Category: Corporate law

Securities and Exchange Commission (SEC) Sanctions Revlon Financial Makeover; Tips for Setting a Strong Foundation for Going Private Transaction Success

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On June 13, 2013, the SEC entered into a cease and desist order and imposed an $850,000 civil money penalty against Revlon, Inc. (Revlon) in connection with a 2009 “going private” transaction (the Revlon SEC Order).  This article identifies some of the significant challenges in executing a going private transaction and highlights particular aspects of the Revlon deal that can serve as a teaching lesson for planning and minimizing potential risks and delays in future going private transactions.

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Background of Revlon Going Private Transaction.

The controlling stockholder of Revlon, MacAndrews & Forbes Holdings Inc. (M&F), made a proposal to the independent directors of Revlon in April of 2009 to acquire, by way of merger (the Merger Proposal), all of the Class A common stock not currently owned by M&F (the Revlon Minority Stockholders).  The Merger Proposal was submitted as a partial solution to address Revlon’s liquidity needs arising under an impending maturity of a $107 million senior subordinated term loan that was payable to M&F by a Revlon subsidiary.  A portion of this debt (equal to the liquidation value of the preferred stock issued in the Merger Proposal) would be contributed by M&F to Revlon, as part of the transaction.  This was submitted as an alternative in lieu of potentially cost-prohibitive and dilutive financing alternatives (or potentially unavailable financing alternatives) during the volatile credit market following the 2008 sub-prime mortgage crisis.

In response to the Merger Proposal, Revlon formed a special committee of the Board (the Special Committee) to evaluate the Merger Proposal.  The Special Committee retained a financial advisor and separate counsel to assist in its evaluation of the Merger Proposal.  Four lawsuits were filed in Delaware between April 24 and May 12 of 2009 challenging various aspects of the Merger Proposal.

On May 28, 2009, the Special Committee was informed by its financial advisor that it would be unable to render a fairness opinion on the Merger Proposal, and thereafter the Special Committee advised M&F that it could not recommend the Merger Proposal.  In early June of 2009, the Special Committee disbanded, but the independent directors subsequently were advised that M&F would make a voluntary exchange offer proposal to the full Revlon Board of Directors (the Exchange Offer). Revlon’s independent directors thereafter chose to continue to utilize counsel that served to advise the Special Committee, but they elected not to retain a financial advisor for assistance with the forthcoming M&F Exchange Offer proposal, because they were advised that the securities to be offered in the Exchange Offer would be substantially similar to those issuable through Merger Proposal.  As a result, they did not believe they could obtain a fairness opinion for the Exchange Offer consideration.  The Board of Directors of Revlon (without the interested directors participating in the vote) ultimately approved the Exchange Offer without receiving any fairness opinion with respect to the Exchange Offer.

On September 24, 2009, the final terms of the Exchange Offer were set and the offer was launched.  The Exchange Offer, having been extended several times, finally closed on October 8, 2009, with less than half of the shares tendered for exchange out of all Class A shares held by the Revlon Minority Stockholders.  On October 29, 2009, Revlon announced third quarter financial results that exceeded market expectations, but these results were allegedly consistent with the financial projections disclosed in the Exchange Offer.  Following these announced results, Revlon’s Class A stock price increased.  These developments led to the filing of additional litigation in Delaware Chancery Court.

The Revlon SEC Order and Associated Rule 13e-3 Considerations.

A subset of the Revlon Minority Stockholders consisted of participants in a Revlon 401(k) retirement plan, which was subject to obligations under the Employee Retirement Income Security Act of 1974, as amended (ERISA) and a trust agreement (the Trust Agreement) between Revlon and the Plan’s trustee (the Trustee).  Provisions of ERISA and the Trust Agreement prohibited a 401(k) Plan participant’s sale of common stock to Revlon for less than “adequate consideration.”

During July of 2009, Revlon became actively involved with the Trustee to control the flow of information concerning any adequate consideration determination, to prevent such information from flowing back to Revlon and to prevent such information from flowing to 401(k) participants (and ultimately Revlon Minority Stockholders); certain amendments to the Trust Agreement were requested by Revlon and agreed to by the Trustee to effect these purposes.  This also had the additional effect of preventing the independent directors of Revlon from being aware that an adequate consideration opinion would be rendered for the benefit of Revlon’s 401(k) Plan participants.

On September 28, 2009, the financial advisor to the 401(k) Plan rendered an adverse opinion that the Exchange Offer did not provide adequate consideration to 401(k) Plan participants.  As a result, the Trustee informed 401(k) Plan participants, as previously directed by Revlon, that the 401(k) Plan Trustee could not honor tender instructions because it would result in a “non-exempt prohibited transaction under ERISA.”  Revlon Minority Stockholders, including 401(k) Plan participants, were generally unaware that an unfavorable adequate consideration opinion had been delivered to the Trustee.

