Category: Mergers & Acquistions

Structuring the Acquisition of an S Corporation

Introduction

S corporations, or S-corps, are one of the most popular entity choices for businesses. In contemplating the sale of an S-corp, it is important to plan how the transaction is structured from a tax perspective (ideally before an LOI is signed), both to maximize the gain on the sale and avoid pitfalls that can result in liabilities for the selling shareholders.

For corporate purposes, businesses are generally formed as limited liability companies, partnerships, or corporations. For tax purposes, however, entities are taxed as corporations, partnerships, or disregarded entities.[1] Corporations[2] are taxed as either a C corporation or an S corporation. C corporations are taxed at the corporate level and again at the shareholder level.[3] S corporations are corporations that, for federal tax purposes, elect to pass corporate income, losses, deductions, and credits through to their shareholders and are only taxed at the shareholder level.[4]

To qualify as an S corporation, the corporation must meet the requirements of Section 1361,[5] which provides that the corporation not have more than 100 shareholders, not have non-individual shareholders (with the exception of certain types of trusts, estates, and tax-exempt organizations), not have a nonresident alien as a shareholder, not have more than one class of stock, and not be an ineligible corporation (as defined in the Code).[6]

When sellers begin to explore the sale of their business, tax considerations are important to discuss at the outset so that the seller and buyer are on the same page – no one wants to attempt to renegotiate the terms of a deal in the middle of a transaction. For tax purposes, acquisitions of companies are categorized as either an asset purchase or stock purchase. In general, owners prefer to sell their stock (as opposed to the company’s assets) for a few reasons. First, a stock sale results in capital gain to the shareholders because their stock is a capital asset.[7] In an asset sale, however, noncorporate sellers (including S-corp shareholders) recognize ordinary income or capital gain, depending on the type of asset sold. Second, unlike in an asset sale, a stock sale may not require the seller to transfer company assets and licenses or obtain third party consents.

On the other hand, buyers usually want to engage in an asset sale to obtain a step-up in basis of the purchased assets. In a stock acquisition, the buyer gets a carryover basis in the acquired corporation’s assets, without any basis step-up. In an asset purchase, however, the buyer takes a cost basis in the assets, including in the target corporation’s goodwill (which otherwise will generally have a zero basis), and allows the buyer to take higher depreciation deductions to reduce the buyer’s annual tax liability.[8] Unless otherwise agreed, the buyer also does not assume corporate liabilities in an asset sale.

Sellers who agree to engage in an asset sale should negotiate with the buyer to be compensated for the additional tax that the seller may incur for engaging in an asset sale.

There are two additional ways for a buyer to obtain a basis step-up in the seller’s assets. The first is a 338(h)(10) election under Section 338 and the second is an F reorganization pursuant to Section 368(a)(1)(F) and consistent with Revenue Ruling 2008-18.[9]

Making the 338(h)(10) Election

A buyer and seller will sometimes make a 338(h)(10) election, which treats an acquisition of a corporation’s stock as a sale of assets for federal income tax purposes, but a sale of stock for legal purposes.[10] The sale is treated as if buyer and seller engaged in a regular asset sale for income tax purposes (so the buyer obtains a step-up in the tax basis of the assets), yet the seller does not need to re-title each asset.[11] Seller does not have capital gain on the sale of stock. Instead the parties must allocate the sales price among the assets based on each asset’s fair market value.[12] The price paid in excess of the fair market value of the tangible assets of the business is allocated to business intangibles and then to goodwill.[13]

The 338(h)(10) election is only available if a “qualified stock purchase” is made.[14] A “qualified stock purchase” is defined as any transaction (or series of transactions) in which a corporation purchases at least 80% of the stock (both voting and value) from a member of a consolidated group(as defined in 1.1502-1) or from shareholders of a S corporation during a 12 month period.[15] If during diligence it is revealed that the target corporation in fact failed to qualify as an S corporation, the 338 election will be invalid.[16] If the Section 338(h)(10) election is invalid, the transaction will be treated as a straight stock sale and buyer will not receive a basis step-up in the target’s assets.

A section 338(h)(10) election is made jointly by the purchaser and seller on Form 8023.[17] S corporation shareholders who do not sell their stock must also consent to the election. The election must be made not later than the 15th day of the 9th month beginning after the month in which the acquisition date occurs.[18]

If the target failed to qualify as an S corporation (thereby becoming a C corporation), an election can be made to treat the sale of the corporation’s stock as an asset sale under Section 336(e). The election can be made if target is owned by a parent corporation that sells at least 80% of target’s stock.[19] A 336(e) election closely resembles a 338(h)(10) election, but the purchaser does not have to be a corporation.[20] Note that a transaction that qualifies under both 336(e) and 338(h)(10) will be treated as 338(h)(10) transaction.[21]

Consequences of a 338(h)(10) Election

Under the Regulations, the target corporation is treated as making a deemed sale of its assets and liquidating following the deemed asset sale.[22] The transaction is treated as a taxable acquisition of 100% of the target’s assets for income tax purposes.[23] This means that the stock cannot be acquired in a tax free transaction or reorganization (such as a transfer to a controlled corporation, merger or spinoff) or a transaction where the seller does not recognize the entire amount of gain or loss realized on the transaction.[24]

Issues with a 338(h)(10) Election

While the 338 election can be a useful way for a buyer to achieve a basis step-up without burdening the seller to retitle and transfer assets, the following disadvantages of the election should be considered:

  1. The rules under Section 338 require all S corporation shareholders (whether or not they sell their stock) to pay tax on all of the target’s assets, even if selling less than 100% of the target.[25] This effectively eliminates any structuring of a deal on a tax-deferred basis (i.e. where seller only pays tax on the consideration attributable to non-rollover equity). Sellers need to be aware that they will pay tax on all of the target company’s assets regardless of the percentage of assets sold.
  2. The election presents an issue for rollover transactions where the seller rolls over more than 20% of its equity on a pre-tax basis in a Section 721 or Section 351 transaction (in which seller receives equity in buyer, buyer’s parent, a holding company that holds target, or another form of equity). Rolling over more than 20% of equity will invalidate the 338(h)(10) election because it will not meet the “purchase” requirement under Section 338.[26]
  3. If the target company’s S corporation election turns out to be invalid (which happens frequently due to the ease with which S corporation status can be voided), the 338(h)(10) election will be invalid, thereby eliminating any advantage provided by the election.[27] Note that the seller will also be in breach of its representations and warranties under the purchase agreement.

F-Reorganization

An alternative to a 338(h)(10) election is an F reorganization, or F reorg., which allows sellers to avoid the potential issues that come with a 338 election. In an F reorg., the seller recognizes gain only with respect to the assets that it is deemed to have sold, allows the seller to roll over equity on a pre-tax basis, and avoids some of the risk that the target may have not properly qualified as an S-corp (thereby invalidating a Section 338(h)(10) election).

