Worldwide mergers and acquisitions volume for announced transactions in 1998 was close to $2.5 trillion, far surpassing the 1997 record of over $1.5 trillion, which far exceeded the 1996 record of over $1 trillion. [Paul M. Sherer, The Lesson from Chrysler, Citicorp and Mobil: No Companies Nowadays Are Too Big to Merge, Wall St. J., Jan. 4, 1999, at R8.] Cross-border merger and acquisition activity is a large and growing component of this record breaking volume, constituting $672 billion of the deal volume in 1998 and $393 billion in 1997. [Securities Data Company.]
A variety of developments are stimulating and should continue to stimulate cross-border mergers and acquisitions. Some cross-border acquisitions are driven by the globalization of the economies of the developed countries and the desires of some of the leading companies to have a global presence and impact. We have certainly seen this in the last year in the banking, telecommunications, pharmaceutical, auto and oil sectors, among others. A number of the leading non-U.S. companies in these sectors have made and will make acquisitions in the U.S. in order to participate in the large and lucrative U.S. market.
Clearly the worldwide reduction in protectionism and the increasing willingness of a growing number of nations to permit open, competitive markets has dramatically encouraged cross-border acquisitions. In some cases these openings of markets have been by global agreement. In 1997, for example, more than 60 nations entered into a global telecommunications pact, sponsored by the World Trade Organization, opening telecommunications markets in these countries to foreign competition and committing these countries to allowing foreign companies to acquire interests in domestic telecommunications providers.
Likewise, the trend towards breaking up country-wide monopolies (particularly national telecommunication monopolies) has produced a proliferation of cross-border transactions, including acquisitions by U.S. companies and European companies of telecommunication licenses in countries in which there was previously only one government-licensed provider. The Peoples' Republic of China plans to privatize 350,000 companies; if only 1% of these privatized companies attracts foreign investors, it will spur a torrent of cross-border investing.
The unification of Europe has broken down barriers and opened up a market more populous than that of the United States, spawning a great deal of cross-border merger and acquisition activity, which is expected to continue, especially given the recent introduction of the Euro. The merger and acquisition departments of the leading U.S. investment banks are devoting substantial resources to merger and acquisition activity in Europe. In fact, as recently reported in the Wall Street Journal, U.S. investment banks dominated the "league" tables for advising on merger and acquisition activity involving European targets for 1998. [Paul M. Sherer and Jeffrey L. Hiday, U.S. Investment Banks Take Top Spots from Europeans in Mergers Ranking, Wall St. J., Jan. 7, 1999, at A6.] The most prominent U.S. leveraged buy-out firms, with their coffers full, are now devoting more time and energy to Europe.
In Japan, continuing financial reforms, as part of the so-called "Big Bang" liberalization of the Japanese financial system, as well as the weakness of a number of Japanese financial institutions have resulted in some significant acquisitions of Japanese companies by U.S. investors in the financial industry. In other industries, companies facing difficulties in Japan's current recessionary conditions have become increasingly open to acquisitions by, and strategic partnerships with, foreign investors in order to improve their competitiveness and gain financial and technological support. As a result, a number of commentators expect the number of cross-border transactions involving Japanese companies as targets to continue to increase.
Several commentators point to a worldwide glut of capacity (whether in banking services, car manufacturers, airlines or steel production) as the driving force towards consolidation -- reducing capacity and creating opportunities for better margins. Low oil prices are expected to force more combinations in 1999. Still other commentators are concerned that deflation will become more widespread and could have a chilling effect on merger and acquisition activity.
Additional cross-border acquisitions may be driven by perceived differences in value between businesses in different countries. Just as Japanese companies saw great value in the United States in the late-80s, when the Japanese economy was soaring and the value of the yen was very high relative to the dollar, U.S. and European companies might see value opportunities now in Latin America and Asia, as well as opportunities to gain strategic footholds in regions which are expected to experience significant growth in the next century.
The tremendous growth in market capitalizations of companies traded on U.S. and European stock exchanges has facilitated the use of stock as an acquisition currency. In 1998, stock accounted for 67% of the consideration in U.S. merger activity. [The Year of the Mega Merger, Fortune, Jan. 11, 1999, at 62, 64.] As the various regulatory authorities, particularly in the U.S., work to make the listing of foreign stock easier, the ability of foreign companies to acquire domestic companies will continue to grow. Moreover, money is available for acquisitions -- merchant banks with equity, a recovering commercial bank market with relatively low interest rates, a healthy investment-grade debt market and a recovering high-yield debt market.
For all of the foregoing reasons, and a variety of others, merger and acquisition activity in general, and cross-border combinations in particular, are expected to continue to grow at a record-setting pace into the foreseeable future.
In order to place some practical parameters around the topic, this paper will attempt to deal only with transactions in which a U.S. entity is one of the principals, either the acquirer or the target, in a cross-border transaction. In 1998, over 3,400 transactions, with a total value in excess of $360 billion, were announced in which a U.S. company and a non-U.S. company intended to merge, and over 2,200, with a total value in excess of $280 billion, were completed.
