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Spin-offs
Going-Private Transactions
Sales of Divisions
M&A activity in 2000 and through the first six months of 2001 continued to yield a significant number of transactions involving spin-offs, sales of divisions and going-private transactions. There were 116 tax-free spin-offs to shareholders announced by public companies in the 18 months ended June 30 2001 and 78 going-private transactions during the same period.(1) Divestitures - defined as sales of subsidiaries, minority interests or divisions - accounted for 2,501 transactions or 26% of all M&A activity in 2000.(2) Each type of transaction raises issues under the federal securities laws which affect how these transactions are structured, negotiated and reported. This update summarizes the principal elements of these transactions, with special attention to relevant issues under the federal securities laws.
Spin-offs
Types of spin-off
In its conventional form, a spin-off involves a company's pro rata distribution of the stock of an existing or newly created subsidiary to shareholders in the form of a special dividend. Alternative spin-off structures include:
• a subsidiary initial public offering (IPO) followed by a conventional spin-off;
•a 100% subsidiary IPO; and
•an exchange offer in which parent stockholders exchange parent shares for stock of a subsidiary - sometimes referred to as a 'split-off' or 'split-up'.
During the 1990s and continuing today, several companies began issuing targeted or 'tracking' stock, which results in an economic, rather than a legal, separation of the company into separate units.
Securities law issues
Staff Legal Bulletin 4
In September 1997 the Securities Exchange Commission's (SEC) Division of Corporate Finance released a staff legal bulletin setting forth the factors the division would consider to determine whether a subsidiary being spun off by its parent company would be required to register the spin-off under the Securities Act 1933, as amended.(3) The division stated that it would not require registration in cases where:
•the parent shareholders do not provide consideration for the spun-off shares;
•the spin-off is pro rata to the parent shareholders;
•the parent provides adequate information about the spin-off and the subsidiary to its shareholders and to the trading markets;
•the parent has a valid business purpose for the spin-off; and
•if the parent spins off 'restricted securities', it has held those securities for at least two years.
The division explained that the first two factors help satisfy the requirement that the spin-off not involve a 'sale' of the securities by the parent, by ensuring that shareholders do not give up value for the spun-off shares. To satisfy the third factor, the subsidiary, if not already a reporting company under the Securities Exchange Act 1934, as amended, is required to file with the SEC on a Form 10 and provide to the shareholders an information statement, which contains essentially the same disclosure as required for a registration statement on Form S-1 under the 1933 act.(4) The fourth factor - the need for a valid business purpose - also addresses the issue of whether the parent company receives value for the spun-off shares. Examples of a valid business purpose are:
• allowing management of each business to focus solely on that business;
•providing employees of each business stock-based incentives linked solely to his or her employer;
•enhancing access to financing by allowing the financial community to focus separately on each business; and
•enabling the companies to do business with each other's competitors.
For the division, the fifth factor ensures that the parent will not be deemed an underwriter engaged in a public distribution of 'restricted securities'. The two-year holding period does not apply where the parent formed the subsidiary being spun off.
Staff Bulletin 4 also confirms that the division will not require 1933 act registration simply because the parent company asks its shareholders to vote on the proposed spin-off. As long as there is a valid business purpose for the spin-off, the division declared that a vote on the asset transfer that may be involved in the spin-off does not change the overall nature of the transaction.
Form 10 registration statement
Form 10 is used to register the spun-off securities under the 1934 act. Much like an S-1 prospectus, the information statement included in the Form 10 describes the spun-off company's business, properties and management, and includes information on:
• executive compensation;
• employee benefit plans;
• financial data;
• management's discussion and analysis of results of operations;
• and financial condition and historical and pro forma financial statements.
SEC review of a Form 10 registration statement is substantially similar to that for an S-1.
Recent no-action letters in spin-offs
In Staff Bulletin 4 the division stated that it would no longer respond to no-action letter requests related to the matters addressed in the bulletin in the absence of novel or unusual factors and, consistent with that position, the division has issued few no-action letters on spin-offs since the release of the bulletin. The division's more noteworthy responses to no-action letter requests related to spin-offs are summarized below.
Liberty Media Group, February 7 2001. In connection with its acquisition of Tele-Communications, Inc in 1999, AT&T had created two classes of tracking stock for its Liberty Media Group, a group of businesses providing a variety of video entertainment, information and home shopping programming services. The tracking stock was registered under the 1934 act and listed on the New York Stock Exchange. The combined financial statements of the Liberty Media Group were separately reported in AT&T's annual and quarterly 1934 act reports, and AT&T's annual Form 10-K contained a detailed description of the business of the Liberty Media Group. AT&T had established corporate governance and operating structures providing a substantial degree of managerial and operational autonomy for the Liberty Media Group to ensure that the holders of the Liberty tracking stock benefited from the economic performance of transactions involving the Liberty group's assets.
