SPIN OFFS

GREGORY E. OSTLING PARTNER WACHTELL, LIPTON, ROSEN & KATZ Gregory is a corporate partner focusing primarily on and complex corporate and securities law matters. He has been involved in numerous major domestic and cross-border merger and acquisition transactions, leveraged , joint ventures, divestitures, public offerings, proxy fights and defenses.

DAVID K. LAM PARTNER WACHTELL, LIPTON, ROSEN & KATZ David is a corporate partner focusing on mergers and acquisitions, securities transactions and corporate governance. His practice includes a wide range of matters, such as public and private acquisitions and divestitures, domestic and international transactions, carve- out IPOs, spin-offs, split-offs, joint venture transactions and transactions.

42 September 2014 | practicallaw.com The Decision to Separate and Considerations for the Board

Spin-offs provide companies with a means to potentially command higher valuations for certain businesses by separating them through the creation of one or more separate, publicly traded companies. When deciding to pursue a spin-off, boards must consider the myriad financial, legal, tax and other issues involved in these complex transactions. © OJO Photography/Veer Images

Practical Law The Journal | Transactions & Business | September 2014 43 spin-off involves the separation of a company’s „„Managing ongoing reporting obligations and public businesses through the creation of one or more investor relations. separate, publicly traded companies. Spin-offs have been popular because many investors, boards Against this background, this article explores: and managers believe that certain businesses may „„The advantages and disadvantages of a spin-off. Acommand higher valuations if owned and managed separately, „„Separation transaction alternatives available to companies, rather than as part of the same enterprise. An added benefit is in addition to a spin-off. that a spin-off can often be accomplished in a manner that is „„Considerations related to the of the parent tax-free to both the existing public company (referred to as the and the spin-off company following the transaction. parent) and its shareholders. „„Other key issues for boards to consider when contemplating Recently, robust debt markets have enabled companies to lock a spin-off. in low borrowing costs for the business being separated and monetize a portion of its value. There were 201 domestic and Search Spin-offs for a general overview of spin-off transactions. foreign spin-offs announced in 2013 and 175 in 2012, with an Search Transaction Checklist: Spin-offs for key issues to consider aggregate value of $45 billion and $61 billion, respectively. So when conducting a spin-off transaction. far in 2014, there have been 91 spin-offs announced with an aggregate value of $7.6 billion. The process of completing a spin-off is complex and requires ADVANTAGES AND DISADVANTAGES OF SPIN-OFFS consideration of myriad financial, capital markets, legal, tax REASONS FOR A SPIN-OFF and other factors. The issues that arise in an individual situation There are several drivers of spin-off activity. The principal depend largely on: reasons often cited by companies for pursuing spin-offs include „„The business goals of the transaction. the following: „„The degree to which the businesses were integrated before „„Enhanced business focus. A spin-off allows each business to the transaction. focus on its own strategic and operational plans without diverting „„The extent of the continuing relationships between the human and financial resources from the other businesses. businesses after the transaction. „„Ability to pursue a business-appropriate capital „„The structure of the transaction. structure. A spin-off enables each business to pursue the capital structure that is most appropriate for its business Where the businesses were tightly integrated before the and strategy. Each business may have different capital transaction or are expected to have significant business requirements that may not be optimally addressed with a relationships following the transaction, it takes more time single capital structure. and effort to: „„Creation of a distinct investment identity. A spin-off creates „„Specify assets and liabilities. distinct and targeted investment opportunities in each „„Identify personnel that will be transferred. business. A more “pure-play” company may be considered „„Separate employee benefits plans. more transparent and attractive to investors focused on a particular sector or growth strategy, thereby counteracting „„Obtain consents relating to contracts and other rights. the “ discount” and enhancing the value of the „„Document ongoing arrangements for shared services (for business. example, legal, finance and human resources). „„Increased effectiveness of equity-based compensation. „„Continue supply, technology sharing and other commercial or A spin-off increases the effectiveness of the equity-based operating agreements. compensation programs of both businesses by tying the value Where the parent is expected to own a substantial portion of the of the equity compensation awarded to employees, officers spin-off company after the closing, it must carefully plan around and directors more directly to the performance of the business issues that may create potential conflicts, such as: for which these individuals provide services. „„The composition of the new company’s board. „„Use of equity as acquisition currency. By creating a separate publicly traded , a spin-off enhances the ability of the „„Independent director approval of related-party transactions. spin-off company to effect acquisitions using its stock as „„The handling of corporate opportunities and other matters. consideration. In addition to these separation-related issues, spin-offs raise Shareholder activism is another and more recent potential driver various issues associated with taking a company public, including: of spin-off activity. Shareholder activists have become a more „„Drafting and filing the initial disclosure documents. dominant force in the corporate landscape, and many activists „„Applying for listing on a stock exchange. agitate for “value maximizing” activity, including spin-offs. Activists are often a catalyst for spin-off activity, and the rise „„Implementing internal controls.

