Governance Issues In Spin-Off Transactions via Gibsuon Dunn
Spin-off transactions require a focused, intensive planning effort. The deal team must make decisions about how best to allocate businesses, assets and liabilities between the parent and the subsidiary that will be spun-off. It must address complex tax issues, securities law questions and accounting matters, as well as issues related to capital structure, financing and personnel matters. In addition, it must resolve a long list of governance issues, including questions about the composition of the spin-off company board, the importance of mechanisms for dealing with conflicts of interest and the desirability of robust takeover defenses.
Transaction planners do not always give the governance issues high priority. They may assume that the spin-off company can simply replicate the governance mechanisms that the parent uses, and that any issues can be addressed during the late stages of the planning effort. In fact, however, designing an effective governance structure for the spin-off company can be quite complex. Even relatively simple issues can take time to resolve because of the need to ensure that the business leaders are satisfied with the choices being made. To take an obvious example, the parent board and the management team are likely to be very interested in who will serve on the spin-off company’s board of directors. As a result, identifying, vetting and selecting candidates for the new board can take months.
Spin-off transactions proceed more smoothly if the deal team begins its work with a clear understanding of the governance issues they must address and if they start work on these issues early. The balance of this client alert describes some of the most important governance questions planners will need to consider and answer.
Should the spin-off company simply replicate the parent’s governance structure?
The transaction planners often say that they want to copy the parent’s governance structure when they create the spin-off company. For example, they will propose that the spin-off company adopt a set of bylaws that look like the parent’s bylaws and duplicate the parent’s board committee charters and conflict policies. For a variety of reasons, however, copying the parent’s governance structure may not make sense. Instead, the parent’s structure should be viewed simply as a useful starting point.
The typical parent in a spin-off transaction is a large, long-established public company. It has dealt with its stockholders for many years and may have adjusted its governance structure in response to criticisms from institutional investors, activists, stockholder proponents and proxy advisory firms. For example, it may have dismantled takeover defenses or adopted proxy access rights giving stockholders the ability to include director nominees in company proxy materials.
The spin-off subsidiary, by contrast, will be a new public company with the ability to write on a clean governance slate. The directors and management of the spin-off company will address issues very different from the issues that the leaders of the pre-spin combined company confronted. Among other things, because the new company does not have a stand-alone operating history and is smaller than the combined company from which it was spun-off, it may be more vulnerable to activists and hostile bidders. At the same time, the spin-off company may have a lower profile than the pre-spin parent company, and therefore may be less likely to attract the attention of stockholder proponents and other governance reformers. Given these differences, fresh thinking is entirely appropriate.
The spin-off company will also have the opportunity to take actions that the parent company does not have the realistic ability to consider. For example, transaction planners might consider whether the spin-off company should incorporate in the same state as the parent or should incorporate in a state with more management-friendly laws, especially if there are business reasons to justify the move.
Should the spin-off company implement a classified board and other similar takeover defenses?
The transaction planners should consider implementing robust takeover defenses. For example, they should examine whether it makes sense to establish a classified board, limit stockholders’ rights to call special meetings, and establish supermajority stockholder approval requirements for mergers and substantial asset sales. The planners will be able to make good arguments in favor of these measures given the spin-off company’s relative vulnerability to hostile bidders and activists.
The transaction planners should recognize, however, that investor resistance to provisions that restrict stockholder rights grows stronger every year. In particular, there is a greater risk that the proxy advisory firms will make recommendations to withhold votes from, or vote against, directors up for election at the company’s first annual meeting.
As an historical matter, spin-off companies have been able to adopt classified boards and other shark repellents out of the public eye, before the spin-off, without drawing immediate challenges from investors or proxy advisory firms. They were sometimes even able to incorporate shark repellents in their charters, because obtaining the required stockholder approval for charter amendments is relatively easy when the spin-off company is still a subsidiary of the parent. These companies understood that over time, they would come under pressure from investors, activists and stockholder proponents to dismantle their defenses. But they chose to begin life as a public company in a relatively aggressive position.
In the future, however, spin-off companies may not get a free pass from proxy advisory firms Institutional Shareholder Services (“ISS”) and Glass, Lewis & Co., Inc. (“Glass Lewis”) when they adopt takeover defenses without stockholder approval. ISS recently adopted a policy regarding so-called “unilateral” bylaw or charter amendments—provisions adopted without public stockholder approval. Under this policy, beginning in 2015, it will generally recommend withholding votes from or voting against directors who, without putting the provision to a stockholder vote, approved bylaw or charter provisions that have the effect of restricting stockholder rights. ISS noted the “recent trend of companies adopting a suite of shareholder-unfriendly governance provisions shortly before, or on the date of, their initial public offerings.” Recognizing that some investors may wish to evaluate governance actions on a case-by-case basis, ISS added the timing of adoption (pre or post IPO) to the list of factors it will consider under its policy regarding restrictive provisions.
Glass Lewis also recently modified its approach relating to anti-takeover measures. Glass Lewis ordinarily gives new public companies a one-year grace period to allow them time to comply with applicable regulatory requirements and meet basic corporate governance standards. However, if the company implements an anti-takeover measure such as a rights plan or a classified board before its initial public offering, without offering a sunset for the rights plan of three years or less or a “sound rationale,” and the measure is not subsequently put to a stockholder vote, Glass Lewis will consider recommending voting against all members of the board who served at the time the measure was adopted. This policy change took effect beginning in 2015.
As a result of these policy shifts, there is a significant risk that ISS and Glass Lewis will recommend withholding votes from or voting against directors of a spin-off company who participated in the decision to implement anti-takeover provisions such as a classified board, or other provisions viewed as unfriendly to stockholders. This outcome is not a certainty, but spin-off companies that adopt classified boards or other shark repellents before they go public may subsequently have to