Morris Trust

[Sapphire Capital]

Morris Trust
Basic Principles
A "Morris Trust" or "reverse Morris Trust" transaction is an M&A technique for a company to effectuate a sale of a division or divisions to a Buyer without incurring any corporate tax in the transaction
In a Morris Trust, all assets other than those being acquired are spun off into a new public company, with the remaining assets being merged with the Buyer. In a reverse Morris Trust ("RMT"), the assets to be acquired are spun off and promptly merged with the Buyer
The reverse Morris Trust format is currently much more common than the Morris Trust format as it typically provides the most direct means to effectuate the transaction
The reverse Morris Trust and Morris Trust structures can also be executed as split-offs as well as spin-offs
The March 2007 Weyerhaeuser/Domtar transaction is the first reverse Morris Trust executed as a split-off; structure can be attractive as a means to ensure that shares are placed in the right hands
Key structuring issues:
50% Requirement: Shareholders of Seller must receive over 50% of the vote and value of the surviving entity in the merger (the "50% Test"). For purposes of this requirement, shares in the pro forma company owned by the Seller shareholders by virtue of equity positions in the Buyer are generally counted under the Shareholder Overlap rules.
Equity Financing: Dilution of Seller shareholders by planned post-transaction equity issuances by the surviving entity will be counted for purposes of the "50% Test". Equity issuances within a 2-year period of the transaction may be treated as "planned" for this purpose
Monetization Possible: The debt/equity and debt/debt swap techniques described under Monetizing Spin-Offs are equally available to Seller here and have been utilized in numerous such transactions ruled upon by the IRS. However, such strategies will reduce the percentage of the merged entity owned by historic Seller shareholders, putting pressure on the 50% Test (see Heinz/Del Monte)
Post-Merger M&A: Under the revised Morris Trust rules, as long as the Seller and potentially the Buyer have not had significant M&A discussions with a Target for the 2 years preceding the spin, the combined entity can commence M&A dialogue with respect to the Target promptly after the closing of the Morris Trust transactions. If such discussions have occurred, a 6-month or 1-year wait may be required. A similar analysis applies to M&A dialogue by the Seller, although the Seller will have greater "cushion" on the 50% Test due to the absence of any change in shareholder base in the transaction
Corporate Governance: Notwithstanding the 50% requirement, the Buyer in a Morris Trust acquisition can retain effective control over the Board of Directors and senior management of the surviving entity (see P&G/J.M. Smucker and Mariner/Forest Oil)
Precedent transactions: FairPoint/Verizon, Alltel/Valor, Weyerhaeuser/Domtar, Forest Oil/Mariner, Heinz/Del Monte, JIF/J.M. Smucker, AT&T Broadband/Comcast
Corporate Governance
The principal tax requirement is that the Seller shareholders receive greater than 50% of the vote and value of the pro forma company, as per Section 355(e)
In the RMT context, the IRS has not typically required that this greater-than-50% vote be reflected in any initial or future composition of the Board or Management of the pro forma Company, as long as (i) the Board is elected through normal shareholder voting going forward, and (ii) the normal powers of the Board over major corporate decisions are respected going forward
As the chart below shows, in several recent deals the Board and senior management of the Buyer have dominated the governance of the pro forma company on a going-forward basis (although there is also precedent where the Seller has predominated)
Based on these precedents, the Buyer should have significant flexibility from a tax perspective to have the Board and senior management of its choice, notwithstanding the Section 355(e) requirements around shareholder ownership
Any mechanisms put into place which could mitigate the impact of the Seller shareholder voting rights (unusually long Board terms, limits on ability of Board to control major corporate decisions, appoint senior management, etc.) will, however, be carefully scrutinized by the IRS
In some deals (e.g. AT&T Broadband/Comcast), the Buyer shareholders have obtained the right to a special class vote over major corporate transactions
Such mechanisms would be permissible for tax purposes if they are limited to transactions which would normally come to a shareholder vote (e.g. large-scale M&A, amendments of the charter, etc.)
While such provisions do give Buyer greater control going forward, they do also imply having two classes of public securities.