44 September 2014 | practicallaw.com in shareholder activism may explain some of the increase in and receipt of regulatory approvals (such as antitrust approvals) spin-off activity. in order to close.

POTENTIAL DRAWBACKS OF A SPIN-OFF Purchase agreements with third parties also often include various representations and warranties about the target Although spin-offs often have advantages, they also may involve business, supported by post-closing indemnities. By contrast, a variety of disadvantages, including: in a spin-off the business usually is transferred to the spin-off „„The potential loss of both revenue and cost synergies company on an “as-is, where-is” basis. associated with having two separate public companies. Within the category of transactions involving the sale or „„Disruptions to the business as a result of the spin-off. distribution of the stock in a new public company, a variety of „„Separation costs. structures can be employed to accomplish different financial and „„Reduced size and diversification, which could potentially legal objectives, including: result in greater cash flow volatility and reduced access to „„A full, or 100% spin-off. capital markets, and may affect the company’s credit rating. „„A partial spin-off. „„The potential reduction of equity research coverage and „„An initial (IPO) plus spin-off/Up-C Structure. investor focus if the separated companies are too small. „„An IPO plus split-off. „„Potential index exclusion depending on the size or nature of the companies. „„A sponsored spin-off. „„The possible increased susceptibility to unsolicited takeover „„A spin-off combined with an M&A transaction. activity (given that the businesses of both the parent and the „„A real estate investment trust (REIT) separation transaction. spin-off company will both be less diversified and smaller than the former consolidated parent). 100% SPIN-OFF These potential drawbacks should be considered in deciding In a typical 100% spin-off, all of the shares of the spin-off whether or not to pursue a spin-off and weighed against the company are distributed to the shareholders of the parent as a benefits of a spin-off. dividend. This results in a full separation of the two entities in a single transaction.

SEPARATION ALTERNATIVES There are other corporate mechanics available for accomplishing It is common for a company in the initial planning phases to a spin-off. For example, in 2005 IAC/InterActiveCorp spun off consider other types of separation transactions in addition to a Expedia by a charter amendment that reclassified each share spin-off. Separation transactions can generally be divided into of IAC common stock into a share of IAC common stock and a two categories: fraction of a share of mandatory exchangeable that automatically exchanged into a share of Expedia common „„A sale to a third party of the business being separated. stock immediately following the reclassification. Because this „„A sale or distribution of the stock in a new public company structure involves a charter amendment, it requires a vote of the holding the business being separated. parent’s shareholders. Conversely, a spin-off does not require a shareholder vote to issue the dividend under the law of most The decision as to which type of separation transaction to pursue jurisdictions. depends on a variety of factors. A sale to a third party can often generate the largest amount of PARTIAL SPIN-OFF cash proceeds to the parent. However, a sale or distribution of In some cases, the parent may distribute fewer than all of the the stock in a new public company can often result in greater shares of the spin-off company. Typically, the parent would not value to the parent’s shareholders for two reasons: intend to retain the remaining shares long-term, but rather „„The public market may place a higher value on the business would use them to generate cash proceeds or retire existing than a third party. debt of the parent. However, for a spin-off to be tax-free, the parent generally must: „„A distribution of stock in a new public company to the parent’s shareholders can be accomplished in a manner that is tax-free „„Distribute “control.” Control represents at least 80% of the to both the parent and its shareholders, whereas a sale for voting power of all of the shares and at least 80% of any cash would be a taxable transaction. non-voting shares of the spin-off company. „„Have a valid business purpose. The parent must establish As compared to a spin-off, there is a greater risk that a sale to to the satisfaction of the Internal Revenue Service (IRS) that a third party may not close, for any number of reasons. Also, it has a valid business purpose for retaining any shares of the the parent can generally determine the terms and timing of a spin-off company. spin-off. However, a sale to a third party requires the negotiation of price, timing and other terms with a third party, execution of In addition, the parent must dispose of the retained shares of the a definitive agreement that typically includes closing conditions, spin-off company within five years following the spin-off for the