In 2000 AT&T decided to split off Liberty pursuant to an exchange of all outstanding Liberty group tracking stock for an equal number of shares of a corresponding series of new common stock of Liberty Media Corporation, the parent company of the Liberty Media Group. The proposed split-off by means of a stock exchange was contemplated by certain optional redemption provisions in the AT&T charter applicable to the tracking stock. A stockholder vote was not required for the redemption. In a letter to the SEC dated December 20 2000, AT&T sought confirmation from the SEC that the split-off could occur without registration of the new Liberty common stock and that such stock would not be deemed to be 'restricted securities' under Rule 144. In its letter AT&T acknowledged that the proposed exchange was not a conventional spin-off of the type contemplated by Staff Bulletin 4. AT&T contended, however, that the split-off satisfied each of the factors set forth in the bulletin for a permitted spin-off.
The SEC disagreed. Without articulating its rationale, the SEC replied that it was unable to provide the no-action relief requested, and that "this will be the division's position going forward in similar situations involving the redemption of 'tracking stock' of a parent company in exchange for shares of a subsidiary".(5) An explanation for the SEC's position may be related to the question of whether any AT&T shareholders were giving up value in connection with the transaction, and the fact that the distribution would not be pro rata to all AT&T shareholders, but only pro rata to the holders of the Liberty tracking stock. As a legal matter, holders of ordinary AT&T common stock could be deemed to have given up potential value in an extreme scenario, such as a bankruptcy of AT&T. The giving up of value by such shareholders would imply an offsetting exchange of value by the holders of the Liberty tracking stock, and it is possible that the SEC's perception of an exchange of value, as well as the non-pro rata element of the distribution, caused it to deny the relief requested. In light of the SEC's response, AT&T filed a registration statement for Liberty on February 21 2001 and closed the split-off four months later.
TB&C Bancshares, Inc, July 25 2001. TB&C Bancshares, Inc was a vehicle for holding shares in Synovus Financial Corp, a 1934 act reporting company. In a proposed reorganization and liquidation of TB&C, shares of Synovus common stock held by TB&C would be exchanged for an equal number of new shares of Synovus, which would then immediately be distributed in a liquidating distribution to the shareholders of TB&C. Particularly in light of the position the SEC had taken in relation to the Liberty Media Group, both TB&C and Synovus sought confirmation from the SEC that the share exchange followed by the distribution could be effected without registration under the 1933 act and without the distribution to TB&C shareholders of any disclosure document other than a brief summary of the transaction. As a basis for the latter request, counsel analogized the distribution to a spin-off by a parent of shares of a 1934 act reporting subsidiary and the limited information requirements permitted by Staff Bulletin 4.
To distinguish the Liberty Media Group share exchange, counsel emphasized that, whereas Liberty involved a new security and a new issuer, the proposed exchange/liquidation by TB&C involved principally a conversion of an indirect beneficial ownership into a direct beneficial ownership. In its response, the SEC issued the requested no-action relief.(6)
Digital Commerce Corporation, June 21 2000. Digital Commerce Corporation sought to spin off its wholly owned subsidiary, Power Trust.com, Inc, by dividending 100% of the Power Trust shares to its shareholders. Neither company was a reporting company under the 1934 act, although an IPO of Digital Commerce was expected to close shortly after completion of the spin-off. After contending that the spin-off would satisfy the five-factor test in Bulletin 4 for spin-offs generally, counsel contended that the spin-off would also satisfy the additional requirements that Bulletin 4 established for spin-offs of a non-reporting subsidiary by a non-reporting parent - that is, that:
•the parent stockholders receive an information statement that describes the spin-off and the subsidiary that substantially complies with Regulation 14A or Regulation 14C;
•the holders of the spun-off securities can only transfer the securities in specific, limited situations;
•the information statement advises the security holders concerning the transfer limits;
•the spun-off securities contain information on them that describes the transfer limits; and
•the spun-off subsidiary's stock transfer books include stop transfer instructions that indicate the transfer limits.
Noting that the transfer restrictions on the Power Trust Shares would remain in place to ensure that a public market did not develop in the Power Trust shares prior to their registration under Section 12 of the 1934 act, the SEC issued the requested relief.(7)
Other no-act letters regarding spin-offs. Other no-action letters issued by the SEC in relation to spin-offs or analogous transactions include:
• requests concerning demerger transactions by a foreign issuer (Sanpaolo IMI SpA, available October 28 1999, and Sears plc, available June 19 1988);
•distributions by a liquidating trust (JMB Income Properties, Ltd-Xiii, available May 13 1999); and
•other forms of spin-offs by foreign issuers (Instituto Nazionale delle Assicurazioni SpA, available October 27 1998).
Advantages/disadvantages of spin-offs
Advantages
There are a number of reasons why a parent company may wish to spin off a subsidiary. In recent years, unlocking the value in a line of business that may trade at a higher price-to-earnings ratio than the parent company has often been cited both as an impetus for a spin-off and as the rationale for the establishment of a tracking stock. Other objectives include:
• freeing the parent company to focus on its core business;
•facilitating a more direct incentive structure for management compensation;
• obtaining better access to debt and equity capital markets for both parent and subsidiary; and
•separating from the parent the regulatory burdens that may affect the spun-off subsidiary, or vice versa.