Transaction Structure - RMT
Step 1 Transaction Steps

P signs a contract to sell S to Buyer
Closing condition to acquisition that P spin-off S

Step 2 Transaction Steps

P spins off S, which merges with Buyer
If monetizing spin-off technology utilized, S dropped into NewCo to facilitate debt/equity, debt/debt swap

Transaction Structure - RMT with Debt-for-Debt Exchange
Step 1 - Formation of NewCo


ParentCo contributes assets and debt up to its tax basis in the wanted assets to a NewCo in exchange for NewCo equity and notes

Step 2 - Debt-for-Debt Exchange

Investment Bank buys ParentCo debt in open market
ParentCo delivers NewCo Notes to Investment Bank in exchange for ParentCo debt in a debt-for-debt swap; Investment Bank sells NewCo Notes to investors

Step 3 - NewCo Merges with InvestorCo


Transaction Structure - Morris Trust
Step 1 Transaction Steps

P enters into contract to sell S2 to Buyer
Closing condition that P first spin off S1

Step 2 Transaction Steps

P spins off S1 and then merges with Buyer
If monetizing spin-off technology to be utilized, P drops S1 into NewCo to facilitate debt/equity, debt/debt swaps

Advantages & Disadvantages

Advantages
Permanently tax-free disposition of business
Significant monetization possible through debt/equity, debt/debt swaps
Shareholders get benefits of synergies of merger and, potentially, a control premium
Buyer can retain effective control of Board of Directors and senior management of surviving entity, notwithstanding Section 355 requirements

Disadvantages
Monetization limited by market capacity and Section 355 limitations
Limited universe of merger partners due to Section 355 requirement
Post-transaction equity issuance may be limited under Section 355

[Sapphire Capital]

Here is a new sample:

Liberty Media (LMCA) has announced that its plans to take control of Sirius XM (SIRI) will eventually lead to a Reverse Morris Trust (RMT). For those who are not familiar with a RMT, I will break it down.

First the parent company creates a separate external company (we'll call it LMCA-b). Next the parent company sells off the asset and at the same time merges the spin-off with the separate external company (LMCA-b). Then the new and separate merged company (we'll call it SIRI Holdings) distributes its shares back to the parents company's shareholders .



The figure on the left is what the entities would look like immediately before the RMT and the figure on the left immediately after. The only difference is that after the RMT, the Liberty Media shareholders have direct control of the new entity' ('SIRI Holdings') shares whereas before they only controlled Sirius XM through Liberty Media.

Because Liberty Media is not outright selling its asset but spinning off its investment and merging it with a new company, it gets to avoid paying taxes on its gains on investment. This can only be done if the parent company has over 50% control of the subsidiary , which is why Liberty Media has been looking to boost its ownership over that 50% mark.

Currently Liberty Media shareholders cannot sell their partial ownership of SIRI because it is a minority investment (<50%) of Liberty Media's. Liberty Media acquired 40% ownership back in 2009 of Sirius XM in return for a loan to bail them out. That 40% is preferred shares which have not been part of the float ever since Liberty originally acquired them.

If Liberty eventually acquires 50.1% of SIRI, and performs a RMT, Liberty shareholders will get shares distributed from the new merged company (SIRI Holdings) in the amount of 50.1% per share of Liberty Media they currently own. Liberty Media shareholders would then get to decide what they would want to do with their new 'Siri Holdings' shares.

This would essentially flood the market with LMCA's 40% preferred shares AND the remaining 10.1% acquired SIRI shares. Sirius XM currently has about 3.8 billion common shares (60%) and 2.5 billion preferred shares (Liberty's 40%) (taken from Yahoo Finance). The 40% has never been part of the float of Sirius XM because they have always been preferred shares owned by Liberty Media the company and not Liberty Media's shareholders.

As previously stated, after the RMT, 50.1% per share LMCA of SIRI will be distributed to LMCA shareholders and they will then be able to decide whether to buy, sell, or hold. If we assume that the same percentage of these distributed shares will become floating shares as the percentage of Liberty Media's current float, then 2.83 billion shares will be added to the 'Sirius Holding' float after completing the RMT. The calculation of that is as follows:

LMCA has 108.51MM floating shares out of 120.74MM total shares (taken from Yahoo Finance). That means 89.8% or(108.51MM/120.74MM=89.8%) of their shares are freely tradeable.