Practical Law The Journal | Transactions & Business | September 2014 45 transaction to be tax-free. Examples of this type of transaction structure is to structure the as an “Up-C.” An Up-C include: structure has the following characteristics: „„Valero’s 2013 spin-off of Corner Store Holdings. „„The business to be separated is contributed to an operating „„Ralcorp’s 2012 spin-off of Post Holdings. company that is a limited liability company or limited partnership (and is treated as a partnership for tax purposes). „„Cardinal Health’s 2009 spin-off of CareFusion. „„The public purchases low-vote stock in a newly formed IPO PLUS SPIN-OFF/THE “UP-C” STRUCTURE corporation that holds a minority economic interest in the A parent may structure a separation transaction through an IPO operating company and a majority of the vote and control over of a portion of the common stock of the company to be spun the operating company. off followed by a distribution of common stock to shareholders „„The parent holds both non-economic high-vote stock in of the parent. In the IPO, the parent would sell a portion of the the newly formed corporation, giving it control over the shares of the subsidiary to the public in an underwritten offering, corporation and at least a 50% direct economic interest in the with the proceeds either retained by the subsidiary or distributed operating company. to the parent. An IPO allows the formation of a natural investor When the parent subsequently spins off its remaining interest base for the subsidiary in advance of distributing the remainder after the IPO, the operating company merges with the of the parent’s stake in the spin-off. corporation. Creating an investor base in advance of a spin-off may be helpful The Up-C structure allows the parent to sell up to 50% of the because the persons entitled to receive shares in a spin-off are economics of the business being separated and, until it spins the shareholders of the parent on the record date for the spin-off off the remaining interest, receive cash distributions from the dividend, and those shareholders may or may not wish to hold operating company on a tax-efficient basis. Distributions can be shares of the spin-off company. In addition, an IPO not only received on a tax-efficient basis because the operating company allows for an additional means by which the parent can raise is a partnership for tax purposes rather than a non-consolidated capital in the spin-off, but it also allows for the spin-off company corporate subsidiary. The main downside of the structure is that to establish a trading market and market before the parent may pay tax on the upfront proceeds from the IPO the distribution of the spin-off company stock to the parent’s of the corporation. As with the traditional high-vote/low-vote shareholders. structure, the IRS no longer rules on spin-offs of corporations For the subsequent spin-off to qualify as tax-free, the parent that have issued low-vote (or high-vote) stock in anticipation of must generally retain at least 80% of the voting power of the the spin-off. shares of the subsidiary after the IPO. An IPO followed by the Some companies determine not to pursue a carve-out IPO distribution of the offering proceeds to the parent is generally because of the additional costs (such as additional tax-free to the corporations involved, provided the amount fees) and complications involved in an IPO. An IPO also raises of cash distributed is less than the parent’s basis in the stock governance issues because the parent continues to control the of the subsidiary and certain other requirements are met. To subsidiary between the time of the carve-out IPO and the later effect a tax-free spin-off of the subsidiary in the future, an IPO spin-off, creating fiduciary duties to the subsidiary’s public should be limited to 20% of the voting stock of the subsidiary to shareholders. ensure that the subsequent spin-off will satisfy the 80% control requirement. IPO PLUS SPLIT-OFF Issuing low-vote stock to the public may preserve the ability to In a split-off, the parent makes an offer to its shareholders to spin off the subsidiary in a subsequent step if the parent wants exchange their parent stock in exchange for all or a portion of more than 20% of the value of the stock of the subsidiary to the shares of the subsidiary. It is equivalent to a share buyback of be issued to the public. However, the IRS no longer issues the parent’s stock using stock in a subsidiary as the consideration rulings regarding the tax consequences of a spin-off in which a instead of cash. A split-off is typically done after the spin-off high-vote/low-vote structure is put into place in anticipation of company has been taken public as a result of an IPO, so that the the spin-off. pricing of the split-off exchange ratio reflects a premium relative to the trading price of the spin-off company’s shares. Accordingly, under current IRS practice, any such spin-off would have to be done on the basis of an opinion of counsel, rather Because the parent’s shareholders elect whether to participate than an IRS private letter ruling. If the distribution of proceeds in a split-off, ownership of the spin-off company following the exceeds the parent’s aggregate tax basis in the stock of the transaction generally is not proportionate (unlike a spin-off, subsidiary, the excess would generally be includible in income in which shareholders receive a proportionate number of of the parent either when the distribution occurs or when the shares of the spin-off company), and the transaction must be parent divests the subsidiary. registered under the Securities Act of 1933 because it involves an investment decision by the parent’s shareholders. A split-off If the parent desires to sell to the public more than 20% of the is also an issuer under the Securities Exchange Act stock of the subsidiary, while preserving the ability to spin off its of 1934 and, therefore, the parent must comply with the tender remaining interest in the subsidiary subsequently in a tax-free offer rules. manner, an alternative to the traditional high-vote/low-vote