The ability to use the common stock of the spun-off subsidiary to pursue strategic acquisitions to develop the spun-off business has also been a primary objective of many spin-offs. However, as a result of recent changes to the tax rules applicable to spin-offs, including the issuance of Treasury regulations under the so-called 'anti-Morris Trust' rules, business purposes that involve the issuance of equity by the parent or the spun-off subsidiary may become less favoured.
Disadvantages
There are also disadvantages attendant to a spin-off. Spin-offs can involve significant transaction costs, and the parent company receives no proceeds from the distribution of shares. The market may view a spin-off as the shedding of an unwanted or sub-par asset by the parent company. There is also the possibility that the spun-off subsidiary will not remain viable as a stand-alone business, which is a risk that has been realized by a number of parent companies that effected partial spin-offs of internet businesses in the late 1990s by means of a subsidiary IPO, only to find themselves buying back the subsidiary a year or two later as the market for such stocks - and the stand-alone financing for such businesses - collapsed. In addition, following the enactment of the anti-Morris Trust rules, a spin-off will generally limit the flexibility of the parent and the spun-off subsidiary to engage in certain change of control transactions or other significant equity issuances during the two-year period following the spin-off.
Structuring considerations
Separation issues
Unless the spun-off business has been operating autonomously on both an operating and financing basis, a spin-off will raise a series of separation issues, including:
•the allocation of assets and liabilities, including contingent liabilities and debt between the parent and the subsidiary;
•transitional arrangements between the two entities covering general administrative services and information systems;
•management of the two businesses and the division of employees, and the treatment of employee benefit plans and stock options;
•putting on an arm's length basis formal or informal arrangements for the purchase of goods or services, if applicable;
•establishing inter-company licensing arrangements for shared technology and trademarks; and
•the allocation of tax liabilities and tax benefits.
Addressing these issues in a workable manner requires the same kind of due diligence investigation and issue-spotting required for an IPO or a divestiture of a division to a third party. Particularly because the spun-off business will be subject to the disclosure and ongoing reporting requirements of the 1934 act, and will require audited financial statements on a stand-alone business, the parent company will want to ensure that all separation issues are thoroughly settled in the spin-off process.
Debt-holder issues
A significant due diligence issue is whether the spin-off will violate the terms of the indentures or credit agreements governing the debt of either the parent company or the subsidiary. Many indentures and credit agreements restrict the amount of dividends or distributions to shareholders, or the disposition of 'all or substantially all' or significant portions of a company's assets. These types of covenants may restrict a company's ability to effect a spin-off without the debt-holders' consent. Other debt-holder issues include the effect of the spin-off on each company's ability to access the credit markets and obtain funds on reasonable terms, and the response of rating agencies to the spin-off. In allocating outstanding debt between the parent and the subsidiary, the parent will typically consult with the rating agencies as part of its evaluation of the appropriate capital structure for each entity.
Tax issues
Unlike most distributions by corporations, spin-offs can often be completed on a tax-free basis for federal income tax purposes under Section 355 of the Internal Revenue Code.(8) To qualify as tax free under Section 355, a spin-off must satisfy a number of technical requirements. Although a complete discussion is beyond the scope of this update, the principal requirements are summarized below:
•The parent and the spun-off company each must be engaged in an active trade or business, and must have been so engaged during the entire five-year period prior to the spin-off. Pursuant to the IRS's ruling guidelines, a company that is directly engaged in an active trade or business will qualify if the active trade or business constitutes 5% or more of the fair market value of the company's gross assets. A company that is not directly engaged in an active trade or business, such as a holding company, may also qualify, but only if substantially all of its assets (90% of the fair market value of the company's gross assets under the IRS ruling guidelines) consist of stock and securities of one or more corporations that are engaged in an active trade or business.
•In the spin-off, the parent must distribute stock of the spun-off company that constitutes 'control' of the spun-off company; that is, at least 80% of the spun-off company's voting stock and 80% of each other class of stock. In addition, except in certain limited circumstances, the parent may not retain any interest in the spun-off company after the spin-off.
•The spin-off must be undertaken for a non-tax 'corporate business purpose'. Benefiting shareholders is not considered a corporate business purpose. To avoid uncertainty, companies that engage in spin-offs typically invoke a corporate business purpose that the IRS has accepted in its ruling guidelines. These corporate business purposes include: (i) enhancing the value of the two businesses by separating them and thereby enabling each company to resolve management and other systemic problems attributable to operating the businesses as a combined unit ('fit and focus'); (ii) achieving significant cost savings; (iii) improving access to credit or equity markets; (iv) compensating key employees with equity of the spun-off company; and (v) using shares of the spun-off company as acquisition currency.
•The spin-off cannot be principally a 'device' to distribute earnings tax free to the shareholders of the parent. For example, pre-negotiated post spin-off sales of large blocks of parent or the spun-off company stock and taxable acquisitions of either company soon after a spin-off could cause the spin-off to be taxable. A strong business purpose for the spin-off is evidence that the spin-off is not principally a device to distribute earnings.
