Inside M&A - May/June 2008
May/June 2008
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Poison Pill Redux – Now More Than Ever
By Robert Schreck and Bryan Steil
Despite depressed stock prices and a weak dollar, U.S. companies continue the trend away from traditional structural defenses to ward off hostile takeovers, including the one considered most effective, the poison pill. Post-Enron, institutional investor services and activist shareholders have actively championed increasing shareholder power. As a result, they have attacked provisions that may entrench current management and put pressure on U.S. public companies to modify or eliminate their shareholder rights plans, also known as “poison pills.”
Return of Hostile Takeovers
A potential acquiror often resorts to a hostile takeover when its overtures to management are rebuffed. In the current environment, a publicly traded company with a depressed stock price, a dependable cash flow and a healthy balance sheet is particularly vulnerable. Macroeconomic factors may cause a target company’s shares to be undervalued, and management may have a long-term plan to increase shareholder value. But, a well-financed company interested in such a target can go directly to the target’s shareholders, inducing arbitrageurs and other short-term investors to sell out the target’s long-term potential.
In the mid-1980s, in response to a market favoring hostile tender offers, public companies routinely adopted shareholder rights plans, along with other provisions in their charters and bylaws, to limit a “corporate raider’s” ability to acquire control of the company. The effort focused upon limiting the ability of a corporate raider to take shareholder action without prior board approval. Following Enron, though, concerns over entrenched management and corporate accountability gave activists a platform to argue for the elimination of restrictions on the ability of shareholders to effect a change in control. Now that unsolicited or hostile offers are back in vogue, the utility of protective measures (“shark repellent” provisions) is being revisited.
A shareholder rights plan is arguably the most effective tool available to discourage a hostile takeover. A shareholder rights plan is designed to force the acquiror to negotiate with the target’s board, rather than make the offer directly to the shareholders, which in turn buys time for the target’s board to mount a defense to the unsolicited offer or to negotiate for a higher price on the behalf of all shareholders.
Mechanics of a Poison Pill
In the typical shareholder rights plan, the board declares a dividend of one stock purchase right for each outstanding share of common stock. Initially, each right is attached to the share of common stock, is not exercisable and is not separately transferable. At issuance, each right entitles the holder to purchase one share of common stock (or a unit of preferred stock) at a specified price, which is usually set to represent the board’s informed prediction as to the likely market price of the company’s common stock five to 10 years in the future. The right has no economic value, unless and until a person acquires a specified percentage (typically 20 percent) of the company’s voting stock without board approval. If the person exceeds the specified ownership, all other shareholders become entitled to purchase additional voting stock at a discount to market price (typically 50 percent), substantially diluting the acquiror. As a result, the acquiror is deterred from acquiring shares in excess of the threshold without board approval. The board retains the ability to amend, redeem or exchange the rights. A rights plan provides the target’s board with greater negotiating power, as well as the opportunity to exercise its superior knowledge and fulfill its fiduciary duties. A rights plan does not change the target’s value structure and does not make the target any less attractive to a potential acquiror. Also, a rights plan does not prevent proxy contests, since the rights plan is triggered by beneficial ownership and not by the receipt of proxies.
Poison Pills in the United States
Generally, the number of publicly traded U.S. companies with structural defenses, such as staggered boards, poison pills and other measures, has been declining. The decline of poison pills is particularly striking. According to Georgeson, the number of public companies with poison pills in force dropped from 60 percent in 2002 to approximately 30 percent by year-end 2007. A rights plan is often viewed as a mechanism that entrenches management, erodes accountability and unduly limits a shareholder’s ability to consider a change of control transaction. Although the target’s board still has a fiduciary duty to consider all unsolicited offers, activist shareholders contend that the power to decide whether and on what terms to sell control of the company should not be restricted. As a result, modern rights plans contain “shareholder friendly” provisions to address management entrenchment and director independence concerns.