In the Revlon SEC Order, the SEC concluded that Revlon engaged in a series of materially misleading disclosures in violation of Rule 13e-3.  Despite disclosure in the Exchange Offer that the Revlon Board had approved the Exchange Offer and related transactions based upon the “totality of information presented to and considered by its members” and that such approval was the product of a “full, fair and complete” process, the SEC found that the process, in fact, was not full, fair and complete.  The SEC particularly found that the Board’s process “was compromised because Revlon concealed from both minority shareholders and from its independent board members that it had engaged in a course of conduct to ‘ring-fence’ the adequate consideration determination.”  The SEC further found that “Revlon’s ‘ring-fencing’ deprived the Board (and in turn Revlon Minority Stockholders) of the opportunity to receive revised, qualified or supplemental disclosures including any that might have informed them of the third party financial advisor’s determination that the transaction consideration to be received by the 401(k) members . . . was inadequate.”

Significance of the Revlon SEC Order.

The Revlon Order underscores the significance of transparency and fairness being extended to all unaffiliated stockholders in a Rule 13e-3 transaction, including the 401(k) Plan participants whose shares represented only 0.6 percent of the Revlon Minority Stockholder holdings.  Importantly, the SEC took exception to the fact that Revlon actively prevented the flow of information regarding fairness and found that the information should have been provided for the benefit of these participants, as well as all Revlon Minority Stockholders.  This result ensued despite the fact that Revlon’s Exchange Offer disclosures noted in detail the Special Committee’s inability to obtain a fairness opinion for the Merger Proposal and the substantially similar financial terms of the preferred stock offered in both the Merger Proposal and the Exchange Offer transactions.

Going Private Transactions are Subject to Heightened Review by the SEC and Involve Significant Risk, Including Personal Risk.

Going private transactions are vulnerable to multiple challenges, including state law fiduciary duty claims and wide ranging securities law claims, including claims for private damages as well as SEC civil money penalties.  In the Revlon transaction, the SEC Staff conducted a full review of the going private transaction filings.  Despite the significant substantive changes in disclosure brought about through the SEC comment process, the SEC subsequently pursued an enforcement action and prevailed against Revlon for civil money penalties.

Although the SEC sanction was limited in scope to Revlon, it is worth noting that the SEC required each of Revlon, M&F and M&F’s controlling stockholder, Ronald Perelman, to acknowledge (i) personal responsibility for the adequacy and accuracy of disclosure in each filing; (ii) that Staff comments do not foreclose the SEC from taking action including enforcement action with regard to the filing; and (iii) that each may not assert staff comments as a defense in any proceeding initiated by the SEC or any other person under securities laws.  Thus, in planning a going private transaction, an issuer and each affiliate engaged in the transaction (each, a Filing Person) must make these acknowledgements, which expose each Filing Person (including certain affiliates who may be natural persons) to potential damages and sanctions.

The SEC also requires Filing Persons to demonstrate in excruciating detail the basis for their beliefs regarding the fairness of the transaction.  These inquiries typically focus on the process followed in pursuing and negotiating the transaction, the procedural fairness associated with such process, and the substantive fairness of the overall transaction, including financial fairness.  As a result of this, each Filing Person (including certain natural persons) in a going private transaction should be prepared to diligently satisfy cumbersome process and fairness requirements as part of the pre-filing period deliberative process, and later stand behind extensive and detailed disclosures that demonstrate and articulate the basis of the procedural and substantive fairness of the transaction, including financial fairness.

Damages and Penalties in Going Private Transactions Can Be Significant.

It is worth noting that civil money penalties and settlements that have been announced to date by Revlon for its Exchange Offer going private transaction is approximately $30 million.  After factoring in professional fees, it would not be surprising that the total post-closing costs, penalties and settlements approach 50 percent of the implied total transaction value of all securities offered in the Exchange Offer transaction.  From this experience, it is obvious that costs, damages and penalties can be a significant component of overall transaction consideration, and these risks must be factored in as part of overall transaction planning at the outset.

Given the risks of post-transaction damages and costs, it is essential that future going private transactions be structured and executed by Filing Persons with the foregoing considerations in mind in order to advance a transaction with full transparency, a demonstrably fair procedural process and deal consideration that is substantively fair and demonstrably supportable as fair from a financial point-of-view.

