IN THIS ISSUE
Top Five Traps for the Unwary in Spin-Offs
Key Tax Considerations in Spin-Offs
Trademark, Domain Name and Other IP Considerations in Spin-Offs
Employee Benefits Issues in Spin-Offs
Top Five Traps for the Unwary in Spin-Offs
by Thomas P. Conaghan and Jeffrey Rothschild
A wave of corporate breakups has swept through the United States over the last few years as investors have taken notice of the fact that smaller companies focused on a single business tend to outperform their more diversified peers. A primary vehicle for these breakups has been the spin-off transaction, in which a publicly traded parent company distributes the shares of the spin-off company (spinco) to its own shareholders, creating a new, independent publicly traded entity. The New York Times, citing Dealogic, reported that there were 93 spin-off transactions worth $128 billion in 2011, and that 2012 kept pace with 85 spin-off transactions worth $109 billion. The rationale for a spin-off often is to unlock the value in a business or division that is trapped in a larger corporate bureaucracy. Conglomerates tend to spread capital across all of their divisions rather than focusing on the individual opportunities within each business that are the most promising. Holding company structures also can make decision-making more cumbersome and equity incentives less incentivizing for division management who feel as though their hard work is being diluted by the underperformance of other divisions or businesses.
Spin-offs, however, are complicated transactions that require a great deal of advance planning. In many cases, an announcement that a parent company is considering the spin-off of one of its businesses is actually the start of a “dual-track” process wherein the parent company considers and plans for a spin-off while also remaining open to potential bids from third parties to acquire the business. In even more complicated cases, a parent company agrees to sell a business to an acquirer in connection with a spin-off transaction.
The vast majority of spin-off transactions are designed to qualify under the rules of the Internal Revenue Code as “tax free” to the parent company and the shareholders who receive the spinco stock.
With this in mind, any company considering spinning off a division or business should keep in mind the following five potential traps.
1. Tax-Free Qualification – Legitimate Business Purpose
The spin-off must satisfy a legitimate business purpose in order to qualify under both the tax-free rules of the Internal Revenue Code and the Securities Act of 1933. The tax authorities require that the spin-off be motivated in whole or in substantial part by one or more legitimate corporate business purposes in order to ensure that the purpose of the transaction is not simply “tax avoidance.” The business purpose requirement is one of many requirements under the tax laws to qualify for a tax-free spin-off. Because the costs of triggering tax in a spin-off transaction often are very high, most parent companies obtain a legal opinion from outside counsel and obtain a ruling from the Internal Revenue Service as a condition to completing a spin-off transaction. As discussed in relation to trap number five below, a legitimate business purpose for the spin-off also is required under the securities laws in order for the distribution of the spinco stock to not be treated as a “sale” of securities by the parent company or the spinco requiring Securities Act of 1933 registration and the strict liability standard of care that comes with such a registration. See the article entitled, “Five Key Tax Considerations for Spin-Off Transactions” for a more in depth discussion of tax issues raised in spin-offs.
2. Separation of Assets and Liabilities
Before a business or a division can be spun off, both its assets and its liabilities must be separated. Large companies with long operating histories often find that the process of separating out the spinco business is not straightforward, because the legal entities that house the business might also house other businesses and divisions that share assets, services, products, employees, vendors and customers with the spinco business. The pre-spin separation transactions should avoid triggering contractual defaults and remedies under commercial agreements, financing agreements, intellectual property licensing agreements, collective bargaining agreements, employment contracts, benefit plans, etc. Often the spinco and the parent company or another legacy business must enter into complex sharing or licensing agreements or joint ventures relating to valuable intellectual property, such as trade names, trademarks or patents, as well as employee matters. See the article entitled “Trademark, Domain Name and Other IP Considerations for Spin-Offs” for a more in depth discussion of IP issues raised in spin-offs and see the article entitled, “Employee Benefit Issues in a Spin-Off” for a more in depth discussion of employee benefit issues raised in spin-offs.