Over 100 of those announced transactions involved value in excess of $500 million. [Securities Data Company.] In 1998, foreign entities announced purchases of U.S. companies with a gross value exceeding $220 billion. [Id.] U.K. buyers of U.S. companies in 1998 tallied more than $60 billion in announced transactions. During 1998, U.S. companies acquired a record number of European-based companies, with UK companies representing the largest number of targets. Towards the end of this paper, there is a brief summary of some of the cross-border aspects of a few of those transactions.
Structuring a cross-border acquisition or combination involves all of the issues of an entirely domestic merger or acquisition, with an added degree of difficulty produced by the introduction of a foreign party to the transaction. There are two sets of laws and regulations which must be understood and reconciled, two sets of tax and accounting rules, two cultures, two political systems, in some cases two securities markets, and a myriad of other issues with which to contend. A cross-border merger or acquisition might also involve other financial issues which do not have a domestic counterpart, including raising funds in one market for investment in another, changes in the exchange rate and other issues. This paper will attempt to identify some of those issues and some of the approaches used to address them.
The first bit of practical advice to attorneys involved in executing a cross-border acquisition or combination is to engage qualified local counsel. In the case of a U.S. company acquiring a foreign company, it is imperative that the law firm representing the U.S. acquirer have expertise in the target country or that the acquirer's U.S. counsel retain local counsel in the country in which the acquisition target is incorporated. Likewise, when representing a foreign acquirer of a U.S. company, it is important to have expertise in the country of the acquiring company or to retain local counsel that has such expertise. Local counsel can provide necessary advice regarding the impact of foreign law on the proposed transaction and on the variety of regulatory issues that will likely arise. Local counsel may also be a useful source of information regarding the local practicalities of transaction execution and cultural and political issues.
Blending of Cultures and Styles
The blending of styles and cultures is difficult enough in mergers between two U.S. companies. The issues and country pride involved in cross-border mergers can make such combinations extremely difficult and emotional, particularly in mergers of companies of similar size. In all of these mergers, the parties must determine the place of incorporation of the surviving company, the name of the surviving company, the location of the headquarters and whether there will be more than one headquarters, the mix of the board, chairman or co-chairman, CEO or office of the chairman, where the stock will be listed, etc. These "social" issues are often the most sensitive issues that need to be resolved before a cross-border transaction can occur.
Merger of Equals Challenges
Trying to accomplish a cross-border "merger of equals" presents great challenges. From a legal perspective, describing a transaction as a merger of equals means very little (except perhaps in the event that a hostile third party expresses an interest in acquiring one of the parties to the merger, in which case characterizing the transaction as a merger of equals or a strategic combination, as opposed to a "change of control" or a sale of the company, provides the board of directors of a target company with a rationale to resist an unsolicited offer, at least under Delaware law).
From a business perspective, however, describing a transaction as a merger of equals may mean a great deal, and it has the potential to be a particularly emotional issue in an international transaction. In some instances relatively large companies are only willing to consider a merger if it can be described as a "merger of equals."
In a merger of equals, neither company is "taken over" by the other, the premium being paid, if any, is relatively modest, the consideration is all stock or predominantly stock, the new board of directors is usually composed of a fairly equal number of directors from the boards of the two companies and the senior management positions of the combined company are fairly evenly divided between the senior management of the two companies.
Because of cultural and business differences, solving the social issues in a cross-border "merger of equals" is extremely challenging; in recent years, while a number of cross-border mergers of equals have been completed, others have been proposed or rumored, but not completed.
Sorting Out the Social Issues
When attempting to piece together a "merger of equals," it is essential that the two CEOs or the two prospective continuing senior executives spend considerable time together, sorting out the "social issues" - which senior officers are going to have which role, how is the balance of power going to work? Unless a fairly open and respectful relationship develops between these two individuals, it is difficult to produce the necessary board support for a merger of equals and hence difficult to reach agreement. In a cross-border merger of equals, the challenge in harmonizing the social issues is complicated by the significant pressures exerted by the respective CEOs' constituencies - the shareholders, the boards of directors, the management teams and the employees.
Not all of these constituencies may share the same global vision. Management teams are frequently concerned with their future roles and these concerns are severely exacerbated when a substantial number of the senior management team may have to relocate to a different country.
In regulated businesses, such as telecommunications, the choice of senior management, the location of the headquarters, the jurisdiction in which the combined company is incorporated and related matters can have a significant impact on the ease or lack of ease with which a transaction receives the necessary regulatory approvals, as well as regulatory cooperation post-closing.
