Measuring Continuity of Interest in Reorganizations

Posted by James Morphy, Sullivan & Cromwell LLP, on Monday January 23, 2012 at 9:48 am
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Editor’s Note: James Morphy is a partner at Sullivan & Cromwell LLP specializing in mergers & acquisitions and corporate governance. This post is based on a Sullivan & Cromwell publication by Avi S. Alter, Ronald E. Creamer, Jr., and David C. Spitzer.

On December 16, 2011, the Internal Revenue Service (the “IRS”) and Treasury Department issued final and proposed regulations (“the Final Regulations” and “the Proposed Regulations,” respectively) that generally provide rules for the proper timing of the valuation of consideration offered in respect of a reorganization, for purposes of satisfying the “continuity of interest” requirement for tax-free reorganizations. The Final Regulations issue in finalized form rules previously described in temporary regulations, which allow in certain circumstances for the valuation of consideration on the date prior to the signing of a merger agreement, known as the “signing date” rule, with some additional clarification.

The Proposed Regulations would expand the signing date rule and would allow for the use of an average share price under certain circumstances. Specifically, under the Proposed Regulations, for purposes of determining whether the “continuity of interest” requirement is satisfied:

  • where (i) a binding merger agreement provides for adjustments in the amount of non-share consideration as a result of fluctuations in the share price of the issuing corporation’s stock, but only above a certain floor price, (ii) the value of a share of the issuing corporation on the date prior to signing is greater than or equal to the floor price, and (iii) the value of a share of the issuing corporation on the date of the closing of the merger is below the floor price, the value of the consideration is measured as of the day prior to the signing date, using the floor price as the value of the issuing corporation’s shares;
  • where (i) a binding merger agreement provides for adjustments in the amount of non-share consideration as a result of fluctuations in the share price of the issuing corporation’s stock, but only below a certain ceiling price, (ii) the value of a share of the issuing corporation on the date prior to signing is less than or equal to the ceiling price, and (iii) the value of a share of the issuing corporation on the date of the closing of the merger is above the ceiling price, the value of the consideration is measured as of the day prior to the signing date, using the ceiling price as the value of the issuing corporation’s shares; and
  • where (i) a merger agreement utilizes an average price for the issuing corporation’s shares to determine the number of shares and the amount of non-share consideration to be paid pursuant to the merger, and (ii) the average price is based on prices of the issuing corporation’s shares between the signing and closing dates, the value of the consideration is measured using the average price of the issuing corporation’s shares.

Background

The Internal Revenue Code generally provides tax-free treatment for corporations (and their shareholders) that are parties to a reorganization, if certain statutory and regulatory requirements are met. One such regulatory requirement, the “Continuity of Interest” requirement, requires that a substantial part of the value of the proprietary interests in the target corporation be preserved in the reorganization. [1] Preservation of 40% of the proprietary interest in the target corporation is sufficient to satisfy the Continuity of Interest requirement. [2]

On March 20, 2007, the Treasury Department issued temporary regulations (“the Temporary Regulations”) clarifying when Continuity of Interest is measured. [3] Under the Temporary Regulations, if a binding merger agreement provides for “fixed consideration,” then Continuity of Interest is measured based on the value of the issuing corporation’s stock on the “last business day before the first day such contract is a binding contract” [4] (the “Signing Date Rule”). If the agreement does not provide for “fixed consideration,” then Continuity of Interest is instead measured on the date of the transaction’s closing. An agreement provides for “fixed consideration” if it provides the number of shares of each class of stock of the issuing corporation and the amount of money or other property to be exchanged for all the proprietary interests in the target corporation, or to be exchanged for each share of the target corporation. [5]

Absent the “Signing Date Rule,” fluctuations in the issuing corporation’s stock price during the period between the signing of the reorganization agreement and the closing of the transaction could cause the agreed-upon stock consideration to fail to meet the Continuity of Interest requirement as of the closing date, thereby causing the reorganization to be fully taxable. As described in the preamble to the Temporary Regulations, the principle underlying the Signing Date Rule is that, where a binding contract provides for “fixed consideration,” the target-corporation shareholders should be viewed as subject to the economic fortunes of the issuing corporation as of the signing date. Accordingly, the signing date is the appropriate moment at which to determine whether or not the Continuity of Interest requirement has been satisfied. However, consideration that would vary the amount of cash and/or the number of shares of the issuing corporation to be tendered to target shareholders based on fluctuations in the price of the issuing corporation’s stock after the signing date would generally not qualify as “fixed consideration” under the Temporary Regulations.

On March 18, 2010, one day prior to the expiration of the Temporary Regulations, [6] the IRS issued Notice 2010-25, [7] which allowed taxpayers to rely on the Temporary Regulations even after their expiration.

The Final Regulations

The Final Regulations [8] adopt the 2007 Temporary Regulations, with some additional clarification. Specifically, the Final Regulations clarify that a target shareholder’s election to receive a mixture of stock, money, and/or other property in exchange for stock in the target corporation does not prevent a contract from providing for “fixed consideration,” provided that the number of shares of the issuing corporation’s stock exchanged for target shareholders’ shares in target is determined using the value of the issuing corporation’s stock on the last business day before there is a binding contract.

The Proposed Regulations

The Proposed Regulations [9] expand the Signing Date Rule and address circumstances in which an averaging of the share price is used. The preamble to the Proposed Regulations explains that the underlying principles of the Signing Date Rule support additional methods for determining whether the Continuity of Interest requirement has been satisfied. Specifically, the Proposed Regulations outline three circumstances and the appropriate valuation determination for purposes of testing for Continuity of Interest.