The sharing of liabilities is often the most complicated endeavour because of the slew of legal obligations that are triggered. In allocating liabilities to the spinco, the parent company must evaluate the impact such allocation will have on the solvency of the parent and the spinco. Parent company directors can face personal liability under state corporate law for making an unlawful dividend because the company lacked sufficient capital to make such a dividend or for rendering the parent company insolvent by distributing out the spinco business, and the parent company itself can face claims of constructive fraudulent conveyance—i.e., the parent company received less than equivalent value, and either the parent or spinco was rendered insolvent (assets do not exceed liabilities), the parent and/or spinco was left with unreasonably small capital to run its respective business, or the parent or spinco was left with debts that exceed its respective ability to pay those debts as they become due. Parent company directors can rely on legal experts and financial advisors to assist them in satisfying their duty of care. A solvency opinion from a nationally recognized provider of such opinions is often a condition to the consummation of a spin-off transaction. Such an opinion may be helpful to the directors of the parent company and spinco for a variety of reasons: (i) it can help to show that the directors properly exercised their duty of care in determining to enter into the spin-off transaction; (ii) it can assist in rebutting a fraudulent conveyance claim; and (iii) it can assist in rebutting a claim that the company had insufficient capital to make such a dividend.
3. Transition Services
While one of the key rationales for spinning off a business or division is to allow the enterprise to operate independently, the reality in most cases is that, at least during the first year or so post-spin, a spinco must rely on its former parent company to provide many key administrative and operational services during the spinco’s transition period to a self-sufficient, independent public company. During the pre-spin planning period, companies should consider, among other things, which transition services will be required, how they will be provided, for how long and under what pricing terms. Typical transition services include legal, internal auditing, logistics, procurement, quality assurance, distribution and marketing. These arrangements often have durations that last between six and 24 months. Many parent companies agree to provide such transition services purely on a cost basis, while others will use a “cost plus” or “market” rate.
4. Spinco Management and Board of Directors
Again, while independence from the former parent company is a key benefit for most spincos, having corporate managers with institutional knowledge and history with the enterprise is an important factor in assisting the spinco to successfully transition to independence. Many spinco management teams include members who have served as executives at the former parent company. In many cases, these are managers who served as division leaders who reported to the parent company CEO or CFO and are now ready to step into executive roles on their own. It is also common for between one and three members of the parent company board to agree to take seats on the spinco board to provide the new public company board with a source of the company’s history and culture to ensure a smooth transition. However, because of the competing fiduciary duties that these directors will face if they hold seats on both the parent and spinco boards, it is important for the spinco board to also have a majority of truly independent directors. Spinco directors who are former executive officers of the parent also must be aware that the stock exchanges and influential shareholder services firms such as Institutional Shareholder Services will not view them as being truly independent from a corporate governance standpoint for some time after the completion of the spin-off. This will inhibit their ability to serve on key board committees of the spinco.
5. Preparation of the Disclosure
Under the U.S. Securities and Exchange Commission’s rules, a spin-off of the shares of a subsidiary to a parent company’s shareholders does not involve the sale of securities by either the parent company or the subsidiary as long as the following conditions are met: (i) the parent company does not provide consideration for the spun-off shares; (ii) the spin-off is pro rata to the parent company shareholders; (iii) the parent company provides adequate information about the spin-off and the subsidiary to its shareholders and to the trading markets; and (iv) the parent has a valid business purpose for the spin-off.
To meet the adequate public information requirement, parent companies are required to prepare and disseminate detailed “information statements” that effectively look like initial public offering registration statements for the spinco. These information statements are filed with the spinco’s Form 10 registration statement, which is required in order to register the spinco’s shares under the Securities Exchange Act of 1934 and to permit listing of such shares on a national securities exchange. The preparation of the spinco information statement can take up to three or four months and requires a great deal of effort and cooperation among the lawyers, the business leaders, the finance department, the human resources/employee benefits department and the auditors. In addition, under New York law, a spin-off of all or substantially all of a company’s assets may require a vote of such company’s shareholders, while under Delaware law, such a requirement is much less likely.