Mergers; Tender Offers
The range of structures available in a cross-border acquisition is not a great deal different than the range of structures available in an all-U.S. transaction, except that a U.S. and a foreign company cannot merge directly with each other. The most commonly used U.S. merger structure, in which the acquiring corporation creates an acquisition vehicle (a subsidiary) and then that subsidiary either merges into a target (a reverse subsidiary merger) or a target merges into that subsidiary (a forward subsidiary merger), is, of course, available in a merger between a foreign company and a U.S. company. The foreign acquirer simply needs to form a U.S. subsidiary to effect the merger.
In acquisitions of public companies, the tender offer structure, whether using cash or shares of the acquiring entity, is even more commonly used outside the U.S. than in the U.S. In each of Canada, the U.K. and Japan, for example, a tender for the target's shares is the preferred structure for acquiring a public company, even in a friendly transaction.
A cross-border "merger of equals," has many of the same characteristics as a domestic merger of equals: little or no premium, a fixed exchange ratio, balanced representations and warranties, few conditions to close, even-handed treatment of the "social" issues discussed earlier and limited, if any, fiduciary out provisions for the two companies' boards of directors. One of the issues that arises in a merger of equals is where and how to reflect the agreement on governance (the number of board seat representatives from the two companies, the arrangements regarding the chairman and chief executive officer, etc.).
Often the governance provisions are contained in the merger agreement with no binding obligation surviving the closing. In other transactions the governance provisions are built into the articles or by-laws for a specified period.
Less Conventional Structures
Avoidance of "Flow Back;" Dual Listing
With lofty stock market prices creating valuable currency, stock-for-stock mergers or exchange offers are fairly common acquisition structures for U.S. public companies acquiring other U.S. public companies. As discussed below, such transactions can be tax-free to the target company shareholders. If the acquiring company is foreign, but has ordinary shares or ADRs registered with the SEC and listed on a U.S. exchange or is prepared to register its shares and have its shares listed on a U.S. exchange, a stock-for-stock merger or exchange offer is available as a structure to such foreign company acquiring a U.S. public company. However, in a cross-border acquisition employing this structure, a phenomenon known as "flow back" sometimes intervenes to reduce the market demand for the shares of the combined company.
Stock markets in different countries value performance differently. In the U.S., there are hundreds, if not thousands, of examples of high flying stocks with little or no earnings trading at high multiples of projected revenues and projected earnings. In other countries' stock markets, such as that of the United Kingdom, investors--particularly institutional investors--are much more yield conscious. In a merger of two public companies from two different countries, the norm is that even if shares of the surviving company ultimately trade on the exchanges of both countries, the predominant trading for those securities will occur only in one country's market.
"Flow back" refers to the phenomenon in which securities issued to shareholders in that country that does not end up having the dominant trading market for the shares of the surviving company sell those shares and shareholders of the country that emerges with the dominant trading market buy those shares. This can be a particularly acute issue when a U.S. company wishes to issue its shares to acquire a non-U.S., non-Canadian company, since many non-U.S. institutions are severely limited in their ability to hold shares of companies located outside their home country.
In the case of a combination of a U.S. company with a U.K. company, for example, if the U.S. company emerges as the survivor, U.K. institutions (pension funds, etc.) simply will not hold significant amounts of non-U.K. stock. Numerous attempts have been made to effect cross-border combinations that preserve both sets of shareholders, but, with the exception of some U.S.-Canadian combinations, few involving a U.S. company have been particularly successful. The recent Daimler-Benz-Chrysler combination seems to be another exception to past experience.
One structure designed to preserve both sets of shareholders in a cross-border combination is the dual listing approach. Probably the best known example of this structure is Royal Dutch Shell (the Royal Dutch/Shell merger occurred in 1903) in which two companies are separate legal entities trading on separate exchanges (in the case of Royal Dutch Shell, the LSE and the Amsterdam Stock Exchange), however, the companies and their shareholders share the economic results of the two companies. Unilever and Reed Elsevier are likewise dually listed in the UK and the Netherlands.
Dual Listing Structure
Combining two companies in two different countries using the dual listing structure is accomplished as follows:
- The companies enter into sharing agreements which define the relationship between them: a unified management structure, uniform dividends and capital distributions; each agrees to guarantee certain present and future obligations to each other; separate shareholder voting agreements regulate the manner in which special voting shares are exercised; and the parties enter into an agreement regarding the composition of the common board of directors.
- Amendments are made to both companies' articles of association and by-laws to permit the companies to operate as a single entity.
- Despite the companies' unified economic interest, the two companies continue to exist as separate legal entities domiciled in their respective countries and no change is required in legal or beneficial ownership of assets of either company.
In the case of Royal Dutch Shell, most of the subsidiaries are jointly owned by the two "parent" companies.
This structure has not been implemented with a U.S. company as a party for a variety of reasons, among which are that:
- the SEC will not permit this structure to be treated as a pooling of interests for accounting purposes and
- the operating arrangements between the two companies would likely be deemed by the Internal Revenue Service to be a partnership which could subject worldwide income to tax in the United States.
