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Strafford Webinar: Structuring Divisive Mergers Under the Delaware and Texas Statutes

On April 23, 2019, Strafford presented a CLE webinar and Q&A featuring Jackson Walker partners Byron F. Egan and William H. Hornberger and Morris Nichols Arsht & Tunnell partner R. Jason Morris as panelists.

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Strafford Webinar: Structuring Divisive Mergers Under the Delaware and Texas Statutes

  1. 1. Strafford Webinar | April 23, 2019 Byron F. Egan Jackson Walker Dallas, Texas William H. Hornberger Jackson Walker Dallas, Texas R. Jason Russell Morris, Nichols, Arsht & Tunnell LLP Wilmington, Delaware Structuring Divisive Mergers Under the Delaware and Texas Statutes
  2. 2. 2 Welcome
  3. 3. 3 Outline I. Delaware and Texas Divisive Merger statutes: Structuring alternative to M&A spinoffs and carve-outs II. Mechanics of a divisive merger A. Plan of a Divisive Merger: Key terms B. Approval of Divisive Merger C. Certificate of division or merger III. Effect of the Divisive Merger: Allocation of assets, properties, licenses, debts, liabilities and duties of the dividing entity among multiple survivors IV. Federal income tax treatment of Divisive Mergers V. Concerns for lenders and other counterparties and best practices going forward
  4. 4. 4 Delaware and Texas Divisive Merger Statutes: Structuring alternative to M&A spinoffs and carve-outs
  5. 5. 5 Texas Divisive Merger Statute • Divisive mergers have been permitted under Texas law since 1989 • Applies to corporations, partnerships and LLCs and can involve entities organized under the laws of another state so long as such state permits divisive mergers • TBOC 1.002(55): Defines “merger” to include “(A) the division of a domestic entity into two or more new domestic entities or other organizations or into a surviving domestic entity and one or more new domestic or foreign entities or non-code organizations.”
  6. 6. 6 Texas Divisive Merger Statute • Mechanics • Must adopt a plan of merger that provides (1) the manner and basis for allocating and vesting the property of the parties and (2) the manner and basis of allocating each liability and obligation of the parties or making adequate provision for the payment and discharge thereof • Plan should specifically set forth the mechanism under which contingent assets and contingent liabilities for the parties are to be allocated and satisfied or provided for • If properly allocated in the plan, all assets and liabilities of the parties to the merger will be allocated (subject to existing contracts, liens and encumbrances) among the surviving entities in the manner provided in the plan, and not to any other party. • If the plan fails to provide for the allocation or vesting of any particular item of property or any liability or obligation of any party to the merger, TBOC 10.008(b) provides that “the unallocated property is owned in undivided interest by, or the liability or obligation is the joint and several liability and obligation of, each of the surviving and new organizations, pro rata to the total number of surviving and new organizations resulting from the merger”
  7. 7. 7 Texas Divisive Merger Statute • Must file a certificate of merger and certificate of formation for new entities with Secretary of State of Texas • Approval • Approve plan of merger in the same manner as a traditional plan of merger unless otherwise provided in the governing documents of the entity • Dissent and Appraisal Rights: Shareholders of Texas corporations are entitled to assert dissenters rights when objecting to a merger (including a divisive merger) and seeking to be paid the value of their shares as determined in a judicial appraisal. • LLCs and partnerships do not have statutory rights of dissent and appraisal unless the entity’s governing documents expressly grant these rights • Rights of creditors may be impaired by a divisive merger when the pool of assets available to satisfy an obligee’s claims are divided, but creditors’ perfected liens and rights under fraudulent transfer and similar laws remain intact.