•There must be continuity of interest at the shareholder level, which requires that shareholders of the parent maintain ownership of the stock of both the parent and the spun-off company after the spin-off (50% or more of the stock of each company, under the IRS's ruling guidelines).
Since many of the spin-off rules are somewhat subjective and are largely governed by Internal Revenue Service (IRS) ruling practice, it may be advisable to apply for an IRS private-letter ruling confirming that a proposed spin-off qualifies under Section 355.
In addition, recent changes to Section 355 have significantly restricted a parent company's ability to effect a tax-free spin-off prior to or following acquisitions of 50% or more of the stock of the parent or the spun-off company. Prior to 1997, if an acquiring company wanted to acquire one or more of a target's businesses on a tax-free basis, but also wanted to leave one or more businesses behind, the acquisition could often be effected by first having the target spin off the unwanted business on a tax-free basis; thereafter, the acquiring company would acquire the target (without the unwanted business) in exchange for acquiring company stock in a tax-free reorganization. This type of transaction was known as a Morris Trust transaction, after the Tax Court case that first approved the technique.
In 1997, following a series of highly-publicized Morris Trust-type transactions that were perceived as abusive, Congress enacted Section 355(e) - the so-called 'anti-Morris Trust' rules - which provides that, if a spin-off is part of a plan pursuant to which one or more persons acquires 'control' of either the parent or the spun-off company, the spin-off will be treated as taxable to the parent company, but not the shareholders. For this purpose, 'control' means stock comprising 50% or more of the vote or value of the relevant company. Section 355(e) provides that a plan will be presumed to exist if a change of control of parent or the spun-off corporation occurs at any time during the two years prior to, or the two years following, the spin-off.
Treasury regulations issued in 2001 provide additional guidance on when a spin-off and an acquisition of control are considered to be part of a plan for purposes of the anti-Morris Trust rules. The regulations list a number of facts and circumstances that must be weighed in determining whether the acquisition is part of the plan. In the case of an acquisition following a spin-off, these factors include:
•whether the spin-off was motivated by a business purpose to facilitate the acquisition or a similar acquisition of parent or the spun-off company;
•whether the parent or the spun-off company discussed the acquisition or a similar acquisition (including discussions with a different buyer) prior to the spin-off; and
•in the case of an acquisition involving a public offering, whether the parent or the spun-off company discussed the acquisition with an investment banker or other outside adviser before the spin-off.
The Treasury regulations also provide for several safe harbours which, if satisfied, prevent a spin-off and an acquisition from being considered as part of a plan within the meaning of the anti-Morris Trust rules. For example, a safe harbour applies if the acquisition of control occurs more than six months after the spin-off and there was no agreement, understanding, arrangement or substantial negotiations concerning the acquisition prior to the spin-off, but only if the spin-off was motivated in whole or substantial part by a business purpose other than to facilitate an acquisition of the parent or the spun-off company. Only one safe harbour is available if the business purpose of a spin-off is to facilitate an acquisition. To satisfy the acquisition safe harbour, (i) there must be no agreement, understanding, arrangement or substantial negotiations concerning the acquisition of control prior to the spin-off, and (ii) the acquisition that constitutes the business purpose for the spin-off must be limited to 33% of the stock of the parent or the spun-off company, and no more than 20% must be acquired (or be subject to an agreement, understanding, arrangements or substantial negotiations) during the six-month period following the spin-off.
The anti-Morris Trust Treasury regulations provide guidance on the rather obscure language of Section 355(e). In particular, the first safe harbour described above allows a parent company to avoid the application of Section 355(e), in the case of a spin-off with a non-acquisition business purpose, by enforcing a six-month post spin-off 'cooling off' period. As a result, business purposes that involve issuance of equity by the parent or the spun-off subsidiary may become less desirable, particularly since the business purpose safe harbour is limited in its application.
In addition to the anti-Morris Trust rules, under Section 355(d) a spin-off will be treated as taxable to the parent company, but not the shareholders, if as a result of the spin-off either: (i) a person holds 'disqualified stock' in the parent that constitutes control of the parent, or (ii) a person holds 'disqualified stock' in the spun-off company that constitutes control of the spun-off company. For this purpose, 'disqualified stock' generally means stock that is acquired in a taxable transaction during the five-year period prior to the spin-off. For example, if a person or entity acquired 60% of the shares of parent in a taxable transaction four years prior to a pro rata spin-off that otherwise satisfied the requirements of Section 355, the spin-off would be taxable to the parent, but tax-free to the shareholders.