Subsidiary Holding Company
Another structure that combines two companies' operations, but leaves both legal entities and both sets of shareholders in place, is a "subsidiary holding company" structure. Assuming company A, a U.S. company, represents 40% of the combined value and company B, a U.K. company, represents 60% of the combined value, company A could contribute all of its assets to a newly formed "subsidiary holding company" ("Sub Holdco"), in return for 40% of the stock of Sub Holdco, and company B could contribute all of its assets in return for 60% of the stock of Sub Holdco. As a variation on the foregoing, multiple "subsidiary holding companies" can be used, each in a different jurisdiction, as needed, to achieve the optimal holding structure for the various local country operations. Assuming each "subsidiary holding company" is owned in the same ratio, differing values of contributed assets can be equalized with disproportionate assumptions of debt, or with preferred stock.
Smithkline Beckman Corp., a U.S. company ("Smithkline"), merged with Beecham Group PLC, a U.K. company ("Beecham"), in 1989 using a stapled share structure. The main objectives of using the stapled share structure was to preserve U.K. shareholder tax credits while reducing the tax consequences of the transaction to U.S. shareholders. Smithkline Beecham PLC, a U.K. publicly traded company ("SBPLC"), was incorporated for the purpose of effecting the merger. As a result of the merger, Smithkline and Beecham became subsidiaries of SBPLC and the shareholders of the companies each held approximately 50% of the equity in the new company. The former shareholders of Beecham received Class A ordinary shares in SBPLC which paid dividends and had voting rights. The former shareholders of Smithkline were entitled to receive a number of Class B ordinary shares in Smithkline Beecham, which had only voting rights, and preferred stock issued by Smithkline, which paid a dividend equal to that of the Class A shares.
The SBPLC Class B shares were stapled to the preferred shares issued by Smithkline and traded as one equity unit. The stapled shares were deposited at the Morgan Guaranty Trust Co. of NY and used as the guarantee for the issuance of ADRs that were traded on the NYSE.
Transactions such as Smithkline Beecham in which voting stock in a parent corporation is stapled to preference shares in a subsidiary are potentially subject to Internal Revenue Code §269B. That section provides that, in certain circumstances, if a domestic corporation and a foreign corporation are stapled entities, the foreign corporation will generally be treated as a domestic corporation for all purposes of the Code. Application of Code §269B can be quite detrimental; for example, because the parent/acquirer is treated as a domestic corporation, it generally will pay U.S. taxes on its worldwide income.
The stapling rules do not apply, however, if either
- 50% or less in value of the beneficial interests in either the target or the acquirer is stapled or
- 50% or more of both the domestic and the foreign entities are owned by foreign persons.
Thus, the stapling rule could be avoided if less than 50% of the shares in the acquirer (SBPLC) were stapled to target (Smithkline) preference stock. Because the acquirer shares that were stapled (the SBPLC B ordinary shares) had dividend rights that were inferior to the unstapled acquirer shares (the SBPLC A ordinary shares), the stapled acquirer shares represented less than 50% of the value of the acquirer, and the first exception to the stapling rules, enumerated above, applied. The stapled share structure also avoided U.K. taxation by diverting income directly to the shareholders and enabling it to bypass U.K. tax.
Although this structure had advantages for the Smithkline/Beecham combination, it was unwound in July 1996. Besides being very complicated, the structure depends on both nations' tax codes, which are constantly changing.
"Top Hat" Structure
In "merger of equals" cross-border transactions, the parties are often very interested in creating the appearance that neither party is acquiring the other. To that end, a structure that is sometimes suggested is the so-called "top hat" structure in which a new holding company is formed which conducts an exchange offer for the shares of both companies. The top hat company could be incorporated in a tax-advantaged country or in the same country as one of the companies. Because of the "double tax," without any credit for corporate taxes paid, on dividends of U.S. companies, in cross-border transactions, the top hat company is typically incorporated in a jurisdiction outside the United States, which affords more favorable tax treatment to dividends. As for governance, it is obviously easier to achieve balance when starting with a clean slate.
Issues Involved When a Foreign Company Acquires a U.S. Company
Issues If the Target Company Is a U.S. Public Company
In an acquisition by a foreign company of a U.S. public company for cash or stock the foreign company needs to comply with U.S. securities laws, including disclosure laws and tender offer rules, or, if the acquisition is effected through a merger requiring a shareholder vote, then the foreign company must comply with U.S. proxy rules and state corporate law.
If a bidder is tendering for equity securities in the U.S. and it is offering securities as consideration for the tender (an exchange offer), the bidder must comply with the U.S. Securities Act of 1933, as amended (the "Securities Act"), which requires that the distribution of securities in the U.S. be made pursuant to an effective registration statement or an exemption from registration. The foreign company will need to file a Form F-4 instead of the Form S-4 registration statement filed by a domestic acquirer.