America Invents Act – Practical Considerations for Portfolio Companies

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Private equity funds should familiarize themselves with recent changes to U.S. patent law that affect patent protection strategies for their portfolio companies.  In September 2011, the U.S. Congress enacted the America Invents Act (AIA) patent reform bill, which significantly overhauled U.S. patent law.  This article summarizes practical considerations that private equity funds should bear in mind when evaluating and managing the patent portfolio of their investments.

First Inventor to File 

In the broadest sense, the AIA converts U.S. patent law into a “first-inventor-to-file” system from a “first-to-invent” system.  This conversion harmonizes U.S. patent law with the rest of the world’s patent laws.  In practice, it means that businesses should not delay filing patent applications, as they can no longer antedate patent-defeating prior art with an earlier invention date.

Challenges to Patent Rights 

Effective September 12, 2012, the AIA provided businesses new post-issuance patent validity challenge options that may be exercised before the U.S. Patent and Trademark Office (USPTO).  The new post-issuance challenges provide businesses new and predictable avenues to test the validity of a competitor’s patent that is, or may in the future be, an impediment to commercialization.  These post-issuance challenges include post-grant review, inter partes review and the Transitional Program for Covered Business Methods.  Each of the three post-issuance challenges is defined briefly here.

Post-Grant Review

Someone other than the patent owner may file a petition for post-grant review challenging the validity of a patent within nine months of the patent’s date of issue or reissue on any statutory grounds for invalidity.  Thus, even if a patent has been grated to a portfolio company, it may be subject to challenge by third parties in the time period immediately following issuance.  Similarly, a portfolio company could elect to challenge a competitor’s rights, even after a patent has been issued.

Inter Partes Review 

Someone other than the patent owner may file a petition for inter partes review challenging the validity of the patent nine months after the date of issue or reissue on limited invalidity grounds.  Inter partes review may only be instituted after the time period for post-grant review has expired and offers only a subset of the challenges available in post-grant review.  This means that throughout the entire life of an issued patent, generally 20 years from the filing date of the earliest priority document, it may be subject to challenge and invalidation.  Private equity funds should closely consider any potential challenges that could be lodged against a portfolio company and should evaluate potential risk before investing.

Transitional Program for Covered Business Methods

With regard to business method patents, someone other than the patent owner may file a petition for covered business method review challenging the validity of a patent if (1) the petitioner has been sued for infringement or threatened with an infringement suit, and (2) the patent claims a financial product or service.  Practically speaking, this scope is broader than mere financial products or services, such that any patent claiming anything related to money may potentially be challenged using a covered business method review.  Versata Development Group Inc. recently filed suit against the USPTO in the Eastern District of Virginia alleging that such a scope is impermissibly broad.  Until the result of that case or guidance is issued by the USPTO, private equity funds should proceed under the broad definition of “financial product or service” when evaluating a portfolio company with patents that may be challenged under the covered business method review.

Conclusion

Whether used against competitors’ patents or in defense of a business’ own interests, the new post-issuance challenges available under the AIA are powerful new tools in a portfolio company’s strategic toolbox.

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Financial Innovation for Clean Energy Deployment: Congress Considers Expanding Master Limited Partnerships for Clean Energy

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Technological innovation is driving renewable energy towards a future where it is cost competitive without subsidies and provides a growing share of America’s energy. But for all the technical progress made by the clean energy industry, financial innovation is not keeping pace: access to low-cost capital continues to be fleeting, and the industry has yet to tap institutional and retail investors through the capital markets. This is why a bipartisan group in Congress has proposed extending master limited partnerships (MLPs), a financial mechanism that has long driven investment in traditional energy projects, to the clean energy industry.

Last month Senators Chris Coons (D-DE) and Jerry Moran (R-KS) introduced the Master Limited Parity Act (S. 795); Representatives Ted Poe (R-TX), Mike Thompson (D-CA), and Peter Welch (D-VT) introduced companion legislation (H.R. 1696) in the House of Representatives. The bills would allow MLP treatment for renewable energy projects currently eligible for the Sec. 45 production tax credit (PTC) or 48 investment tax credit (ITC) (solar, wind, geothermal, biomass, hydropower, combined heat and power, fuel cells) as well as biofuels, renewable chemicals, energy efficient buildings, electricity storage, carbon capture and storage, and waste-heat-to-power projects. The bill would not change the eligibility of projects that currently qualify as MLPs such as upstream oil and gas activities related to exploration and processing or midstream oil and gas infrastructure investments.

