Top Five Spinoff Worries Beyond Taxes

Before a business or a division can be spun off, both its assets and liabilities must be separated from the parent.

Thomas P. Conaghan,  partner, McDermott, Will & Emery

Thomas P. Conaghan, partner, McDermott, Will & Emery

A wave of corporate breakups has swept through the United States in recent years as investors recognize that smaller companies focused on single businesses are outperforming their more diversified peers.

Many of these breakups have been spinoffs, whereby a publicly-traded parent company (parent) distributes the shares of the spinoff company (spinco) to its own shareholders, creating a new, independent, publicly-traded entity.

Companies often spin off businesses or divisions to unlock value when those entities are trapped in larger corporate bureaucracies or holding-company structures that offer inadequate capital, encumber decision-making and dilute equity incentives for division management.

While they’re popular, spinoffs are complicated and require a great deal of planning. Although CFOs must remain highly focused on preventing parent company and shareholder tax exposure, they must also keep in mind many critical non-tax considerations when embarking on spinoffs.

1.  Separation (and Potential Sharing) of Assets
Before a business or a division can be spun off, both its assets and liabilities must be separated from the parent. Large companies with long operating histories may struggle in the separation process. Often that’s because the entities that house the business may also house others that share assets, services, products, employees, vendors and customers.

Analysis_Bug16Pre-spin separation transactions should avoid triggering contractual defaults and remedies under commercial, financing, intellectual property licensing and collective bargaining agreements, as well as employment contracts, benefit plans, and more. Often spinco and parent or other legacy businesses must enter into complex sharing or licensing agreements or joint ventures relating to valuable IP, like trade names, trademarks or patents, as well as employee matters.

2.  Separation of Liabilities and Solvency Concerns
Pre-spinoff liability-sharing is often extremely complicated in the spinoff because it provokes many legal obligations. When allocating liabilities to the spinco, CFOs and outside advisors should evaluate the potential impact they will have on the solvency of both parent and spinco. Parent directors may face personal liability under state law for making an unlawful dividend if the parent company lacks sufficient capital to do so or if the dividend renders the parent insolvent.

The parent may also face constructive fraudulent conveyance claims. For example, the parent may receive less than equivalent value when it spins a business off, and either is rendered insolvent (its assets do not exceed its liabilities), is left with unreasonably small capital to operate, or is left with debts that exceed its ability to pay them as they become due. 

3.  Transition Services
Although operational independence is an important benefit — and often the purpose — of a spinoff, in most cases, spincos must rely on their former parent companies to provide some administrative and operational services during its transition to a self-sufficient, independent company.

During the pre-spin planning period, CFOs should consider which transition services will be required, how to provide them, for how long and under what pricing terms. Typically, transition services include legal, internal auditing, logistics, procurement, quality assurance, distribution and marketing. These arrangements often last between six and 24 months and many parent companies provide them purely on a cost basis, while others will use a “cost plus” or “market” rate.

4.  Spinco Management and Board of Directors
Having corporate managers with institutional knowledge and history of the enterprise is also an important success factor in spinoffs. Many spinco management teams include former executives of the parent. In many cases, these are former division leaders, who previously reported to the CFO or another senior executive, but are now ready to step into an executive role themselves.

In order to maintain a sense of institutional history, one to three members of the parent board may also agree to take seats on the spinco board. Because of competing fiduciary duties that these directors may face from sitting on both boards, it is important for the spinco board to maintain a majority of truly independent directors. Also, from a corporate governance standpoint, stock exchanges and influential shareholder services firms like Institutional Shareholder Services will not immediately view former executive officers of parent as truly independent, inhibiting their ability to serve on key board committees of spinco.

5.  Preparation of the Disclosure
Under Securities and Exchange Commission rules, a spinoff of a subsidiary’s shares to a parent’s shareholders does not involve the sale of securities by either parent or the subsidiary as long as the following conditions are met: (i) the parent does not provide consideration for the spun-off shares; (ii) the spinoff is pro rata to parent shareholders; (iii) the parent provides adequate information about the spinoff and the subsidiary to its shareholders and to the trading markets; and (iv) the parent has a valid business purpose for the spinoff.

To meet the commission’s public information requirement, the parent must prepare and disseminate detailed “information statements,” similar to IPO registration statements, for the spinco. These statements are filed with the spinco’s Form 10 registration statement, which is a requirement to register the spinco’s shares under the Securities Exchange Act of 1934 and to permit their listing on a national securities exchange. The preparation of the spinco information statement can take three or four months and requires significant time and effort from the CFO and the CFO’s team.

Thomas P. Conaghan is a partner with McDermott, Will & Emery. He would like to thank Jeffrey L. Rothschild for his role in preparing this article.

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