The Januvary 31, 2019 MAMA& Tax Report Decenber 2018 Volume 27, Number 5 The Monthly Review of Taxes, Trends & Techniques Deposed CEOs at the Gate: EDITOR-IN-CHIEF Robert W. Wood Poison Pills and Tax Wood LLP By Donald P. Board • Wood LLP San Francisco

PRODUCTION EDITOR More than 30 years ago, shareholder rights plans—known to friends Mina Schultz Wood LLP and foes alike as “poison pills”—transformed public-company M&A. San Francisco Martin Lipton, the Dr. Salk who vaccinated corporate America against hostile tender offers, got the idea for the shareholder rights plan in ADVISORY BOARD 1982, a few years into the boom. As soon as the Delaware Donald P. Board Supreme Court endorsed the pill as a legitimate exercise of business XX Wood LLP San Francisco judgment [see Moran v. Household Int’l, Inc., 500 A.2d 1346 (Del. 1985)], hundreds of public companies beat a path to Messrs. Wachtell, Lipton, Michael R. Faber Cooley LLP Rosen & Katz’s golden door. New York The shareholder rights plan has been a fantastically effective piece 2018 Jonathan R. Flora of legal technology. In addition to buying a targeted company time Montgomery McCracken to consider alternatives, a poison pill greatly strengthens incumbent Walker & Rhoads, LLP management’s bargaining position vis-a-vis an unwelcome suitor. In Philadelphia 2002, fully 60 percent of the S&P 500 had rights plans in force. XX Stuart M. Finkelstein Then things shifted a bit. Shareholder proposals to dismantle ex- Skadden, Arps, Slate, isting rights plans became more common, and they were frequently Meagher & Flom LLP New York successful. Proxy advisory firms, to which institutional investors were increasingly “outsourcing” their voting decisions, started Steven R. Franklin Month Gunderson Dettmer to recommend voting against the directors of any company that Menlo Park adopted or renewed a poison pill without committing to put the Lawrence B. Gibbs matter to a shareholder vote within 12 months. Corporate America Miller & Chevalier got the memo. Washington By the end of 2008, only 22 percent of the S&P 500 had a rights plan Ivan Humphreys in force—almost a two-thirds decline in just six years. But that doesn’t Wilson Sonsini mean the pill was going the way of the dinosaurs. Incumbent manag- Goodrich & Rosati ers generally concluded that they could avoid a lot of flak, yet remain Palo Alto securely ensconced, by keeping a rights plan “on the shelf.” If an in- Steven K. Matthias surgent started pounding on the door to the C-suite, the pre-vetted Deloitte Tax San Francisco plan could be up and running in less than 24 hours. Mark J. Silverman Steptoe & Johnson Washington ALSO IN THIS ISSUE Robert Willens Update: PE Firms Converting to C ...... 6 Robert Willens, LLC New York THE M&A TAX REPORT

