When management focuses on maximizing value, it continually reassesses the mix of businesses in the company's portfolio to determine which ones to hold, grow through investment or dispose. Typically, a disposition would be effected by selling the business to a third party. Management should, however, always evaluate whether stockholders would be better served by a spin-off, particularly where a sale would not capture the growth value of a divested business.
The term "spin-off" is commonly used to refer to a wide variety of transactions, including subsidiary IPOs (also called "carve-outs" or "equity carve-outs") and issuances of tracking stock. A true spin-off generally occurs when the parent company distributes, as a dividend to its stockholders, shares of stock of the subsidiary holding the business to be divested. Following the distribution, the parent's stockholders hold stock of both the parent and the subsidiary. In a subsidiary IPO, the parent will typically sell subsidiary stock to the public in a public offering registered under the Securities Act. Alternatively, the subsidiary itself may issue stock to the public. In either case, through various mechanisms, proceeds may be retained by the parent or subsidiary or may be shared by both. It is not uncommon to combine a spin-off and subsidiary IPO, in which case some subsidiary stock would be sold in an IPO and some would be distributed to the parent's stockholders as a dividend. These transactions may take place in multiple steps and over time. In some situations, the parent may prefer to maintain legal ownership of the business but distribute securities that effectively track performance of the business. This "tracking stock" is typically issued as a new class of parent securities and distributed as a stock dividend, sold in a public or private offering, or issued as consideration for an acquisition.1
All of these types of transactions implicate a number of U.S. securities law issues that must be considered prior to launching the deal. This article summarizes some of those issues, primarily with respect to spin-offs and subsidiary IPOs.
Part I addresses transactions structured to avoid registration of the subsidiary securities under the Securities Act (but not the Exchange Act). Part II, to be published in next month's issue, will examine the steps required for registration of subsidiary securities and the related restrictions on issuer communications and increased obligations as a public company.
Avoiding Securities Act Registration Requirements
No Consideration. Securities Act Section 5 generally makes it unlawful for a company to offer or sell its securities to the public unless a registration statement relating to the securities has been filed with and declared effective by the SEC (or an exemption applies). As the SEC acknowledged in its Staff Legal Bulletin No. 4, dated September 16, 1997 ("SLB 4"), no "sale" occurs in a pure dividend of subsidiary stock because the recipient does not give consideration ( i.e., pay) for or make an investment decision regarding the stock: the spin-off stock is merely distributed to the recipient solely because the recipient holds stock in the parent. This would not be the case if the parent received consideration in exchange for the dividend, which may occur if the parent requires its stockholders to waive certain rights or to exchange securities.
Other Conditions. In addition to the "no consideration" condition, SLB 4 sets forth a number of other conditions that must be satisfied in order to avoid the Securities Act's registration requirements. The first condition is that the subsidiary stock be distributed pro rata among the parent's stockholders. While SLB No. 4 does not expressly indicate whether registration would be required if the parent retains an ownership interest in the spun-off subsidiary, the SEC has granted no-action relief to companies that intended to retain up to 95% ownership.
The second condition, which is primarily driven by antifraud concerns, requires the parent to furnish adequate information about the transaction and the subsidiary to its stockholders. What constitutes "adequate" information depends largely on whether the subsidiary is already a public company. If the subsidiary is not public (which is typically the case) or is foreign, the parent should, at a minimum, furnish its stockholders with an information statement or (if stockholder approval will be sought) an Exchange Act proxy statement. In addition, the subsidiary must file and provide to the parent's stockholders a registration statement on Exchange Act Form 10, which is a substantial disclosure document that, like a Securities Act registration statement, generally requires significant time and effort to prepare. The Form 10 is usually "wrapped" around the proxy or information statement and delivered to stockholders as a single disclosure document.
Third, the spin-off must be undertaken for a valid business purpose. The SEC has stated that the purpose of a spin-off would not be valid if it is solely to create a public market in the stock of a subsidiary that has minimal operations or assets, is in the development stage and has no specific business plans, or has plans to engage in a business combination with an unidentified company.
A final condition is that, if the parent acquired the subsidiary's stock in an unregistered transaction ( e.g., if the parent did not form the subsidiary), the parent must have held the securities for at least two years because they are deemed to be "restricted" under Securities Act Rule 144. Once the stock of the subsidiary is distributed as a dividend, it will not be restricted so long as it is not held by an affiliate or controlling stockholder with the power to initiate the spin-off (in which case the stock may be sold only under Rule 144 or another applicable exemption).
Other Considerations. In addition to registration considerations, there may be other securities-related issues to consider. For example, the parent may be prohibited from engaging in a spin-off or subsidiary IPO without the consent of holders of its debt securities under an indenture. As a result, solicitation of consents from such holders may be required. Further, under applicable corporate law, the parent may need to obtain stockholder approval, which would generally trigger a proxy solicitation and the need to hold a stockholders' meeting.
The terms of the parent's stock incentive plans will need to be reviewed, since the spin-off could impact vesting schedules, tax treatment or even the stock covered by the plans. In the latter event, the parent may desire or need to limit the amount of subsidiary stock issuable under the plans. Such a need may arise in order to minimize the risk of loss of favorable tax treatment to the parent, in the case of a subsidiary IPO, or pursuant to adjustment or anti-dilution provisions of the plan. If the plan does not allow the parent to impose such limit unilaterally, the parent may need to do so by amending the plan with the consent of relevant employees or by conducting an exchange offer in which it offers replacement incentives. In the case of an exchange, the parent may need to file a Schedule TO with the SEC. In addition, registration of the subsidiary stock issuable under the plans may be required. The SEC will generally permit the subsidiary to register such stock using a Form S-8, which becomes effective immediately upon filing ( i.e., no waiting period or SEC review). Further, depending on the nature of the amendment or the exchange, the parent may need to obtain stockholder approval thereof, pursuant to the terms of the plan or applicable stock exchange rules, triggering the need for a stockholders' meeting and proxy solicitation.
In Part II, we will examine the subsidiary IPO process in situations where SLB 4 's conditions are not satisfied.
1 Although tracking stock is not addressed in great detail in this article, the securities law implications are similar to those applicable to spin-offs and subsidiary IPOs. The type of transaction through which the securities are placed is the most important determinant of the applicable securities law requirements. A stock dividend would be governed by the principles set forth in Staff Legal Bulletin No. 4 discussed herein; a private placement would need to comply with the applicable exemption from registration; and a public offering would be subject to the procedures described in Part II of this article.
M. Ridgway Barker is Chair of the Corporate Finance & Securities Practice Group of Kelley Drye & Warren LLP. Randi-Jean G. Hedin is a Partner in the Corporate Finance & Securities Practice Group. Acknowledgement is given to Jeffrey A. Letalien, an Associate in the Corporate Finance & Securities Group, for his efforts in the preparation of this article.