Form F-4 requires disclosure of information about the transaction including the terms of the transactions, risk factors, financial information, and material contacts with the company being acquired. The filing company must furnish financial information about itself and the company being acquired. If the foreign company's ordinary shares or ADRs are not already registered in the U.S., then the registration of the foreign shares on Form F-4 will essentially be the commencement of an initial public offering, with the added challenge that all of the foreign company's financial data must be reconciled to, or restated in accordance with, U.S. GAAP.
The time-consuming nature of this process can put a foreign company at a significant timing disadvantage if the foreign company is competing with a public U.S. company to acquire the U.S. target.
Another feature of the Form F-4 is a section describing the differences in the rights of a shareholder in the U.S. target company, under its charter, by-laws and the appropriate state law, and the rights of a shareholder in the foreign acquiring company, pursuant to the foreign company's organic documents and the laws of that country.
Once a foreign company has registered its ordinary shares or ADRs pursuant to the Securities Act, the foreign company will be a reporting company under the U.S. Securities Exchange Act of 1934, as amended (the "Exchange Act"), and will be required to either prepare U.S. GAAP financial statements or prepare a U.S. GAAP reconciliation of its local financial statements and otherwise comply with S.E.C. reporting requirements on a continuing basis.
For non-U.S. acquirers that already have ordinary shares or American Depositary Shares (with shareholders holding American Depositary Receipts ("ADRs")) listed in the United States, the process is not as difficult. The U.S. stock exchanges only welcome trading in stocks denominated in U.S. dollars paying dividends in U.S. dollars. ADRs exist as a surrogate for foreign company ordinary shares (representing some number of ordinary shares on deposit with a trustee), but denominated in dollars rather than the local currency, and usually trade in a close relationship with the ordinary shares, subject to fluctuations in the exchange rate between the dollar and the local currency.
In recent years, ADRs have gained increased acceptance and their use has grown dramatically. At the end of 1998, there were approximately 445 non-U.S. companies listed on NASDAQ and approximately 368 non-U.S. companies listed on the NYSE, either as ordinary shares or as ADRs. In 1998 one out of every four new listings on the NYSE were by non-U.S. companies. According to Richard Grasso, Chairman and CEO of the New York Stock Exchange, by the end of 1999, the NYSE expects to have over 500 non-U.S. companies listed on the NYSE (from over 40 countries). Again, all of these companies report their financial results in accordance with U.S. GAAP or reconciled to U.S. GAAP.
Reasons for ADR Listing Popularity
In the last few years, the listing of foreign ordinary shares or ADRs in the U.S. has become increasingly popular for a number of reasons, including the following:
- foreign companies recognize that the U.S. market, as the largest equity market in the world, affords opportunities for efficient and sizeable capital raising transactions and
- as stock-for-stock acquisition transactions have blossomed, U.S. listed stock or ADRs are an excellent acquisition currency and the only effective currency for a tax-free business combination with a U.S. public company.
A number of Canadian, Bermudian and other North American companies list their ordinary shares (rather than ADRs) on a U.S. exchange - their shares are denominated in U.S. dollars. The Daimler-Benz - Chrysler merger represented a breakthrough in listing a German company's ordinary shares on the NYSE. The combined company's ordinary shares trade in the U.S. in dollars and on the Bourse in Frankfurt, Germany in Deutsche marks. In fact, the ordinary shares of DaimlerChrysler are now traded on nineteen markets around the world.
It is expected that the use of a world-wide single equity instrument by major global companies will proliferate. The NYSE is working on listing ordinary shares of the company to be created in the pending British Petroleum Co.-Amoco Corp. merger, and has a pilot program in the works for a dozen other companies. Richard Grasso has also predicted that the NYSE will become a multi-currency market. One of the many ramifications of these anticipated developments will be to make acquisitions by foreign companies using stock as consideration easier.
Obviously, a merger or acquisition in which a U.S. public company is being acquired and the shareholders of the target company will receive shares in the foreign company raises additional issues for the board of directors, management and their legal and investment banking advisors. Even if those foreign shares or ADRs will be registered in the U.S., the board and its advisers need to consider the volume of ordinary shares/ADRs that will be traded in the U.S. whether a significant market will develop, the trading dynamics of the foreign stock and whether the foreign shares or ADRs will be acceptable to the target company's major shareholders. All of these factors and others go into the analysis by the board of the consideration being offered by the foreign acquirer.
In November 1998, the U.S. Securities Exchange Commission (the "SEC") issued a Release proposing significant changes to existing SEC rules and regulations under both the Securities Act and the Exchange Act aimed at updating and simplifying the rules and regulations applicable to tender offers, mergers and acquisitions. [SEC Release No. 33-7607; 34-40633; IC-23520 (November 3, 1998) (the "M&A Release").]
The proposals were the SEC's response to the increased use of securities as consideration in business combinations and the advances in communications which have made frequent, timely and direct communication with security holders more likely than in the past. The M&A Release is subject to change after the comment process and will likely not become effective until the year 2000, if enacted. Any simplification of the rules and regulations governing business combinations can only serve to facilitate cross-border transactions.