MLPs have been successfully utilized for traditional fossil-fuel projects because they offer an efficient means to raise inexpensive capital. The current total market capitalization of all energy-related MLPs exceeds $400 billion, on par with the market value of the world’s largest publicly traded companies. Ownership interests for MLPs are traded like corporate stock on a market. In exchange for restrictions on the kinds of income it can generate and a requirement to distribute almost all earnings to shareholders (called unitholders), MLPs are taxed like a partnership, meaning that income from MLPs is taxed only at the unitholder level. The absence of corporate-level taxation means that the MLP has more money to distribute to unitholders, thus making the shares more valuable. The asset classes in which MLPs currently invest lend themselves to stable, dividend-oriented performance for a tax-deferred investment; renewable energy projects with long-term off-take agreements could also offer similar stability to investors. And since MLPs are publicly traded, the universe of potential investors in renewable projects would be opened to retail investors.

The paperwork for MLP investors can be complicated, however. Also, investors are subject to rules which limit their ability to offset active income or other passive investments with the tax benefits of an MLP investment. Despite the inherent restrictions on some aspects of MLPs, the opportunities afforded by the business structure are generating increasing interest and support for the MLP Parity Act.

Proponents of the MLP Parity Act envision the bill as a way to help renewable energy companies access lower cost capital and overcome some of the limitations of the current regime of tax credits. Federal tax incentives for renewable energy consist primarily of two limited tools: tax credits and accelerated depreciation rates. Unless they have sizeable revenue streams, the tax credits are difficult for renewable project developers to directly use. The reality is only large, profitable companies can utilize these credits as a means to offset their income. For a developer who must secure financing though a complicated, expensive financing structure, including tax equity investors can be an expensive means to an end with a cost of capital sometimes approaching 30%. Tax credits are a known commodity, and developers are now familiar with structuring tax equity deals, but the structure is far from ideal. And as renewable energy advocates know all too well, the current suite of tax credits need to be extended every year. MLP treatment, on the other hand, does not expire.

Some supporters have noted that clean energy MLPs would “democratize” the industry because private retail investors today have no means to invest in to any meaningful degree in clean energy projects. Having the American populace take a personal, financial interest in the success of the clean energy industry is not trivial. The initial success of ‘crowd-funded” solar projects also provides some indication that there is an appetite for investment in clean energy projects which provide both economic and environmental benefits.

Sen. Coons has assembled a broad bipartisan coalition, including Senate Finance Energy Subcommittee Chair Debbie Stabenow (D-MI) and Senate Energy and Natural Resources Ranking Member Lisa Murkowski (R-AK). Republican and Democratic cosponsors agree that this legislation would help accomplish the now-familiar “all-of-the-above” approach to energy policy.

However, some renewable energy companies that depend on tax credits and accelerated depreciation are concerned that Republican supporters of the legislation will support the bill as an immediate replacement for the existing (but expiring) suite of renewable energy tax credits. Sen. Coons does not envision MLP parity as a replacement for the current production tax credits and investment tax credits but rather as additional policy tool that can address, to some degree, the persistent shortcomings of current financing arrangements. In this way, MLPs could provide a landing pad for mature renewable projects as the existing regime of credits is phased out over time, perhaps as part of tax reform.

So would the clean energy industry utilize MLP structures if Congress enacts the MLP Parity Act? The immediate impact may be hard to predict, and some in renewable energy finance fear MLP status will be less valuable than the current tax provisions. This is in part because the average retail investor would not be able to use the full share of accompanying PTCs, ITCs, or depreciation unless Congress were also to change what are known as the “at-risk” and “passive activity loss and tax credit” rules. These rules were imposed to crack down on perceived abuse of partnership tax shelters and have tax implications beyond the energy industry. Modifying these rules is highly unlikely and would jeopardize the bipartisan support the bill has attracted so far. But other renewable energy companies believe they can make the structure work for them now, and industries without tax credits — like renewable chemicals, for instance — would not have the same concerns with “at-risk” and “passive activity loss” rules. Furthermore, over the long term, industry seems increasingly confident the structure would be worthwhile. Existing renewable projects that have fully realized their tax benefits and have cleared the recapture period could be rolled up into existing MLPs. Existing MLP infrastructure projects could deploy renewable energy assets to help support the actual infrastructure. Supporters of the legislation see the change as a starting point, and the ingenuity of the market will find ways to work within the rules to deliver the maximum benefit.

The future of the MLP Parity Act will be linked to the larger conversation in Congress regarding tax reform measures. The MLP Parity Act is not expected to pass as a stand-alone bill; if it were to be enacted, it would most likely be included as part of this larger tax-reform package. Congress currently is looking at ways to lower overall tax rates and modify or streamline technology-specific energy provisions. This has many renewable energy advocates on edge: while reform provides an opportunity to enact long-term policies (instead of one-year extensions) that could provide some level of stability, it also represents a chance for opponents of renewable energy to exact tough concessions or eliminate existing incentives. As these discussions continue in earnest this year, the reintroduction of the MLP Parity Act has already begun to generate discussions and mentions in policy white papers at both the House Ways and Means Committee and the Senate Finance Committee. Whether a highly partisan Congress can actually achieve such an ambitious goal as tax reform this year remains uncertain. But because of its bipartisan support, the MLP Parity Act certainly will be one of the many potential reforms Congress will consider seriously.

