POOLING PERAMBULATIONS: LOCK-UP OPTIONS AND TERMINATION FEES
Pooling, as we have noted previously in these pages, is scheduled
to affect transactions initiated on or after January 1, 2001. Until then,
pooling remains desirable because of its capacity to minimize the earnings
dilution resulting from an acquisition. To qualify a transaction for pooling,
neither party to the transaction can have changed its voting common equity
interests in contemplation of the pooling. Generally, changes occurring
during the two-year period preceding its initiation (the date on which
the major terms of the plan, including the exchange ratio, are publicly
announced) are presumed to be in contemplation of the deal. But in many
cases, the parties are able to rebut this presumption by demonstrating
that the changes were undertaken for independent business reasons (that
is, unconnected with the pooling).
Lock-Up Options
A grant of lock-up options may muddy the waters. In EITF Issue No.
97-9, it is acknowledged that the parties to a business combination will
often exchange options. If the merger is consummated, these options will
expire unexercised. Yet, if a specified event occurs that interferes with
the planned transaction (such as an interloper obtaining a controlling
interest in one of the participants), the options become exercisable. EITF
No. 97-9 then concludes that the lock-up options would not preclude the
use of pooling for the business combination that gave rise to the granting
of the options, but would preclude the use of pooling for any business
combination that would trigger the ability to exercise options.
On the surface, Pfizer's goal to pool Warner-Lambert seems likely
to fail. Pfizer, on the other hand, is seeking to have the options (as
well as the termination fee) set aside in court. If the court strikes down
the options as if they never existed, the options will be regarded as never
issued. That means Pfizer's pooling ambitions will not be adversely affected.
Such suits don't always work though. Crane was unsuccessful in getting
a Pennsylvania court to set aside the lock-up options that were exchanged
in the Coltec/BF Goodrich deal.
What happens if Warner-Lambert and American Home Products voluntarily
rescind the options? While this seems unlikely, too, rescission would presumably
work where the pooling rules are potentially violated by a grant of employee
options (or an alteration of the terms of existing options) in close proximity
to the initiation of a pooling. Indeed,it is well-accepted that the damage
can be undone if the option grant is canceled or otherwise rescinded prior
to the time the offending options are exercised.
It would seem that a voluntary rescission of lock-up options, which
restores the status quo prior to the time they become exercisable, should
have a similar impact. How about a payment to American Home Products for
the purpose of inducing it to terminate its option? That probably would
not work. The only effective avenues seem to be a voluntary rescission
or a finding by a court that the options should be set aside.
Termination Fees
The presence of a termination fee provision does not by itself preclude
the use of pooling. Thus, Topic D-59 says the SEC will not find that a
termination fee has a fatal impact on pooling where: (1) the parties to
the previous merger agreement (in connection with which the fee arose)
were unrelated; (2) the fee was negotiated at arm's length and was paid
pursuant to the terms of the previous merger agreement; and (3) a termination
fee is customary in merger agreements, and the amount of the fee is within
the range of fees customarily negotiated. Here, the termination fee is
less than 3% of the deal value and, thus, seems to be within the permissible
range. The payment of the termination fee, while loathsome to Pfizer, at
least would not preclude pooling with Warner-Lambert.
Deductible is Good
As we all know, the payment of a termination fee will be much less
painful if it is deductible by Warner-Lambert. In the Federated Department
Stores case, Federated paid a break-up fee to two "white knights" (including
the DeBartolo interests) whose efforts were thwarted when Federated was
ultimately acquired by the Campeau interests. The court concluded that
the fees were deductible under Section 162. However, the decision, may
have been influenced by the fact that the Campeau acquisition was an unmitigated
disaster. The court stated that Campeau's takeover did not provide the
type of synergy found in INDOPCO because, among other things, Campeau was
inexperienced in Federated's business and did not have resources available
to improve Federated's business.
Perhaps it was difficult to find that the Campeau acquisition resulted
in long-term benefits to Federated, the amorphous INDOPCO legal standard
for classifying an expenditure as capital rather than deductible. Some
observers feel that Federated is not persuasive precedent for concluding
that all termination fees are automatically deductible. However, the Federated
court also concluded that the fees were deductible under Section 165. This
provision allows a deduction for losses. The court stated that the failed
merger (with the white knight) and the ultimate merger were separate and
distinct transactions.
Thus, the break-up fee in Federated related to an abandoned transaction.
It is reasonably clear that expenses incurred in connection with abandoned
transactions are deductible. (See Revenue Rulings 73-580, 1973-2 C.B. 86,
and 79-2, 1979-1 C.B. 98.) The lesson of Federated is that while an IRS
challenge to termination fees can be expected, the alternative Section
165 holding by the Federated court provides nice support for claiming a
current deduction for the payment of a termination fee.
Two arrows are always better than one!
More Pooling Points
To qualify for pooling, the voting common shareholders of the acquired
corporation must all be offered and receive only voting common stock of
the issuing corporation. However, the issuing corporation may pay cash
(or other property) for less than 10 percent of the stock, provided that
the cash is paid only to dissenting shareholders (and entails the purchase
of all of their stock), or is used to pay cash in lieu of issuing fractional
shares. In the latter case, the payment must represent a mere mechanical
rounding off of the fractions and not be separately bargained for consideration.
Careful, though. This 10 percent basket is reduced if either corporation
holds "tainted" treasury shares or an intercorporate investment in the
other corporation. With respect to the former, neither corporation can
have reacquired shares of its voting common stock during the period beginning
two years prior to the initiation of the pooling, and extending through
the date of its consummation. Because the prohibition regarding reacquisitions
has always been considered together with the other items that comprise
this 10% basket, this rule is relaxed in cases where the number of such
shares is not material in relation to the total number of shares issued
in the deal.
This would limit tainted shares to a maximum of 10 percent of the
total number of shares to be so issued. Still, this potential pooling violation
can be cured. In effect, the taint can be removed if the offending shares
are issued at any time prior to consummation. The taint may be curable
by issuing the shares for fair value to an independent third party (or
into the market) prior to consummation.
Pooling Perambulations: Lock-Up Options and Termination Fees,
Vol. 8, No. 6, M&A Tax Report (January 2000), p. 6.
The battle being waged between Pfizer and American Home Products,
for control of Warner-Lambert has thrust into prominence so-called lock-up
options and termination fees as defense mechanisms. American Home Products
and Warner-Lambert exchanged options that permit the optionee to purchase
up to 19.9% of the grantor's stock upon the occurrence of specified events.
Should the deal not be completed, the jilted party will be entitled to
receive, as salve for its wounds, some $2.5 billion. (Not a bad salve!)
Pfizer has filed suit to have these provisions rendered null and void.
One of the primary objectives of the suit is Pfizer's desire to account
for the acquisition of Warner-Lambert as a pooling of interests, a goal
that these options might thwart.