46 September 2014 | practicallaw.com One advantage of a structure over a Morris Trust structure is that a Reverse Morris Trust generally does not require approval by the parent’s shareholders for the spin-off or merger.

SPONSORED SPIN-OFFS is the sole shareholder of the spin-off company. In contrast, a A spin-off also can be combined with a significant investment Morris Trust transaction often requires approval by the parent’s transaction in a “sponsored spin-off.” In this type of transaction, shareholders because the merging party (usually the parent) the parent distributes the shares of the subsidiary in a tax-free is already a public company at the time that the merger is spin-off concurrently with the acquisition by a sponsor of up submitted for approval by the parent’s shareholders. to 49.9% of either the parent or the spin-off company. The sponsor’s investment allows the parent to raise proceeds in REIT SEPARATION TRANSACTIONS the spin-off without having first to go through the IPO process, Many companies have made substantial real estate investments and can help demonstrate the value of the target business to in connection with their businesses. While real estate holdings the market. Sponsored spin-offs raise a number of complex give a company control over assets that can be critical from an issues, including those related to valuation, capital structure and operational perspective, they also tie up capital and may require governance. significant management attention. One potential means of unlocking the value of a company’s real estate in a tax-efficient SPIN-OFFS COMBINED WITH M&A TRANSACTIONS manner is to split the company into an operating company A spin-off can also be used concurrently with an M&A and a separate REIT that owns the company’s real estate. transaction, although there are limitations on the types of these Long-term lease and other contractual relationships can be transactions that can be accomplished in a tax-free manner. For established between the two companies to ensure the operating example, “Morris Trusts” and “Reverse Morris Trusts” effectively business’s ability to continue to use the real estate assets on allow the parent to transfer a business to a third party in a satisfactory terms. transaction involving stock consideration in a manner that is Separation transactions involving REITs can be complex given tax-free to the parent if certain requirements are met. the requirements for tax-free treatment and the rules that an In a traditional Morris Trust, all of the parent’s assets other than entity must comply with to be treated as a REIT. Among other those that will be combined with the third party are spun off or things, for the separation to be tax-free, the following criteria split off into a new public company and then the parent merges must be met: with the third party. In a Reverse Morris Trust, all assets to be „„The separation must have a non-tax corporate business combined with the third party are spun off or split off into a new purpose. public company and then the new company merges with the „„The REIT must conduct an “active trade or business.” third party. „„The REIT must have no earnings and profits from the pre- To be tax-free, the Morris Trust and Reverse Morris Trust REIT period. structures generally require, among other things, that the Examples of recent REIT separation transactions include: merger partner be smaller than the spun-off business (with shareholders of the divesting parent owning a majority of the „„CBS’s 2014 IPO of its CBS Outdoor Americas business. stock of the combined entity). One advantage of a Reverse „„Simon Property’s 2014 spin-off of its strip center business and Morris Trust structure over a Morris Trust structure is that a smaller enclosed malls into a REIT. Reverse Morris Trust generally does not require approval by the „„Penn National Gaming’s 2013 spin-off of its real estate assets parent’s shareholders for the spin-off or merger. into the first-ever casino REIT. In a Reverse Morris Trust transaction, the spin-off company is merging or combining with the merger partner, and the parent Search REITs for more on the requirements that must be satisfied to entity approves of this merger at the time when the parent entity achieve REIT status.