Senate Finance Committee Leadership Releases Tax Reform Framework

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A major step forward on tax reform occurred today with Senate Finance Committee Chairman Max Baucus (D-MT) and Ranking Member Orrin Hatch (R-UT) releasing their tax reform framework.  They are planning a “blank-slate” approach:  stripping the tax code of all current tax deductions, credits, and expenditures in place of a lower individual and corporate tax rate.

In their “Dear Colleague” letter sent out today, Senators Baucus and Hatch announced their plan to hold a markup on a bill after the August recess.  Members of the Senate have been invited to submit by July 26th a “wish list” of which tax provisions they would like to keep alive, and the Senators are encouraging the submission of legislative language.  This approach, requiring Senators to defend the provisions they would like retained, rather than cut breaks they don’t support, is a departure from current practice.  Baucus and Hatch did note that any benefit that ends up in the tax code will reduce the amount of revenue that could go towards reducing the overall rate or reducing the deficit.

Motions To Adjourn – Do They End Or Continue A Meeting?

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I’ve previously remarked on the different usages attached to the word “adjourn”.  Often a meeting will end with a motion to adjourn.  Sometimes, a meeting will be prorogued – that is, continued to another date.  ”Adjourn” is derived from the Latin words “ad” and “diurnus”, meaning “to” and “daily” (a diurnal flower opens only during the day).  The word came into the English language through Old French “ajorner” (“soup du jour” is the soup of the day).  Based on etymology, an adjournment is a moving a meeting to another day.  This is the meaning given by William Shakespeare to Cardinal Campeius (Lorenzo Campeggio) when in Act II, Scene 4 of Henry VII Katherine of Aragon leaves her divorce proceedings:

So please your highness,
The queen being absent, ’tis a needful fitness
That we adjourn this court till further day:

Strangely, many meetings end with a motion to adjourn.  Those inclined to greater precision might move to adjourn the meeting sine die (i.e, without a day – ”diurnus” is an adjective derived from the Latin word for day, “dies”).  Thus, when a motion to adjourn sine die is reduced to its original meaning, it becomes a motion to move to a day without a day!

Corporations Code Section 602(b) allows for either meaning.  It provides:

The shareholders present at a duly called or held meeting at which a quorum is present may continue to transact business until adjournment notwithstanding the withdrawal of enough shareholders to leave less than a quorum, if any action taken (other than adjournment) is approved by at least a majority of the shares required to constitute a quorum or, if required by this division or the articles, the vote of a greater number or voting by classes.

If “adjournment” means the end of the meeting, the statute simply allows shareholders to continue to transact business even though some shareholders have left a quorum has been lost.  In this case, the “until adjournment” is stating the obvious – no shareholder action can be taken after the meeting has ended.  If “adjournment” means until such time as the meeting is continued, then the statute’s special dispensation for quorumless action ends when the meeting is continued.

In a future post, I’ll discuss the question of who has the power to decide to adjourn a meeting.

Final Section 336(e) Regulations Allow Step-Up in Asset Tax Basis in Certain Stock Acquisitions

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Final regulations were issued last month under IRC Section 336(e). These regulations present beneficial planning opportunities in certain circumstances.

For qualifying transactions occurring on or after May 15, 2013, Section 336(e) allows certain taxpayers to elect to treat the sale, exchange or distribution of corporate stock as an asset sale, much like a Section 338(h)(10) election. An asset sale can be of great benefit to the purchaser of the stock, since the basis of the target corporation’s assets would be stepped up to their fair market value.

To qualify for the Section 336(e) election, the following requirements must be met:

  1. The selling shareholder or shareholders must be a domestic corporation, a consolidated group of corporations, or an S corporation shareholder or shareholders.
  2. The selling shareholder or shareholders must own at least 80% of the total voting power and value of the target corporation’s stock.
  3. Within a 12-month period, the selling shareholder or shareholders must sell, exchange or distribute 80% of the total value and 80% of the voting power of the target stock.