Key Tax Considerations in Spin-Offs
by Robert A. Clary, II and Jeffrey C. Wagner
A critical consideration in the disposition of any business is the tax cost. If properly structured, a disposition structured as a spin-off can be tax free to both the distributing corporation and its stockholders, while at the same time permitting the distributing corporation to pay down debt or buy back its stock, which otherwise would utilize the company’s cash. In contrast, federal and state corporate tax in excess of 40 percent (depending on the state) is imposed on a more straightforward sale by a corporation of a business unit. The stockholders also are subject to tax if the corporation distributes the proceeds as a dividend or in redemption of some of its stock. Numerous requirements must be satisfied to obtain the tax-advantaged treatment of a spin-off at both the corporate and stockholder level. This article sets forth some of the more critical tax considerations associated with a spin-off transaction. Of particular note, the Internal Revenue Service (IRS) recently announced that it will no longer provide rulings on certain critical aspects of spin-off transactions, a move which may leave taxpayers with less certainty than desired regarding the tax consequences when engaging in such a significant transaction.
Legal Opinion or Private Letter Ruling
A threshold question for any corporation undertaking a spin-off transaction is whether to obtain a tax opinion from counsel or seek a private letter ruling from the IRS. The stakes are usually very high. If the distribution of the stock of the controlled corporation does not qualify for tax-free treatment, the distributing corporation pays tax on the gain, and the recipient stockholders are taxable on the receipt of the controlled corporation stock. Often the gain inherent in controlled corporation stock is significant. Additionally, although the dividend to the stockholders generally should qualify for the lower qualified dividend rate, the stockholder generally will not be able to offset the gain with any basis the stockholder may have in the stock of the distributing corporation. Further, because a spin-off transaction is generally not coupled with a liquidity event, there is no cash generated in the transaction to fund the resulting income taxes.
The decision whether to obtain a ruling often is dictated by time constraints and the level of certainty required. If the distributing corporation is publicly traded, a ruling may be required. Even if a tax opinion is the chosen route, there often may be specific issues for which a ruling is sought, either because a legal opinion at the desired level is not feasible or the issue is one on which the IRS will rule but for which it is difficult to render an opinion. Similarly, in most cases where a ruling is obtained, one or more tax opinions also are obtained because there are certain issues on which the IRS will not provide a ruling (for example, the IRS will not issue a ruling that the spin-off satisfies the business purpose requirement). Unfortunately, recent IRS guidance expands the list of issues for which the IRS will not provide a ruling, resulting in less certainty available to taxpayers. Further, although recently the IRS sought to provide spin-off rulings in 10 weeks (provided the taxpayer complied with certain requirements, including timely providing information to the IRS), the IRS recently abandoned the 10-week program, leaving the timing of an IRS ruling more uncertain.
In most cases, the separation of one or more businesses in a spin-off transaction requires significant restructuring to align the separate businesses. These restructuring transactions often involve multiple legal entities, both U.S. and non-U.S., which often operate both the distributing and controlled businesses. The separation of these businesses raises issues under U.S. and non-U.S. tax law. For example, a U.S. parent corporation may have an international structure with a single operating subsidiary in each of the relevant jurisdictions. If each of these entities operates both the distributing and controlled businesses, the businesses must be separated from each legal entity prior to the spin-off. Often it is desirable to form a new subsidiary to hold the separated business. However, the legal, tax and regulatory regimes in each of these jurisdictions must be carefully analyzed, in addition to U.S. tax issues. One transaction that often occurs in connection with a spin-off may raise what has become known as a “north-south” issue. Simply put, this transaction involves the contribution of certain assets to a subsidiary (the south portion), in conjunction with a distribution of property, generally stock of a lower-tier subsidiary from the recipient corporation (the north portion). The concern is that the properties are treated as transferred in exchange for one another, creating an unintended taxable event. Historically, the IRS provided comfort to taxpayers via private letter rulings that the north and south transaction would not be integrated to create a taxable event, provided that the taxpayer was able to make certain representations. However, effective for 2013, the IRS announced that it would no longer provide rulings on this issue. Thus, taxpayers are left with more uncertainty as to the treatment of these critical pre-spin-off transactions and likely will seek advice of counsel.
For many spin-offs, the pre-transaction restructuring steps garner the most time and cost, particularly the restructuring steps involving non-U.S. businesses. Companies considering a spin-off should create an efficient work plan early in the process to manage the restructuring steps, utilizing the correct team of advisors to assist in the process.