  8. 8. 8 Delaware Statutory Division • Methods to Separate Assets and Liabilities • Internal Division (no separation of liabilities) • Series • Protected • Registered (new and effective as of August 1, 2019) • New Division Statute (effective as of August 1, 2018) • Note: Statutory division may be available for limited partnerships effective August 1, 2019 • How to Effect Division Prior to Statute • Convert to Pennsylvania or Texas entity, divide pursuant to statute, then convert back to Delaware • Form wholly-owned subsidiary and drop-down assets and liabilities
  9. 9. 9 Delaware Statutory Division • General: New Section 18-217 enables an LLC to divide into two or more LLCs, with the dividing LLC either continuing its existence or terminating as part of the division • Vocabulary: • “Dividing company”: the LLC effecting a division • “Resulting company”: a domestic LLC formed as a consequence of a division • “Surviving company”: a dividing company that survives • “Division company”: a surviving company, if any, and each resulting company
  10. 10. 10 Delaware Statutory Division • Mechanics • A division is effected by (i) the adoption of a plan of division setting forth the terms and conditions of the division, including, among others, the allocation of assets, property, rights, series, debts, liabilities and duties of the dividing LLC among the resulting LLCs and, if it survives, the dividing LLC and (ii) the filing with the Delaware Secretary of State of a certificate of division and a certificate of formation for each newly formed LLC
  11. 11. 11 Delaware Statutory Division • Plan of Division • How are interests treated: exchanged/converted into cash, property, rights or securities of, or interests, in, the surviving company or any resulting company; may remain outstanding • Is dividing company surviving? • Name of resulting companies • Allocation of assets, property, rights, debts, liabilities • Name and business address of contact person that has a copy of the plan of division • Similarities to considerations in a merger • For example, may amend LLC agreement of surviving company
  12. 12. 12 Delaware Statutory Division • Approval • Division approved as provided in the LLC agreement • If not specifically addressed and not prohibited, approved in same manner as for merger or consolidation as set forth in LLC agreement • If LLC agreement is silent, division must be approved by members who own more than 50% of the then current percentage or other interest in the profits of the dividing company • Fiduciary duties – similar to merger
  13. 13. 13 Delaware Statutory Division • Certificate of Division • Name of the dividing company and whether it survives • The date of filing of the dividing company’s original certificate of formation • The name of each division company • The name and business address of the contact person • Effective date • Division has been approved in accordance with 18-217 • The plan of division is on file and state address • A copy of the plan of division will be provided to any member of the dividing company • Certificate of formation for each resulting company
  14. 14. 14 Effect of the Divisive Merger • Delaware 18-217(l)(2): For all purposes of the laws of the State of Delaware, all of the rights, privileges and powers, and all the property, real, personal and mixed, of the dividing company and all debts due on whatever account to it, as well as all other things and other causes of action belonging to it, shall without further action be allocated to and vested in the applicable division company in such a manner and basis and with such effect as is specified in the plan of division, and the title to any real property or interest therein allocated to and vested in any division company shall not revert or be in any way impaired by reason of the division • If debts and liabilities are not allocated by the plan, they shall be the joint and several debts and liabilities of all of the division companies. • Texas 10.008(a): Generally provides that, if properly allocated in the plan, all assets and liabilities of the parties to the merger will be allocated (subject to existing contracts, liens and encumbrances) among the surviving entities in the manner provided in the plan, and not to any other party. • If, however, the plan does not provide for such allocation, the unallocated property is owned in undivided interest by, or the liability or obligation is the joint and several liability and obligation of, each of the surviving and new organizations, pro rata to the total number of surviving and new organizations resulting from the merger • Transfer: Both Texas and Delaware law expressly provide that the interest in the property of the LLC shall not be deemed, as a result of the division, to have been assigned or transferred
  15. 15. Structuring Divisive Mergers Under the Delaware and Texas Statutes Federal Income Tax Consequences of a Divisive Merger: One Size Does Not Fit All Strafford April 24, 2019 William H. Hornberger Jackson Walker L.L.P. 2323 Ross Ave., Ste. 600 Dallas, Texas 75201 214-953-5857 © 2019 William H. Hornberger
  16. 16. USE OF DIVISIVE MERGERS WITH C CORPORATIONS REV. RUL. 2000-5 (SITUATION 1) Target Corporation (T) Acquiring Corporation (A) Shareholders Shareholders Asset B Asset A Asset B and certain liabilities pass to A in divisive merger Rev. Rul. 2000-5 - Conclusion: The transactions described in Situations (1) and (2) do not qualify as reorganizations under section 368(a)(1)(A). However, the transactions described in Situations (1) and (2) possibly may qualify for tax-free treatment under other provisions of the Code. Cf. Treas. Reg. § 1.368-2, Example 1 (same facts as above), concluding: (ii) Analysis. The transaction does not satisfy the requirements of paragraph (b)(1)(ii)(A) of this section because all of the assets and liabilities of Z, the coming entity of the transferor unit, do not become the assets and liabilities of Y, the combining entity and sole member of the transferee unit. In addition, the transaction does not satisfy the requirements of paragraph (b)(1)(ii)(B) of this section because the separate legal existence of Z does not cease for all purposes. Accordingly, the transaction does not qualify as a statutory merger or consolidation under section 368(a)(1)(A). 16
  17. 17. 17 USE OF DIVISIVE MERGERS WITH C CORPORATIONS REV. RUL. 2000-5 (SITUATION 2) Target Corporation (T) Acquiring Corporation (A) Shareholders Asset B to A in divisive merger Step 1: Asset B and certain liabilities pass to A in divisive merger Asset A Asset B Acquiring Corporation 2 (A2) Asset A and certain liabilities pass to A2 in divisive merger A1 stock Rev. Rul. 2000-5 – Conclusion: The transactions described in Situations (1) and (2) do not qualify as reorganizations under section 368(a)(1)(A). However, the transactions described in Situations (1) and (2) possibly may qualify for tax-free treatment under other provisions of the Code.