The poison pill got a P.R. boost during the This Time It’s Personal Great Recession. Citigroup and other corpo- The in terrorem effect of the shareholder rights rations with Brobdingnagian losses started to plan is undiminished. Rational economic adopt low-trigger plans to avert “ownership actors understand that launching a hostile changes” described in Code Sec. 382(g). The takeover will do them about as much good as goal was to protect their massive NOLs from banging their heads against a wall. For bet- Code Sec. 382(a), which severely limits the ter or worse, we are still living in Mr. Lipton’s utilization of “pre-change losses.” Proxy ad- world. visory firms recognized that something more This is not to say that poison pills have disap- than was at stake, peared from the news. But the focus seems to so they went along with these “NOL rights have shifted from the coolly calculating raid- plans.” ers of yesteryear to a rather different threat: Nevertheless, the number of plans in force has deposed founder-CEOs. Let’s look at two re- continued to fall. At the end of 2015, only 19 cent episodes involving charismatic CEOs companies in the S&P 500—less than four per- whose controversial behavior got them kicked cent—had a poison pill in place. But there were out of their own companies. many hundreds of rights plans sitting on the In the initial glare of publicity, the CEOs shelf, ready for deployment if their corporate quietly turned over the keys. But it was not sponsors should find themselves “in play.” long before they were looking to regain con- trol. As founders, they already owned lots of , so their former companies quickly adopted rights plans. The American Apparel MA& Tax Report Dov Charney founded American Apparel in The MonthlyThe ReviewMonthly of Review Taxes, Trends of Taxes, & Techniques Trends & Techniques his college dorm room in the late 1980s. The company’s daring advertisements—which EDITOR-IN-CHIEF MANAGING EDITOR Robert W. Wood Michael Henaghan sometimes included Mr. Charney himself— COORDINATING EDITOR and idealistic labor practices made it a cul- Velavan BS tural icon. The mercurial founder-CEO owned The M&A Tax Report is designed to provide accurate and 43 percent of American Apparel’s stock. authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged Notwithstanding explosive growth, Amer­ in rendering legal, accounting, or other professional service. If ican Apparel always had trouble turning legal advice or other expert assistance is required, the services of a competent professional person should be sought—From a Declaration a profit. In March 2014, following a severe of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers. financial squeeze, Mr. Charney’s ownership was reduced to 27 percent. In June, the board THE M&A TAX REPORT (ISSN 1085-3693) is published monthly of directors suspended (and later terminated) by Wolters Kluwer, 2700 Lake Cook Road, Riverwoods, Illinois 60015. Mr. Charney as CEO. The board cited, among Subscription inquiries should be directed to 2700 Lake Cook Road, Riverwoods, IL 60015. other issues, allegations that Mr. Charney Telephone: (800) 449-8114. Fax: (773) 866-3895. Email: [email protected]. had sexually harassed numerous employees. © 2018 CCH Incorporated and its affiliates. All rights reserved. Once he had left the building, Mr. Charney Permissions requests: Requests for permission to reproduce content started buying up American Apparel shares should be directed to Wolters Kluwer, [email protected]. at a rapid clip. With his 43-percent stake Photocopying or reproducing in any form in whole or in part is a restored, he called for a special meeting of violation of federal copyright law and is strictly forbidden without the publisher’s consent. No claim is made to original governmental shareholders. Mr. Charney demanded that works; however, within this product or publication, the following are subject to CCH Incorporated’s copyright: (1) the gathering, the board be expanded and stocked with compilation, and arrangement of such government materials; (2) the his supporters. He also threatened legal magnetic translation and digital conversion of data, if applicable; (3) the historical, statutory, and other notes and references; and action if he was not restored as CEO. (4) the commentary and other materials. American Apparel adopted a pill right after Mr. Charney filed his Schedule 13D. The pur- CCH Journals and Newsletters pose of the pill was to “limit the ability of any Email Alert for the Current Issue person or group, including Dov Charney, to

Sign Up Here... CCHGroup.com/Email/Journals 2 THE M&A TAX REPORT seize control of the company without appro- How it will all turn out is anybody’s guess. But, priately compensating all American Apparel unless Mr. Schnatter can get the pill removed, stockholders.” Although the rights plan can’t the dispute will not be decided by a race to ac- take all the credit, Mr. Charney’s bid collapsed. quire a majority of the company’s stock.

