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And the SEC bulletin....................
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SECURITIES LAW
'Spin-Off' Transactions
Recent SEC Bulletin Clarifies Certain Issues
The New York Law Journal
December 15, 1997
BY LOIS HERZECA
A RECENT Bulletin1 of the Staff of the Corporation Finance Division of the Securities and Exchange Commission has clarified the Staff's position on certain significant securities law issues arising in spin-off transactions, and reduced the need to seek no-action relief in those areas.
The Bulletin addresses such central issues as whether: (i) the securities issued in a spin-off must be registered under the Securities Act of 1933 (the Securities Act); (ii) the subsidiary can satisfy the Rule 144 reporting requirements under the Securities Exchange Act of 1934 (the Exchange Act) on the date of the spin-off; (iii) the subsidiary can consider its parent's Exchange Act reporting history in determining its eligibility to use Form S-3 after the spin-off; and (iv) the applicability of õ16 of the Exchange Act to spin-offs.
Although the Bulletin offers few surprises to seasoned practitioners, it clarifies and consolidates the Staff's position, and in one instance revises the Staff's position, on traditional spin-offs as expressed in no-action letters over the past 10 years. The Bulletin does not address variations on traditional spin-offs such as split-ups, split-offs, Morris Trusts or spin-offs of "targeted stock."
According to published reports, in the last five years over 170 spin-off transactions, with an aggregate market value of over $75 billion, have been consummated.
In a traditional spin-off, a parent company transfers the business to be spun off to a new subsidiary, and then declares and pays a pro rata dividend to its stockholders consisting of all or a majority of the shares of capital stock of the subsidiary. The stockholders receive the shares without paying any consideration and the subsidiary becomes a separate company, with publicly traded securities and, initially, a stockholder base identical to that of the parent company.
A spin-off is sometimes accomplished in two steps. The parent sells to the public an interest of less than 20 percent in the subsidiary in a registered public offering for cash proceeds. Then, usually within the following three years, the parent pays a dividend of the remaining shares of the subsidiary to the parent's stockholders. These traditional spin-offs (including the second step of the two-step spin-off) generally constitute a dividend for state corporate law purposes and a tax-free distribution under õ355 of the Internal Revenue Code.
Spin-offs have become increasingly attractive alternatives to negotiated private sales for several reasons. Most significant, they are tax-efficient dispositions. In general, a company that distributes assets to its stockholders, including stock of a subsidiary, recognizes gain as though it had sold such assets for their fair market value, and the distributee stockholders recognize dividend income on the receipt of the distribution. A spin-off that satisfies the requirements of õ355 of the Internal Revenue Code is tax-free to both the parent and its stockholders.
In addition to their tax advantages, spin-offs have generally been well received by the investment community and can allow a business to be divested in situations where contingent liabilities or speculative future earnings make it difficult to negotiate an acceptable purchase price.
Registration
One of the first issues securities lawyers typically consider in a spin-off is whether all or a portion of the securities to be issued must be registered under the Securities Act. Although the parent is distributing the securities to its stockholders, the subsidiary to be spun off is the technical issuer and would be the registrant under the Securities Act.
For subsidiaries which are U.S. issuers intending to register their common stock under the Exchange Act, registration under the Securities Act typically would not require additional disclosure or increase the time required to consummate the transaction. Registration under the Exchange Act in such situations requires the filing of a Form 10, which generally contains the same business and financial information as a Form S-1 under the Securities Act and is subject to the same SEC review procedure.
The primary practical difference between a Form 10 filing under the Exchange Act and a Form S-1 filing under the Securities Act is the filing fee. The SEC has eliminated the filing fee for a Form 10 while the filing fee for a Form S-1, at the current rate of $295 per $1 million of securities being distributed, can be substantial.
The Staff stated that an issuer registering shares in a spin-off must look to Rule 457(f) under the Securities Act to determine the appropriate measure of value for the filing fee. Although this rule addresses mergers and recapitalizations and does not specifically mention spin-offs, it provides that if there is a market for the securities being registered, the fee is based on the aggregate market value, and if there is no market, the fee is based on the aggregate book value of the issuer's assets.