While a stock-for-stock acquisition of a U.S. target by a U.S. acquirer can generally be structured as a tax-free reorganization, additional requirements apply for tax-free treatment where the acquirer is a foreign corporation, including the following:
- the U.S. shareholders of the U.S. target must receive no more than 50% of both the total voting power and the total value of the stock of the foreign acquirer;
- U.S. officers, directors and 5% or greater shareholders (by vote or value) of the U.S. target must own, in the aggregate, no more than 50% of each of the voting power and value of the foreign acquirer immediately after the transaction;
- the foreign acquirer must have been engaged in an active trade or business outside the U.S. for the entire 36-month period immediately preceding the transfer;
- at the time of the transfer, neither the U.S. target shareholders nor the foreign acquirer can have an intention to substantially dispose of or discontinue such trade or business; and
- the fair market value of the foreign acquirer must be at least equal to the fair market value of the U.S. target at the time of the transfer.
In addition, any U.S. target shareholder that owns 5% or more of the foreign acquirer measured by vote or value (including any ownership attributed to such shareholder) must enter into a 5-year gain recognition agreement. In general, the gain recognition agreement provides that if the foreign acquirer disposes of U.S. target stock or the U.S. target disposes of substantially all its assets within five years of the transaction, the 5% shareholder must file an amended return for the year of the transaction and report the gain realized but not recognized together with interest.
In the case of a purchase of a U.S. target corporation by a foreign acquirer, the foreign acquirer may wish to minimize the U.S. tax burden of the U.S. target following the acquisition. Often this will involve increasing the leverage in the U.S. target in order to generate U.S. interest deductions to offset income earned in the United States. To accomplish this, a foreign purchaser may borrow and capitalize a U.S. subsidiary (either existing or newly formed) with debt and use this company to acquire the U.S. target.
Alternatively, the U.S. acquiring subsidiary could borrow the funds directly from a third party by means of a loan guaranteed by the foreign parent corporation. Interest on the debt can then be deducted against the income of the U.S. target under the consolidated return rules.
A number of U.S. tax issues are raised by this technique, including the characterization of the loan as debt and not as equity, minimizing withholding tax on interest payments to the foreign parent (in the case of an intercompany loan), and limitations on the deductibility of interest (with respect to intercompany debt and debt guaranteed by a foreign parent).
In a taxable sale by a U.S. corporation of a foreign subsidiary, the primary tax issues that arise for the U.S. seller are the character of the gain or loss on the sale and the impact on the U.S. seller's ability to use foreign tax credits. While gain on the sale of subsidiary stock is generally treated as capital gain, in the case of the sale of a foreign subsidiary, the gain may be recharacterized in whole or in part as a dividend under provisions of the Internal Revenue Code that govern sales of controlled foreign corporations.
Given that there is currently no differential between ordinary and capital gain tax rates for corporations, dividend treatment can be beneficial to the U.S. seller because it may entitle the U.S. seller to claim foreign tax credits for taxes paid by the foreign subsidiary. Care must be taken in structuring such transactions because certain actions taken by the purchaser following the acquisition may affect the U.S. seller's foreign tax credits.
A U.S. seller of a foreign corporation may also be subject to foreign tax on the sale of a subsidiary in countries in which capital gains tax is imposed on the sale of a corporation formed in the jurisdiction. Many tax treaties override this capital gains tax; in other jurisdictions it may be possible to use an alternative acquisition structure, such as first transferring the foreign target corporation into a holding company formed in a different jurisdiction and then selling that holding company.
In situations in which a U.S. target corporation with foreign subsidiaries is acquired by a foreign acquirer, it may be desirable for the foreign acquirer to restructure its international operations following an acquisition. Having a U.S. corporation in a chain between two foreign corporations may give rise to additional U.S. tax. The U.S. and foreign tax consequences of post-acquisition restructuring should be carefully considered because adverse U.S. tax consequences may result from transferring the foreign subsidiaries from the U.S. target, or from spinoffs and other intercompany distributions.
Structuring a transaction in a manner which will allow it to be accounted for under U.S. GAAP as a pooling of interests can be more complicated in a cross-border transaction. The recent Teleglobe (Canadian Co.) stock-for-stock merger with Excel (U.S. Co.), was accounted for as a pooling of interests under U.S. GAAP, but because the original Teleglobe shareholders ended up owning over 50% of the combined company, the merger was required to be treated as a purchase under Canadian GAAP.
As reported by Elizabeth MacDonald in the Wall Street Journal on December 16, 1998, the Financial Accounting Standards Board released a report from "G4 + 1," a delegation of accounting rule makers from the U.S., the U.K., Canada, Australia and New Zealand, saying that purchase accounting should be the only business-combination method used worldwide and pooling of interests treatment should be eliminated. [Elizabeth MacDonald, FASB Moves to Buttress Its Opposition to Use of Pooling of Interests in Mergers , Wall St. J., Dec. 16, 1998, at B8.]
