Morris Trust transactions are on dealmakers' radar screens. At least nine of these spin/merger or sponsored spinoff deals have been struck since the start of 2005. Examples include Weyerhaeuser Co.'s $6 billion deal with Domtar Inc. to combine their white-paper businesses, Alberto-Culver Co.'s $3 billion sponsored spinoff of its Sally beauty supply distribution business to Clayton, Dubilier & Rice Inc., and Walt Disney Co.'s $2.7 billion radio station deal with Citadel Broadcasting Corp.
The Morris Trust structure enables a public company to divest a part of its business in a tax-efficient way. A successful transaction results in a tax-free distribution of the spun-off company's shares to shareholders while the parent company incurs no corporate income tax on what may look and feel like a divestiture -- either through a merger with another public or private company or, in a structure referred to as a "sponsored spinoff," by a sale of a substantial percentage of the stock of the spun-off company to an investor.
These deals look and feel like divestitures partly because the merger partner often obtains effective control of management through the designation of directors and the appointment of senior executive officers. At the same time, the parent may receive cash from debt incurred by the spun-off business.
To execute a so-called reverse Morris Trust, a parent corporation contributes the stock or assets of the business to be divested to a subsidiary. The subsidiary is then distributed to the parent corporation's shareholders, generally through a pro-rata spinoff. Immediately after the spinoff, the spun subsidiary merges with the counterparty that is the partner in the transaction. Typically, the spun subsidiary incurs debt to fund a transfer of cash to the parent immediately prior to the spinoff. In a straight Morris Trust, the order is reversed, with the merger partner combining with the distributing or parent company. Sponsored spinoffs can occur in either direction.
This is not a structure for every deal. The 1997 enactment of Internal Revenue Code Sec. 355(e) made these deals taxable unless the shareholders of the parent company doing the spinoff will have a 50% or greater interest in the combined company. But when it is available, a Morris Trust transaction can be quite attractive. The adoption by the IRS of final regulations interpreting Sec. 355(e) has combined with a booming M&A market to make these deals increasingly popular.
At first glance, a Morris Trust may look a lot like a typical public-company merger, with similar representations and warranties, which typically do not survive closing, and similar covenants. But these transactions also require dealmakers to confront additional complexities more typical of private buyouts and divestitures. Usually, the parent hasn't operated the spun business as a standalone enterprise, so carve-out financial statements need to be prepared. The parties may need to negotiate transitional service arrangements so the new company can operate after the closing, as well as long-term arrangements to preserve vital business relationships between the parent and the spinoff .
To add to the complexity, the assets and liabilities of the business to be spun off often need to be transferred to a special-purpose subsidiary. Where assets have been historically held in entities that also conduct the business the parent wishes to retain, carving out the spinoff business takes on all the complexity of an asset deal in the private context. The merger partner will likely insist upon an asset-sufficiency representation and will need to conduct thorough due diligence to ensure it's getting all the assets it expected, and no extraneous liabilities.
It is also not uncommon for a merger partner or sponsored spin investor to negotiate for the retention by the parent company of particular risks, such as environmental or product liabilities or unfunded pension obligations, backed up by a post-closing indemnity. Post-closing purchase price adjustment provisions are also often included. These kinds of provisions are far more reminiscent of private-deal practice than the world of public deals, in which it is generally not possible to pursue any post-closing remedy.
Due diligence can also be more time consuming than in a public merger. Since the business to be spun off often represents only a portion of the parent company's overall operations, the parent may not have disclosed in its public filings information about the spun business at the same level of detail as the merger partner's own public disclosure.
At the same time as the parties navigate some of the most complex elements of both public and private deals, they must also preserve the tax benefits of the structure. While the parent will typically seek a private letter ruling from the IRS and a legal opinion as to the tax-free status of the spinoff, this does not eliminate the tax risk. The combined company will generally need to accept limits on its activities during the two years after closing, including restrictions on the issuance of capital stock and on the sale of a substantial part of the business that was spun off. These limits could present an issue if the company -- which may have been heavily leveraged in the course of the transaction -- needs to raise cash during this period.
While Morris Trust transactions are complex and present real challenges, the structure also offers significant benefits to the savvy dealmaker. We expect to see many more in the years ahead. - Paul S. Bird and Jonathan E. Levitsky
Paul S. Bird is a partner at Debevoise & Plimpton LLP and the co-chair of the firm's M&A practice group. Jonathan E. Levitsky is an associate at the firm. Debevoise advised Clayton, Dubilier & Rice and Domtar in the transactions referred to above.
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