Although the rules of Section 338(h)(10) are generally followed in connection with a Section 336(e) election, there are a few important differences between the two elections:

  1. Section 336(e) does not require the acquirer of the stock to be a corporation. This is probably the most significant difference; and, to take advantage of this rule, purchasers other than corporations may wish to convert the target without tax cost to a pass-through entity (e.g., LLC) after the purchase.
  2. Section 336(e) does not require a single purchasing corporation to acquire the target stock. Instead, multiple purchasers—individuals, pass-through entities and corporations—can be involved.
  3. The Section 336(e) election is unilaterally made by the selling shareholders attaching a statement to their Federal tax return for the year of the acquisition. Purchasers should use the acquisition agreement to make sure the sellers implement the anticipated tax strategy

Section 336(e) offers some nice tax planning opportunities, by allowing a step up in tax basis in the target’s assets where a Section 338(h)(10) election is not allowed.

Example: An S corporation with two shareholders wishes to sell all of its stock to several buyers, all of which are either individuals or pass-through entities with individual owners. A straight stock purchase would not increase the basis of the assets held inside the S corporation, and an LLC or other entity buyer would terminate the pass-through tax treatment of the S corporation status of the target. A Section 338(h)(10) election is not available since the purchaser is not a single corporation. However, a Section 336(e) election may be available, whereby the purchase of the stock would be treated as a purchase of the corporation’s assets (purchased by a “new” corporation owned by the purchasers). The purchasers could then convert the purchased corporation (the “new” corporation with the stepped-up assets basis) into an LLC, without tax, thereby continuing the business in a pass-through entity (single level of tax) with a fully stepped-up tax asset basis.

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If You Pay More, Do You Actually Get More? Re: Limited Partnerships and Limited Liability Companies

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The typical private fund is organized as a limited partnership or limited liability company that is managed by a general partner or manager.  The fund manager is usually compensated in three ways – an annual management fee (often 2%), a carried interest (often 20%), and an investment in the fund (often 1%).  In a recently presented paper, Professors David T. Robinson and Berk A. Sensoy tackled the question of whether private fund managers actually earn their keep.

Given the limited rights of limited partners and members and asymmetrical access to information, one might expect that these professors would conclude that fund managers who charge more, actually under perform.  Based on an analysis of 837 buyout and venture capital private equity funds from 1984-2010 to, the two scholars reach the opposite conclusion:

[W]e find no evidence that high-fee funds underperform an on a net-of-fee basis [sic].  Management fees and carried interest are generally unrelated to net-of-fee cash flow performance.  This suggests that private equity GPs that receive higher compensation earn it in the form of higher gross returns.  When we examine the relation between GP ownership and performance, our evidence flatly contradicts the argument that GPs with low skin in the game demonstrate poor performance.

You can read the entire paper here.  Unfortunately, the authors don’t reveal the source of their data, but rather mysteriously describe it as having been “obtained from a large, institutional limited partner with extensive investments in private equity”.  The paper was presented at the inaugural Sustainability and Finance Symposium held last week which was hosted by the California Public Employees Retirement System and the UC Davis Graduate School of Management.

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Yahoo!/Tumblr Deal and the Tax Cost of Cash Acquisition Payments

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When Yahoo! recently acquired the blogging service Tumblr, the two companies structured the deal so that virtually all of the $1.1 billion price tag for Tumblr will be paid in cash. In the current economy, many companies, particularly tech companies, have a lot of cash available, making the more traditional payment in stock appear less desirable. However, tax planning during mergers or acquisitions can be invaluable because, with proper counsel, the organizations can anticipate and mitigate the tax ramifications for the companies, individuals and shareholders.

Specific information about any tax planning in the Yahoo!/Tumblr deal hasn’t been released, but let’s consider the potential tax consequences of an essentially all-cash deal.

Most of Tumblr’s existing shareholders likely purchased their stock for substantially less than it was valued at the time of Yahoo’s acquisition. Since capital gains taxes are levied on the difference between the purchase price and the sale price, those Tumblr shareholders may be facing a hefty capital gains tax bill that will come due as soon as the transaction is complete.

If the deal had been structured as a stock transaction, on the other hand, it might have been structured to defer the capital gains tax for those shareholders until they actually sell their stock to Yahoo! There are a number of methods, such as 1031 exchanges, Section 368 tax-free reorganizations, and or 338(h)(10) stock purchase elections, that might also be effective in mitigating the tax burden.

An all-cash deal also presents challenges for Yahoo! in that it could affect the incentives for Tumblr’s founder and senior management going forward. In a tax-free reorganization, for example, they would generally be compensated in Yahoo! stock, which automatically creates an incentive for Tumblr’s leadership to build value for Yahoo! Without stock, a different incentive plan is needed.

According to The New York Times’ DealBook blog, Yahoo! may not need to worry about incentivizing Tumblr’s leadership, however, as it plans to continue to run the blog service as a separate company with the same group of executives. That may leave the existing incentives for success in place.