A number of companies that eliminated their rights plans adopted “fiduciary out” poison pill policies, expressly reserving the right to adopt rights plans in the future, but agreeing to submit them for shareholder approval within one year of adoption. Anheuser-Busch, Companies, Inc., for example, allowed its rights plan to expire on October 31, 2004, but adopted a policy allowing the adoption of a rights plan without first seeking shareholder approval, if the board determines doing so is in the best interests of its shareholders and the plan is submitted to a shareholder vote within 12 months. Some shareholder proposals seek not only to eliminate existing rights plans, but also to amend bylaws to restrict a board’s ability to implement a rights plan in the future. J.C. Penney Company, Inc., for example, recently enacted a bylaw provision that any rights plan not ratified by shareholders expires one year after its adoption, unless at least 75 percent of the board approves an extension.
Poison Pills in Japan
The U.S. trend, eliminating or limiting shareholder rights plans, runs counter to strategies currently favored in other large economies, such as Japan. In Japan, stocks are trading at historically low price-to-earning ratios, making these Japanese companies attractive takeover candidates. Unlike U.S. companies, Japanese companies have overwhelmingly increased use of the U.S.-style shareholder rights plan. Approximately 500 Japanese companies have instituted poison pill provisions over the past five years (“Japanese Companies Start to Question ‘Poison Pill,’” Junko Fujita & Alison Tudor, International Herald Tribune, May 8, 2008, available at http://www.iht.com/articles/2008/05/08/business/pill.php). This contrast demonstrates the pressures U.S. companies face to limit restrictions on shareholder action and to weaken their hostile takeover defenses.
Conclusion
In the United States, the movement to enhance shareholder rights and reduce management entrenchment has led some U.S. companies to limit the use of poison pills and other anti-takeover defenses. Nonetheless, a shareholder rights plan remains a very effective tool for warding off unsolicited takeovers. Properly structured, poison pill defensive techniques can empower a target’s board to maximize shareholder value without unduly restricting shareholder rights.
Without a Net: Delaware Court Decision Undermines Director and Officer Protections
By Jake Townsend, David A. Cohen and Allison Matthews
On March 28, 2008, the Delaware Chancery Court handed down a decision in Schoon v. Troy Corporation that threatens directors’ reliance on indemnification and advancement of fees rights contained in most corporate bylaws. The decision provided that a Delaware corporation has the power to amend its bylaws to eliminate such rights prior to the assertion of an indemnifiable claim against a director or officer. Accordingly, directors and officers must consider additional measures of protection that cannot be repealed unilaterally by the corporation.
Delaware corporation laws traditionally afford broad indemnification and advancement of fees rights to directors and officers for a number of legitimate policy reasons. For example, indemnification and advancement of fees provisions promote board service and assure that directors’ abilities to carry out official duties are not affected by personal liability. Risk-taking behavior has played an important role in advancing the success of corporations; therefore, the court’s decision to allow for removal of protections for directors and officers may leave them treading cautiously to a fault.
Although Delaware courts consistently supported the laws’ broad grant of rights in the past, Schoon signals a different approach. The facts of Schoon present a unique situation, which may explain the Delaware court’s anomalous holding. William Bohnen, a former director of Troy Corporation, owned a large stake in Troy through an investment holding company, Steel Investment Company. Steel sought to sell its Troy shares and offered Bohnen and Steel’s financial consultant, Richard Schoon, incentive payments if they could complete the sale within a year. In the interim, Bohnen resigned as Troy’s director and Schoon replaced him. Schoon and Steel brought an action pursuant to Section 220 of the Delaware General Corporation Law to gain access to Troy’s records and documents, allegedly to value Steel’s shares in Troy. Troy’s answer and counterclaim asserted Schoon breached his fiduciary duties to the company by sharing Troy’s confidential information with third parties.
After filing suit against Schoon, Troy amended its bylaws repealing advancement of fees rights for former directors. Shortly thereafter, Troy initiated a separate action against Bohnen for breach of fiduciary duties similar to those brought against Schoon. In an attempt to recover fees and expenses incurred in defending the breach of fiduciary duty action, Bohnen filed suit in the Chancery Court against Troy, stating that his rights to advancement had vested at the time of his appointment to the Troy board.