One of the requirements for a tax-free spin-off is that the distributing corporation must distribute “control” of the controlled corporation. Control is defined as stock constituting 80 percent of the voting stock and 80 percent of all other classes of stock. If the distributing corporation owns less than 80 percent of the overall value of the stock of the controlled corporation, it often can recapitalize shortly before the transaction to achieve the requisite 80 percent ownership by using high-vote/low-vote stock. Generally, nothing precludes converting the stock back to a single class of voting stock. Notwithstanding the “temporary” nature of the “control,” the IRS generally has blessed this approach in private letter rulings, notwithstanding that it may have been difficult for counsel to provide a tax opinion at the desired level. This is no longer the case. T
he IRS announced in early 2013 that it would no longer rule on whether the control requirement is satisfied if, in anticipation of the spin-off, (i) the distributing corporation acquires control of the controlled corporation in any transaction involving an exchange of higher-vote stock for stock with lesser voting power, or (ii) the controlled corporation issues stock with a different voting power per share than the stock held by the distributing corporation. As a result, the certainty that taxpayers historically could obtain from the IRS has been significantly limited, and taxpayers likely will rely on advice of counsel to determine whether these transactions will be respected in connection with the spin-off.
Establishing the capital structure of the distributing and controlled corporations is critical. It is often desirable for the distributing corporation to retire a portion of its outstanding debt securities by transferring certain debt securities of the controlled corporation to its security holders. These debt-for-debt exchanges can be structured to be tax-free to the distributing corporation. Under current law, these debt-for-debt exchanges can be accomplished in a tax-efficient manner without regard to the tax basis the distributing corporation has in the stock of the controlled corporation; however, there have been legislative efforts to limit this type of exchange. Often the debt-for-debt exchange utilizes a financial intermediary that purchases the distributing corporation’s debt on the public market, receives the controlled corporation’s debt securities in exchange for the newly purchased distributing corporation securities, and sells the controlled corporation’s debt securities on the public market. These transactions raise a number of technical questions under the spin-off rules. In recent years, the IRS provided guidance in private letter rulings that permitted these transactions on a tax-free basis, including permitting the new issuance of distributing corporation debt prior to, and in contemplation of, the spin-off, provided the taxpayer could demonstrate certain facts and make certain representations. However, in early 2013, the IRS announced that it would no longer rule on the tax-free nature of a distribution of controlled corporation debt securities in exchange for distributing debt securities, if the distributing debt securities are issued in anticipation of the spin-off. However, it is believed that the IRS will continue to rule on transactions in which financial intermediaries acquire distributing debt securities from third parties and then such securities are exchanged for debt securities of the controlled corporation.
Tax Sharing/Matters Agreements
In connection with a spin-off, it is common for the distributing and controlled corporations to enter into an agreement that governs the responsibility for taxes. This agreement is commonly referred to as a “tax sharing agreement” or “tax matters agreement.” The label “tax matters agreement” often is chosen to avoid having two key spin-off agreements (the transition services agreement and the tax sharing agreement) with the acronym TSA. The agreement generally governs the responsibilities and rights of the parties following the spin-off with respect to known tax liabilities, unknown/contingent tax liabilities, tax return preparation and filing, tax audits, tax controversies and tax attribute utilization. In addition, the agreement generally prohibits certain post-transaction acts that could jeopardize the intended tax-free nature of the spin-off.
Many different approaches have been adopted. For example, if the businesses historically have been separately operated in separate corporate entities, it is often the case that the distributing and controlled corporations each will assume the tax liabilities associated with their respective businesses, and in turn, retain power over tax returns, audits and controversies related to those liabilities. However, where businesses have been historically operated as divisions of a single corporation, it is not uncommon to see an agreement that assigns all historic liabilities to the distributing corporation (particularly if the distributing corporation is larger), with the distributing corporation maintaining control of tax returns, audits and controversies (generally with input and cooperation of the controlled corporation). In many cases, the end result falls somewhere in between these two approaches. Companies engaging in a spin-off should recognize that they will have to live, often for many years, with the agreement they adopt. Thus, careful consideration should be given to the level of granularity of the agreement. While it is often tempting to attempt to solve any potential issue that could arise, in many cases this is not practical and results in the companies having far more interaction than desirable or anticipated at the time of the spin-off. The process of drafting an agreement can become contentious (even though the companies are not yet separated) if there are clear divisions within the company advocating for each of the soon-to-be-separated companies. However, often conflict can be avoided with an initial understanding that the goal of the agreement is to maximize stockholder value and consistency with other inter-company agreements (e.g., the separation and distribution agreement).
