To ensure the successful execution of a transaction for both SpinCo and RemainCo, both companies need to position the carveout to successfully operate as a stand-alone company.
ParentCo’s board must satisfy its duties of care and loyalty to its stockholders in making the decision to distribute SpinCo’s stock to its stockholders and satisfy itself that the distribution is a permissible dividend. For purposes of this calculation, actual current value, not book value, should be used. This typically results in a substantial increase in surplus (relative to book value) and provides a path for unlocking value through this type of transaction.
Although ParentCo’s board of directors do not have duties to SpinCo (as a fiduciary matter, they are free to consider the interests of only ParentCo’s shareholders in establishing the terms of the spin-off), in practice they don’t want to set up SpinCo for commercial failure, or insolvency, which could lead to a breach of fiduciary duty claim or possible claims of fraudulent conveyance, as ParentCo’s shareholders will receive the SpinCo shares.
This paper outlines specific steps and best practices in the spin-off process, starting with robust S-1-like disclosures. The authors guide deal teams to start by determining which financials are required for Form 10, which can be a time-consuming and rigorous process to ensure accuracy of the disclosure. This is a key gating issue, as legal opinions on the disclosure in a Form 10 are not given and comfort letters are not provided by the accountants, as they would be in a traditional IPO.
A natural tendency and common mistake is for ParentCo to simply duplicate ParentCo’s governance structure. Companies should tailor the governance approach and consider issues during and after a spin-off, especially regarding tax elections and treatments. For example, the carveout will need to elect a board of directors, build effective internal controls over financial reporting, and implement take-over protection provisions.
The authors provide a helpful note there is no “honeymoon period” for SpinCos with regard to activists and hostile acquirers. In fact, they suggest using this unique period to implement take-over protections, including a classified board, prohibitions on the calling of special meetings, or actions by written consent, by shareholders, and omit majority vote, proxy access, and similar “shareholder-friendly” mechanisms. During this time such protections will not have a particularly adverse impact on shareholder approval or “purchase” decisions by investors in the spin-off distribution paradigm.
The second part of the paper looks at methods for precisely defining the business that is being separated; which specific assets and (unwanted) liabilities, including contracts, intellectual property, and real estate that will move to SpinCo. The carveout’s capital structure and indemnification provisions between the parties, which often survive indefinitely post-closing and can be the subject of post-closing disputes, are also considered by the authors.
The last section of this paper deals with achieving tax objectives through successful and efficient spin-offs. For most companies, a spin-off is beneficial only if it qualifies as a tax-free transaction. Protecting the parent company’s shareholders from unexpected taxes is vital, and the authors provide a concise overview of the principal tests companies must meet to avoid burdensome tax obligations. Another best practice is to negotiate tax agreements between the parent and spin-off entity to conclusively settle potential future tax implications.
Cathy Birkeland is the Chicago Office Managing Partner and former Global Co-Chair of the Capital Markets Practice at Latham & Watkins. She helps issuers, underwriters, and investors execute successful capital markets transactions, and advises public companies and boards of directors on corporate governance and securities law matters.