The court examined the intricate facts in the context of Section 145 of the Delaware Code. Section 145 permits Delaware corporations to indemnify directors but provides corporations with great flexibility in determining when and how indemnification and advancement of fees rights should be granted and vested. Accordingly, the court found that a corporation is free to amend its bylaws to deny advancement of fees rights to former directors prior to the filing of an indemnifiable claim against a former director. According to the court, the right to advancement of fees and indemnification vests at the time of the claim and being named a defendant, not at the time of becoming a director. Therefore, since Troy amended its bylaws before it filed a claim against Bohnen, Bohnen had no vested right to advancement.
The court’s deference to Troy’s freedom of contract signals that directors’ and officers’ exposure to liability is at the mercy of the corporation in a broad sense. After Schoon, current and former directors and officers of Delaware corporations should assume they are at risk of losing advancement and indemnification protections following an amendment to a corporation’s bylaws provided that the amendment is made prior to the origination of a suit against the director or officer.
While it seems there are no guaranteed protections left in these bylaw provisions after Schoon, directors and officers may pursue a variety of avenues to circumvent bylaw amendments aimed at stripping them of indemnification privileges. Likely the best method to preserve indemnification and advancement rights is for the director or officer to enter into a separate indemnification agreement with the corporation. Such an agreement would stand as a genuine contract with contract rights arising at the time the contract is made and which rights the corporation may not alter unilaterally. Additionally, directors and officers may want to consider a supplementary insurance policy known as “former director liability insurance,” which cannot be terminated by the corporation because it belongs solely to the director or officer who purchases it. Further, a Delaware corporation can insert indemnification and advancement provisions into its charter, which under Delaware law can only be amended by the stockholders, and any bylaw amendment made thereafter must be consistent with the corporate charter. Another potential solution is an amendment to corporate bylaws with a provision stating that no bylaw amendment shall affect advancement and indemnification rights in place for directors and officers. However, there is no guarantee that such a provision cannot be repealed by a subsequent bylaw amendment.
In conclusion, directors and officers should evaluate the documents that pertain to their current advancement and indemnification rights and consider employing a combination of the above measures to protect and preserve their advancement of fees and indemnification rights. For greatest assurance, any combination of supplementary protections should include an individual indemnification agreement with the corporation to ensure that rights and protections traditionally enjoyed by directors and officers continue post-termination and cannot be amended without such director’s or officer’s consent.
UK Takeover Panel Proposes Changes to Rules on Competition References During an Offer Period
By Brigid Breslin and Davina Garrod
The UK Takeover Panel has proposed changes to the Takeover Code which will be of particular interest to bidders for UK public targets and to funds engaged in event-driven strategies. In the interests of maintaining an orderly framework for the conduct of takeover bids, the changes are designed to make it clearer to market participants what will be the effect of a competition reference and what happens upon clearance following a reference. Some proposed amendments codify existing practice of the Panel; others are new provisions.
By way of background, currently the UK Takeover Code stipulates that if a takeover offer or possible offer is referred to the UK Competition Commission or if the European Commission initiates proceedings, the offer period ends (save when the offer is by way of scheme of arrangement). A “competition reference period” begins upon announcement that this has occurred and continues until clearance by the relevant competition authorities. A new offer period commences when the competition reference period ends (i.e., on clearance).
The main impact of the new proposals can be summarized as follows.
What will happen during a competition reference period?
During a competition reference period, without the consent of the Panel, the offeror and concert parties are subject to restrictions, including restrictions with regard to the acquisition of control of the target’s shares.
What will happen on clearance?
It is proposed that within 21 days of clearance, an offeror or potential offeror must make its intentions toward the target company clear, either by announcing an offer or by stating that it has no intention of making an offer (the latter statement would result in the offeror or potential offeror being locked out for 6 months). This is a new requirement.
What happens if the offer was announced subject to a pre-condition of clearance from the competition authorities?
The Panel wishes to distinguish between, on the one hand, offerors who announce a firm intention to make an offer but subject to a competition pre-condition (who are, upon clearance, committed to continue with the offer on the terms announced), and, on the other hand, potential offerors and offerors whose offers are not subject to pre-conditions (in respect of neither of whom is there any certainty they will, upon clearance, make an offer or upon what terms). In respect of the former, the offer period would, under the new proposals, be deemed to continue during a competition reference period (that relates to clearance by the UK competition authorities or the European Commission only).