For those subsidiaries which do not intend to register their securities under the Exchange Act, however, a requirement to register under the Securities Act can be not only costly but significantly burdensome.
The Bulletin sets forth the Staff's view that, if the following five conditions are satisfied, a spin-off does not have to be registered under the Securities Act:
The parent's stockholders do not provide consideration for receipt of the shares. The Staff views the payment of consideration as the transfer of securities for value, constituting a "sale" under õ5 of the Securities Act, which requires registration absent an exemption.
The spin-off is a pro rata distribution. The Staff believes that if the spin-off is not pro rata, then the relative interests of the stockholders change as a result of the spin-off and therefore some stockholders have given up value for their shares.
The parent provides adequate information to the stockholders and the trading markets. If the subsidiary is a reporting company, the parent provides adequate information if the subsidiary has been subject to the Exchange Act for at least 90 days by the time of the spin-off, the subsidiary is current in its Exchange Act reporting, and the parent gives its stockholders information about the distribution ratio, the treatment of fractional shares and the spin-off's expected tax consequences.
If the subsidiary is not a reporting company, this requirement is satisfied by providing the parent's stockholders with an information statement complying with Regulation 14A or 14C of the Exchange Act and registering the securities under the Exchange Act. If the parent and the subsidiary are both non-reporting companies before and after the spin-off, the adequacy of the information provided will depend on an analysis of the particular facts and circumstances.
The Staff has indicated that it will continue to provide no-action guidance for foreign issuers which do not intend to register the subsidiary's shares under the Exchange Act.
There is a valid business purpose for the spin-off. The Staff believes that where there is a valid business purpose for the spin-off, the parent is less likely to receive value indirectly for the subsidiary's shares through the creation of a market for those securities. Valid business purposes include the need for management focus on the subsidiary's business and the ability to provide equity-based incentive programs linked solely to the subsidiary's business. Invalid business purposes include the creation of a market in shares of a subsidiary having minimal operations or assets or that is a development stage company without a business plan.
If the parent has obtained a tax ruling or a legal opinion as to the tax-free nature of the spin-off, this condition should be easy to satisfy.
If the parent spins off "restricted securities," it must have held them for at least two years. If less than two years have elapsed, the Staff believes that the parent may be an underwriter. The two-year period does not apply where the parent formed the subsidiary itself.
Stockholder Approval
The question of whether shares issued in a spin-off must be registered under the Securities Act has been particularly troublesome in situations where the parent is seeking stockholder approval for the spin-off, or for a transaction in connection with the spin-off. Rule 145 of the Securities Act requires that securities issued in certain business combination transactions must be registered under the Securities Act if stockholders vote on the issue of whether to accept a new security in exchange for their existing securities. The vote is treated as an investment decision and may be deemed to be a sale.
In a spin-off, the parent may transfer substantial assets to the subsidiary to be spun off. Under many state corporation statutes, a stockholder vote is required for the sale or transfer of all or substantially all of the assets of a corporation. Since state law is often unclear as to what constitutes "all or substantially all," particularly in the case of a spin-off, it is conservative practice in many cases to have a stockholder vote on the asset transfers occurring in connection with a spin-off.
The Staff has generally refused to take no-action positions when a spin-off transaction includes a stockholder vote on an asset transfer to the subsidiary. In the Bulletin, the Staff has reconsidered its position and stated that where the parent wholly owns the subsidiary, it will no longer require registration solely as a result of a stockholder vote on the asset transfer.
In many spin-off transactions, the ratio for distributing shares to the parent's stockholders would result in the issuance of a large number of fractional shares. Accordingly, the issuer may seek to aggregate those fractional shares, sell them and deliver the proceeds to stockholders.
The Staff expressed the view that the sale of fractional shares need not be registered under the Securities Act if the spin-off itself is not required to be registered and (i) an independent agent conducts the process and makes the sales in the open market; (ii) the independent agent determines the mechanics, timing and pricing of the sales without the influence of the parent and subsidiary; and (iii) the independent agent and the broker-dealers it uses are not affiliates of the parent and subsidiary.