LMCA will most likely need to acquire 50.1% of Sirius XM to perform the RMT and therefore LMCA shareholders will get 50.1% of a 'SIRI Holdings' share per share owned of LMCA

3.8 B common shares + 2.5 B preferred shares = 6.3 B shares (also explained above) will be outstanding after Liberty Media converts the preferred shares to common shares

Therefore take 89.8% x 50.1% x 6.3B = 2.83B floating shares.

This is a big deal because currently Sirius XM has 3.34B floating shares. With a flood of 2.83B shares hitting the market there may likely be a strong movement for Liberty Media shareholders to sell off their position in Sirius XM.

It can and will be argued that these new shares that will hit the market are already taken into account for the market cap, float etc. However, I know that If I were distributed shares of 'Sirius Holdings' then I would give some serious thought to selling them in the open market.

source: seekingalpha.com/article/731151-what-the-reverse-morris-trust-means-for-sirius-xm-shareholders

[Daniel Wolf]

Even with the recent slowdown in M&A activity, spin-offs have been among the transactions of choice in the past year. With everyone from economic mainstays like ConocoPhillips and Kraft to high-profile new players like TripAdvisor engaging in separation deals in the latest round of deconsolidation, it is an opportune time for dealmakers to consider the general implications of a spin-off on transformational corporate merger activity and certain structures that may allow for a combination of the two.

Corporations engage in spin-offs for a variety of business and financial reasons. A corporation’s goals can be accomplished without U.S. federal income tax to the distributing corporation and its stockholders so long as the transaction meets the requirements of Section 355 of the Internal Revenue Code.

Failure to meet these requirements either before or after the transaction can cause a spin-off to be taxable to the distributing parent company (in the form of corporate- level gain generally equal to the appreciated value of the spun-off subsidiary), to the distributing parent’s stockholders (in the form of dividend income equal to the value of the spun-off business), or both. These taxes can be prohibitively or even catastrophically expensive.


Section 355(e) of the Internal Revenue Code is particularly relevant to M&A activity — under that section, if 50% or more of the vote or value of the distributing parent or the spun-off subsidiary is acquired as part of a “prohibited plan” with the spin-off, the spin-off is taxable to the distributing parent (but not to its stockholders).

Under these rules, there is a rebuttable presumption that any acquisition of the distributing parent’s or the subsidiary’s stock that occurs during the two years prior to, and the two years after, a spin-off transaction is part of a “prohibited plan”. However, an acquisition that fits within one of several regulatory safe harbors is not treated as part of such a plan. The safe harbors most relevant to M&A activity generally require that there be no “agreement, understanding, arrangement or substantial negotiations” regarding the contemplated deal (or a similar transaction) within a specified time frame of the spin-off (which can range, depending on the safe harbor, from a two-year period ending on the distribution date, to a one-year period beginning on the distribution date). These safe harbors therefore put a premium on avoiding discussions with the potential counterparty regarding a deal during the relevant “black-out” periods. Determining whether an agreement, understanding, arrangement or substantial negotiations exist with respect to any particular transaction requires examination of all the contacts between the corporation involved in the spin-off (and its officers, directors, controlling stockholders and agents) and the potential counterparty. In particular, conversations regarding price or exchange ratios generally will disqualify a transaction from the relevant safe harbors.

The fact-specific nature of the safe harbor inquiry, the high stakes and the highly technical nature of the tax analysis present significant practical concerns for dealmakers advising a client involved in both a spin and a transformational acquisition. Though deals predicated on satisfying a safe harbor certainly occur, they may not be possible or practical.

An alternative to a so-called “safe-harbor deal” is a post-spin M&A transaction where former stockholders of the distributing parent continue to own more than 50% by vote and value of the corporation involved in the spin-off (or its successor) after the closing of the transaction. A Reverse Morris Trust transaction, or RMT, is one such structure (named after a 1966 case blessing the structure). In an RMT transaction, as part of a plan, a merger partner merges with the distributing parent or spun-off subsidiary immediately after the spin-off in a tax-free transaction. The key to the tax free nature of an RMT transaction is that immediately after the transaction, historic stockholders of the distributing parent own more than 50% of the stock by vote and value of the combined company. As a result, an RMT is only practical if the merger partner is approximately the same size as, or smaller than, the spun-off subsidiary (or distributing parent). Where the two companies are approximately the same size, the merger partner may “right-size” itself by, for example, borrowing money and distributing the cash to its stockholders. In addition, though the >50% test is a bright line, the parties do have some greater flexibility in allocating between the two merger partners the initial composition of the combined company’s board of directors and management team.