Practical Law The Journal | Transactions & Business | September 2014 47 CAPITAL STRUCTURE CONSIDERATIONS In preparing for a spin-off, a key step is for the board to determine the capital structure of the parent and the spin- off company after the spin-off and the actions required to implement the desired capital structure. A company engaging in a spin-off generally wants to reallocate its existing cash and debt between itself and the spin-off company, as well as potentially raise additional cash. There are a variety of techniques that can be used to accomplish the desired capital structure, and the strategy is often driven by tax considerations and the legal documents governing the company’s existing debt. A common strategy is for the spin-off company to issue new debt in exchange for cash before the spin-off, and distribute that cash to the parent. The parent may then use the cash to retire its existing debt. The distribution of cash from the spin-off company to the parent can be effected in different ways, for example: „„The spin-off company can make a cash distribution to the parent. „„The parent can redeem some of its own shares in exchange for cash. „„The spin-off company can pay off an intercompany payable that is owed to the parent. „„The spin-off company can pay cash to acquire assets from the parent. To retain favorable tax treatment, the proceeds of certain distributions made by the spin-off company to its parent must be further transferred by the parent to its shareholders or creditors. As an alternative, the spin-off company may assume some of the parent’s indebtedness. However, the parent’s existing debt agreements may restrict the assumption of debt. Each of these strategies raises complex tax issues, including potentially triggering gain recognition to the parent to the extent the payment or assumption of indebtedness exceeds the parent’s basis in the spin-off company’s stock or assets. A parent may, however, be able to extract value from the spin-off company in excess of the parent’s basis in the spin-off company’s stock without recognizing gain for US federal income tax purposes. The techniques for doing so involve the parent’s use of debt or equity of the spin-off company to retire the parent’s indebtedness. While the variations are plentiful, the parent’s use of the spin-off company’s equity for this purpose is often called a “debt-for-equity exchange,” and the parent’s use of the spin-off company’s debt for this purpose is often called a “debt-for-debt exchange.” In one variation, the parent distributes less than 100% of the stock of the spin-off company at the same time as it closes a debt-for-debt exchange, and then completes a debt-for-equity exchange at a later date. Another technique involves a spin-off with a simultaneous debt-for-debt exchange, but without a subsequent debt-for-equity exchange. Yet another structure is an IPO through a debt-for-equity exchange, followed by a subsequent distribution of the parent’s remaining shares in the spin-off company. The IRS recently announced that it will not issue private rulings on the tax treatment of debt-for-debt or debt-for-equity