Papa John’s In 1984, John Schnatter sold his 1971 Camaro Flipping Off Corporate Raiders: Z28 and purchased $1,600 worth of used pizza Tax Analysis equipment. He then started selling pies out Shareholder rights plans have become a fact of converted broom closet in the back of his of corporate life. It is testimony to their effec- father’s bar. His company—now Papa John’s tiveness that they have generated next to noth- International, Inc.—went public in 1993, and ing by way of tax litigation or IRS guidance. currently has more than 5,000 outlets around The only authority on point is Rev. Rul. 90-11 the world. [1990-1 CB 10], which held that the adoption of a Mr. Schnatter, the eponymous “Papa John,” poison pill—a dividend under state corporate figured prominently in the company’s ad cam- law—did not result in the realization of gross paigns. In October 2017, he attracted unwel- income by the target company’s shareholders. come publicity when he became embroiled Rev. Rul. 90-11 assumed that, when the plan in the controversy surrounding NFL players’ was adopted, the likelihood that it would be “take-a-knee” protests. Shortly after the NFL triggered was “both remote and speculative.” canceled its marketing agreement with Papa What does this imply for a plan adopted in re- John’s, Mr. Schnatter announced that he was sponse to a specific threat, e.g., rumblings from stepping down as CEO. an angry ex-CEO? And even if adoption is not On July 11, 2018, it was reported that Mr. a taxable event, what are the tax consequences Schnatter had made racially charged state- if a poison pill is actually triggered? ments on a call with the marketing agency that had been hired to help him avoid further Pill Mechanisms controversy. A few hours later, the ex-CEO The first shareholder rights plans were devel- resigned as chairman of the . oped in a hurry, in response to pending emer- The company terminated the agreement that gencies. Over the decades, they have evolved had established Mr. Schnatter as the public face primarily by the accretion of more and more of Papa John’s—the first step toward removing bells and whistles. Today’s plans get the job his smiling visage from the pizza box. done, but Mr. Lipton’s signature innovation is It was only a week until Mr. Schnatter re- now a bit of a Rube Goldberg machine. vealed that his resignation had been a “mis- Fortunately, we can limit ourselves to review- take.” His lawyer announced that the original ing the operation of just two basic pill mecha- Papa John was “not going to go quietly in the nisms. They work by threatening the would-be night.” On July 26, the deposed CEO sued for acquirer (Insurgent) or Insurgent’s sharehold- access to the company’s books and records, ers with dilution if the target company (Target) speculating that the directors had participated does not take timely steps to turn off the pill in a “coup.” after it has been triggered. This is supposed to The company had seen this coming. force Insurgent to negotiate an acquisition with Three days before, it had adopted a limited- Target’s incumbent management—or else un- duration poison pill with a 15-percent owner- dertake a difficult and expensive . ship threshold. Mr. Schnatter is grandfathered A “flip-in” plan gives Target’s sharehold- in as the holder of 30.3 percent of the company’s ers (except for Insurgent) the right to pur- common shares, but the pill will be triggered if chase additional shares at a large discount his ownership increases beyond 31 percent. if Insurgent’s ownership percentage crosses While Mr. Schnatter has been testifying about some threshold, e.g., 20 percent. When share- the coup in the Delaware Court of Chancery, holders (or their transferees) exercise these hedge funds and other adventurous investors discount purchasing rights, they will di- have been acquiring positions in the company. lute both the value of Insurgent’s stake and

3 THE M&A TAX REPORT the percentage it represents in the battle for also become transferable, so shareholders who control. do not feel like fronting any cash can sell their The original shareholder rights plans relied Rights to somebody who does. on a different mechanism. Under a “flip-over” In the old days, poison pills were adopted plan, Insurgent can acquire shares of Target as a matter of good corporate hygiene. That’s to its heart’s content and never suffer dilu- how 60 percent of the S&P 500 came to have tion. But, if Insurgent gains control and tries to one in force by the early 2000s. There was no squeeze out Target’s remaining shareholders, reason for Target to wait for Insurgent to show the flip-over plan turns the tables. up before taking action. Consequently, the vast The plan lets Target’s historic shareholders majority of rights plans were adopted when purchase shares of Insurgent at a 50-percent there wasn’t a cloud in the sky. discount. Insurgent does not suffer dilution, The right to buy Target stock at half price but its shareholders certainly do. This is un- is theoretically valuable, even if it does not likely to go over well with the folks who elect confer any benefit prior to a triggering event. Insurgent’s board of directors. Under Code Sec. 305(d), rights to acquire stock Flip-over pills were initially portrayed as a are considered “stock,” so could adoption of a device to compensate Target’s shareholders for rights plan subject Target’s shareholders to the loss of the higher price they would presum- current tax under Code Sec. 305(b)(2)? After all, ably have received in a negotiated acquisition. the essence of a flip-in plan is that it increases But the dilution they would inflict was enough the proportionate interest of some of Target’s to deter most takeover bids. However, flip- shareholders at the expense of another (viz., over plans proved useless against insurgents Insurgent). who were willing to live with minority share- But if a plan is adopted when there is no threat holders after obtaining control. This was fa- on the horizon, which shareholders should be mously demonstrated in 1985, when Sir James taxed as having received a disproportionate Goldsmith seized control of Crown Zellerbach distribution? All of them? In that case, where without triggering his prey’s flip-over plan. is the disproportion? If Insurgent isn’t even in Thanks to inertia and word processing, flip- the picture, the pro rata distribution of Rights over provisions remain common in poison doesn’t seem any worse than a pro rata distri- pills even today. Because of their weakness as bution of common stock. an anti-takeover device, they are invariably Even if we get past this objection, where accompanied by a flip-in feature, which does is the companion distribution of property to all the heavy lifting. Flip-over provisions per- the “other” shareholders that is required by sist, but they have become largely vestigial, Code Sec. 305(b)(2)(A)? Under Reg. §1.305- like the human appendix. 3(b)(4), payments of dividends or even in- terest to the “other” shareholders can fill the Tax Consequences of Adoption gap. But that doesn’t help unless we assume For corporate-law purposes, Target’s adop- that our merely hypothetical Insurgent al- tion of a shareholder rights plan is a dividend ready owns Target shares or when the of one “Right” on each of its common shares. pill is adopted. Prior to a triggering event, the exercise price of The IRS started to engage with these issues in a Right is set wildly out of the money. In addi- the late 1980s. America’s biggest corporations tion, the Rights are not represented by separate were falling over themselves to adopt share- certificates, and they cannot be transferred in- holder rights plans, and the IRS was under dependently of the related common shares. pressure to let them do so without tax com- Things get interesting once a triggering event plications. As an IRS official acknowledged occurs. First, any Rights attached to Insurgent’s at a conference in 1988, “One way or another, shares become void. Second, Target’s other we are going to permit the tax-free creation of shareholders become free to exercise their poison pill rights.” [See Lee A. Sheppard, IRS Rights and purchase additional shares of Target Will Allow Tax-Free Creation of Poison Pills, 41 (let’s focus on flip-in plans) worth twice what Tax Notes 258 (1988) (quoting James Dahlberg, they are required to pay for them. The Rights Branch Chief of the Tax Division).]