The Panel recognizes that competition reference periods may last for many months, and it can be burdensome to comply with particular rules applying during an offer period (such as policing of shareholder meetings by the financial adviser and approval by the Panel of circulars). However, dispensations may be granted by the Panel in that regard during competition reference periods on a case-by-case basis if it would be proportionate to do so.
What pre-conditions relating to competition clearance will be acceptable going forward?
Currently the Code provides that the offer may be pre-conditional upon a decision being made that there will be no reference to the Competition Commission or initiation of proceedings by the European Commission or referral by the European Commission to a competition authority in the United Kingdom. It is proposed that the Code be amended to clarify that the pre-condition could, in addition, relate to clearance following a reference. Also, it is proposed that the invocation of competition pre-conditions will not be subject to the “material significance” threshold in Rule 13.4(a) of the Code.
What will be the impact of the grant of conditional clearance or actions other than clearance on the part of the competition authorities?
The Code is to be amended to reflect more accurately UK and EU competition law in this regard. It is proposed that the Code will clarify that either conditional or unconditional clearance will constitute “clearance” for the purposes of determining when the competition reference period ends. Similarly, if the European Commission fails to make a decision in the requisite timeframe or the UK Secretary of State intervenes, the competition reference period will also end in these circumstances. If the UK or European authorities issue a decision prohibiting the offer and the competition reference period ends, no new offer period will begin.
Proposed Regulations Expected on Loss Utilization in Corporate Acquisitions
By Thomas W. Giegerich and Kumar Paul
As part of a buyer’s initial assessment of the acquisition of the stock or assets of a target company, the tax attributes of the target must be factored into the analysis. If a target has significant net operating loss carryovers (NOLCs), an asset sale—which generally will provide the acquirer a stepped-up basis in the target assets for tax purposes—may be a viable option, as the seller generally can shelter its gain on sale with the NOLCs (subject to a relatively small amount of alternative minimum tax that generally cannot be avoided). Alternatively, the transaction may proceed as a stock sale, in which case the buyer will acquire the loss corporation with its NOLCs intact. The target’s NOLCs can be a valuable asset but, of course, only to the extent that the tax law permits their exploitation following the acquisition.
Section 382 of the Internal Revenue Code (the Code) places certain limitations on the use of NOLCs of a target corporation following a change in ownership of the loss corporation in order to deter “trafficking” in net operating losses. The effect of these limitations on the practical value of a target’s NOLCs requires careful evaluation.
This article provides a broad overview of the current and anticipated Internal Revenue Service (IRS) guidance with respect to the calculation of the section 382 limitation on the use of a target’s NOLCs following an acquisition, with particular emphasis on the treatment of built-in gains and losses of a loss corporation following an ownership change.
Earlier this year, at a discussion panel on the future of Notice 2003-65 (regarding loss corporations under section 382), Mark Jennings, a branch chief in the IRS Office of Associate Chief Counsel (Corporate), indicated that the IRS will “deliver” this year on regulations under section 382(h) that will provide greater clarity on how built-in gains and losses are to be treated for purposes of section 382.
Brief Overview of Section 382
In General
Section 382 provides that, after an “ownership change,” the amount of a loss corporation’s taxable income for a post-change year that can be offset by pre-change losses cannot exceed the “section 382 limitation” for that year. U.S. Congress intended the section 382 limitation to apply when shareholders that did not bear the economic burden of the losses acquire a controlling interest in the loss corporation.
A loss corporation generally is a corporation that has a net operating loss (NOL), an NOLC, or a net unrealized built-in loss for the taxable year in which an ownership change occurs (a pre-change loss). An ownership change occurs, in general, if the percentage of stock of the loss corporation owned by one or more “5 percent shareholders” has increased by more than 50 percentage points relative to the lowest percentage of stock of the loss corporation owned by those 5 percent shareholders at any time during the testing period (generally a three-year period).