State law considerations
The business judgment rule
The decision by a parent company's board of directors to authorize a spin-off will ordinarily be subject to the traditional business judgment rule. As in the case of any significant board decision, directors should inform themselves adequately and act as reasonably prudent persons in similar situations would act. Courts have held that a spin-off does not give rise to special fiduciary duties by the parent company to the shareholders of the company to be spun off, and that the parent company is under no obligation to provide the subsidiary with independent representation during the spin-off process.(9)
Unlawful dividends
A traditional spin-off involves the declaration and payment of a dividend. Under most state corporation statutes, directors who approve an unlawful dividend are personally liable to the company's shareholders or creditors for the full amount of the dividend. In Delaware, for example, directors who wilfully or negligently approve an unlawful dividend will, at any time within six years of payment of the dividend, be jointly and severally liable for the full amount of the dividend to the company and, in the event of the dissolution or insolvency of the company, to its creditors. Although Delaware law permits a company to adopt a charter provision limiting the personal liability of directors for monetary damages, such a provision cannot exempt directors from liability for an unlawful dividend. Directors are protected, however, if they reasonably rely in good faith on the opinions of experts as to, among other things, the amount of surplus from which dividends may be paid.
Delaware law provides that a company may pay dividends either out of its 'surplus' (the amount by which total assets exceed total liabilities, plus stated capital) or out of its net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year. Most other states apply similar rules. In determining the company's ability to pay a dividend, directors may rely on financial statements, a fair valuation, or other methods that are reasonable under the circumstances and based on acceptable data.
Fraudulent conveyance
Federal bankruptcy law and most state fraudulent conveyance laws provide that creditors or a bankruptcy trustee may set aside transfers for less than 'reasonably equivalent value' if:
•the company was insolvent at the time of, or was tendered insolvent by, the transfer;
•the company was left with an unreasonably small amount of capital to conduct its business; or
•the company intended or believed that it would incur debts beyond its ability to pay as they matured.
As a general matter, to comply with fraudulent conveyance laws the transfer must be for a reasonable price, or both the transferor and the transferee must be solvent and independently viable entities after giving effect to the transfer.
Fraudulent conveyance issues arise in spin-offs because dividends are not transfers for 'reasonably equivalent value'. When a financially weak parent company spins off a healthy business, the parent's creditors may claim that the parent was left insolvent. Even where a financially strong parent spins off a financially weak subsidiary, however, the subsidiary's creditors may attempt to bring fraudulent conveyance claims if a restructuring or an allocation of liabilities effected in connection with the spin-off further weakens the subsidiary.
Shareholder approval
Shareholder approval is not required for most spin-offs. Section 271 of the Delaware General Corporation Law requires shareholder approval only for a sale, lease or exchange of all or substantially all of a company's assets. The relevant cases suggest that a spin-off is not a sale, lease or exchange. Further, in the majority of spin-offs the assets being spun off will not represent 'all or substantially all' of the company's assets. Delaware courts have interpreted the phrase 'all or substantially all' to mean at least 70% of the company's assets, income and revenues (although in one case a Delaware court held that a sale of a division accounting for 51% of the company's assets, and 45% of the net sales, of a parent company would be a sale of 'substantially all' of its assets). A transaction involving a major reshuffling of the company's subsidiaries or assets, followed by the spin-off of substantially all of the company's assets, may require shareholder approval under Delaware law. Some other states, such as New York, require shareholder approval for a sale, lease, exchange or other disposition of all or substantially all assets. In these states shareholders must approve a spin-off involving substantially all of a company's assets.(10)
Going-Private Transactions
Types of transaction
In a going-private transaction an affiliate of a publicly held company proposes to take the company private by buying out the public's stockholdings. The acquisition by an affiliated buyer imposes certain additional disclosure requirements under Rule 13e-3 of the 1934 act, and requires that the target and the affiliated buyer (and possibly its affiliates) file a Schedule 13E-3. The Schedule 13E-3 calls for information regarding:
• the parties to the transaction;
• the transaction history;
•the terms of the transaction;
• the post-transaction plans of the parties;
•the source of funds for the transaction; and
•the fairness of the transaction to the unaffiliated public shareholders.
Rule 13e-3(a)(3) sets forth a two-part test for defining a Rule 13e-3 transaction. If a transaction described in the first part of the test has one of the effects described in the second part of the test, the transaction will be deemed a Rule 13e-3 transaction. The first part of the test includes:
• purchases of, and tender offers for, any equity securities by the issuer or an affiliate of the issuer;
•solicitations of proxies or consents subject to the proxy rules by the issuer or an affiliate in connection with a merger; or
•similar corporate transactions between an issuer and its affiliate, or the sale of substantially all the assets of an issuer to its affiliate.
The second part of the test requires that the transaction or series of transactions have either a reasonable likelihood or the purpose of directly or indirectly causing: (i) any class of equity securities of an issuer subject to the 1934 act to be held of record by less than 300 persons; or (ii) any class of equity securities of an issuer which is either listed on a national securities exchange or authorized to be quoted in an inter-dealer quotation system to be neither so listed nor so quoted.(11)
The issue of affiliate status may cause several different types of transaction to be characterized as 13e-3 going-private transactions, including:
•an acquisition by a large or controlling shareholder of the public shares;
•an acquisition by an otherwise unaffiliated third party of the minority public shares if a large or controlling shareholder retains all or a substantial portion of its stockholdings after the transaction; or
•a leveraged buyout by an otherwise unaffiliated private equity firm if management of the target is to receive or roll over a significant block of equity, particularly if management is represented on the target board prior to the transaction.