  18. 18. 18 USE OF DIVISIVE MERGERS WITH C CORPORATIONS D Corporation (C Corporation) Shareholders Sub Corporation (C Corporation) Substantial Other Assets 100% of the Stock STEP 1: D Corporation passes group of assets and liabilities to C Corporation in exchange for 100% of the stock of C Corporation in divisive merger STEP 2: D Corporation distributes 100% of stock in Sub Corporation to shareholders Taxable or Nontaxable? Assets
  19. 19. 19 USE OF DIVISIVE MERGERS WITH ENTITIES CLASSIFIED AS DISREGARDED ENTITIES FOR FEDERAL INCOME TAX PURPOSES Sub LLC1 (Disregarded Entity) Asset A Sub LLC2 (Disregarded Entity) Asset B Holding LLC Asset B and certain liabilities pass to SubLLC2 in divisive merger
  20. 20. Use of Divisive Mergers With Entities Classified As Partnerships For Federal Income Tax Purposes - Partnership Division Regulations 20
  21. 21. • Identify: – Prior Partnership – Resulting Partnership – Divided Partnership – Recipient Partnership 21
  22. 22. • In the division of a partnership into two or more partnerships, the resulting partnerships (other than any resulting partnership the members of which had an interest of 50- percent or less in the capital and profits of the prior partnership) are considered a continuation of the prior partnership. Any other resulting partnership is not considered a continuation of the prior partnership but is considered a new partnership. • If none of the members of the resulting partnership owned an interest of more than 50-percent in the capital and profits of the prior partnership, the prior partnership is terminated. • Where members of a partnership that has been divided do not become members of a resulting partnership that is considered a continuation of the prior partnership, such partner’s interest is considered liquidated as of the date of the division. 22
  23. 23. General Rules Concerning Form of Partnership Division • Assets - Over Form • Asset - Up Form
  24. 24. 24 PARTNERSHIP DIVISION REGULATIONS EXAMPLE (ASSETS-OVER FORM)
  25. 25. Selected Partnership Transactions Falling Outside Divisive Merger Regulations
  26. 26. Partnership Division Regulations Preamble to Final Regulations: “To have a division at least two members of the prior partnership must be members of each resulting partnership that exists after the transaction.” Thus, the following is not a division: 26
  27. 27. Member A Member B AB, LLC (Texas LLC) Property Pool X Property Pool Y A, LLC (Texas LLC) Property Pool X B, LLC (Texas LLC) Property Pool Y Divisive Merger Member A Member B 27
  28. 28. AB, LLC (Texas LLC) Property Pool X Property Pool Y A, LLC (Texas LLC) Property Pool X B, LLC (Texas LLC) Property Pool Y Divisive Merger (with Liabilities) Encumbered by Liability Encumbered by Liability What is impact on A, LLC? Member A Member B Member A Member B 28
  29. 29. AB, LLC (Texas LLC) Property Pool X Property Pool Y A, LLC (Texas LLC) Property Pool X B, LLC (Out of State LLC) Property Pool Y (located in TX) Divisive Merger (Out of State) Member A Member B Member A Member B 29
  30. 30. AB, LLC (Texas LLC) Property Pool X Property Pool Y A, LLC (Texas LLC) Property Pool X B, LLC (Out of State LLC) Property Pool Y (located in TX) Divisive Merger (Out of State with Liabilities) What is impact if Property Pool Y is encumbered by liabilities? Member A Member B Member B Member A 30
  31. 31. AB, LLC (Texas LLC) Property Pool X Property Pool Y A, LLC (Texas LLC - formerly AB, LLC) Property Pool X HOLDCO, LLC (Out of State LLC) Property Pool Y (located in TX) Divisive Merger Illustration (with Member) Holdco, LLC Member A Member B Member A Member B 31
  32. 32. 32 Concerns for Lenders & Creditors • A divisive merger/division may alter and reduce the pool of assets to which a creditor may look for repayment • A division could result in moving collateral that secures a loan to a new entity that is not credit-worthy without breaching the terms of the credit agreement • Applies to lenders and all other creditors
  33. 33. 33 Protections • Delaware: • Under Delaware statute, with respect to any LLC formed prior to August 1, 2018 that is party to any written contract, indenture or other agreement entered into prior to August 1, 2018 that by its terms restricts, conditions or prohibits such LLC from (x) consummating a merger or consolidation with or into another party or (y) transferring assets, such restriction shall be deemed to apply to a division as if it were a merger, consolidation or transfer of assets • A “division contact” must be specified in the plan of division to be available for 6 years following the division to advise creditors as to the division company to which such creditor’s claim was allocated • Any action or proceeding pending against a dividing company may be continued against the surviving company as if the division did not occur and against any resulting company to which the asset, property, right, series, debt, liability or duty associated with the action was allocated pursuant to the plan of division • Each division company is jointly and severally liable for any liabilities if the division would constitute a fraudulent transfer under applicable law • Texas: Fraudulent transfer protections and creditor will continue to possess all other rights otherwise available to it under law and contract, including all security interests in the property of the debtor securing the payment of the creditor’s claim
  34. 34. 34 Best Practices for Creditors • Delaware Note: For LLCs formed after August 1, 2018, the LLC/borrower might be able to transfer a secured lender’s collateral to a new LLC that is not credit-worthy without breaching its credit agreement. • Agreement (such as a credit agreement) could expressly address division • Consider expanding definitions of assets sales, mergers, reorganizations, etc. to address divisions • Consider expanding negative covenants to prohibit divisions without the consent of the lender in the same manner as asset sales, mergers, reorganizations, etc. • Consider whether typical SPE covenants in a bankruptcy remote transaction, provide sufficient protection.
  35. 35. 35 Q & A

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