Engaging in an F-Reorganization

The first step in an F reorg. is to engage in a tax free reorganization of the S-corp.[28] Shareholders of the target S-corp (“T”) form a new corporation (“Holdco”) and transfer their shares in T to Holdco in exchange for Holdco shares. As a result of the transaction, T shareholders own all shares of Holdco, which in turn owns all shares of T, making T a fully owned subsidiary of Holdco. Holdco then elects to treat T as a Qualified Subchapter S Subsidiary (“QSub”) by making the election on form 8869. For federal tax purposes, T, as a QSub, becomes a disregarded entity and all assets and liabilities of T are treated as part of Holdco.[29] Note that the QSub election made by T also suffices as the S-corp election for Holdco.[30] After T becomes a QSub of Holdco, T converts into a limited liability company (“LLC”) under state law in a nontaxable transaction by converting from one disregarded entity to another.[31] Holdco will need to obtain its own EIN, but T retains its old EIN after the conversion.[32] Once the conversion to an LLC is complete, the shareholders of Holdco can sell some or all of the LLC interests of T; the sale is treated as an asset sale for tax purposes, thereby resulting in a step up in basis for the purchaser.[33] The seller recognizes gain from the deemed sale of each asset of T. If less than 100% of the LLC interests are sold to the buyer, the transaction is treated as the purchase of a proportionate interest in each of the LLC assets, followed by a contribution of the respective interests to a partnership in exchange for ownership interests in the partnership, resulting in a stepped up basis in the assets for buyer.[34] In this scenario, T is no longer a QSub and is converted to a partnership for tax purposes.[35]

Note that a straight conversion of the existing S corporation target from an S-corp to an LLC should not be done because it is treated as a taxable liquidation of the S corporation (i.e. a deemed sale of its assets) resulting in a fully taxable event to the shareholders.[36]

Alternatively, the S-corp could form a new LLC, contribute all its business assets and liabilities to the new LLC in exchange for the LLC interests, and sell the LLC interests to the buyer. However, the transfer of assets might require third party consents; the F reorg. achieves the same result without any potential assignment issues, and even preserves the historical EIN of the S-corp.

Advantages of an F-Reorganization

The F-reorganization is an effective way to avoid the issues that arise with a 338(h)(10) election:

  1. If the acquisition is for less than 100% of the target, the S-corp shareholders will only recognize gain on the portion of the LLC sold by the S-corp parent. Any portion of the LLC interests rolled over will be tax-deferred. Rollover transactions are perfectly suitable in a F reorg. and do not present the issues that come with a 338(h)(10) election.
  2. The converted LLC retains its old EIN number and is essentially the same entity for legal purposes. This can be useful for a target in a regulated industry (such as healthcare, food services, manufacturing, etc.) by possibly avoiding the need to reapply for new permits and licenses.
  3. An F reorg. can be useful for planning purposes under Section 1202 (Qualified Small Business Stock, or QSBS), which allows shareholders of a C corporation to exclude from their taxable income the greater of ten million dollars or ten times the adjusted basis of their stock upon a sale.[37] One requirement is that the stock must be stock of a C corporation, not an S corporation.[38] S corporation shareholders who want to qualify under 1202 can perform an F reorg. and contribute the LLC interests of their operating company to a newly formed C corporation in a tax free exchange under 351. The S corporation (which owns the C corporation which owns the LLC) is now an eligible shareholder of QSBS and will qualify for favorable treatment under Section 1202.[39]

Footnotes

[1] Reg. §301.7701-2. Entities may also be taxed as cooperatives or as tax-exempt organizations if the statutory requirements are met.

[2] For purposes of this article, a corporation includes a limited liability company (LLC) that has elected to be taxed as a corporation.

[3] IRC §11(a).

[4] IRC §1363. For state tax purposes, treatment of S corporation status varies – certain states either conform with the federal treatment or conform with certain limitations and adjustments, while others do not recognize the S election at all and tax S corporations as regular corporations. In particular, California imposes an entity level tax of the greater of $800 or 1.5% of net income.

[5] Section references are to the Internal Revenue Code of 1986, as amended.

[6] See IRC §1361 (for example, an insurance company or certain financial institutions). In addition, Form 2553 must be filed to make the S corporation election.

[7] See IRC §1221(a).

[8] See IRC §1012(a) and §167.

[9] A 338(g) election also obtains a basis step-up, but results in two layers of tax and is not generally used for domestic transactions.

[10] IRC 338(a).

[11] Reg. 1.338(h)(10)-1(d)(9).

[12] In accordance with the allocation provisions set forth in IRC 1060 and Reg. 1.338-6 and 1.338-7.

[13] Reg. 1.338-6(b)(vi) and (vii).

[14] IRC 338(a).

[15] IRC 338(d)(3) and Reg. 1.338(h)(10)-1(c). For the purposes of this article, we assume that target is a standalone S-corp.

[16] Reg. 1.338(h)(10)-1(c)(5). However, the transaction may still qualify under Section 336(e). See below.

[17] Reg. 1.338(h)(10)-1(c)(3). Form 8883 also needs to be filed. If an F reorg is done, form 8594 will need to be filed.

[18] Reg. 1.338(h)(10)-1(c)(3).

[19] Reg. 1.336-2(a). The election is made unilaterally by seller and target. See Reg. 1.336-2(h).

[20] Reg. 1.336-1(b)(2). See Reg. 1.336-1 – Reg. 1.336-5 for the mechanics of making the 336(e) election and what qualifies as a “qualified disposition” under 336.

[21] Reg. 1.336-1(b)(6)(ii)(A).

[22] See Reg. 1.338(h)(10)-1 for the tax aspects of the deemed asset sale and liquidation.

[23] A deemed asset sale under Section 338 does not give rise to California sales tax. Cal. Code of Regs. 1595(a)(6).

[24] IRC 338(h)(3). See below for rollover transactions.

[25] Reg. 1.338(h)(10)-1(d)(5).

[26] IRC 338(h)(3)(A)(ii). Beware of situations where the acquiror appears to “purchase” at least 80% of target’s stock (and target rolls over 20% or less of its stock in a 351 transaction), but the acquiror in fact does (or might be deemed to) “purchase” less than 80% of target’s stock, thereby invalidating a 338, 338(h)(10), or 336(e) election. This most commonly occurs where purchaser is a newly formed corporation and target rolls over 20% (or less) of its shares. See Ginsburg, Levin & Rocap, Mergers, Acquisitions, and Buyouts, § 4.06.1.2.2 (relating to redemption of stock held by target’s shareholders and recharacterizing a 351 transaction and cash sale as a single 351 exchange with boot).

[27] See footnote 16.

[28] In accordance with Rev. Rul. 2008-18.

[29] IRC 1361(b)(3).

[30] Rev. Rul. 2008-18. Obviously, Holdco must meet all the requirements of an S-corp. In many cases, the parties will file Form 2553 to treat Holdco as an S corporation as a “belt and suspenders” step.

[31] Upon conversion, T is no longer treated as a QSub per 1361(b)(3). The conversion has no tax consequences; see Reg. 1.1361-5(b)(3), example 2, where the merger of two disregarded entities owned by the same entity is a disregarded transaction for tax purposes because the assets continue to be held by the same entity. The same should apply when one disregarded entity converts to another. The QSub can also merge with a newly formed LLC subsidiary of Holdco to achieve the same result.

[32] Rev. Rul. 2008-18.

[33] Rev. Rul. 99-5; Reg. 1.1361-5(b)(3), example 2.

[34] Rev. Rul. 99-5; see also Rev. Rul. 99-6.

[35] Id. Although not required, a Section 754 election is often required by the Buyer.

[36] IRC 336(a).

[37] IRC 1202(b). See Section 1202 for the requirements to qualify for QSBS.

[38] IRC 1202(c).

[39] The S corporation shares do not qualify as QSBS. The new shares of the C corporation issued after the reorganization qualify as QSBS to begin the 5 year holding period.