Securities law issues
Scope of disclosure
There is nothing private about going private. Schedule 13E-3 and Regulation M-A, which contain the SEC's disclosure requirements for a going-private transaction, call for much more disclosure than would be required for a tender offer or merger with an unaffiliated third party.
For example, in a going-private transaction disclosure must be made as to:
•all expenses incurred in connection with the transaction;
•the purpose of the transaction;
•what alternatives were considered and why they were rejected;
•the reasons for the structure of the transaction;
•why the transaction is being undertaken at this time;
•why the issuer or affiliate believes the transaction is fair;
•firm offers made by any third party for the company during the past 18 months;
•whether the transaction is structured so that approval of at least a majority of the public shares is required;
•any reports, opinions or appraisals relating to the consideration to be received or the fairness of that consideration (similar information is called for in third-party merger proxy statements); and
•extensive financial information (including two years of audited financial statements and the most recent quarterly interim financial statements of the company, and the pro forma effect of the transaction on the company).
The SEC requires strict compliance with the disclosure requirements for a going-private transaction, particularly with respect to the item calling for reports, opinions or appraisals relating to the consideration to be received in the transaction. In this regard, the financial advisers to both the committee and the buyer (and affiliates of the buyer engaged in the transaction) will need to be cautious in preparing even preliminary 'board or blue' books, since they may need to be filed with the SEC. In addition, under Rule 13e-3 an issuer or affiliate engaging in a Rule 13e-3 transaction is required to disclose whether the company or its affiliate has received any "report, opinion (other than an opinion of counsel) or appraisal from an outside party which is materially related to the Rule 13e-3 transaction".(12) The statement must also contain a summary of the report, opinion or appraisal (including the findings and the bases for and methods of arriving at the conclusions contained therein), and a copy of the report, opinion or appraisal must be filed as an exhibit to the Schedule 13E-3.(13)
Even draft reports may be required to be disclosed. The company, the committee or the buyer may well take the position that a draft is not a 'report or opinion', and that only the final board or blue book - the one considered by the committee and the board in approving the going-private transaction or by the buyer in deciding whether to go forward with the transaction - is covered by the rule. But the SEC, in its comments on the Schedule 13E-3, is likely to request to be provided on a supplemental basis with all drafts of the analyses that were furnished to the committee or the board, and may request inclusion in the text of the merger proxy statement or the tender offer of a description of any material differences between earlier drafts and the final book.(14)
Determining 'filing person' status
An issue that often arises in connection with a Rule 13e-3 transaction is what persons or entities are required to file a Schedule 13E-3 and make the required disclosures, particularly the statement of 'reasonable belief' as to the fairness or unfairness of the proposed transaction. Many buyers, including private equity sponsors and any other buyer who commences a transaction without any 'affiliation' with the target, are surprised to discover that they may be required to file a Schedule 13E-3. The SEC has taken an expansive view of the filing person test, which has somewhat incongruous results. On the one hand, target management, who have played little or no role in the pricing, structuring and negotiation of the transaction, may be required to satisfy the Schedule 13E-3 disclosure requirements, and on the other hand, a third-party buyer, who would not be in a position to satisfy the control requirement of the definition of 'affiliate',(15) may also be required to file a Schedule 13E-3 and state why it believes its buyout proposal is fair to the public shareholders.
The SEC has clarified some of these issues in its outline of Current Issues and Rulemaking Projects:
"First, the [SEC] has consistently taken the position that members of senior management of the issuer that is going private are affiliates of that issuer. Depending on the particular facts and circumstances of the transaction, such management might also be deemed to be engaged in the transaction. As a result, such management-affiliate may incur a Schedule 13E-3 filing obligation separate from that of the issuer. For example, the SEC has taken the position that members of senior management of an issuer that will be going private are required to file a Schedule 13E-3 where the transaction will be effected through merger of the issuer into the purchaser or that purchaser's acquisition subsidiary, even though (i) such management's involvement in the issuer's negotiations with the purchaser is limited to the terms of each manager's future employment with and/or equity participation in the surviving company; and (ii) the issuer's board of directors appointed a special committee of outside directors to negotiate all other terms of the transaction except the management's role in the surviving entity.
An important aspect of the SEC's analysis was the fact that the issuer's management would ultimately hold a material amount of the surviving company's outstanding equity securities, occupy seats on the board of this company in addition to senior management positions, and otherwise be in a position to 'control' the surviving company within the meaning of Exchange Act Rule 12b-2 (ie, 'possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise').