In this particular case, we don’t have enough information to determine why Yahoo! and Tumblr structured the acquisition as an all-cash deal. Well-considered tax planning, however, is essential for any business considering a merger or acquisition, stock sale, or major asset sale. Anticipating and minimizing transactional taxes, including business transfer taxes and business succession taxes, can help ensure that companies garner all potential benefits of the deal.

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What’s New Out There? A Trade and Business Regulatory Update

Sheppard Mullin 2012Proposed DoD Rule: Detection and Avoidance of Counterfeit Electronic Parts (DFARS Case 2012-D-005)

On May 16, 2013, the Department of Defense (“DoD”) issued a proposed rule that would amend the Defense Federal Acquisition Regulation Supplement (“DFARS”) relating to the detection and avoidance of counterfeit parts, in partial implementation of the National Defense Authorization Act (“NDAA”) for Fiscal Year (“FY”) 2012 (Pub. L. 112-81) and the NDAA for FY 2013 (Pub. L. 112-239). 78 Fed. Reg. 28780 (May 16, 2013). The proposed rule would impose new obligations for detecting and protecting against the inclusion of counterfeit parts in their products. Public comments in response to the proposed amendment are due by July 15, 2013.

The proposed rule, titled Detection and Avoidance of Counterfeit Electronic Parts (DFARS Case 2012-D-005), partially implements Section 818 of the NDAA for FY 2012 requiring the issuance of regulations addressing the responsibility of contractors (a) to detect and avoid the use or inclusion of counterfeit – or suspect counterfeit – electronic parts, (b) to use trusted suppliers, and (c) to report counterfeit and suspect counterfeit electronic parts. Pub. L. 112-81,§ 818(c). Section 818(c) also requires DoD to revise the DFARS to make unallowable the costs of re-work or other actions necessary to deal with the use or suspected use of counterfeit electronic parts. Id. The new rule also proposes the following in order to implement the requirements defined in Section 818.

  • Definitions: Adds definitions to DFARS 202.101 for the terms “counterfeit part,” “electronic part,” “legally authorized source,” and “suspect counterfeit part.”
  • Cost Principles and Procedures: Adds DFARS section 231.205-71, which would apply to contractors covered by the Cost Accounting Standards (“CAS”) who supply electronic parts, and would make unallowable the costs of counterfeit or suspect counterfeit electronic parts and the costs of rework or corrective action that may be required to remedy the use or inclusion of such parts. This section provides a narrow exception where (1) the contractor has an operational system to detect and avoid counterfeit parts that has been reviewed and approved by DoD pursuant to DFARS 244.303; (2) the counterfeit or suspect counterfeit electronic parts are government furnished property defined in FAR 45.101; and (3) the covered contractor provides timely notice to the Government.
  • Avoidance and Detection System: Requires contractors to establish and maintain an acceptable counterfeit avoidance detection system that addresses, at a minimum, the following areas: training personnel; inspection and testing; processes to abolish counterfeit parts proliferation; traceability of parts to suppliers; use and qualification of trusted suppliers; reporting and quarantining counterfeit and suspect counterfeit parts; systems to detect and avoid counterfeit electronic parts; and the flow down of avoidance and detection requirements to subcontractors.

Potential Impacts on Contractors and Subcontractors

Although the rule is designed constructively to combat the problem of counterfeit parts in the military supply chain, it imposes additional obligations and related liabilities on contractors and subcontractors alike.

  • The proposed rule shifts the burden of protecting against counterfeit electronic parts to contractors, thus increasing contractor costs and potential contractor liability in this area.
  • Under the proposed rule, contractors would need to take steps to establish avoidance and detection systems in order to monitor for and protect against potential counterfeit electronic parts, also increasing the financial and temporal impact on contractors.
  • Avoidance and detection system requirements will need to be flowed down to subcontractors, increasing subcontractors’ responsibility – and thus liability – for counterfeit parts.
  • The proposed rule would also make unallowable the costs incurred to remove and replace counterfeit parts, which could have a significant financial impact on contractors – even under cost type contracts.
  • As it currently stands, the narrow exception regarding the allowability of such costs applies only where the contractor meets all three requirements of the exception, which likely would be a rare occurrence.

Interim SBA Rule: Expansion of WOSB Program, RIN 3245-AG55

On May 7, 2013, the Small Business Administration (“SBA”) issued an interim final rule implementing Section 1697 of the NDAA for FY 2013, removing the statutory dollar amount for contracts set aside for Women-Owned Small Business (“WOSB”) under the Women-Owned Small Business Program. 78 Fed. Reg. 26504 (May 7, 2013). Comments are due by June 6, 2013.