The International Accounting Standards Committee, a London group overseeing international accounting rules, has passed rules that limit pooling of interests treatment to mergers of equals only. The FASB is expected to take the same approach in June. FASB apparently believes that there should be a more consistent approach throughout the world.
Purchase accounting, the prevailing approach among industrialized countries outside the United States, requires acquirers to record the acquired assets on their books at fair market value and to write off goodwill (the amount paid above fair value of assets) over time, taking charges against earnings each year.
Pooling of interests allows companies to combine their book value, without creating goodwill, and, therefore, without creating an additional accounting deduction to each year's earnings. The Daimler-Benz/Chrysler merger used pooling of interests. The FASB has also proposed to cut the length of time a combined company can write off goodwill to a maximum of 20 years, from the present 40 years.
As has been widely reported, the SEC has been extremely rigorous in its examination of pooling of interests transactions, denying pooling in a number of transactions in which the combined companies engaged in subsequent stock buybacks. In connection with the Daimler-Benz/Chrysler merger, Chrysler reissued shares it had bought back in order to gain pooling treatment.
As Robert Willens described in his article "Shifting the Goodwill Hit in Acquisitions by U.K. Firms ," in Mergers & Acquisitions July/August 1998, in some countries, including the United Kingdom, purchased goodwill did not penalize earnings because goodwill was charged against shareholders' equity. Thus, the book value of the company would be reduced but there was no reduction in annual earnings. Now, for periods ending after December 22, 1998, under FRS 10 there is a "refutable presumption" that goodwill and related intangible assets have a useful life of not more than 20 years and the portion of the purchase price allocated to such assets must be amortized over such useful life.
If the company can demonstrate that the assets have an indefinite useful life, the presumption can be rebutted and the purchase price allocated to the assets does not need to be amortized. [Robert Willens, Shifting the Goodwill Hit in Acquisitions by U.K. Firms, Mergers and Acquisitions J., Aug. 1, 1998, at 48.]
Business combinations involving a U.S. company and a foreign partner are subject to both U.S. and foreign anticompetition laws. Under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, if a foreign company purchases more than 15% of a significantly-sized U.S. company, it must file reports with the U.S. Federal Trade Commission and the Department of Justice, and observe a waiting period before consummating the transaction. [Pub. L. No. 94-435, tit. II, § 201, 90 Stat. 1390 (codified as amended at 15 U.S.C. § 18 (Supp. 1994)).] Much has been written recently regarding the Clinton Administration's more vigorous antitrust enforcement activities. In fact, in 1998 federal officials filed a record number of challenges to mergers and other anticompetitive practices and collected record amounts in civil fines and other penalties. [Stephen Labaton, Merger Wave Spurs a New Scrutiny, N.Y. Times, Dec. 13, 1998, at 38.]
One particularly nettlesome social issue in cross-border transactions is compensation of senior executives. Compensation levels for senior U.S. executives (including current and deferred compensation, stock options and severance arrangements) frequently far exceed that of senior executives of similarly sized companies outside the U.S. Foreign acquirers sometimes have difficulty reconciling U.S. compensation arrangements with non-U.S. compensation arrangements.
Moreover, if the cross-border transaction results in the U.S. stock ceasing to exist, the prospect of stock options in the foreign acquirer's stock, traded on a foreign exchange that might not place the same value on growth, may appear less attractive to the U.S. company's senior management. As a result, in order to assure U.S. senior management that they will be compensated in a manner that is similar to other U.S. companies, foreign acquirers of U.S. companies sometimes find it appropriate to enter into employment contracts with key U.S. management employees or to offer an attractive retention bonus program, payable if the target officers/employees stay with the combined company for the requisite period.
As a matter of diligence, the foreign acquirer should attempt to understand the liabilities that may exist in the target company's employee benefits program. Examples include: underfunding of defined benefit pension plans; unfunded nonqualified pension and deferred compensation plans; and severance, retention and change of control agreements and plans.
Know the Terms
It is also important to understand the specific terms of all of the target company's
- employee benefit plans,
- stock option, compensation and bonus plans, and
- employment agreements;
- the existence of any collective bargaining agreement obligations;
- the target's compliance with applicable benefit laws (e.g., prohibited transaction requirements and COBRA continuation coverage requirements);
- and the target's treatment of its benefit obligations in its financial statements.
Various representations, covenants and indemnifications may then be negotiated for inclusion in the acquisition agreement, identifying each party's responsibilities following the closing.
The United States has a more rigorous environmental regulatory scheme than most other countries. On a national level, there is the Environmental Protection Agency and Superfund which are dedicated to environmental clean-up, and a number of states have their own environmental funds. Environmental liabilities are statutory and follow the company and its successors. If the U.S. company being acquired is private, an indemnity is frequently sought. If the U.S. target company is public, the potential exposure is simply a risk that needs to be assessed.