4 THE M&A TAX REPORT

The result was Rev. Rul. 90-11, supra, which Could the IRS have gone even further? These resolved the tax issue without bothering about days, Target is unlikely to adopt a poison pill technicalities. The IRS posited a case in which a except in response to a specific takeover threat. corporation adopted a plan at a time when the Does Rev. Rul. 90-11 apply even if Insurgent is likelihood that the Rights would ever be exer- staring Target in the face? cised was “both remote and speculative.” At a There is a reasonable argument that it does. minimum, that meant plans adopted before an Rev. Rul. 90-11 did not assume that the poison pill insurgent even appeared on the scene. was adopted when the threat of a hostile takeover Rev. Rul. 90-11 conceptualizes a poison pill bid was remote and speculative. What it said was as simply: that the board of directors adopted the plan at a time when the likelihood that the Rights would a mechanism by which the corporation ever be exercised was remote and speculative. could, in the future, provide shareholders Based on their track record, flip-in rights with rights to purchase stock at substan- plans are almost 100-percent effective in deter- tially less than fair market value as a means ring would-be acquirers from taking action of responding to unsolicited offers to acquire that would constitute a triggering event. Even [the corporation]. [Emphasis supplied.] if Target waits till the last minute, adopting a plan will almost certainly prevent Insurgent This formulation shifts the focus from the cre- from taking steps that would result in the di- ation of the Rights on paper to the activation of lution of its interest. Hence, the likelihood that those Rights following a triggering event. The Rights will be exercised will be “both remote “real” tax event is activation. That is when the and speculative” even if Target adopts the plan Rights become exercisable in an economically in response to a specific threat. meaningful way, as well as transferable like Well, maybe not always. Suppose that a most other forms of property. deposed founder-CEO credibly announces On this view, adopting a rights plan merely that he is going to damn the torpedoes and sets the stage for a future transaction. So, the proceed full steam ahead to regain control of IRS decided to wipe the slate clean. Rev. Rul. “his” company. Even if Target knows that the 90-11 declares that installation of a poison pill deposed CEO will not be deterred by dilution, is a complete non-event: it will probably still adopt a pill for the benefit of its more tractable shareholders, including The adoption of Plan by [the corporation’s] incumbent management. board of directors does not constitute the Under this scenario, the likelihood of the distribution of stock or property by [the Rights being exercised would not be remote corporation] to its shareholders, an ex- and speculative at the time of adoption. By change of property or stock (either taxable its terms, Rev. Rul. 90-11 would not apply. In or nontaxable), or any other event giving theory, the IRS would have to decide whether rise to the realization of gross income by adoption of the plan in response to the ex- any taxpayer. CEO’s bid was a taxable event to Target’s shareholders. Although the IRS acted by administrative fiat, If such a case were to arise, the tax stakes its conclusion makes sense. The value of the might not be great. If the deposed CEO charges Rights created when a company adopts a plan ahead, the Rights will be exercised in the near depends on somebody triggering the plan. If future. So, it’s fairly likely that adoption and the pill is doing its job, that will never happen. exercise will occur in the same tax year. Still, the Rights have some theoretical value as What if the plan is adopted in December options, no matter how contingent the trigger- 2018, but the headstrong CEO does not get ing event. But the IRS’s decision to go with a around to triggering it until January 2019? That “wait-and-see” approach is not hard to defend would give shareholders and the IRS a timing from an administrative perspective. The IRS issue to fight about. The question would be may have painted with a broad brush, but any whether Target’s shareholders are actually tax- damage to the fisc has been immaterial. able when their Rights are activated.