Sales in Connection with Spin-Offs
In many cases, the rationale for a spin-off is that holding disparate businesses does not maximize investment return under a single corporate structure. For example, a single corporation may operate a high-growth international business and simultaneously operate a more mature U.S. business with stable cash flows but lower growth opportunities. The separation of the businesses is often believed to maximize the prospects (and, in turn, the stock trading price in the case of public companies) for each. In many cases, one or both of the distributing or controlled corporations may be attractive to potential acquirors. Section 355(e) prevents the avoidance of corporate-level tax for dispositions of 50 percent or more of the distributing or controlled corporation stock that are undertaken as part of the same plan that includes the spin-off. The rationale for this rule is to prevent corporations that desire to sell a business from undertaking a spin-off in order to avoid the corporate-level tax. The regulations under section 355(e) contain a number of factors that are used to determine whether a sale is part of the plan that included the spin-off. In addition, the regulations contain certain safe harbors that can be satisfied to avoid the application of section 355(e). The regulations contain a presumption that a sale is part of the same plan that includes the spin-off if the sale occurs within two years of the spin-off. The taxpayer must rebut this presumption through factual proof that no such plan existed.
Companies engaging in a spin-off should carefully consider those facts that could be subsequently used to show the existence or absence of a “plan,” including any level of discussion of a potential sale. Similarly, companies considering the acquisition of a target that was recently part of a spin-off (i.e., within the previous two years) should carefully consider the application of section 355(e) and the possibility of inheriting certain tax liabilities associated with the spin-off. Note that the IRS will not provide a ruling as to whether a sale of the distributing or controlled corporation is part of the same plan that includes a spin-off.
Trademark, Domain Name and Other IP Considerations in Spin-Offs
by Joanne Ludovici and Jennifer M. Mikulina
When planning for a spin-off, companies should address important trademark, domain name and related intellectual property (IP) matters alongside the myriad other matters involved in this complex type of transaction. The parties (the former parent company and the spin-off company, or spinco) should consider the following questions and implications.
Will the spinco have a new name/branding strategy post-separation?
If the spinco will have a new name or branding strategy, it is critically important to engage trademark counsel early in the process, in addition to confirming that the new name is available for registration as a business or trade name with the secretary of state in each state in which the spinco will conduct its business post-separation. Counsel will conduct and analyze trademark searches to confirm that the proposed name is available to the spinco, both for its use as a trademark, meaning free from serious risk of objection by third parties, and for registration at the U.S. Patent and Trademark Office. In addition, in order to further differentiate itself from the former parent company, the spinco may wish to consider adopting a new design/logo and slogan/tagline, for which searches also should be conducted and reviewed by trademark counsel. If the spinco plans to conduct business activities outside the United States, similar trademark searches should be carried out in those jurisdictions. Finally, the spinco should confirm that the new name is available for registration as a domain name and, if the spinco is a public company, that any proposed stock ticker be cleared prior to filing or registering with the U.S. Securities and Exchange Commission.
Will the spinco use or “share” the former parent company’s name or other trademarks/service marks/logos?
If the spinco will use the former parent company’s name or some version of it in its name or in its branding strategy post-separation, the parties must agree on the details regarding such use. For example, will the former parent company assign certain brand rights to the spinco, or will it retain ownership and permit the spinco to use its marks through a license? Will any limitations be placed on the spinco’s post-separation rights? For example, can the spinco use trademarks that are the same as or similar to the former parent company’s marks? Will the spinco be prohibited from or restricted to certain goods or services, fields of use, or geographic or business areas? Written agreements must be in place to clarify the spinco’s use of the former parent company’s name and other brand-related assets in order to help avoid post-separation misunderstandings about, and misuse of, the parent former company’s brands.