The section 382 limitation is generally defined as an amount equal to the product of the fair market value of the loss corporation immediately before the ownership change multiplied by the long-term tax-exempt rate, a figure published monthly by the IRS. If the amount of the limitation exceeds taxable income for any year, the excess can be carried forward. The annual section 382 limitation is intended to approximate the amount of income that the loss corporation could have produced as a return on equity, absent the change in its ownership, had it invested its capital in tax-exempt securities.
Built-in Gains and Losses
Section 382(h) provides special rules for the treatment of built-in gains and losses associated with assets owned by the loss corporation at the change date.
A loss corporation has a net unrealized built-in gain (NUBIG) to the extent that the fair market value of its assets immediately before the ownership change exceeds the aggregate tax basis of the assets. NUBIG that exists on the change date can increase the “section 382 limitation”, dollar for dollar, to the extent of gains recognized during the five-year recognition period (the recognition period) on the disposition of any qualifying asset of the old loss corporation. Recognized built-in gain (RBIG) includes any gain recognized during the recognition period on the disposition of any asset to the extent that the loss corporation establishes that (i) it held the asset immediately before the change date and (ii) the gain does not exceed the excess of the fair market value of the asset on the change date over its tax basis on that date. In addition, “[a]ny item of income which is properly taken into account during the recognition period but which is attributable to periods before the change date” is treated as RBIG.
A loss corporation has a “net unrealized built-in loss” (NUBIL) on the change date to the extent that the fair market value of its assets immediately before the ownership change is less than the aggregate tax basis of the assets. If a loss corporation has a NUBIL, section 382(h) limits the use of losses recognized during the recognition period. Recognized built-in loss (or RBIL) includes any loss recognized during the recognition period on the disposition of any asset except to the extent the loss corporation establishes that (i) it did not hold the asset immediately before the change date or (ii) the loss exceeds the excess of the tax basis of the asset on the change date over its fair market value on that date. RBIL also includes depreciation, amortization or depletion for any period within the recognition period except to the extent the loss corporation establishes that the amount so allowable is not attributable to built-in loss. In addition, “[a]ny amount which is allowable as a deduction during the recognition period (determined without regard to any carryover) but which is attributable to periods before the change date” is treated as RBIL.
If the NUBIG or NUBIL does not exceed the lesser of $10 million or 15 percent of the fair market value of the loss corporation’s assets (excluding cash and cash items) immediately before the ownership change, then the NUBIG or NUBIL, as applicable, is deemed to be zero. Thus, while a loss corporation cannot have both a NUBIG and a NUBIL, it can have neither.
In the case of dispositions of assets during the recognition period, section 382(h)(2) places the burden on the loss corporation to establish that any gain recognized is RBIG, and, conversely, that any loss recognized is not RBIL.
Notice 2003-65
In General
In September 2003, the IRS issued interim guidance in the form of Notice 2003-65 on how to calculate NUBIG and NUBIL and identify RBIL and RBIG for purposes of section 382(h). This guidance may be relied on by taxpayers until regulations are issued. The notice provides for two safe harbors: (1) the 1374 Approach and (2) the 338 Approach. The main differences between the two approaches reside in the identification of the items to be treated as RBIG or RBIL.
Under the notice, NUBIG and NUBIL are calculated in the same manner under both the 1374 Approach and the 338 Approach using what could be referred to as a hypothetical sale model that looks to the amount that would be realized if the loss corporation sold all of its assets, including goodwill, immediately before the change date at fair market value to a third party that assumed all of its liabilities. This amount is decreased by the loss corporation’s aggregate tax basis in all of its assets and any deductible liabilities of the loss corporation that would be included in the amount realized on a sale and adjusted (upwards or downwards) to take into account certain other items, to determine the amount of the corporation’s NUBIG or NUBIL. A positive value constitutes NUBIG and a negative value constitutes NUBIL (subject to the de minimis test discussed above).
Choosing between the 1374 Approach and the 338 Approach
As noted, Notice 2003-65 provides two safe harbor methods for determining RBIG or RBIL. As an introduction to this topic, one of the advantages of the 338 Approach is highlighted below. However, there are a number of important differences between the two safe harbors, and a taxpayer should carefully analyze the advantages and disadvantages of each method in light of its individual circumstances before choosing.
