Form of Acquisitive Reorganization

1
Form of Acquisitive Reorganization

• P.V. Viswanath

Class Notes for FIN 648 Mergers and Acquisitions
2
Deal Design

• Taxation
• Risk Exposure
• Control
• Continuity
• Form of Payment

3
Tax-free Deals

• The structure of the acquisitive form can make
  the benefits from the deal immediately taxable to
  the target shareholders or not (tax-free or
  deferred).
• Tax deferral requires the ability to view the
  acquisition as one of the entire concern. This
  allows the fiction that there is no taxable
  event for target shareholders.
• One may compare it to an employee whose company
  has been acquired but nothing in his/her working
  conditions have changed.
• In a tax-free deal, since the purchase is of a
  going-concern, Net Operating Loss Carryforwards
  can be used by the acquirer.

4
Taxable Deals

• If only cash or debt is used, the deal is usually
  taxable.
• Conceptually, this is like target shareholders
  having sold their shares, which can be thought
  of as a taxable event, similar to a private sale
  of stock. Consequently, capital gains taxes have
  to be paid by target shareholders.
• For the buyer, in taxable deals,
• the tax basis of the acquired assets can be
  stepped up, thus allowing a larger depreciation
  shield.
• Hence there is an advantage for the buyer, but a
  disadvantage for a seller.

5
Taxes and Merger Activity

• Evidence suggests that tax considerations can
  actually cause merger activity. The motivations
  are
• Exploitation of Net Operating Loss tax
  carryforwards and tax credits
• Step-up in basis on which tax shields
  (depreciation expense) are computed
• Exploitation of debt tax shields through
  increased financial leverage.
• However, it is often possible to realize the tax
  benefits without resorting to an otherwise
  unnecessary merger.

6
Factors in choice of form

• Tax liability
• Exposure to targets liabilities
• If the deal is structured as a purchase of assets
  only, exposure may be avoided.
• Need for shareholder vote
• Increase risk since shareholders may not approve
  deal.
• Survival of target company
• Sometimes key contracts, warranties and retail
  leaseholds may not be assignable to other
  entities, even if the other entity is the new
  owner.
• Flexibility can be affected by the form
• E.g., no taxfree deals are allowed within two
  years of a spin-off (before or after) without
  incurring tax on the distribution of stock.

7
Sovereign Bancorp Case

• Wall Street Journal. New York, N.Y. Nov 15,
  2005. pg. C.6
• The New York Stock Exchange is expected to decide
  within two weeks whether to require Sovereign
  Bancorp Inc. to allow shareholders to vote on its
  controversial transaction with a Spanish bank and
  a New York thrift.
• At issue is the Philadelphia bank's plan to sell
  a 19.8 stake in itself to Banco Santander
  Central Hispano SA and use the proceeds to help
  buy Independence Community Bank Corp. Sovereign
  officials say the 2.4 billion deal doesn't need
  shareholder approval, citing an NYSE rule that
  requires votes only on sales of stakes of 20 or
  more.
• But shareholders, including Relational Investors
  LLC and Franklin Mutual Advisers, argue the deal
  does require a shareholder vote under NYSE rules,
  in part because it would effectively change
  control at Sovereign.

8
Purchase of Assets, using Cash/Debt

• Buyer exchanges cash for the targets assets.
• Target liabilities are not transferred except by
  express agreement.
• After the transaction, the target may liquidate
  or remain as a holding company for other
  investments.
• The case of Marriott the original company
  created a new subsidiary that was left holding a
  lot of liabilities bondholders saw their value
  diminished.

9
The case of Marriott

• The New York Times, March 12, 1993
• The Marriott Corporation said yesterday that it
  had agreed to issue new bonds at higher interest
  rates and to shift some debt between the two new
  companies.The original plan to split, announced
  in October, angered bondholders and brought
  lawsuits because virtually all of Marriott's
  nearly 3 billion in debt would have been left
  with the new real estate company, rather than the
  profitable management company. News of the
  planned reorganization in October had sent the
  price of Marriott's 20-year bonds plunging by 30
  percent. Yesterday, the bonds were up slightly
  after the news of the revision. Marriott's stock,
  which rose 12 percent the day the proposed
  reorganization was announced, closed yesterday on
  the New York Stock Exchange at 26.50, up 75
  cents.

10
Purchase of Assets, using Cash/Debt

• Immediately taxable to target company. However,
  if target shareholders retain their shares, they
  do not realize capital gains or losses until
  target liquidates or shareholders dispose of
  their shares.
• Step-up of asset values for buyer
• Buyer has no exposure to targets liabilities,
  except as agreed.
• No need for buyer shareholder vote target may
  need to vote if there is substantial change in
  nature of target.
• No stock is purchased hence no need to deal with
  minority holdouts.
• The target may or may not survive, since it may
  have no assets.

11
Acquisition of assets in tax-free exchange

• The buyer acquires targets assets in a tax free
  exchange under Section 368 in exchange for the
  buyers stock.
• Target stockholders exchange their stock for
  acquirers stock. Target shareholders do not pay
  tax on the exchange.
• The acquirer takes a carryover basis the in
  targets assets (i.e. tax basis to buyer is the
  same as for target)
• The buyer will acquire targets tax attributes

12
Cash purchase of stock

• Immediately taxable to seller.
• The buyer can treat this as a purchase of assets
  if so, there is a step-up of asset values for the
  buyer, but the targets tax attributes (such as
  NOLs) are lost. However, the target can use NOLs
  to offset recapture and capital gains taxes.
• Else, there is no change in basis and target NOLs
  are kept.
• Purchase of stock means that both assets and
  liabilities are purchased buyer exposed to
  target liabilities.
• The target company is not making any decisions
  individual shareholders are hence no shareholder
  vote is needed.
• There is no merger hence acquiring
  shareholders dont have to vote, either.
• The target will usually survive it becomes
  majority-owned by the acquirer.