If the spinco will not use the former parent company’s name, trademarks/service marks/logos or other brand-related assets, what transition period for current usage is appropriate?
The parties should coordinate early in the separation planning to assess what transition period and post-separation “sunset” license(s) will be feasible. They should consider, for example, whether the spinco will need to sell off existing inventory, use up printed materials (marketing collateral, letterhead, business cards, etc.), replace stamping machinery and change signage anywhere the parties currently conduct business. The parties also should consider whether, and under what conditions, the spinco will need to share a common website or landing page for some period of time post-separation. As with any post-separation brand-sharing arrangements, written transition agreements specifying the terms and conditions of all transition-related uses should be in place. These agreements also are beneficial in avoiding potential infringement claims after separation.
Will the spinco need to use the former parent company’s software after separation?
One easily overlooked issue is whether the former parent company’s pre-separation software licenses, including docketing software, will cover use of the software by the spinco after separation. Some software license agreements do not permit divisions. An enterprise-wide license may cover only a single entity and may not include spin-offs. The parties should identify the critical software that the spinco will need, and review all relevant software agreements prior to separation to assess whether an amendment or new license is necessary.
Will any existing company agreements affect the spinco’s ability to use certain IP post-separation?
The parties should review all existing agreements that pertain to or affect any of the former parent company’s IP assets that the spinco plans to acquire or use post-separation (it is likely that these agreements also will be binding on the spinco). The parties should consider whether any provisions will affect the spinco’s use of these assets. For example, a trademark coexistence agreement with a third party may limit use of certain trademarks to a particular geographic area or to certain goods and services. The spinco must understand and comply with any limitations.
Executing a successful and timely spin-off involves coordination of several moving parts. Including IP rights in your planning and involving IP counsel early and often in the process are critical steps that will ensure that each party owns, or has the necessary rights to use, the valuable IP that it needs to conduct its business on day one post-separation.
Employee Benefits Issues in Spin-Offs
by Joseph S. Adams and Jeffrey M. Holdvogt
In a corporate spin-off, both the existing company and the new company (spinco) must consider the implications for employees, employee benefit plans and executive compensation arrangements. Benefit plans and compensation arrangements can represent significant liabilities and responsibilities, and typically are expressly allocated in an employee matters agreement (EMA). This article provides a brief summary of some of the key employee benefit plans issues to consider in a spin-off.
Separating Employees and Management
For most employees, it will be clear whether they are primarily related to the future profile of the parent company or of the spinco following the separation. The EMA should carefully delineate the status of each employee or employee group. For executives and management, particularly where existing managers have responsibilities that cover both the parent company and the spinco, the parent and the spinco should carefully consider their management personnel, including whether additional management may be necessary for the spinco’s successful transition.
Continuing Salary and Benefits; Transfers Post-Spin
Once the parties are separate, will the spinco employees continue salary and benefits at the same levels? To reassure spinco employees, the parent company and the spinco may want to establish a transition period guaranteeing salary and benefit levels following the separation. Will employee transfers between the parent company and the spinco be anticipated (or perhaps prohibited) post-separation? If so, the parent company and the spinco should address this issue in the EMA.
The spinco (or the parent company, if key personnel leave it) may need support for payroll, tax, human resources and other functions immediately following the separation. A cost-sharing agreement may be necessary to cover costs related to benefits and administration for former employees. The parent company and the spinco also should consider establishing data sharing and privacy practices for the post-separation period.
Separating and Establishing New Employee Benefit Plans
The spinco may already maintain its own separate employee benefit plans, in which case the transition will be easier. However, if the spinco does not maintain separate plans, it must create its own plans prior to separation in order to assume the assets and liabilities from the parent company’s plans related to spinco current employees (and perhaps former employees). If those new spinco plans cannot be set up prior to the spin-off, it may be necessary to structure arrangements to allow spinco employees to continue to participate in the parent company’s plans for a limited period of time (and to implement appropriate plan documentation, administration and reporting/non-discrimination testing procedures).
If the former parent company has a defined benefit plan in which spinco employees participate, the parties should consider the following questions:
Will the spinco create a new, active defined benefit plan for its employees?