Second, questions have arisen regarding the nature and scope of the Schedule 13E-3 filing obligation of an acquiring person, or 'purchaser,' in a merger or other going-private transaction. In the situation described above, where management of the issuer-seller that will be going private is essentially on both sides of the transaction, the purchaser also may be deemed to be an affiliate of the issuer engaged in the transaction and, as a consequence, required to file a Schedule 13E-3. (See Exchange Act Release 16075 (August 2 1979), noting that 'affiliates of the seller often become affiliates of the purchaser through means other than equity ownership, and thereby are in control of the seller's business both before and after the transaction. In such cases the sale, in substance and effect, is being made to an affiliate of the issuer'). Accordingly, the issuer-seller, its senior management and the purchaser may be deemed Schedule 13E-3 filing persons in connection with the going-private transaction. Where the purchaser has created a merger subsidiary or other acquisition vehicle to effect the transaction, moreover, the staff will 'look through' the acquisition vehicle and treat as a separate, affiliated purchaser the intermediate or ultimate parent of that acquisition vehicle. Accordingly, both the acquisition vehicle and the entity or person who formed it to acquire the issuer would have separate filing obligations (although, as noted, a joint filing may be permitted)."(16)
Structuring considerations
Structuring a going-private transaction raises a number of basic issues. Should the transaction take the form of a one-step merger, or be effected pursuant to a merger agreement that contemplates a tender offer as its first step? The company's shareholders will usually get their money sooner in a tender offer than in a merger, because there is no need for prior SEC review before launching a tender offer, as there is before a merger proxy statement can be mailed. Moreover, if enough stock is tendered in the tender offer, the merger typically could be effected on a short-form basis, without the need for a meeting of the company's shareholders or the solicitation of proxies.(17)
From the buyer's point of view, there are other reasons to prefer a first-step tender offer. The company's shareholders will not have any appraisal rights with respect to shares that they tender (although they would have appraisal rights with respect to the second-step cash-out merger). Moreover, under the Delaware case law, while a controlling shareholder must offer a fair price in a merger,(18) a controlling shareholder does not have a fiduciary duty to offer a fair price in a tender offer, since that is viewed as a transaction with shareholders rather than with the corporation.(19) However, the controlling shareholder does have a duty under the Delaware case law to make disclosure in the tender offer of all material information.(20)
The issue also arises as to whether the merger should be conditioned on approval by holders of a majority of the company's publicly held shares, or if there is a first-step tender offer, whether it should be conditioned on tender of a majority of the publicly held shares. Under the Delaware case law, if there is adequate disclosure to the public shareholders, conditioning a merger on approval by a majority of the publicly held shares will shift to the plaintiff the burden of showing that the transaction is not entirely fair.(21) On the other hand, particularly if the public float is small, conditioning the deal on approval by a majority of the public float may invite gamesmanship by arbitrageurs. Moreover, the buyer may see little incremental benefit from such a minimum condition, since if the committee is appropriately constituted and does its job correctly, that in itself should shift to the plaintiff the burden of showing that there was something not entirely fair about the transactions.(22)
State law considerations
If the buyer in a going-private transaction is a controlling shareholder, the transaction may be subject to a higher legal standard under applicable state corporation law due to the conflicting interests of the buyer and the public shareholders, and the fact that the buyer typically is represented on the board of the company. The directors appointed by the buyer - and the buyer itself, if it is a controlling shareholder - have fiduciary obligations to the public shareholders of the company. At the same time, the buyer's financial interest is to pay as little as possible to buy out the public shareholders. In Delaware, a going-private transaction that is a corporate transaction such as a merger (rather than a tender offer) must satisfy a test of 'entire fairness', rather than the normal business judgment rule test.(23) Because of these factors, and to make the transaction as arm's length as possible, the company's board of directors typically appoints a special committee of outside directors to review the buyer's proposal, negotiate with the buyer and make recommendations to the full board. The committee appoints its own financial and legal advisers, at the company's expense.(24)
Several issues arise as to the scope of the committee's authority. For example, is the committee authorized only to approve or disapprove the buyer's initial proposal, or is it also authorized to negotiate with the buyer? The record is better if the committee is authorized to negotiate. Under Delaware case law, as noted earlier, a merger with a controlling shareholder must be shown to be entirely fair to the public shareholders, but the burden shifts to the plaintiff to show that the transaction was not entirely fair if the transaction is negotiated by a special committee of independent directors that has the freedom to negotiate at arm's length, and that in fact does so.(25) To shift the burden:
"the committee must function in a manner which indicates that the controlling shareholder did not dictate the terms of the transaction and that the committee exercised real bargaining power 'at an arms length'."(26)
Is the committee also authorized to explore alternatives? Is that realistic, given the buyer's stockholdings? Is the buyer a potential seller, or only interested in acquiring the company? Often, the buyer, if a large shareholder, will make clear in its initial proposal that it has no interest in selling its position. If so, and if the buyer has a controlling position, then the committee's task, under the Delaware case law, becomes not to obtain a full control premium for the public shareholders, but to get the best price available from the buyer for a non-controlling block of stock.(27) To establish that the committee has done its work carefully, so as to shift the burden of proof to the plaintiff, it is important to make a record of the meetings of the committee, including telephone meetings, with appropriate minutes reflecting the members' knowledge of the company's business and their careful consideration of the issues.(28)
Other considerations
Role of the financial adviser
The committee will typically engage a financial adviser to help it evaluate the buyer's proposal and to assist in negotiations with the buyer. As noted earlier, the committee, in selecting its financial adviser, should inquire into whether a potential adviser has done business for or is otherwise beholden to the buyer. If the financial adviser is part of a multi-function financial services organization, the committee should consider ties and business relationships of affiliates of the financial adviser (eg, banking relations, underwritings or other advisory relationships). Schedule 13E-3 requires that the adviser's recent material business relationships both with the company and with the buyer be disclosed to the company's shareholders.(29)
The compensation of the committee's financial adviser may be structured in a different way in a going-private transaction. If the transaction were an acquisition of the company by an unaffiliated third party, the target company's investment banker would typically receive most of its fee only on closing of the transaction. In a going-private transaction, it might be argued that such a fee structure would tend to give the committee's financial adviser an economic incentive to issue a favourable opinion as to the fairness of the transaction so to make a closing (and with it the payment of a transaction fee) more likely. For this reason, it is not uncommon in a going-private transaction to see most or all the financial adviser's fee (apart from an initial portion intended to compensate the adviser for the cost of the time needed to become familiar with the company's business) become payable when the financial adviser, at the committee's request, is prepared to deliver its opinion (favourable or unfavourable) about the proposed transaction with the buyer. In addition, any portion of the fee payable upon closing is often due even if the transaction proceeds without the committee's approval.