48 September 2014 | practicallaw.com exchanges in spin-offs where the parent’s debt that is spin-off company’s new debt documents are likely to govern its exchanged for either debt or equity of the spin-off company activities for five years or more, companies should also consider was issued in anticipation of the spin-off. The inability to obtain involving the spin-off company’s future treasury and financial a ruling where the parent debt is newly issued will likely lead officers in the negotiations of the spin-off company’s debt to decreased use of this monetization technique. However, agreements, even if doing so might require identification of companies may consider undertaking debt-for-debt or debt-for- these officers earlier than might otherwise be planned. equity exchanges using historical parent debt. The IRS has not announced any changes in its ruling practice regarding these In some cases, existing debt may logically “belong” with, or may exchanges. be explicitly associated with, a specific business, such as debt used to fund the activities of a finance subsidiary or secured IMPACT OF RELATED FINANCING ON CHOICE OF STRUCTURE by assets used in a specific business. If the entity to be spun off has operated as a standalone subsidiary, an appropriate Spin-offs often require significant coordination of related level of debt may already exist at the subsidiary level. In other financing matters, which could include any of the following types cases, the parent debt may need to be allocated based on the of transactions: desired balance of the capital structures of the businesses to be „„Incurrence of new term debt. The spin-off company may separated, as well as tax considerations. incur new term debt, in the form of a credit facility or notes, in order to fund a distribution to the parent. From a diligence perspective, existing debt must be reviewed to determine the limitations on assumption of the debt by each „„Entry into a revolving credit facility. The spin-off company of the businesses, as well as the contours of any covenants that may enter into a revolving credit facility or other line of credit may limit the parent’s ability to spin off major portions of its to fund future liquidity needs. business. These covenants can be restrictions on dividends or „„Refinancing of debt. The parent may need to amend or the ability to dispose of “all or substantially all” of the parent’s refinance its debt to avoid defaults or to right-size the now- assets, or financial maintenance tests. smaller parent’s capital structure. In some cases it may be appropriate to seek consents for debt One significant complicating factor is that the parent and/or covenants. To the extent that covenants in the parent’s existing the spin-off company may have different creditworthiness debt prevent the desired allocation of debt among the various and business plans than the combined predecessor company. businesses, it may be possible to incur new debt at the level Each company will also have smaller assets and earnings of the spin-off company and dividend the proceeds up to the (sometimes significantly) than the combined predecessor. As parent. These proceeds may in turn be used to repay the parent’s a result, the terms (including pricing, financial and operating existing debt. covenants and required guarantees and collateral support) of the credit documents of the parent and spin-off company can be The need for new financing in a spin-off has the potential to dramatically different than those of the predecessor firm. introduce conditionality and risk into the spin-off transaction. If market conditions or other circumstances prevent the issuance Therefore, these transactions can require a significant amount of the required debt, then the spin-off could be delayed or even of new drafting, negotiation and disclosure. Because of abandoned. Companies can mitigate these risks in a number these considerations, the negotiation and execution of spin- of ways, including by obtaining financing commitments (the off-related financing can take substantially more time than conditionality of which will need to be negotiated) during the corporate officers have been accustomed to spending on similar spin-off planning process or by issuing debt or executing loan transactions. documents substantially in advance of completing the spin-off. It is important that companies considering a spin-off begin to These approaches, however, often come with their own risks, take action early in the spin-off planning process. Specifically, costs and considerations, which should be evaluated and companies should: discussed at the outset of the spin-off planning process. „„Identify the optimal financing structure for the parent and the spin-off company. OTHER KEY BOARD CONSIDERATIONS „„Consider ideal terms of their debt instruments. There are several other key issues that boards should focus on in determining whether or not to pursue a spin-off and how to „„Initiate discussions with potential financing sources and credit implement it, including issues related to: rating agencies. „„Separate legal representation for the parent and spin-off „„Consider the timing of the financing transactions in relation to company. the anticipated effective date of the spin-off (especially in light of then-prevailing market conditions). „„The duties of the parent board. „„IRS tax rulings and tax opinions. The financing considerations should play a critical role in the determination of the structure for the spin-off itself, as the „„The legality of spin-off-related dividends. size of the spin-off company and the parent, and their capital „„Shareholder approval requirements. structures and creditworthiness (including whether or not they „„Overlapping directors on the boards of the parent and spin- will receive investment-grade ratings), can dramatically affect off company. their and the terms of their debt. Because the