Article By Ben Gruen of Stubbs Alderton & Markiles, LLP

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© Copyright 2023 Stubbs Alderton & Markiles, LLP

EU Foreign Subsidies Regulation Enters Into Force In 2023

On December 23, 2022, Regulation (EU) 2022/2560 of December 14, 2022 on foreign subsidies distorting the internal market (FSR) was published in the Official Journal of the European Union. The FSR introduces a new regulatory hurdle for M&A transactions in the European Union (EU), in addition to merger control and foreign direct investment screening. The FSR’s impact cannot be overstated as it introduces two mandatory pre-closing filing regimes and it gives the Commission wide-reaching ex officio investigative and intervention powers. Soon, the Commission will also launch a public consultation on a draft implementing regulation that should further detail and clarify a number of concepts and requirements of the FSR.

The bulk of the FSR will apply as of July 12, 2023. Importantly, the notification requirements for M&A transactions and public procurement procedures will apply as of October 12, 2023.

We highlight the key principles of the FSR below and provide guidance to start preparing for the application of the FSR. We refer to our On The Subject article ‘EU Foreign Subsidies Regulation to Impact EU and Cross-Border M&A Antitrust Review Starting in 2023’ of August 2, 2022 for a more detailed discussion of the then draft FSR. We also refer to our December 8, 2022 webinar on the FSR. Given the importance of the FSR, we will continue to report any future developments.

IN DEPTH

FSR in a Nutshell

The FSR tackles ‘foreign subsidies’ granted by non-EU governments to companies active in the EU and which ‘distort the internal market’.

  • First, a ‘foreign subsidy’ will be considered to exist where a direct or indirect financial contribution from a non-EU country or an entity whose actions can be attributed to a non-EU country (public entities or private entities) confers a benefit on an undertaking engaging in an economic activity in the EU internal market, and where that benefit is not generally available under normal market conditions but is, instead, limited, in law or in fact, to assisting one or more undertakings or industries. A ‘financial contribution’ covers a broad spectrum and encompasses, amongst others, positive benefits such as the transfer of funds or liabilities, the foregoing of revenue otherwise due (e.g., tax breaks, the grant of exclusive rights below market conditions, or the provision or purchase of goods or services).

  • Second, a ‘distortion in the internal market’ will be considered to exist in case of a foreign subsidy which is liable to improve the competitive position of an undertaking and which actually or potentially negatively affects competition in the EU internal market. The Regulation provides some guidance on when a foreign subsidy typically would not be a cause for concern:
    – A subsidy that does not exceed EUR 200,000 per third country over any consecutive period of three years is considered de minimis and therefore not distortive;
    – A foreign subsidy that does not exceed EUR 4 million per undertaking over any consecutive period of three years is unlikely to cause distortions; and
    – A foreign subsidy aimed at making good/recovering from the damage caused by natural disasters or exceptional occurrences may be considered not to be distortive.

The FSR looks at ‘undertakings’, as is the case for merger control. Therefore, the Commission will not look merely at the legal entity concerned, but at the entire corporate group to which the entity belongs in order to calculate the total amount of foreign financial contributions granted to the undertaking. Even companies headquartered in the EU that have entities outside of the EU that have received foreign financial contributions are covered by the FSR.

The FSR introduces three tools for the European Commission (Commission): (i) a notification requirement for certain M&A transactions, (ii) a notification requirement for certain public procurement procedures (PPP) and (iii) investigations on a case by case basis.

Notification Requirement for Certain M&A Transactions

M&A transactions (or “concentrations”) involving a buyer and/or a target that has received a foreign financial contribution shall be notifiable if they meet the following cumulative conditions:

  • At least one of the merging undertakings, the acquired undertaking (target, not buyer) or the joint venture is established in the EU and has an EU turnover of at least EUR 500 million, AND

  • The combined aggregate financial contributions provided to the undertakings concerned in the three financial years (combined) prior to notification amounts to more than EUR 50 million.

M&A transactions that meet these criteria will need to be notified and approved by the Commission prior to implementation. During its review, the Commission will determine whether the foreign financial contributions received constitute foreign subsidies in the sense of the FSR and whether these foreign subsidies actually or potentially distort or negatively affect competition in the EU internal market. The Commission likely will consider certain indicators including the amount and nature of the foreign subsidy, the purpose and conditions attached to the foreign subsidy as well as its use in the EU internal market. For example, in a case of an acquisition, if a foreign subsidy covers a substantial part of the purchase price of the target, the Commission may consider it likely to be distortive.

Notification Requirement for Certain Public Procurement Procedures

A notifiable foreign financial contribution in the context of PPP shall be deemed to arise where the following cumulative conditions are met:

  • The estimated value of the public procurement or framework agreement net of VAT amounts to at least EUR 250 million, AND

  • The economic operator was granted aggregate foreign financial contributions in the three financial years prior to notification of at least EUR 4 million from a non-EU country.

Where the procurement is divided into lots, the value of the lot or the aggregate value of all lots for which the undertaking bids for must, in addition to the two criteria set out above, also amount to at least EUR 125 million.

Through this procedure, the Commission will ensure that companies that have received non-EU country subsidies do not submit unduly advantageous bids in public procurement procedures.

During the Commission’s review, all procedural steps may continue except for the award of the contract.

Even if the thresholds are not met, the Regulation requires undertakings to provide to the contracting authority in a declaration attached to the tender a list of all foreign financial contributions received in the last three financial years and to confirm that these are not notifiable, which the contracting authority will subsequently send to the Commission.

Investigations on a Case-by-case Basis

The Commission may on its own initiative investigate potentially distortive foreign subsidies (e.g. following a complaint). These investigations are not limited to M&A transactions or PPP. However, on the basis of this power, the Commission may investigate M&A transactions and awarded contracts under PPP which do not fall within the scope of the notification requirements set out above.

If the Commission carries out an ex-officio review, its analysis will be structured in two phases: a preliminary examination and an in-depth investigation. Although these phases have no time limits, the Commission will endeavor to take a decision within 18 months of the start of the in-depth investigation.

HOW TO PREPARE FOR THE APPLICATION OF THE FSR

Application of the FSR – Timetable

As mentioned above, the FSR will apply as of July 12, 2023. The FSR shall apply to foreign subsidies granted in the five years prior to July 12, 2023 where such foreign subsidies create effects at present, i.e., they distort the internal market after July 12, 2023. By way of derogation, the FSR shall apply to foreign financial contributions granted in the 3 years prior to July 12, 2023 where such foreign financial contributions were granted to an undertaking notifying a concentration or notifying a PPP pursuant to the FSR.

The FSR shall not apply to concentrations for which the agreement was signed before July 12, 2023. The FSR shall also not apply to public procurement contracts that have been awarded or procedures initiated before July 12, 2023.

In general, the FSR shall apply from July 12, 2023 while the notification obligations for M&A transactions and PPP shall only apply from October 12, 2023. However, it is advisable to start preparing immediately for the application of the FSR, given the substantial scope of the regulation.

Actions to Take Now

Businesses which conduct activities in the EU, should put in place a system to monitor and quantify foreign financial contributions received since at least July 2020 – to cover the three-year review – and, preferably, July 2018. In particular, attention should be paid to positive benefits and reliefs from certain costs normally due by the company. External counsel can assist in determining whether these foreign financial contributions constitute a ‘foreign subsidy’.