A potentially attractive feature of an RMT transaction is the ability of the distributing parent to partially monetize its interest in the distributed subsidiary on a tax-efficient basis. For example, prior to the distribution of the subsidiary, it is fairly common for the distributing parent to cause the subsidiary to borrow money and distribute the cash to the parent. In another common structure, as part of the internal reorganization of assets by the distributing corporation to create and prepare a subsidiary for a spin-off, the subsidiary issues debt securities to the parent, which in turn exchanges those securities for outstanding parent indebtedness. In both cases, the parent has received a benefit from the subsidiary’s leverage (that is, receipt of cash or debt relief ), but the distributed subsidiary, and not the parent, has the obligation to repay the indebtedness. There are tax-based limitations on both of these strategies as well as a potential practical obstacle created by further driving down the value of the distributed subsidiary while the parties are trying to stay above the 50% minimum.

A recent example of an RMT transaction is Procter & Gamble’s plan to dispose of its Pringles brand (now troubled due to accounting issues at the merger partner, Diamond Foods). In the Pringles deal, after Procter & Gamble distributes the subsidiary holding its Pringles brand, the subsidiary will merge with a subsidiary of Diamond, with historic P&G stockholders receiving approximately 57% of the combined company. As part of the deal, P&G (a repeat RMT customer after combining its Folgers business with JM Smucker in 2008) expects to receive from Pringles approximately $850 million in cash on a tax efficient basis (subject to adjustment within a collar based on the trading price of Diamond’s stock around the time that the exchange offer or distribution occurs), a substantial portion of which will be used to retire existing P&G debt. In another recent proposed RMT deal, Entergy has announced that it plans to distribute its electric transmission business, which thereafter will combine with ITC. Prior to the transaction, ITC will right-size itself by borrowing approximately $700 million and will either distribute the proceeds to its stockholders or engage in a stock buyback. In the combination of ITC and the Entergy subsidiary, former Entergy stockholders are expected to receive 50.1% of the combined entity’s equity by vote and value. Because of the high stakes of failing to satisfy Section 355(e)’s 50% test, Entergy has requested a ruling letter from the U.S. Internal Revenue Service on the transaction. If Entergy does not receive certain of its requested rulings, the agreements for the separation of the electric transmission business and the merger with ITC include a complicated adjustment mechanism designed to ensure that former Entergy stockholders do in fact hold more than 50% of the combined company by vote and value post-merger. This unusual feature shows another path for right-sizing entities to satisfy the requirements for a tax-free RMT transaction.

Although generically referred to as spin-offs, the separation transactions we have described can be structured as either a pro-rata distribution of shares of the subsidiary to the stockholders of the distributing parent (a true spin-off ) or a voluntary exchange of the distributing parent’s securities for those of the subsidiary at a set exchange ratio (a true split-off ).

Under the right circumstances, RMTs can be a powerful method for planning a tax-free spin -off followed by a transformational transaction. While a straightforward direct sale of the distributed business would be taxable to the distributing parent, an RMT facilitates such a sale (and potential associated leveraging) on a tax-free basis. If a split-off (as opposed to a spin-off ) is successfully employed, the distributing company achieves the added benefit of “repurchasing” some of its outstanding stock, with a resulting increase in EPS. By combining the attractive elements of a spin- or split-off with the strategic benefits of a stock-for-stock combination, an RMT can provide stockholders with increased value and diversification, allow a distributing parent to streamline its business and even create a monetization opportunity.

[Sapphire Capital]

There was an idea for ConocoPhillips (“COP”) plan to spinoff massive undisclosed environmental liabilities into a bankrupt-at-birth Phillips 66 (“PSX”) using reverse Morris Trust structures and I see trouble looming there.