The new rule would amend SBA 127.503 to permit Contracting Officers (“COs”) to set aside contracts for WOSBs and Economically Disadvantaged WOSBs (“EDWOSBs”) at any dollar amount if there is a reasonable expectation of competition among WOSBs as follows: (1) in industries where WOSBs are underrepresented, the CO may set aside the procurement where two or more EDWOSBs will submit offers for the contract and the CO finds that the contract will be awarded at a fair and reasonable price; or (2) in industries where WOSBs are substantially underrepresented, the CO may set aside the procurement if two or more WOSBs will submit offers for the contract, and the CO finds that the contract will be awarded at a fair and reasonable price.

The new rule would amend SBA 127.503 to permit Contracting Officers (“COs”) to set aside contracts for WOSBs and Economically Disadvantaged WOSBs (“EDWOSBs”) at any dollar amount if there is a reasonable expectation of competition among WOSBs as follows: (1) in industries where WOSBs are underrepresented, the CO may set aside the procurement where two or more EDWOSBs will submit offers for the contract and the CO finds that the contract will be awarded at a fair and reasonable price; or (2) in industries where WOSBs are substantially underrepresented, the CO may set aside the procurement if two or more WOSBs will submit offers for the contract, and the CO finds that the contract will be awarded at a fair and reasonable price.

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The Libor Scandal: What’s Next? Re: London Interbank Offered Rate

GT Law

The London Interbank Offered Rate (Libor) is calculated daily by the British Banking Association (BBA) and published by Thomson Reuters. The rates are calculated by surveying the interbank borrowing costs of a panel of banks and averaging them to create an index of 15 separate Libor rates for different maturities (ranging from overnight to one year) and currencies. The Libor rate is used to calculate interest rates in an estimated $350 trillion worth of transactions worldwide.

The Libor Scandal

The surveyed banks are not required to provide actual borrowing costs. Rather, they are asked only for estimates of how much peer financial institutions would charge them to borrow on a given day. Because they are not required to substantiate their estimates, banks have been accused of Libor “fixing,” or manipulating the Libor rate by submitting estimates that are exaggeratedly higher or lower than their true borrowing costs. This scandal has resulted in the firing and even arrest of bank employees.

Libor’s reputation came under fire in June 2012 when Barclays PLC agreed to pay over $450 million to settle allegations that some traders fixed their reported rates to increase profits and make the bank appear healthier than it was during the financial crisis. In the wake of this settlement, investigative agencies around the world began to look deeper into Libor rate fixing, leading to a $750 million settlement by the Royal Bank of Scotland and a record-setting $1.5 billion settlement by UBS AG. To date, there have been over $2.5 billion in settlements, with many more investigations ongoing. One investment bank estimates that, in total, legal settlements could amount to as much as $35 billion by the time investigations conclude.

Replacing the Libor

In the wake of the Libor scandal, international and domestic agencies have advocated for its replacement. The BBA, the group responsible for setting Libor since the 1980s, voted to relinquish that authority, and a committee of the UK’s Financial Reporting Council is currently vetting bids from other independent agencies interested in administering the new rate.

The International Organization of Securities Commissions (IOSCO) Task Force on Benchmark Rates, led by the head of the UK Financial Services Authority Martin Wheatley and the US Futures Trading Commission Chairman Gary Gensler, released a report last month saying that the new system should be based on data from actual trades in order to restore creditability. Wheatley and Gensler agree on the need to create a transaction-based rate, but disagree on how to transition from Libor to the new system.

Wheatley proposes that: the estimate-based Libor system be kept in place while a new transaction based rate is introduced to run alongside it under a “dual-track” system (so as to avoid disrupting existing transactions), and that the decision as to if and when to abandon Libor be left to market participants as opposed to regulators.

Gensler proposes a wholesale replacement of Libor as soon as possible and cautions that its continued use undermines market integrity and threatens financial stability.

IOSCO is also pushing for a code of conduct that would hold banks to a higher standard of honesty in reporting and setting index rates, while other agencies, including the Financial Stability Board and the European Union, are working on the development of other potential solutions including stricter regulations and greater penalties for rate-fixing conduct.

The future of Libor is unclear, but it is certain that whomever is chosen to replace the BBA will be under immense pressure and scrutiny from the international financial community.

Recommendations

To stay prepared, parties to financial transactions should view existing and future contracts with an eye towards potential benchmark changes. Parties should perform contractual due diligence to establish the range of Libor definitions and benchmarks to which they are exposed. In addition, parties should review the fallback provisions dealing with change or discontinuance of Libor and other benchmark rates to understand the potential impact of such changes.

Going forward, parties should include fallback provisions in their contracts to allocate risk and set up alternatives to mitigate the uncertainty that could arise in the event of any changes to the Libor system or other relevant benchmarks.

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