Section 338 provides an election under certain circumstances to treat an acquisition of stock of a target corporation as an acquisition of the assets of the target corporation, such that the assets have a stepped-up basis in the hands of the acquiring corporation. The basic methodology of the 338 Approach is to compare the actual items of income, gain, deduction and loss realized during the five-year recognition period with those that would have resulted had a section 338 election been made with respect to a hypothetical purchase of all of the outstanding stock of the loss corporation on the change date.
Among other things, the 338 Approach assumes that, for any taxable year, an asset that had a built-in gain on the change date generates income equal to the cost recovery deduction that would have been allowed for such asset if an election under section 338 had been made with respect to the hypothetical purchase. The permitted cost recovery deduction by reason of the fictional section 338 election is based on the asset’s fair market value on the change date and a cost recovery period that begins on the change date. An amount equal to the excess of the cost recovery deductions (had this election been made) over the loss corporation’s actual allowable cost recovery deductions is treated as RBIG.
Thus, under the 338 Approach, certain built-in gain assets may be treated as generating RBIG even if they are not disposed of at a gain during the recognition period. This is not true of the 1374 Approach and therefore can prove to be a significant advantage over the 1374 Approach, especially in the case of a loss corporation with significant intangible assets.
For example, LossCo has a NUBIG of $300,000 that is attributable to various non-amortizable assets with an aggregate fair market value of $710,000 and an aggregate adjusted basis of $500,000, and a patent with a fair market value of $120,000 and an adjusted basis of $30,000. The patent is an “amortizable section 197 intangible” for which 10 years of tax depreciation remain. In Year 1 of the recognition period, LossCo has gross income of $75,000. In Year 1, $5,000 is RBIG attributable to the patent (the excess of the $8,000 amortization deduction that would have been allowed had a section 338 election been made with respect to a hypothetical purchase of all of the stock of LossCo ($120,000 fair market value divided by 15, the amortization period) over $3,000 (the actual allowable amortization deduction)). This $5,000 of RBIG increases LossCo’s section 382 limitation for Year 1.
Pending the issuance of regulations, in the event of an ownership change taxpayers are allowed to use either the 1374 Approach or the 338 Approach (but may not pick and choose between parts of both), and the IRS will not assert an alternative interpretation of section 382(h) against any taxpayer that consistently applies one of the safe harbors. The two methods serve only as safe harbors, however, and are not exclusive. Taxpayers can use “other” identification methods, which will be tested for accuracy on a case-by-case basis.
Proposed Regulations Expected Under Section 382(h)
Notice 2003-65 indicates that the IRS intends to publish regulations providing a single set of rules to identify built-in items for purposes of section 382(h). However, recent news articles reporting comments made by IRS officials have suggested that the forthcoming proposed regulations, like Notice 2003-65, may delineate alternative safe harbor methods for identifying built-in items where there is a change in ownership, as opposed to a single definitive method for making the determination.
One concern that practitioners have expressed in advance of the U.S. government’s issuance of the proposed regulations is that, through the rulemaking process associated with the section 382(h) regulations, the U.S. Treasury Department and the IRS may define terms for purposes of section 382 that will also be used for purposes of section 384—a provision in some ways mirroring section 382 that, among other things, in certain circumstances prohibits the use of pre-acquisition losses of an acquiring corporation as an offset against built-in gains of an acquired corporation recognized within a five-year recognition period. Given the differing underlying presumptions of section 382 and section 384 (in particular, as to whether gains are presumed to constitute built-in gains), this could effect some questionable outcomes. However, Treasury and IRS officials are not focused on this at the moment. Thus, while one IRS official has noted that the inquiry about the interplay with section 384 is “appropriate,” he added that the government will assess to what extent it wants the yet-to-be issued section 382(h) regulations to apply for section 384 purposes “[once] the government gets to the point where it’s comfortable with its 382(h) approach.”
In evaluating the potential acquisition of a loss corporation, the selection of the approach under Notice 2003-65 with respect to its NOLC’s most appropriate to the case at hand can significantly affect the “value proposition.” The direction the upcoming proposed regulations will take in this regard remains to be seen.