Related Issues
Interestingly, the Bulletin does not address a related issue arising from the mechanics of the spin-off process. The distribution ratio in a spin-off may result in numerous "odd-lot" holders of the subsidiary's shares. This can be an expensive and burdensome situation for the new public subsidiary. Therefore, issuers often establish a commission-free trading program in the first several months after the spin-off in which odd-lot holders (holders receiving less than a specified number of shares in the spin-off) can either sell down their entire position or "round-up" their position to a specified amount.
The Staff has generally granted no-action relief in those situations where the programs are managed by independent agents, under the conditions described above, and the number of shares held by odd-lot holders is not a substantial percentage of the issuer's outstanding shares.
The Staff also addressed two related issues under Rule 144. The Staff expressed the view that, absent unusual circumstances (e.g., when there is one very large stockholder), securities received in a spin-off that is not required to be registered under the Securities Act are not restricted securities. Affiliates of the subsidiary who wish to sell shares they receive in the spin-off must nonetheless comply with the applicable provisions of Rule 144, or another exemption from registration.
In addition, on the date of the spin-off the subsidiary will satisfy the 90-day reporting requirement of Rule 144 if the parent is current in its Exchange Act reporting and the subsidiary has substantially the same assets, business and operations as a segment for which the parent has reported extensive segment data and other financial and narrative disclosure in its Exchange Act periodic reports for at least 12 months before the spin-off.
The Staff noted that the segment data must include at least revenues; operating profit or loss; identifiable assets; expenses from depreciation, depletion and amortization; capital expenditures; and any other information required by Statement of Financial Accounting Standards (FAS) No. 14 (Financial Reporting for Segments of a Business Enterprise) or, for fiscal years beginning after Dec. 15, 1997, FAS No. 131 (Disclosures About Segments of an Enterprise and Related Information). The Exchange Act reports must also have discussed the subsidiary as a separate segment in the business and management discussion sections of those reports.
Under normal circumstances, a company must have timely filed its Exchange Act reports for at least 12 months in order to be eligible to use a Form S-3. The Staff expressed the view that a subsidiary would satisfy this eligibility requirement on the date of the spin-off if the parent had satisfied the segment data reporting conditions with respect to the subsidiary described above.
The Staff expressed the view that during the period after a subsidiary becomes an Exchange Act reporting company, but before the spin-off occurs, the subsidiary may register the shares underlying "make-whole options" granted to parent employees on a Form S-8 if the options are not transferable; the parent has not had any unusual grant activity under its option plans; and employees of the parent and subsidiary will receive the same information about the subsidiary's stock option plans under which it grants the options.
The Staff noted that Rule 16a-9(a) exempts the receipt of securities in a spin-off transaction from õ16 if all holders of a class of securities participate on a pro-rata basis. Nonetheless, directors, officers and 10 percent beneficial owners must report their initial holdings on a Form 3 at the time the subsidiary becomes subject to the Exchange Act, and must file a Form 4 to reflect the shares received in the spin-off.
The Bulletin does not address a related and interesting issue under õ13(d) of the Exchange Act. A 5 percent beneficial owner of the parent's securities may be a Schedule 13G filer because it acquired those shares before the parent was registered under the Exchange Act. In the spin-off transaction, the 5 percent beneficial owner will acquire the subsidiary's shares after the subsidiary becomes an Exchange Act filer (since the initial Exchange Act filing is generally made before the actual distribution of the shares). The question is whether the 5 percent beneficial owner can, nonetheless, be a Schedule 13G filer with respect to the subsidiary's shares.
The Bulletin does provide useful guidance in several important areas, particularly with respect to spin-off transactions which are subject to a stockholder vote. Given the number and dollar volume of spin-off transactions in recent years, however, it would be useful for the SEC to issue a global release dealing with a variety of spin-off transactions and a wider range of Securities Act and Exchange Act issues.
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Notes
(1) Staff Legal Bulletin No. 4 (CF), Sept. 16, 1997. Staff Bulletins do not have the legal force of an SEC rule or statement, and are not specifically approved by the SEC. They do, however, represent the views of the Staff, which has indicated that they will no longer respond to issues addressed in the Bulletin.
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Lois Herzeca is a partner at Fried, Frank, Harris, Shriver & Jacobson, where she specializes in corporate and securities law matters, including spin- offs, acquisitions and public offerings. |
