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Despite running into a potential deal-breaker, Folgers parent Proctor & Gamble successfully uses a reverse Morris Trust transaction in its latest pact with Smucker.
Robert Willens, CFO.com | US
October 6, 2008
Procter & Gamble (P&G) and J.M. Smucker Co. will be using (for the second time in the past six years) a "reverse Morris Trust" transaction. In this case, the stock of Folgers will be distributed by P&G to its shareholders in exchange for a portion of their P&G stock. The exchange ratio is expected to include a premium to induce P&G shareholders to tender their P&G shares.1
Immediately after the distribution is completed, and as part of the overall plan, a subsidiary of Smuckers will be merged with and into Folgers. In the merger, the former shareholders of Folgers will exchange their Folgers stock for voting common stock in Smucker. At that point, Folgers will become a wholly-owned subsidiary of Smucker.
The shareholders of Folgers who exchange their stock for Smucker shares will emerge with some 53 percent of the voting power and value of Smucker outstanding stock. Accordingly, the shareholders of Smucker will see their interest in that company fall from 100 percent to approximately 47 percent.
This division of ownership is necessary to insure that the distribution by P&G of Folgers's stock will be tax-free to P&G. Under Section 355(e) — the so-called "anti-Morris Trust" rule — a distribution is taxable at the distributing corporation level if the distribution is part of a plan (or series of related transactions) in which the following is true: One or more persons acquire stock representing a 50 percent or greater interest in either the distributing corporation (P&G), the controlled corporation (Folgers), or any successor company (Smucker).
Here, because the Folgers shareholders will be acquiring a majority of the stock of Folgers's successor (Smucker), there will be no acquisition by one or more persons (the former shareholders of Smucker) of an amount of stock sufficient to cause the transaction to run afoul of the anti-Morris Trust rule. In fact, the deal would not have been proposed had P&G not been confident that its distribution would not be ensnared by the anti-Morris Trust rule.
Surrendering voting rightsTo insure that the present shareholders of Smucker are not unduly deprived of voting privileges, the stock to be issued in the merger embodies an unusual feature. That is, each share to be issued (by Smucker to the former shareholders of Folgers) will entitle the holder to 10 votes per share on each of several matters enumerated in Smucker's charter and by-laws. These matters pertain to major corporate transactions, such as liquidations, mergers, etc. Each such share is entitled to only one vote with respect to the election of Smucker's board of directors.
However, upon a change in beneficial ownership of such shares, the holder is entitled to one vote with respect to the enumerated matters until the holder has held the share for four additional years. Therefore, because some amount of the Smucker stock to be issued in the merger will be given to "short-term holders" (such hedge funds) — who will dispose of the stock with alacrity — it may be that the former shareholders of Smucker will wind up with a majority of the voting rights with respect to the enumerated matters, once the Smucker stock is "fully distributed." Does this likelihood impact the application of the anti-Morris Trust rule?
The regulations state that an acquisition of the stock of the distributing or controlled corporation that is listed on an "established market" is not part of a plan (or series of related transactions) which includes the distribution as long as neither the transferor nor transferee of such stock falls within certain specified categories. (See Regulation Section 1.355-7(d)(7)(i).) Thus, here, since the transferors and transferees of the Smucker stock will not fall within any of those categories, the post-merger acquisitions of Smucker stock (by the parties to whom the short-term holders convey their stock) should not be taken into account in determining whether the anti-Morris Trust rule has been breached.
However, the regulations go on to say that if a transfer of stock to which this otherwise "safe harbor" applies results in an indirect acquisition of voting power by a person other than the transferee of such stock, the safe harbor does not prevent an acquisition of stock by such other person (with the voting power such stock represents after the transfer) from being part of a plan. (See Regulation Section 1.355-7(d)(7)(ii)(B) and Regulation Section 1.355-7(j), Example 5.)
Therefore, consider that the transfer of the Smucker stock issued in the merger causes the voting power of Smucker to shift to the former shareholders. Such a shift in voting power will be treated as attributable to the stock acquired by the former Smucker shareholders (in Folgers's successor) as part of a plan that includes the distribution by P&G of Folgers. That outcome would render Section 355(e) applicable and, undoubtedly, cause the deal to be unceremoniously abandoned.
Voting powerNevertheless, P&G's counsel was able to render an opinion so the transaction does not trigger the provisions of Section 355(e), despite the shift in voting rights caused by the prompt disposal of Smucker stock issued in the merger. This is so because the post-merger transfers of Smucker stock — which would otherwise be eligible for the benefits of the safe harbor — will not result in an indirect acquisition of voting power by a person other than the transferee of such stock.
For tax purposes, voting power means the power to participate in the election of the entity's board of directors. In short, participation in management through the election of directors is the sole criterion of voting power. (See Revenue Ruling 69-126, 1969-1 C.B. 218.) In this case, each share of Smucker carries with it one vote with respect to the election of directors. Moreover, this is true regardless of how long the holder has owned the stock.
Transfers of Smucker's stock in connection with the merger will produce an indirect acquisition of voting rights (with respect to the enumerated matters) by a person other than the transferee of such stock. However, that outcome is not barred by Section 355(e). Instead, that section focuses solely on ownership of stock possessing voting power.
As a result, the shift in voting rights that will occur when short-term holders of Smucker's stock promptly sell the stock will have no impact on the transaction's claim to exemption from the anti-Morris Trust rules. Indeed, the stock will be sold to holders whose voting privileges will be impaired for four years. Thus, it appears that no tax impediment should exist with respect to the scheduled completion of this innovative deal.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
1If all of the shares of Folgers held by P&G are not ᰬ notwithstanding the inducement — subscribed for, the balance of the Folger's shares held by P&G will be distributed, as promptly as practicable, to the remaining holders of P&G shares.