13
Triangular Cash Mergers

• In a reverse triangular merger, the target
  survives. Hence unassignable contracts where the
  target is a party will survive as well. The
  alternative of buying the target for cash will
  not ensure this. However, the buyer is exposed
  to target liabilities.
• In a forward triangular merger, the target does
  not survive, but the buyer is exposed to target
  liabilities. The alternative is buying the stock
  of the target for cash. However, this can leave
  minority shareholders.
• Yet another alternative is to directly buy the
  shares of the target or to merge the target
  directly into the buying company. This will not
  create a subsidiary.
• One advantage of creating a subsidiary is the
  ability to separate assets, so that, e.g., debt
  can be issued solely on the security of the
  subsidiarys assets.

14
Mergers and Consolidations

• In a consolidation, two or more corporations
  combine into one new corporation. This creates a
  merger of equals, which may be necessary to
  accomplish the merger politically.
• In a merger, one company acquires the other.
  Target shareholders exchange their shares in
  return for the buyers stock plus other
  consideration, such as cash or notes, called
  boot.
• The payment in stock is tax deferred to target
  stockholders, but boot is immediately taxable.
• The target company ceases to exist and the buyer
  acquires ownership of the assets of the target in
  an efficient manner

15
Statutory Mergers

• This form is advantageous over buying the stock
  of the target in that
• The buyer need only pay partially with stock, but
  the seller wants cash.
• Minority/Dissident shareholders are eliminated.
• Unwanted assets can be sold prior to the merger
  without jeopardizing the tax-free status of the
  merger.
• The merger is not taxable to the target
  shareholders if boot lt 50.
• Can be structured as a two-tier transaction,
  where a controlling fraction of shares was first
  acquired with cash and the target was then merged
  forcibly into the buyer (or into a special
  subsidiary).
• This can be be coercive, if the first-tier
  sellers are given better terms. As a result,
  recent laws have discouraged this.

16
Acquisition of stock in tax-free exchange

• If P acquires Ts stock in a tax-free exchange
  under S. 368
• Ts shareholders will not generally recognize
  gains on the exchange of their stock for stock of
  P.
• P is not permitted to step up the basis of Ts
  assets.
• P generally retains Ts tax attributes, but it
  might be limited in its ability to use Ts NOLs,
  capital losses and tax credit carryforwards.

17
Campeau and Federated

• PR Newswire, March 13, 1988
• CINCINNATI, March 13 /PRN/ -- Federated
  Department Stores,Inc. (NYSEFDS) announced
  today that when its board met on Friday,March
  11, the directors present unanimously reaffirmed
  theirconclusion that the Macy's tender offer and
  merger transaction issuperior to Campeau's
  coercive two-tier offer for 70.5 million (or
  80percent of the) Federated common shares at 75
  per share with asecond-step merger for the
  remaining shares at 44 per share.  TheFederated
  board noted that the Campeau offer is for a
  blendedconsideration 1.50 per share less than
  Campeau's advisors hadindicated they would
  recommend to Campeau on March 1 for a negotiated
  transaction.

18
Campeau and Federated

• PR Newswire, TORONTO, March 22
• Campeau Corporation todayannounced that it has
  amended its tender offer for FederatedDepartment
  Stores, Inc. to provide for the purchase by
  Campeau ofup to 70.5 million shares of Federated
  common stock (representingapproximately 80
  percent of the shares outstanding) for 82
  pershare in cash.  The tender offer is to be
  followed by a merger inwhich Campeau will pay
  37 per share in cash for all remainingshares.
   The tender offer and merger have a blended value
  ofapproximately 73 per share.  Campeau will no
  longer increase themerger consideration if the
  "break-up" fees agreed upon by Macy'sand
  Federated are invalidated or otherwise not paid
  (butnevertheless will contest their
  validity).    The tender offer, withdrawal
  rights and the proration periodwill now expire
  at midnight, New York City time, on April 4,
  1988,unless extended.  The tender offer remains
  conditioned upon, amongother things, Campeau's
  receipt of a majority of the outstandingFederated
  shares on a fully diluted basis

19
Minority Shareholders

• If a majority, but not all, of the stock of the
  target is purchased, the buyer has a subsidiary
  it controls, but it has to deal with minority
  shareholders.
• The same result occurs if a special subsidiary of
  the buyer buys the stock of the target.
• As long as they exist, this subsidiary has to
  submit annual reports to shareholders, hold
  shareholder meetings, elect a board of directors,
  etc.
• These are all opportunities for bothersome
  actions by the minority shareholders.

20
Avoiding Minority Shareholders

• However, if the buyer obtains shareholder
  approval, it can merger the target into itself or
  into the special subsidiary. This will eliminate
  a minority interest in the target.
• If the target company is merged into the
  acquiring company or into a subsidiary, then the
  target company does not exist hence there are
  no minority shareholders.
• Cash purchases of a targets assets also have the
  same result the buying company has no
  relationship with the target company or its
  shareholders.