As soon as a company decides to engage in an M&A or PPP in the EU, the company should map all relevant foreign financial contributions for the relevant time period to check whether the relevant notification thresholds are met. Subsequently companies must carefully consider whether any such financial contribution constitutes a foreign subsidy and, if so, whether such foreign subsidy may have a distortive effect. It is also advisable to determine whether there any positive effects relating to the subsidy that could be invoked. Companies should ensure that the preparation above is ably assisted by external counsel.

In particular with regard to M&A transactions, companies should carry out an FSR analysis in addition to merger control and foreign direct investment reviews. Even at the stage of due diligence, it would already be advisable to check whether the target has received any foreign financial contributions. If the transaction might eventually trigger a notification to the Commission, the M&A agreement should provide for Commission approval in the closing conditions. When acting as a bidder for a target that meets the EU turnover threshold, your bid will be much better viewed when accompanied with clear assurances that no FSR filing is required or, alternatively, that a filing may be required but that the foreign subsidies received are not distortive of competition.

© 2023 McDermott Will & Emery
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FRB and FDIC Issue Joint ANPR on Possible Resolution Requirements for Large Banking Organizations While FRB and OCC Approve U.S. Bank MUFG Union Bank Merger

The Federal Reserve Board (“FRB”) and Federal Deposit Insurance Corporation (“FDIC”) Board issued an Advanced Notice of Proposed Rulemaking (“ANPR”) titled “Resolution-Related Resource Requirements for Large Banking Organizations.” Separately, but relatedly (if for no other reason than the FRB put it in the same press release as the ANPR), the Office of the Comptroller of the Currency (“OCC”) and the FRB approved their respective applications for the merger of MUFG Union Bank into U.S. Bank.

The ANPR is seeking comment on possible changes to the resolution-related standards applicable to large banking organizations (“LBOs”) that are not global systemically important banks (“GSIBs”). Those possible changes that the FRB and FDIC are contemplating would bring some of what is required for GSIB resolution planning down to LBOs, particularly focusing on “Category III” firms with $250 billion to $700 billion in total assets. The main focus of the ANPR is on whether LBOs ought to be required to issue long-term debt similar to the total loss-absorbing capacity (“TLAC”) requirements for GSIBs. The ANPR notes that the Fed and FDIC are considering “whether an extra layer of loss-absorbing capacity could increase the FDIC’s optionality in resolving the insured depository institution,” but also costs associated with such a requirement.

The ANPR flows logically from remarks made by Acting Comptroller Hsu at the Wharton Conference on Financial Regulation in April (and which we discussed in a previous issue), and that Acting Comptroller Hsu noted in his statement when he voted in favor of the ANPR at the FDIC Board meeting.

As noted above, in the same press release announcing the ANPR, the FRB announced the approval of the application by U.S. Bancorp to acquire MUFG Union Bank. The FRB’s order noted that upon consummation, U.S. Bancorp’s consolidated assets would total approximately $698.7 billion, and noting the close proximity to becoming a “Category II” firm over $700 billion in assets imposed a unique commitment to give quarterly implementation plans for complying with Category II requirements. The commitment by U.S. Bancorp also could trigger a need for U.S. Bancorp to comply with Category II requirements by December 31, 2024, even if its asset size has not gone above the $700 billion threshold. FRB Governor Michelle Bowman issued a statement supporting both the issuance of the ANPR and the approval of U.S. Bancorp’s application, but questioned the appropriateness of imposing Category II requirements on a one-off basis. The OCC’s approval was conditioned, among other things, on U.S. Bank making plans for its possible operability in the event of a resolution in order to facilitate its sale to more than one acquiring institution.

Article By Daniel Meade of Cadwalader, Wickersham & Taft LLP

For more financial legal news, click here to visit the National Law Review.

© Copyright 2022 Cadwalader, Wickersham & Taft LLP

Which Business Entity is Right For You: Sole Proprietorship, Partnership, LLC, C-Corporation, or S-Corporation?

Introduction

Are you getting ready to launch your business? Or maybe you’re currently operating one and wondering what legal structure is best to use. There are a number of different legal entities to choose from. And each has its own set of pros and cons.

To determine which business entity is the best fit, you’ll want to see which one most applies to your situation and then carefully go over the pros and cons. It’s also a great idea to speak with your tax professional and an attorney.

Some things that will affect your decisions, and your long-term success, are liability protection, taxation, the complexity of management, annual requirements, and the ability to raise money from investors, if applicable.

What are the options?

New businesses in the US have a choice of five basic structures:

  • C-Corporation
  • LLC (Limited Liability Company)
  • S-Corporation
  • Sole Proprietorship
  • Partnership (aka General Partnership)

You’ll want to learn about each business structure and decide which best suits your needs. We’ll explain each type below and will also go over how they are different from each other.

Corporation (aka C-Corporation)

  • A Corporation is a separate legal entity created by state law. A Corporation is formed by filing a document called the Articles of Incorporation. This document is filed in the state where the entity is doing business and is filed with the Secretary of State or a similar government agency.
  • A Corporation must designate a Registered Agent in order to receive service of process and state correspondence.
  • By default, a Corporation is taxed under subchapter C of the Internal Revenue Code. This is often why Corporations are referred to as C-Corporations.
  • On the other hand, a Corporation can elect to be taxed as an S-Corporation (aka being taxed under subchapter S of the Internal Revenue Code) by filing Form 2553 with the IRS.
  • If the Corporation is taxed in its default status (taxed as a C-Corporation), the Corporation will face double taxation. Essentially, the Corporation is taxed at the corporate level on its profits. And then the Shareholders are taxed again, at the individual level, after they receive distributions (their share of profit).
  • C-Corporations are also responsible for paying state corporate income tax, if applicable, where they are domiciled and/or transacting business.
  • Corporations also have statutory requirements, such as electing a board of directors, designating corporate offers, holding annual meetings, and recording meeting minutes.
  • Corporations are not commonly used by small business owners. Instead, they are used by larger companies or tech startups often looking to raise venture capital from investors.

LLC (Limited Liability Company)

  • An LLC, aka Limited Liability Company, is a separate legal entity created by state law. An LLC is often formed by filing a document called the Articles of Organization. However, depending on the state, this form is also known as the Certificate of Organization or Certificate of Formation. This document is filed in the state where the entity is doing business and is filed with the Secretary of State or a similar government agency.
  • An LLC must also designate, and maintain, a Registered Agent. A Registered Agent must be located in the state where the LLC is formed. For example, if an LLC is formed in Texas, it must designate a Registered Agent in Texas.
  • The LLC is unique when it comes to tax treatment by the IRS. This means, there is no “LLC tax classification”. Instead, the LLC is taxed based on the number of owners. Alternatively, the LLC can make an election with the IRS, requesting to be taxed as a Corporation (C-Corporation or S-Corporation).
  • An LLC with one owner is known as a Disregarded Entity. This simply means the IRS “looks through” the LLC; looks at who the owner is, and taxes the individual or company accordingly. For example, if an American taxpayer is the single owner of an LLC, the LLC will be taxed as a Sole Proprietorship. If the LLC is owned by two or more people, the LLC will be taxed as a Partnership. And if the LLC is owned by another company, it will be taxed as a branch/division of the parent company.
  • And alternatively, the LLC can elect to be taxed as either a C-Corporation (by filing Form 8832) or an S-Corporation (by filing Form 2553).
  • LLCs taxed as Sole Proprietorship, Partnerships, and S-Corporations are all known as pass-through entities. This means there is no corporate-level taxation (company-level taxation). Instead, the taxes flow through to the owners and are reported and paid on their personal tax returns.
  • In the more uncommon setup – an LLC taxed as a C-Corporation – the LLC would face double taxation, just like a regular Corporation would.
  • And while an LLC may be able to be used for estate planning purposes, it’s often wiser to have your LLC owned by your trust(s). Of course, it’s best to speak with an estate planning attorney on such a matter.
  • In summary, for many small business owners, LLCs are the “best of all worlds”. They receive liability protection, just like a Corporation, but they are, by default, pass-through tax entities. And if the LLC would like to be subject to corporate tax treatment by the IRS, the LLC can make the necessary election. Said another way, while providing liability protection to its owners, the LLC can pretty much choose how it would like to be taxed.
  • LLCs also have more flexible management options and don’t have as many formal, and annual requirements, such as Corporations.
  • LLCs are the most popular type of business entity in the United States, mostly because of their flexibility and the personal liability protection they offer to owners.