Foreign acquirers like to believe that once a deal is signed, it is done. They find the notion of "topping" and the so-called "fiduciary out" - the ability of the board of directors of the target company to accept another offer if its fiduciary duties so require - extremely unappealing. Foreign acquirers of U.S. companies resist provisions entitling the board of directors of the target company to exercise its "fiduciary out" for a "superior proposal," even though in "non-strategic" acquisitions of public companies, such provisions are required by state corporate laws. Foreign acquirers will typically want the "outs" to be as tight as legally permissible and the break-up fees or penalties to be as large as legally permissible.
U.S. and foreign regulatory laws may apply to foreign company acquisitions of U.S. companies, especially in transactions involving companies that conduct business in heavily regulated industries such as telecommunications, media, defense, insurance, banking, utilities and airlines.
The FCC promulgates rules limiting foreign ownership through the U.S. Communications Act of 1934 which prohibits a company with more than 25% foreign ownership from holding a common carrier or broadcast radio license, if the public interest will be served by a refusal or revocation of such license. If a proposed acquisition will result in the transfer of control of a broadcast license, approval of the FCC is required. As a practical matter, the FCC limitation on foreign ownership of a license in some areas of the industry has been relaxed or eliminated. For example, in cross-border acquisitions affecting the telecommunications industry, the FCC's primary concern appears to be establishing that there is or will be reciprocal liberal treatment of foreign acquirers in the acquiring company's home jurisdiction.
Obviously, regulatory approval is usually a condition to closing for both companies in a business combination. In public company combinations, both companies, and particularly the target, are eager that there be as few impediments as possible to closing once a public announcement has been made regarding the transaction. Further, in a cross-border transaction, parties sometimes believe that the companies have some influence over the regulatory outcomes in their respective home countries. As a result, parties to a cross-border combination of public companies are sometimes willing to agree that the regulatory condition to closing shall be considered satisfied so long as no "burdensome conditions" are imposed by the regulatory authorities. Some merger agreements further require the parties to litigate or take appropriate action against the authority imposing the burdensome condition.
Department of Defense
The Department of Defense has certain rules limiting foreign ownership of companies important to U.S. defense matters and has adopted guidelines for granting security clearances to defense contractors acquired or controlled by foreign investors. Under the Defense Industrial Security Regulations, contractors who need access to classified information must be "organized . . . under the laws of the U.S. or Puerto Rico" and must not "be under foreign ownership, control or influence (FOCI)." [Department of Defense, Industrial Security Regulation, Directive 5220.22-R, 2-201(a) (Jan. 1983).]
The determination of FOCI is based on evidence indicating foreign control or influence over the contractor and/or foreign access to sensitive information, foreign ownership of the contractor's securities, including foreign management, foreign debt, foreign revenues or interlocking directors with foreign interests.[Id. at 2-202.] Existing defense contractors who are deemed subject to FOCI are given the opportunity to keep their defense contacts by restructuring the company to eliminate foreign owners or creditors or by adopting a plan that prevents associated foreign parties from gaining access to classified information.
If a FOCI contractor is unable to restructure or adequately protect classified information, the Department of Defense can make an exception to the bar against such contractors, however, these exceptions are usually based on treaty agreements with the foreign investor's home nation, which is an added complication to the merger process.
Another option for a foreign acquisition of a U.S. company in a sensitive industry such as defense, communications, or banking, is the utilization of a "blind trust" for a portion or all of a company's business. Under the blind trust approach, the foreign acquirer has economic ownership over the U.S. company or assets; however, the foreign acquirer receives no information about and has no control over the operations of the company/assets in the sensitive area. Hence, the foreign acquirer "blindly" owns the company or the sensitive assets. If this type of investment is acceptable to a foreign acquirer, it provides a viable option for cross-border acquisitions in certain sensitive industries in the United States.
The Exon-Florio provisions contained in the National Defense Authorization Act empower the President of the United States to suspend or prohibit the acquisition of a U.S. business by a foreign investor if the President finds that the foreign investor might impair the national security and existing laws are not adequate to protect national security. [50 U.S.C. § 2158 et seq. (1982).] The Committee on Foreign Investment in the United States (CFIUS) implements the Exon-Florio provision and sends a report and recommendation to the President. Companies which may be affected by the Exon-Florio provision should give notice to CFIUS prior to completion of the proposed cross-border transaction so that if CFIUS finds that the transaction implicates national security concerns, it can be rearranged to avoid a transfer of control over assets deemed important to national security, thereby helping to prevent the possibility of having the transaction blocked or unwound.
Copyright© 1999. All rights reserved. Mr. Ruegger is a partner at Simpson Thacher & Bartlett. Portions of this article have been, or may be, used in other materials published by the author or his colleagues. Mr. Ruegger wishes to thank his colleagues Ken Logan, Alan Klein, John Lobrano, Brian Stadler, Steve Todrys, Jeff Rothschild, Stacey Nahrwold, Caroline Gottschalk, Janet Andolina, Harold Dichter and Dorothy Whyte for their help with this article.