Practical Law The Journal | Transactions & Business | September 2014 49 SEPARATE LEGAL REPRESENTATION that maximizes value for those shareholders. There is no duty In planning for a spin-off, it is important to understand the role of “fairness” as between the parent and the spin-off company. of the various internal constituencies that will be involved. Some Accordingly, the parent board can make unilateral decisions aspects of the spin-off are, in practice, often largely determined as to the allocation of assets and liabilities between the parent by the board and management of the parent, such as the basic and the spin-off company, subject to insolvency and tax decision as to which businesses will be spun off, as well as the considerations, before the spin-off is completed. selection of the spin-off company’s directors. IRS TAX RULINGS AND TAX OPINIONS Other aspects of the spin-off may appropriately involve more Historically, companies would proceed with a spin-off only if input from the future directors and management of the spin-off they received a ruling from the IRS that the spin-off would be company, such as the terms of its corporate documents (for tax-free under Section 355 of the Internal Revenue Code. In example, committee charters, governance guidelines, insider June 2013, however, the IRS announced that it would no longer trading policies and codes of ethics). Even on these matters, issue rulings for ruling requests received after August 23, 2013, companies often decide to generally follow a “clone and go” but instead will only rule on “significant issues” arising under approach by establishing a presumption in favor of using the Section 355. parent’s documents as models to simplify the already complex process of turning one public company into two (or more). Moreover, the IRS will no longer issue private rulings regarding certain structures that have been utilized regularly in spin- In some cases a company may choose to allow managers of the off transactions, including debt-for-debt or debt-for-equity business to be spun off to take a more active role in planning exchanges where the parent’s debt is issued in anticipation of for the spin-off, such as where the business to be spun off and the spin-off and certain high-vote/low-vote structures at the the remaining business are of relatively equal size and have company to be spun off. As a result, parent companies must historically been managed independently. However, companies now rely more heavily on opinions from its outside tax counsel should recognize that these managers may begin to view or advisors. themselves in a quasi-adversarial position to the parent, as they begin to focus on positioning the business to be spun off in the For a spin-off to qualify as tax-free to both the parent and most advantageous manner. In some cases, the question arises its shareholders for US federal income tax purposes, it must whether management of the business to be spun off should qualify under Section 355 of the Internal Revenue Code. have separate legal representation when negotiating the terms Section 355 aims to provide tax-free treatment to transactions of the spin-off, either initially or when the process is closer to that separate two operating businesses and not to transactions completion. that resemble either: „„Distributions of cash or other liquid assets. Establishing separate legal representation before the spin-off is complete generally is inappropriate, as it would unnecessarily „„Corporate-level sales. exacerbate internal divisions and is inconsistent with the notion Under Section 355, the parent must: that it is the duty of the parent’s board to establish the terms of the separation in a manner that serves the best interests of the „„Distribute “control” of the spin-off company (generally, stock parent’s shareholders (who will also be the initial shareholders representing 80% of the voting power and 80% of each non- of the spin-off company). Moreover, for matters that will not voting class of stock). affect the parent following the spin-off (such as the spin-off „„Establish that any retention of stock or securities is not company’s compensation policies), the spin-off company pursuant to a tax avoidance plan. can make whatever changes it desires following the spin-off, In the spin-off, the parent can distribute stock or stock and lessening the need for internal negotiations over these topics. securities of the spin-off company, and the distributees can be Boards should consider these matters with appropriate shareholders or shareholders and holders. In addition, thoughtfulness and sensitivity, balancing respect for the role each of the parent and the spin-off company must be engaged of the future directors and officers of the company being spun in an “active trade or business” that was actively conducted off with the fundamental premise that the responsibility for the throughout the five-year period before the spin-off, with certain spin-off rests with the parent’s board and management. exceptions.

DUTIES OF THE PARENT BOARD Further, the spin-off must be carried out for one or more corporate business purposes and not be used principally as a Under Delaware law, the parent board’s decision to effect a “device” for the distribution of the earnings and profits of the spin-off typically is protected by the business judgment rule. The parent, the spin-off company, or both. Whether the spin-off is directors of the parent do not owe fiduciary duties to the spin-off a “device” turns on whether the spin-off encompasses planned company. Nor does the parent or its board owe fiduciary duties sales or exchanges of stock of the parent or spin-off company, to prospective shareholders of the spin-off company, even after or other transactions, the effect of which would be to permit the the parent declares its intention to spin off the subsidiary. distribution of corporate earnings without a dividend tax. The In structuring a spin-off transaction, directors of a solvent “business purpose” standard requires that a real and substantial corporation owe their duties to the shareholders of the pre- non-tax purpose germane to the business of the parent, spin-off company and may structure the transaction in a fashion the spin-off company, or both, in fact motivated, in whole or substantial part, the spin-off.