S-Corporation (aka S Corp)

  • An S-Corporation is unique because it is not a legal entity, like an LLC or a Corporation. Instead, it’s a tax election made with the IRS.
  • It’s easier to think of it this way: The S-Corporation tax election “sits on top of” a state-level entity, such as an LLC or Corporation.
  • This is one of the most common myths with S-Corporations. People think you can just “form” an S-Corp. You simply cannot. There is no state or federal filing to “form” an S-Corp. Instead, one must first form an LLC or Corporation, and then timely file Form 2553 with the IRS to request to be taxed under Subchapter S of the Internal Revenue Code.
  • Once the IRS grants the elective status, it’s common to refer to the entity as an S-Corporation and its owners as Shareholders.
  • For most, the primary reason to explore S-Corp tax treatment is to save money on self-employment taxes.
  • Owners of an S-Corporation must take a “reasonable salary” (which is subject to self-employment taxes), but any remaining profit can be taken as a distribution (which isn’t subject to self-employment taxes). And that’s the main appeal of S-Corporations right there.
  • It’s important to keep in mind that with an S-Corporation, you must regularly run payroll, withhold taxes, file quarterly payroll returns (federal and state), hire a bookkeeper (or manage your own books), keep an accurate balance sheet (since it’s required to be filed with the IRS), file a corporate tax return (Form 1120S, K-1s for shareholders/owners, and any additional Schedules), and hire an accountant if you don’t have one already.
  • All of the above costs money. And those costs – which average $2,000 – $4,000 for small business owners – need to be compared to the potential self-employment tax savings; in order to make sure the S-Corp tax treatment makes sense.
  • S-Corporations can be owned by US citizens, US trusts (depending on how they’re taxed), US estates, US resident aliens, and US tax-exempt organizations.
  • S-Corporations cannot be owned by Non-US residents (aka non-resident aliens), foreign companies, C-Corporations, Partnerships, financial institutions, or insurance companies.
  • If you’re considering having your entity taxed as an S-Corporation, it’s important to speak with an accountant to make sure the extra cost – and additional filing requirements – are worth the self-employment tax savings. Having your business entity taxed as an S-Corporation can be a good idea for some, but isn’t necessarily a good idea for everyone.

Sole proprietorship

  • A Sole Proprietorship is an informal “business structure” with one owner.
  • There is no paperwork to file with the Secretary of State, or a similar government agency, to create a Sole Proprietorship.
  • You simply are a Sole Proprietorship once you engage in business activities, or engage in activities with the goal of making money.
  • A Sole Proprietor can do business under their own name or they can file a DBA (Doing Business As) Name. For example, John Doe can do business under his name, John Doe, or he can file a DBA called “John’s Painting Company”.
  • The advantage of a Sole Proprietorship is that they are easy to set up.
  • And taxes are pretty straightforward with a Sole Proprietorship. The owner will simply file a Schedule C and report their business income (or loss) on their personal tax return.
  • The largest disadvantage of Sole Proprietorship is that there is no liability protection for the owner. In the eyes of the law, the owner and their business are one and the same. If the business is involved in a lawsuit, the owner’s personal assets (home, cars, bank account, etc.) could be used to settle business debts and liabilities.
  • Another disadvantage of a Sole Proprietorship is that if you eventually form an LLC or Corporation, there is no official “conversion” filing. So you basically have to start all over again – filing paperwork with the state, getting an EIN (Federal Tax ID Number), opening a business bank account, etc. So if you’re on the fence, between an LLC or Sole Proprietorship, for example, it’s often easier to just form an LLC.
  • However, if you believe your business has a low liability risk and you don’t have money to form an LLC or Corporation, starting your business as a Sole Proprietorship may be the best method to getting your business off the ground.

General Partnership (aka Partnership)

  • A General Partnership (Partnership) is pretty much a Sole Proprietorship with 2 or more people. Said another way, it’s an informal “business structure” with multiple owners.
  • In most states, there is no paperwork to file with the Secretary of State, or a similar government agency, to create a General Partnership (there are few states though that require General Partnerships to register).
  • A Partnership can do business under the names of the owners or it can file a DBA (Doing Business As) Name.
  • The advantage of a General Partnership is that it is easy to set up.
  • Partnership taxes are not as straightforward as with a Sole Proprietorship though. For instance, the Partnership must file a Form 1065 and issue K-1s to the partners. Then the partners report their K-1 income on their personal tax returns.
  • The largest disadvantage of a Partnership is that there is no liability protection for the owners. Again, in the eyes of the law, the owners and their businesses are one and the same. If the business is involved in a lawsuit, the owner’s personal assets (home, cars, bank accounts, etc.) could be used to settle business debts and liabilities.
  • While a Partnership may be a good way to save money and get a business off the ground, most people quickly shift to a legal business entity, like an LLC or Corporation.

Choosing the best entity structure for your business

  • Generally speaking, the LLC is the most adaptable corporate structure, and for that reason the most popular choice in the U.S. The LLC can pretty much choose how it would like to be taxed by the IRS, all while providing its owners’ personal liability protection.
  • Having said that, some owners may elect for their LLC to be taxed as an S-Corporation to save money on self-employment taxes.
  • Or larger businesses (or those raising money) may prefer to form a Corporation, especially if they have large healthcare expenses.
  • And while Sole Proprietorships and General Partnerships may be good to start off with, owners may quickly outgrow them or not feel comfortable with the lack of personal liability protection.

Conclusion

Choosing the best legal entity for your business is a game of weighing the pros and cons. Things to consider are liability protection for the owners, tax treatment by the IRS, and the reporting requirements, among other things. Typically, larger companies or those raising money from investors opt for the Corporation, while most small business owners choose to form an LLC.

Article By Matt Horwitz of LLC University

For more corporate and business legal news, click here to visit the National Law Review.

© Copyright 2010 LLC University

Could the Crypto Downturn Lead to a Spike in M&A?

In 2021, we saw a cryptocurrency boom with record highs and a flurry of activity. However, this year, the cryptocurrency downturn has been significant.  We have seen drops in various cryptocurrencies ranging from 20 to 70 percent, with an estimated $2 trillion in losses in the past few months.

Industry watchers had already predicted a spike in crypto M&A from the beginning of 2022, and in a recent interview with Barron’s, John Todaro, a senior crypto and blockchain researcher at Needham & Company, said he believes this downturn could lead to a wave of mergers and acquisitions in the crypto space for the second half of this year and even into 2023.