Even if the spinco will not have an active defined benefit plan for its employees, will assets and liabilities attributable to pension benefits accrued through the date of the spin-off be transferred from the parent company’s pension plan to a frozen spinco plan?
If there is such a transfer, will it be for only those spinco employees as of the date of the spin-off, or will it also relate to previously terminated or retired employees of the spinco business?
How will the parties measure any unfunded benefit liabilities?
Employee accounts in the parent company’s defined contributions plans typically are transferred to a spinco plan for employees who transfer to the spinco. The parent company and the spinco should work together to coordinate employee elections. If the parent company’s defined contribution plans contain parent company stock as an investment fund, special considerations arise with respect to the valuation and split of the stock as a result of the separation, and fiduciary liability related to maintaining non-employer stock as an investment option post-separation in both the parent company and the spinco’s defined contribution plans (i.e., the parent company may have spinco stock in its plan, and the spinco may have parent company stock in its plan).
Because nonqualified benefits often are unfunded or only informally funded, there can be great sensitivity regarding whether spinco employees’ nonqualified plan benefits should transfer to the spinco or remain with the parent company. If the desire is to distribute those nonqualified benefits rather than keep them with the parent company or transfer them to the spinco, it will be necessary to analyze whether a distribution is permissible. For nonqualified benefits that are subject to Section 409A of the Internal Revenue Code, the Internal Revenue Service takes the position that spin-offs generally do not constitute a “separation from service” that would permit distributions to employees; however, distributions may be possible if the transaction constitutes a change in control as defined in Section 409A.
Health, Welfare and Fringe Benefit Plans
In general, the parent company and the spinco each will be responsible for claims incurred against their own welfare plans post-spin. However, to the extent the parent company maintains or previously maintained a retiree medical program, the parties must determine how to measure and allocate those retiree medical liabilities (i.e., should the spinco be responsible for retiree medical costs of all employees associated with its business—current, terminated vested and retired—or just future retirees, which would leave terminated vested and retired employees as an obligation of the parent company).
In addition, special attention may be necessary to allocate liabilities related to COBRA, long-term disability payments, spending account plans, accrued vacation/paid time off, workers’ compensation, etc.
Severance Plans/Employee Retention Agreements
If the spin-off triggers a change in control or a separation from service, executives and/or employees with existing retention agreements can find themselves in possession of substantial payments earlier than anticipated, and the often unfunded nature of such plans and arrangements can result in significant payments required from general assets. The parent company and the spinco should determine whether severance obligations arise in connection with employee transfers to the spinco and, if so, how to allocate responsibility for such obligations.
In addition, it may be necessary or desirable to implement new retention or change in control agreements for key spinco employees.
Equity Awards/Incentive Plans
Typically, parent company and spinco equity awards are equitably adjusted to preserve the aggregate spread and value of the awards in connection with the spin-off. However, care must be taken to determine what types of adjustments are permitted under the equity plan documents and whether the adjustments will trigger an accounting expense. Adjustments may be made both as to the number of shares underlying the awards and, in the case of options (including options under employee stock purchase plans), the exercise price.
In addition, the parent company and the spinco must determine whether awards will be based on parent company equity or spinco equity. One approach is to convert all awards for spinco employees to spinco awards and to convert parent company employees’ awards into adjusted parent company awards. Another approach is to provide employees with both an adjusted parent company equity award and a new spinco equity award. For executives and management, particularly those with decision-making authority during the period prior to the separation, it may make sense to utilize the latter approach as a way of aligning incentives until the spin-off is complete.
For cash annual and long-term incentive plans, the parent company and the spinco must determine whether either entity will be responsible for the full-year liability or whether each will be responsible for its respective portion.
Numerous other issues will arise depending on the nature and structure of the companies. For example:
The parent company and the spinco must consider obligations under collective bargaining agreements, including potential withdrawal liabilities related to multi-employer defined benefit pension plans (sponsored by unions and maintained pursuant to previous collective bargaining).
The parent company and the spinco also must consider issues related to the treatment of foreign employees, including the transfer of non-U.S. retirement plans.
Compensation arrangements must be established for the new outside directors of the spinco.