Other aspects of the financial adviser's engagement letter also tend to look different from an engagement letter in a third-party acquisition. The letter should make clear that the committee is engaging the financial adviser and will be requesting the adviser's opinion, but that the company will be paying the adviser's fee and indemnifying it against third-party claims. The letter typically will contemplate that the adviser's fairness opinion will be addressed to the committee, but may also make clear that all the directors (including the conflicted directors) may rely on it.
The opinion typically will be as to fairness from a financial point of view of the consideration to be received by the public shareholders. Depending on the facts, the opinion might include, in addition to the usual assumptions:
•the financial adviser's understanding, based on the buyer's statements, that the buyer has no interest in any transaction that would result in the sale of its shareholdings in the company;
•the fact that the financial adviser was not requested or authorized to solicit, and did not solicit, proposals from third parties relating to the acquisition of the company; and
•the fact that the financial adviser had been informed by the buyer that it had no intention to pursue a sale of the company after consummating the transaction.
Stalemates
In many going-private transactions the buyer may well not offer its best price initially, but instead may start somewhere reasonable (typically at a substantial premium over the pre-announcement market price) and negotiate upwards. Such a negotiation may help to demonstrate that the committee has effectively represented the interests of the public shareholders, and that therefore the burden in shareholder litigation challenging the transaction should be on the plaintiff to show that the transaction is not entirely fair.(30)
What if the buyer is not willing to increase its bid price to a level the committee is willing to recommend? The buyer may nevertheless be able to proceed by taking its offer directly to the company's shareholders, by a tender offer, without having a merger agreement that must be approved by the company's directors. However, if the buyer is heavy-handed about threatening the committee that it will proceed with a tender offer at a lower price unless the committee recommends the buyer's proposed merger, this kind of hardline tactic may result in the buyer having the burden of proving the entire fairness of the transaction.(31)
In some cases (although not many) the buyer may be constrained from proceeding with a tender offer by the terms of a standstill agreement or by the existence of a 'poison pill' rights plan. In the absence of such constraints, usually the only leverage available to the committee to deter the buyer from going directly to the shareholders without committee approval is the committee's power to bestow or withhold its blessing of the transaction - or, in the words of the Delaware Chancery Court, "the power to say no".(32) If the committee approves a transaction with the buyer after careful consideration, that will make the transaction harder for plaintiffs to attack in the courts. Conversely, if the buyer goes ahead with a tender offer at a price which the committee was unable to recommend, the shareholders will need to be informed of the committee's position, and that position will make it harder for the buyer to demonstrate the fairness of the transaction - although as noted earlier, the buyer would not need to show fairness of price in the tender offer, as it would in the second-step merger.
Going-private litigation
In light of the conflicting interests between the 'affiliated' buyer and the public stockholders, it is not surprising that shareholder litigation is common in going-private cases. Shareholders may allege that the buyer has breached a fiduciary duty (if the transaction is a merger)(33) or has made inadequate disclosure.(34) In the case of a merger, shareholders may also seek an appraisal of their shares.(35)
Claims of breach of fiduciary duty are often made soon after a going-private proposal is announced - even before the committee has had a chance to retain advisers and decide whether to recommend the buyer's proposal. Plaintiff's counsel often will not seek expedited discovery or a preliminary injunction against the transaction while the committee and the buyer are negotiating. If and when the buyer and the committee agree on the terms of the transaction, the buyer may simultaneously enter into a memorandum of understanding with plaintiff's lawyers for the settlement of the shareholder litigation, subject to certain conditions, including confirmatory discovery as to the fairness of the transaction.
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