Valuations have dropped across the board this year as the market has faced incredible volatility, and Todaro told Barron’s, “The valuations for public crypto companies have fallen by about 70% this year.”  These lower valuations could make these companies increasingly attractive targets for acquisition, and this activity has already started to pick up.

According recent coverage from CNBC, some larger crypto companies are already looking for acquisition targets in order to drive industry growth and to help them acquire more users. Todaro feels most of the M&A activity we will see will be this kind of crypto to crypto acquisition as opposed to traditional buyers, although there is still opportunity for non-crypto companies to capitalize on these lower valuations and some are already doing so.

With more government regulation coming for the crypto sector this year, it could also impact the activity level as well.  Achieving some legal and regulatory clarity could have implications for this uptick in M&A for crypto companies. Our analysis of the SEC’s recent proposed regulations, other government activity in this area, and their potential implications can be found here.

We could of course see a growing number of acquisitions across industries as valuations remain lower than a year ago, but as the crypto sector continues to see this kind of a downturn, the level of activity in this area could be much greater than it has previously seen.  With that said, both the target company and the acquirer should be looking at any transactions with the same level of due diligence instead of rushing into any deal fueled by panic or haste.

Article By Louis Lehot of Foley & Lardner LLP

For more mergers and acquisitions legal news, click here to visit the National Law Review.

© 2022 Foley & Lardner LLP

Constitutionality of FTC’s Structure and Procedures Under SCOTUS Review

Both the Federal Trade Commission (FTC) and the Antitrust Division of the Department of Justice (DOJ) have authority to enforce Section 7 of the Clayton Act by investigating and challenging mergers where the effect of such transaction “may be substantially to lessen competition or tend to create a monopoly.”

However, the enforcement paths of these two federal agencies differ markedly. DOJ pursues all aspects of its enforcement actions in the federal court system. The FTC, on the other hand, only uses the federal district courts to seek injunctive relief, but otherwise follows its own internal administrative process that combines the investigatory, prosecutorial, adjudicative, and appellate functions within a single agency.

Whether a transaction is subjected to DOJ or FTC review is determined by a “clearance” process with no public visibility. To many, including entities in the health care industry—and, in particular, parties to hospital mergers that are now routinely “cleared” to the FTC (exemplified by two recently filed enforcement actions against hospitals in New Jersey and Utah)—this process appears to be arbitrary. It is also particularly daunting because the FTC has not lost an administrative action in over a quarter-century. Because of the one-sided nature and duration of these administrative proceedings, most enforcement actions brought against merging hospitals rise or fall at the injunctive relief stage. This process also appears to embolden the FTC into taking unprecedented actions, including the pursuit of enforcement remedies against parties to abandoned transactions.

However, this may soon change. The Supreme Court of the United States has agreed to hear a case that raises a forceful constitutional challenge to the FTC’s structure and procedures. The Supreme Court recently agreed to combine the briefing schedule of this case with a similar case that successfully challenged the constitutionality of the administrative process of the Securities and Exchange Commission. The outcome of these cases may fundamentally alter the FTC’s enforcement process.

Article By E. John Steren and Patricia M. Wagner of Epstein Becker & Green, P.C.

For more antitrust and trade regulation news, click here to visit the National Law Review.

©2022 Epstein Becker & Green, P.C. All rights reserved.

Antitrust Enforcers’ “Second Listening” Forum On Merger Reform Highlights Issues In The Healthcare Industry

In March of this year the Antitrust Division of the U.S. Department of Justice (“DOJ”) and the Federal Trade Commission (“FTC”) jointly announced a series of “listening forums” that would help gather real world input from participants in key industry segments on possible reforms to the antitrust regulations pertaining to mergers and acquisitions.1 Co-led by DOJ Deputy Assistant Attorney General (“DAAG”) Doha Mekke and FTC Chairperson Lina Khan, the second of the four announced forums, focusing on healthcare, was held on April 14, 2022. 2  In addition to DAAG Mekki and Chairperson Khan, the program included eight panelists that provided perspectives from nurses, doctors, patients, pharmacists and small businesses. 3

DAAG Mekki started off the discussion by reaffirming the antitrust enforcement agencies’ collective commitment that “healthcare markets remain competitive” because it “is essential to our livelihood or the livelihood of the nation.” Mekki referenced ongoing work by the agencies in the healthcare field, including recent DOJ enforcement actions. 4

The healthcare panelists highlighted several ongoing issues in the industry, such as the adverse impact of care due to post-merger hospital staff downsizing that was tied to merger-specific efficiencies, reduced options to tertiary care, higher healthcare costs for patients, and unfair competition in the pharmaceutical and small business markets, and other impacts in the research and labor markets.

Chairperson Khan indicated that the comments resonated with the concerns that the FTC had in the hospital, pharmacy benefits management, and pharmacy industries. Ms. Khan also suggested a renewed interest in examining the potential anticompetitive effects of vertical integration in addition to horizontal mergers and acquisitions, which is consistent with the FTC’s position when it indicated that it wanted to revisit this issue while withdrawing the Vertical Merger Guidelines in 2021. Khan also reaffirmed the importance of examining anticompetitive effects in the labor market. All of these issues, according to Khan, are important in assessing how the antitrust laws can be used to improve the quality of healthcare for patients.

The forum ended with some of the more than two hundred public comments, most of which echoed similar concerns raised by the panelists in addition to concerns such as disparities in hospital-physician group contracting situations and racial disparities in access to healthcare as a result of healthcare system mergers.

Once again, all signs point toward an unprecedented time in antitrust enforcement in the healthcare industry. Accordingly, it is important that healthcare companies revisit, revise, and implement best practices with regard to their respective antitrust compliance programs. A proactive, as opposed to a reactive, approach would provide companies the best risk management strategy. It is also important to engage antitrust counsel early in potential transactions to assess how the antitrust agencies may view the deal.

The DOJ and FTC Listening Forums continue with Media and Entertainment, which was held on April 27, 2022, and the final one on Technology, which will be held on May 12, 2022. Click here to download the alert. 

FOOTNOTES

1    “Forums to focus on markets commonly impacted by mergers: food and agriculture, health care, media and entertainment, and technology,” March 17, 2022, available at: https://www.ftc.gov/news-events/news/press-releases/2022/03/ftc-justice-department-launch-listening-forums-firsthand-effects-mergers-acquisitions

2   See “Antitrust Enforcers’ First ‘Listening Forum’ On Merger Reform Highlights Ongoing Concerns in the Food and Agriculture Industry” May 9, 2022, available at: https://www.polsinelli.com/intelligence/antitrust-forum-highlights-concerns-in-food-and-ag

3 Full transcript of forum available at: https://www.ftc.gov/system/files/ftc_gov/pdf/FTC-DOJ-Listening-Forum-%20Health-Care-Transcript.pdf. It should be noted that Assistant Attorney General Jonathan Kanter did make an appearance at the end of the session, reiterating the importance of this forum.

4    See “DOJ Faces Two Strikeouts in First Health Care Wage-Fixing and ‘No Poach’ Prosecutions,” April 20, 2022, available at: https://www.polsinelli.com/intelligence/doj-faces-two-strikeouts-in-first-health-care

© Polsinelli PC, Polsinelli LLP in California
Article By Arindam Kar with Polsinelli PC.
For more articles about antitrust law, visit the NLR Antitrust law section.