5 THE M&A TAX REPORT

Tax Consequences of Triggering Rights are normally tax-free, Suppose that Insurgent triggers the pill, the but the fact that this one produced the same Rights are activated, and Target’s sharehold- effect as a non-pro-rata stock dividend might ers exercise or sell their Rights. Rev. Rul. 90-11 give us pause. If Selectica managed to pay does not say how the shareholders are taxed Versata some dividends or interest before the when this “remote and speculative” contin- pill was triggered, could the transaction be gency comes to pass. The IRS has left the ques- treated as a series of distributions described tion open for the last 28 years. in Code Sec. 305(b)(2)? After all, some share- The lack of guidance is understandable. In holders increased their proportionate inter- all that time, there has been only one instance ests in Selectica, while others (Versata) got of Rights actually coming into force under a property. flip-in rights plan. In December 2008, Versata Code Sec. 305(c) provides that certain trans- Enterprises, Inc., triggered the flip-in pill re- actions—including recapitalizations—can be cently adopted by Selectica, Inc. Selectica’s treated as distributions under Code Secs. 301 plan had a 4.99-percent threshold, which was and 305(b). However, Code Sec. 305(c) gener- intended to protect its NOL from Code Sec. 382. ally does not apply to a recap unless it is part Versata’s existing stake exceeded five percent, of a plan to “periodically” increase a share- but it was grandfathered in. Versata was still holder’s proportionate interest in the corpo- barred from increasing its interest by more than ration. [See Reg. §1.305-7(c)(i); Proposed Reg. half a percentage point. Versata went on buying §1.305-7(d)(i).] shares, triggered the pill, and got diluted from Once triggered, a flip-in plan will increase 6.7 percent down to 3.3 percent. The matter the “old” shareholders’ interest in the spon- ended up before the Delaware Supreme Court, soring corporation unless the board of direc- which upheld Versata’s dilution under the tors turns it off. If the board keeps reloading low-trigger plan. [See Versata Enterprises, Inc. v. the plan, it can even increase the shareholders’ Selectica, Inc., 5 A.3d 586 (Del. 2010).] interest “periodically.” But corporations obvi- It is hard to know, even after 20 minutes of ously do not adopt poison pills in order to in- poking around on EDGAR, what (if anything) crease anybody’s proportionate interest, so Selectica told its shareholders about the tax Code Sec. 305(c) should not apply. consequences of these events. Maybe not a lot. Diluting Versata increased the interest of Selectica’s historic shareholders by a measly Conclusion 3.2 percent. Selectica’s principal asset was its Someday, perhaps, the IRS will venture out NOL, so it probably wasn’t brimming with beyond the confines Rev. Rul. 90-11. But it is E&P in any event. unlikely to do so until somebody triggers a The shareholders did not exercise their poison pill maintained by a corporation with Rights for cash. Selectica exchanged the Rights a large shareholder basis. It’s going to take a directly for common stock, as it was permit- very rich, very determined, and very ticked-off ted to do under the plan. This adjustment to ex-CEO to cross that bridge. Selectica’s looks like a recapi- If there are big changes at Tesla, it just might talization under Code Sec. 368(a)(1)(E). happen.

6