50 September 2014 | practicallaw.com COMING IN SEPTEMBER WHAT’S MARKET: SPIN-OFFS Instantly answer your market practice questions and access relevant precedent with our easy search and compare tool.

An opinion of tax counsel will rely on representations made by demonstrate that the board was focused on the issue. Whether an officer of each of the parent and the company to be spun off the receipt of an opinion is worth the costs ultimately depends that address the requirements above. on the specific facts, including the creditworthiness of the payor after giving effect to the spin-off. DIVIDENDS, SURPLUS AND SOLVENCY Spin-offs typically involve the payment of at least one dividend SHAREHOLDER APPROVAL (the distribution of the stock of the spin-off company to the Under the law of most jurisdictions, a shareholder vote is parent’s shareholders) and often involve others, including in required for the “sale or other disposition of all or substantially the form of a payment of cash from the spin-off company to the all” of a company’s assets. In Delaware, the shareholder vote parent before the spin-off. requirement is triggered if the corporation wishes to “sell, lease or exchange all or substantially all of its property and assets.” Under the corporate law of most jurisdictions, a company may Because a spin-off is effected by means of a dividend of shares make a distribution to its shareholders only out of surplus or of the spin-off company (as opposed to a sale of assets), there earnings (and only to the extent the company is not insolvent is law to support the view that a spin-off does not constitute a and would not be rendered insolvent by payment of the dividend sale, lease or exchange within the meaning of Delaware law and, or distribution). Directors cannot avoid personal liability for therefore, shareholder approval is generally not required. willful or negligent illegal dividends. Under Delaware law, “surplus” is the excess of the fair market value of the company’s Consistent with this analysis, shareholder approval has not been assets over its total liabilities and capital. sought in significant spin-offs by Delaware companies. In other jurisdictions, however, such as New York and Maryland, the Directors are entitled under Delaware law to rely in good faith analogous statutes governing sales or transfers of substantially on the opinions of experts as to the existence and amount of all of a company’s assets potentially apply to spin-offs. surplus or other funds from which dividends might properly be Accordingly, careful consideration should be given as to whether declared and paid. It is common for boards to obtain valuation or not a shareholder vote is required. reports and opinions as to the availability of surplus. Some states also provide a safe harbor for directors who rely on the OVERLAPPING DIRECTORS company’s financial statements to determine that the company It is possible for a parent and the spin-off company to have has sufficient surplus to make the distribution. overlapping directors once the transaction is complete. Any Under both state fraudulent conveyance law and the federal overlap in directors between the parent and the spin-off Bankruptcy Code, dividends are also subject to subsequent company generally is limited to at most a minority of each board attack and recoupment by the payor or its creditors if a court in order to preserve the tax-free nature of the spin-off. later determines that the payor was insolvent at the time it All of the facts and circumstances should be considered made the distribution. To mitigate this risk, companies often in determining the impact of overlapping directors on the seek solvency opinions from valuation firms regarding either or tax treatment of the spin-off. If the parent decides to have both of the parent and the spin-off company. overlapping directors with a spin-off company, it should consider Although these opinions are not necessarily dispositive in a the possibility that conflicts may arise between it and the spin- subsequent litigation about the payor’s insolvency, they can off company that may make it appropriate for any overlapping be helpful in establishing solvency (along with the far more directors to recuse themselves from deliberations at each important factor of contemporaneous market pricing data company’s board meeting. for the stock and debt of the payor, among other things) and

Practical Law The Journal | Transactions & Business | September 2014 51 If it is possible that the parent and the spin-off company could become competitors of each other in the future, directors should note that Section 8 of the Clayton Antitrust Act prohibits any person from serving as a director or officer of two or more competing corporations unless the sales of competing products or services of the two companies are less than certain de minimis thresholds. Although Institutional Shareholder Services Inc. and Glass, Lewis & Co., LLC do not have a stated view or policy on overlapping boards, they have policies on overboarding generally.

52 September 2014 | practicallaw.com