Ticketmaster, Live Nation Get Booed: Concert-Goers File Class Action for “Unchecked” Abuse of Market Power

Live Nation Threatens Anyone Who Doesn’t Play Along, Plaintiffs Allege

Concert-goers tired of paying “supracompetitive fees” on ticket purchases from Ticketmaster LLC filed a class action against the company and its parent, promoter Live Nation Entertainment, Inc., in U.S. District Court for the Central District of California on April 28 for abusing its more than 70% share of the primary ticketing market (i.e. where tickets are initially sold) for major concerts. The merged companies are also aggressively deploying anticompetitive tactics in pursuit of the lucrative “secondary ticketing” market where tickets are re-sold, typically at higher prices.

Ticketmaster achieved its dominant position through a “web of long-term exclusive dealing agreements” and other anticompetitive activity, the plaintiffs maintain. The companies merged in 2010, putting the ticketing giant together with the nation’s “most dominant concert promoter.” Live Nation controls 60% of the promotion business for major concerts. AEG Live is a distant number two, with 20% market share. Now, the plaintiffs say, Live Nation uses Ticketmaster as a loss leader to bludgeon its competitors and strong-arm venues (Iderstine v. Live Nation Entertainment, Inc. and Ticketmaster LLC, No. 1:20-CV-03888-PA-GJS, C.D. Calif., Western Div.).

“Subsidized by the supracompetitive profits Ticketmaster’s business generates from its domination of primary ticketing services for major concert venues, Live Nation Entertainment is able to keep a stranglehold on concert promotion services – losing tens of millions of dollars annually – by paying its clients exorbitant amounts,” the complaint reads. Live Nation “regularly threatens” concert venues with eliminating them from big-act tours if they use a Tickemaster competitor for ticketing services.

Live Nation has apparently become such an emboldened market bully that its CEO, Michael Rapino, openly boasted last year that if a venue doesn’t use Ticketmaster it will suffer economically because “we don’t hold the revenue.”  This stiff-arm anticompetitive style hasn’t been lost on the Department of Justice Antitrust Division or anyone who’s paying attention in the industry. It’s become the norm. The DOJ said U.S. venues have come to accept that if they don’t use Tickmaster they will lose big-star performers and significant revenue. “Given the paramount importance of live event revenues to a venue’s bottom line, this is a loss most venues can ill-afford,” the DOJ observed.

We recently wrote in our post — DOJ: Event Powerhouse Live Nation Punished Concert Venues for Using Competing Ticketers Despite Bar – of the government’s charge that Live Nation has been violating the DOJ-ordered ban on anticompetitive behavior for years. Now, Live Nation is operating under what the DOJ calls “the most significant enforcement action” of an existing antitrust consent decree in its history, one intended, at least, to secure stricter and longer lasting conditions designed to rein in the event conglomerate’s anticompetitive behavior. The DOJ action began more than a decade ago after the company acquired Ticketmaster. A 2010 final judgment permitted the merger but prohibited the company from retaliating against concert venues for using competing ticket companies, threatening concert venues, or taking other actions against concert venues for 10 years (United States v. Ticketmaster Entertainment, Inc., et al., Case No. 1:10-cv-00139-RMC [July 30, 2010]).

These are highly profitable companies. Live Nation’s 2018 revenues were $10.8 billion. Ticketmaster, a wholly-owned subsidiary following their merger in 2010, made $1.5 billion in 2018.

Despite the 2010 judgment, the DOJ announced earlier this year that Live Nation had been repeatedly violating it for years. The government hopes the modified and extended judgment clarifies for Live Nation what conduct is out of bounds and gives consumers and venues the relief the DOJ wanted in the first place.

Historically, structural remedies (such as divestitures) have been preferable to behavioral remedies (like consent decrees) in addressing antitrust concerns over proposed mergers. As Live Nation and Tickmaster are demonstrating, behavioral remedies are too easily ignored or abused by post-merger behemoths. Too often the benefits of violation outweigh the punishment. Their behavior also highlights the anticompetitive effects that can result from large-scale vertical mergers, which have been rampant in recent years. Bundling, tying, and exclusive contracts are just a few of the competitive concerns that we see playing out here, not to mention a stagnation in the entry of new competitors in various complementary markets.

Seeking relief under Sections 1 and 2 of the Sherman Act, Tickemaster and Live Nation, the Iderstine v. Live Nation complaint says:

  • Engage in anticompetitive exclusive dealing with concert venues;
  • Improperly wield the conditional copyright license Ticketmaster employs to grant access to its online platform, blocking, for example, purchases of a large number of tickets. This forces ticket brokers into exclusivity with Ticketmaster, and not its competitor;
  • Bar individuals from transferring tickets unless they use Ticketmaster to do so;
  • Prevent secondary ticket service providers from being able to do business – and charge consumers lower fees – by forcing venues to use both their concert promotion and concert ticketing services. In other words, tying. Ticketmaster enjoys double-digit annual growth as a result of its “unchecked” anticompetitive conduct, the complaint says.
  • Use “coercion of and threats against disloyal customers, ticket brokers, and others”;
  • Execute vertically arranged boycotts.

Ticketmaster has “clearly engaged in blatant, anti-consumer behavior for years,” the plaintiffs say. In addition to its “behind-the-scenes efforts to feed ticket brokers huge amounts of supply if they sold on Ticketmaster’s secondary platform,” the plaintiffs cite the DOJ’s extension of the 2010 consent decree. It’s only recently come to the attention of ticket-buyers that Live Nation has been “shamelessly” violating the consent agreement for years.  It also notes that the Federal Trade Commission ordered Ticketmaster to stop implying ticket prices were higher on its primary platform than its secondary re-sale platform, when the opposite is true.

The complaint seeks certification of two subclasses:

  1. Primary Ticketing Services Consumer Class. “All end-user purchasers in the United States who purchased a primary ticket and paid associated fees for primary ticketing services for an event at a major concert venue in the United States from Ticketmaster or one of its affiliated entities owned, directly or indirectly, by Live Nation Entertainment, Inc. at any point since 2010.”
  2. Secondary Ticketing Services Consumer Class. “All end-user purchasers in the United States who purchased a secondary ticket and paid associated fees for secondary ticketing services for an event at a major concert venue in the United States from Ticketmaster or one of its affiliated entities owned, directly or indirectly, by Live Nation Entertainment, Inc. at any point since 2010.”

© MoginRubin LLP

Is a Moratorium on Mergers During the Pandemic a Bridge Too Far?

In an interview with Politico’s Leah Nylen and Betsy Woodruff Swan, Rep. David Cicilline (D-R.I.) explained that he wants the next coronavirus relief package to include a moratorium on mergers while the U.S. economy struggles to face the pandemic. According to the report, the Rhode Island Congressman’s proposal would allow deals “only if a company is already in a bankruptcy or is otherwise about to fail.” Any other deals would be on hold at least until the national pandemic declaration is lifted.

In prepared remarks, Rep. Cicilline’s stated: “As millions of businesses struggle to stay afloat, private equity firms and dominant corporations are positioned to swoop in for a buying spree.” The remarks continued: “This is not complicated. Our country can leave room for merger activity that is necessary to ensuring that distressed firms have a fresh start through the bankruptcy process or through necessary divestitures while also ensuring that we do not undergo another period of rampant consolidation.”

These comments were part of the Congressman’s presentation for an event run by the Open Markets Institute (OMI), which recently said that it favors “an immediate ban on all mergers and acquisitions by any corporation with more than $100 million in annual revenue, and by any financial institution or equity fund with more than $100 million in capitalization.” The OMI claims the ban should remain in place during the current economic and health crisis.

