great deal of advance planning. In many cases, an announcement that a parent company is considering the spin-off of one of its businesses is actually the start of a “dual-track” process wherein the parent company considers and plans for a spin-off while also remaining open to potential bids from third parties to acquire the business. In even more complicated cases, a parent company agrees to sell a business to an acquirer in connection with a spin-off transaction.
The vast majority of spin-off transactions are designed to qualify under the rules of the Internal Revenue Code as “tax free” to the parent company and the shareholders who receive the spinco stock.
With this in mind, any company considering spinning off a division or business should keep in mind the following five potential traps.
1. Tax-Free Qualification – Legitimate Business Purpose
The spin-off must satisfy a legitimate business purpose in order to qualify under both the tax-free rules of the Internal Revenue Code and the Securities Act of 1933. The tax authorities require that the spin-off be motivated in whole or in substantial part by one or more legitimate corporate business purposes in order to ensure that the purpose of the transaction is not simply “tax avoidance.” The business purpose requirement is one of many requirements under the tax laws to qualify for a tax-free spin-off. Because the costs of triggering tax in a spin-off transaction often are very high, most parent companies obtain a legal opinion from outside counsel and obtain a ruling from the Internal Revenue Service as a condition to completing a spin-off transaction. As discussed in relation to trap number five below, a legitimate business purpose for the spin-off also is required under the securities laws in order for the distribution of the spinco stock to not be treated as a “sale” of securities by the parent company or the spinco requiring Securities Act of 1933 registration and the strict liability standard of care that comes with such a registration. See the article entitled, “Five Key Tax Considerations for Spin-Off Transactions” for a more in depth discussion of tax issues raised in spin-offs.
2. Separation of Assets and Liabilities
Before a business or a division can be spun off, both its assets and its liabilities must be separated. Large companies with long operating histories often find that the process of separating out the spinco business is not straightforward, because the legal entities that house the business might also house other businesses and divisions that share assets, services, products, employees, vendors and customers with the spinco business. The pre-spin separation transactions should avoid triggering contractual defaults and remedies under commercial agreements, financing agreements, intellectual property licensing agreements, collective bargaining agreements, employment contracts, benefit plans, etc. Often the spinco and the parent company or another legacy business must enter into complex sharing or licensing agreements or joint ventures relating to valuable intellectual property, such as trade names, trademarks or patents, as well as employee matters. See the article entitled “Trademark, Domain Name and Other IP Considerations for Spin-Offs” for a more in depth discussion of IP issues raised in spin-offs and see the article entitled, “Employee Benefit Issues in a Spin-Off” for a more in depth discussion of employee benefit issues raised in spin-offs.
The sharing of liabilities is often the most complicated endeavour because of the slew of legal obligations that are triggered. In allocating liabilities to the spinco, the parent company must evaluate the impact such allocation will have on the solvency of the parent and the spinco. Parent company directors can face personal liability under state corporate law for making an unlawful dividend because the company lacked sufficient capital to make such a dividend or for rendering the parent company insolvent by distributing out the spinco business, and the parent company itself can face claims of constructive fraudulent conveyance—i.e., the parent company received less than equivalent value, and either the parent or spinco was rendered insolvent (assets do not exceed liabilities), the parent and/or spinco was left with unreasonably small capital to run its respective business, or the parent or spinco was left with debts that exceed its respective ability to pay those debts as they become due. Parent company directors can rely on legal experts and financial advisors to assist them in satisfying their duty of care. A solvency opinion from a nationally recognized provider of such opinions is often a condition to the consummation of a spin-off transaction. Such an opinion may be helpful to the directors of the parent company and spinco for a variety of reasons: (i) it can help to show that the directors properly exercised their duty of care in determining to enter into the spin-off transaction; (ii) it can assist in rebutting a fraudulent conveyance claim; and (iii) it can assist in rebutting a claim that the company had insufficient capital to make such a dividend.
3. Transition Services
While one of the key rationales for spinning off a business or division is to allow the enterprise to operate independently, the reality in most cases is that, at least during the first year or so post-spin, a spinco must rely on its former parent company to provide many key administrative and operational services during the spinco’s transition period to a self-sufficient, independent public company. During the pre-spin planning period, companies should consider, among other things, which transition services will be required, how they will be provided, for how long and under what pricing terms. Typical transition services include legal, internal auditing, logistics, procurement, quality assurance, distribution and marketing. These arrangements often have durations that last between six and 24 months. Many parent companies agree to provide such transition services purely on a cost basis, while others will use a “cost plus” or “market” rate.
4. Spinco Management and Board of Directors
Again, while independence from the former parent company is a key benefit for most spincos, having corporate managers with institutional knowledge and history with the enterprise is an important factor in assisting the spinco to successfully transition to independence. Many spinco management teams include members who have served as executives at the former parent company. In many cases, these are managers who served as division leaders who reported to the parent company CEO or CFO and are now ready to step into executive roles on their own. It is also common for between one and three members of the parent company board to agree to take seats on the spinco board to provide the new public company board with a source of the company’s history and culture to ensure a smooth transition. However, because of the competing fiduciary duties that these directors will face if they hold seats on both the parent and spinco boards, it is important for the spinco board to also have a majority of truly independent directors. Spinco directors who are former executive officers of the parent also must be aware that the stock exchanges and influential shareholder services firms such as Institutional Shareholder Services will not view them as being truly independent from a corporate governance standpoint for some time after the completion of the spin-off. This will inhibit their ability to serve on key board committees of the spinco.
5. Preparation of the Disclosure
Under the U.S. Securities and Exchange Commission’s rules, a spin-off of the shares of a subsidiary to a parent company’s shareholders does not involve the sale of securities by either the parent company or the subsidiary as long as the following conditions are met: (i) the parent company does not provide consideration for the spun-off shares; (ii) the spin-off is pro rata to the parent company shareholders; (iii) the parent company provides adequate information about the spin-off and the subsidiary to its shareholders and to the trading markets; and (iv) the parent has a valid business purpose for the spin-off.
To meet the adequate public information requirement, parent companies are required to prepare and disseminate detailed “information statements” that effectively look like initial public offering registration statements for the spinco. These information statements are filed with the spinco’s Form 10 registration statement, which is required in order to register the spinco’s shares under the Securities Exchange Act of 1934 and to permit listing of such shares on a national securities exchange. The preparation of the spinco information statement can take up to three or four months and requires a great deal of effort and cooperation among the lawyers, the business leaders, the finance department, the human resources/employee benefits department and the auditors. In addition, under New York law, a spin-off of all or substantially all of a company’s assets may require a vote of such company’s shareholders, while under Delaware law, such a requirement is much less likely.