First, the Proposed Regulations provide that when, (i) pursuant to a binding merger agreement, the amount of consideration to be exchanged for the proprietary interests of a target corporation changes as the value of a share of the issuing corporation fluctuates above a specified floor price, but will in no case be valued at less than that floor price, (ii) the value of a share of the issuing corporation on the day prior to signing is greater than or equal to the floor price, and (iii) the value of a share of the issuing corporation on the date of the closing of the merger is less than the floor price, then, for purposes of determining whether the Continuity of Interest requirement has been met, the value of the consideration is measured as of the day prior to the signing date, using the floor price as the value of the issuing corporation’s shares.

Second, the Proposed Regulations provide that when, (i) pursuant to a binding merger agreement, the amount of consideration to be exchanged for the proprietary interests of a target corporation changes as the value of a share of the issuing corporation fluctuates below a specified ceiling price, but will not be valued at more than that ceiling price, (ii) the value of a share of the issuing corporation on the day prior to signing is less than or equal to the ceiling price, and (iii) the value of a share of the issuing corporation on the date of the closing of the merger is greater than the ceiling price, then, for purposes of determining whether the Continuity of Interest requirement has been met, the value of the consideration is measured as of the day prior to the signing date, using the ceiling price as the value of the issuing corporation’s shares.

The application of these two proposed rules may be illustrated by the following example. On January 2 of year 1, the value of P stock is $1 per share. On January 3 of year 1, P and T sign a binding contract, pursuant to which T will be merged into P. The contract provides that T shareholders will receive 50 shares of P stock and $50 cash in exchange for all of the outstanding T shares, subject to an adjustment to account for fluctuations in the value of P stock. The adjustment operates as follows: if the price of P stock at the closing of the transaction exceeds $1, then the amount of cash will be reduced by the excess of that price over $1. If the price of P stock at the closing of the transaction is less than $1, the amount of cash included in the exchange will be increased by 50 times the excess of $1 over the average price of P stock. However, in no event will P deliver cash of less than $40 or more than $60. The adjustment ensures that T shareholders will receive aggregate consideration with a value of $100 at closing if the price of the P stock at the closing is between $0.80 (the floor price) and $1.20 (the ceiling price).

On June 1 of year 1, T merges into P. The value of P stock has dropped to $.25 per share. T shareholders receive $60 cash and 50 shares of P stock with an aggregate value of $12.50. Continuity of Interest is measured as of January 2 (the day prior to signing), using the floor price of $.80 per share of P stock. At the floor price, T shareholders would have received $60 cash and P stock worth $40. The transaction therefore satisfies the Continuity of Interest requirement. [10]

If, instead, on June 1 of year 1, the value of P stock has increased to $1.50 per share, T shareholders receive $40 cash and 50 shares of P stock with an aggregate value of $75. Continuity of Interest is measured as of January 2 (the day prior to signing), using the ceiling price of $1.20 per share of P stock. At the ceiling price, T shareholders would have received $40 cash and P stock worth $60. The transaction therefore satisfies the Continuity of Interest requirement. [11]

Finally, the Proposed Regulations provide that, in determining the value of an issuing corporation’s stock at closing for purposes of testing Continuity of Interest, an average stock price may be used instead of the price at closing, provided that the average price is based upon prices of the issuing corporation’s stock between signing and closing. The binding reorganization agreement must utilize that average price in determining the mixture of consideration to be exchanged for the interests in the target corporation.

Effective Date

The Final Regulations are effective as of December 16, 2011. The Proposed Regulations would apply to transactions occurring on or after the date the regulations are published as final in the Federal Register, unless completed pursuant to a binding agreement that was in effect immediately before the date such final regulations are published.

Request For Comments

The IRS and Treasury Department have requested comments on the Proposed Regulations, to be received by March 15, 2012. Specifically, the preamble to the Proposed Regulations describes that future guidance may provide a more general rule stating that an item of consideration is valued for purposes of Continuity of Interest at the earliest date on which the target shareholders become fully subject to the appreciation and depreciation in the value of that item, pursuant to a binding contract to effect the potential reorganization (but not later than the date of the reorganization exchange). Risk of a reorganization agreement not closing would be disregarded in determining whether target shareholders are fully subject to market fluctuations. The IRS and Treasury Department request comments on the propriety of such an approach.

Endnotes

[1] Treas. Reg. 1.368-1(e).
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[2] See Temp. Reg. 1.368-1T(e)(2)(v), Example 1.
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[3] Temp. Reg. 1.368-1T(e)(2), T.D. 9316, 2007-1 C.B. 962 and REG-146247-06, 2007-1 C.B. 977.
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[4] Temp. Reg. 1.368-1T(e)(2)(i).
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[5] Temp. Reg. 1.368-1T(e)(2)(iii).
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[6] Section 7805(e)(2) of the Internal Revenue Code establishes a “sunset rule” applicable to temporary regulations, providing that any temporary regulation expires within three years after the date of issuance.
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[7] 2010-14 IRB, March 18, 2010.
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[8] T.D. 9565.
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[9] REG-124627-11.
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[10] See Prop. Reg. 1.368-1(e)(2)(vii), Example 1.
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[11] See Prop. Reg. 1.368-1(e)(2)(vii), Example 2.
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