According to the OMI, the ban is necessary because enforcement agencies are partially shut down and unable to effectively evaluate mergers. The OMI believes the ban will help “prevent a wholesale concentration of additional power by corporations that already dominate or largely dominate their industries, especially in ways that may significantly worsen the crisis that now threatens America’s health, social, and economic systems. The history of the Panic of 2008 and the subsequent Great Recession instructs us that such a massive, uncontrolled consolidation will result in the unnecessary firing of millions of employees, the unnecessary bankrupting of innumerable independent businesses, a dramatic slowing of innovation in vital industries such as pharmaceuticals, and a further concentration of power and control dangerous both to our democracy and our open commercial systems.”

Piles of Cash

The organization says that private equity firms and corporations “sit today atop vast piles of cash” and can readily swallow up distressed companies.

Rep. Cicilline and the OMI are rightfully concerned about an uptick in unlawful mergers stemming from the pandemic and should be commended for proactively raising the issue. History has demonstrated that well-capitalized firms will use economic downturns and the consequent drop in company valuations to acquire struggling rivals. And antitrust enforcers are certainly not operating at full capacity given current health and safety guidelines.

Even so, a moratorium on mergers seems like an overcorrection. Most mergers are lawful. While we can debate their overall effectiveness, since 2015, federal antitrust authorities have made second requests in less than 3% of qualifying transactions. And lawful mergers can lead to lower prices, higher quality, and increased innovation, as well as providing liquidity events.

Given these realities, lawmakers should craft legislation that aims to preserve the integrity of the pre-pandemic oversight process. This presumably can be achieved by giving regulators the power to slow down the merger review process when necessary. A resolution along these lines would seem to strike a better balance between protecting against rampant, unlawful consolidation and permitting lawful mergers to proceed.

© MoginRubin LLP

ARTICLE BY Timothy Z. LaComb of MoginRubin.
For more on COVID-19 related legislation, see the National Law Review Coronavirus News section.

Is a Pandemic a Material Adverse Event or Change in M&A?

Question already casting clouds over corporate deals.

Reuters has reported that Gray Television Inc. has withdrawn its $8.5 billion offer to buy Tegna Inc. due to the potential impact of the COVID-19 outbreak on regional TV stations like those operated by Tegna. The news agency also reported that Volkswagen’s CFO cited the “curveball” the outbreak has thrown at its liquidity in stating that, while the automaker remains interested in buying U.S. truck-maker Navistar, it must first “conserve cash as it shuts down plants and throttles back production.” The New York Times, meanwhile, has reported that Japan’s SoftBank is threatening to withdraw an offer to purchase as much as $3 billion of WeWork stock due to government investigations, but at a time when the outbreak has reduced the value of WeWork’s “shared office space” business model.

There is no question that the coronavirus pandemic – in addition to the devastating human toll – will deeply disrupt business. That includes mergers and acquisitions. For deals not yet consummated, the validity of withdrawing from a deal comes down to the “material adverse effects” or “material adverse conditions” clauses (MAE/MAC) in deal agreements.

Depending on the negotiated terms of an agreement, the MAE/MAC clause may pertain to a company’s financial condition, operations, properties, prospects, tangible or intangible assets, the ability to repay debt, capitalization, products, intellectual property, or liabilities.

The clause may have exceptions, excluding changes such as those:

• Resulting from actions one party takes at the direction or request of the other;
• Affecting the relevant industry, assuming the changes do not disproportionately affect the parties;
• Triggering the loss of value a company may suffer when the market, suppliers or employees learn of the deal;
• Impacting economic, market or political conditions, including those arising out of war, terrorism or, in this case, a pandemic.

These clauses vary as they are negotiated by the parties. So close examination of the clause is required to determine if pulling out of a deal is a viable option. Buyers will want to see if pandemics are included or specifically excluded.

Merging companies will also want to anticipate the slowing down of necessary approvals and antitrust reviews. For example, the DOJ Antitrust Division announced that for pending mergers or those that may be proposed, it may take an additional 30 days to complete its review of transactions after parties comply with document requests.

What’s the impact on “long-term earnings power over a commercially reasonable period”?

One of the leading cases cited in answering questions surrounding MAE/MACs outside of the pandemic context is the Delaware Chancery Court’s 2018 decision in Akorn, Inc. v. Fresenius Kabi AG (2018 Del. Ch. LEXIS 325). A healthcare company terminated a merger with a drug company, because the drug company, as a whistleblower revealed, misrepresented that it was compliant with important government regulations. The drug company tried to enforce the merger agreement, but the court found the misrepresentations had a material adverse effect on the company’s value. The healthcare company’s termination of the deal was valid, the court found. It went on to discuss the high bar set for determining the existence of a MAE/MAC.

“The ‘reasonably be expected to’ standard used in merger agreements to evaluate the deviation between a target business’s as-represented condition and its actual condition is an objective one,” the court held. “When this phrase is used, future occurrences qualify as material adverse effects (MAE). As a result, an MAE can have occurred without the effect on the target’s business being felt yet. Even under this standard, a mere risk of an MAE cannot be enough.”

In the case of a merger, the court said, whether a material adverse change occurred depends on “the long-term impact of the event,” which the court said required a “somewhat speculative analysis.” “The ‘would reasonably be expected’ formulation is best thought of as meaning likely to happen, with likely, in turn, meaning a degree of probability greater than five on a scale of one to ten. In other words, it means more likely than not.” The court said the context of the transaction and the words of the agreement must be examined.

To kill a deal by invoking a MAE clause, the court said, buyers face a heavy burden. “A short-term hiccup in earnings should not suffice; rather the MAE should be material when viewed from the longer-term perspective of a reasonable acquiror. In the absence of evidence to the contrary, a corporate acquirer may be assumed to be purchasing the target as part of a long-term strategy. The important consideration therefore is whether there has been an adverse change in the target’s business that is consequential to the company’s long-term earnings power over a commercially reasonable period, which one would expect to be measured in years rather than months.”

The Delaware court said judges must not rewrite contracts to appease a parties who suddenly believe they have agreed to a bad deal. Parties have a right to enter into good and bad contracts and the law enforces both, the court said. However, turning to the facts presented in Akorn, and given all that needed to be established, the court concluded that “any second thoughts” the healthcare company about purchasing the drug company were “justified by unexpected events” at the drug company.

A justifiable question.

A typical MAE/MAC provision addresses material adverse changes in a company generally. Also, as we have discussed, the clause may delineate specific types of events that constitute adverse changes and list exceptions that would preclude bidders from leaving a deal or seeking a renegotiation.

Surveys, like the Nixon Peabody MAC Survey 2015, have shown that the most common MAE/MAC element is a change in the financial condition of the business, however some of the most common exceptions include changes in the economy and acts of God. Understanding those elements and exceptions, which differ from deal to deal, are key to any determination or litigation over whether financial turmoil facing a business as a result of COVID-19 means that a MAC/MAE has occurred.

Whether a pandemic and its related business effects will constitute a MAE/MAC remains an open question and certainly one which will be repeatedly litigated. However, in light of the various government mandates surrounding the COVID-19 crisis, the dire predictions for the economy from both official sources and highly credible non-official sources, and the recent stock market downside volatility, parties that invoke MAE/MAC clauses at this time appear to have supportable justifications.

© MoginRubin LLP

ARTICLE WRITTEN BY Dan Mogin and Jennifer M. Oliver  & Edited by Tom Hagy of MoginRubin.