I. Consolidation of Special Purpose Entities
A. FACTORS TO CONSIDER IN DETERMINING SPONSOR OF SPE (RAGONE, 2000)
The staff has received several inquiries relating to the consolidation of special-purpose entities ("SPEs"). As I discussed at this conference last year, when analyzing these transactions, the staff looks to the guidance contained in EITF Issue 90-15, Impact of Nonsubstantive Lessors, Residual Value Guarantees, and Other Provisions in Leasing Transactions, EITF Topic D-14, Transactions involving Special-Purpose Entities, and EITF Issue 96-21, Implementation Issues in Accounting for Leasing Transactions involving Special-Purpose Entities. The guidance in these EITF Issues discusses when a sponsor or transferor should consolidate an SPE. In many SPE transactions, there are several parties involved, and it may not be clear which party is the sponsor. Recently, the staff was asked for its views on how a registrant should determine who is the sponsor of an SPE.
The staff believes that registrants should not apply any one specific factor to determine the sponsor of an SPE, and believes that all of the facts and circumstances of each transaction should be considered carefully. In this regard, the staff believes registrants should consider the following qualitative and quantitative factors in evaluating who the sponsor is of an SPE:
- Purpose. What is the business purpose of the SPE? Name. What is the name of the SPE?
- Name. What is the name of the SPE?
- Nature. What are the types of operations being performed (for example, lending or financing operations, asset management, and insurance or reinsurance operations)?
- Referral Rights. Who has, and what is the nature of, the relationships with third parties that transfer assets to or from the SPE?
- Asset Acquisition. Who has the ability to control whether or not asset acquisitions are from the open market or from specific entities?
- Continuing Involvement. Who is providing the services necessary for the entity to perform the nature of its operations, and who has the ability to change the service provider (for example, asset management services, liquidity facilities, trust services, financing arrangements)?
- Placement of Debt Obligations. Who is the primary arranger of the debt placement, and who performs supporting roles associated with debt placement?
- Residual Economics. Who receives the residual economics of the SPE including all fee arrangements?
- Fee Arrangements. Who receives fees for asset management, debt placement, trustee services, referral services, and liquidity/credit enhancement services? How are the fee arrangements structured?
- Credit Facilities. Who holds the subordinated interests in the SPE?
In summary, the determination of who the sponsor is in SPE transactions requires one to exercise sound professional judgment. The qualitative and quantitative factors discussed above are not intended to be all-inclusive. In analyzing these transactions, registrants should consider and weigh all the factors noted above, among other items particular to the arrangement, before concluding on any given set of facts and circumstances.
B. IMPACT OF TOTAL RETURN SWAPS (PIMENTEL, 1997)
When determining the appropriate accounting for the transfer of financial assets to a special purpose entity, it is important to focus on the potential for consolidation of the SPE to which those assets are transferred. Simply meeting the conditions for sale accounting in FASB 125 is not sufficient to guarantee that those assets and the related SPE financing will be off balance sheet. Prior to the effective date of FASB 125, the literature which provided the guidance for determining whether consolidation of the SPE was appropriate was contained in Topic D- 14 of the EITF Abstracts and EITF Issue 90-15. Topic D-14 is essentially an SEC staff announcement which was developed over several EITF meetings. Subsequent to the issuance of FASB 125, the EITF has discussed Issues 96-20 and 97-6, which provide further consolidation guidance for "qualifying" SPEs as that term is defined in FASB 125. As such, current consolidation guidance is different depending on whether or not an SPE is "qualifying".
Recently, we addressed a transaction where the SPE and the transferor in a securitization transaction entered into similar derivative transactions which, on the whole, placed the transferor essentially in the same position after the transfer as they were prior to the transfer. The transferor believed that they had met the conditions for nonconsolidation of SPEs in Topic D-14 and Issue 90-15. In summary, the transaction was structured as follows.
A transferor transfers equity securities to an SPE. Concurrent with the transfer, the SPE issues debt and equity beneficial interests equal to 97% and 3%, respectively, of the purchase price of the equity securities. The SPE is permitted to sell those equity securities in the future. Because of this specific criteria, this SPE did not qualify as a "qualifying" SPE for purposes of applying FASB 125 — I will talk more about qualifying SPEs a little later. At the date of the transfer the SPE enters into a total return swap with an investment banker which provides for the SPE to receive a floating rate of interest on a notional amount. The notional amount is equal to the initial purchase amount of the equity securities by the SPE. In return for receiving the floating return, the SPE will pay the investment banker the total return from the equity securities. At the same time that the SPE and the investment banker enter into this transaction, the transferor enters into a similar total return swap with the same investment banker. The second total return swap provides for the transferor to pay the investment banker a floating rate of interest based on the same notional amount, and in return the transferor receives payments equal to the total return on the equity securities.
Topic D-14 states in part: Generally, ... the SEC staff believes that nonconsolidation and sales recognition are not appropriate by the sponsor or transferor when: the majority owner of the SPE makes only a nominal capital investment, the activities of the SPE are virtually all on the sponsor's or transferor's behalf, and the substantive risks and rewards of the assets or the debt of the SPE rest directly or indirectly with the sponsor or transferor.
Although the staff believed that an independent party had made more than a nominal capital investment to the SPE, the staff also believed that the facts in this instance confirmed that the transferor had retained all of the substantive risks and rewards of the assets transferred to the SPE. In other words, if the equity securities paid dividends or appreciated in price, the transferor indirectly received those benefits through the total return swap transaction. Similarly, the transferor retained the market risk of the equity securities if they declined in price. The staff, therefore, concluded that the SPE should be consolidated in this instance.
C. APPLICABILITY OF ARB 51 AND STATEMENT 94 TO SPEs (RAGONE, 1999)
The second issue also relates to the consolidation of an SPE that is not a "qualifying" SPE for purposes of applying Statement 125. In this instance, a registrant inquired of the staff about the applicability of ARB 51 and Statement 94 to SPEs. In summary, the transaction proposed by the registrant would be structured as follows:
Company A (the registrant) transferred financial assets to an SPE. Concurrent with the transfer, the SPE issued beneficial interests in the form of debt and equity securities. The equity securities are equal to 20% of the fair value of the original transferred assets and have all the voting rights. Company A retained 80% of the equity securities; the remaining 20% were purchased by an independent third party (Company B).
Company A asserted that they would not be required to consolidate the SPE because they had satisfied all the applicable requirements of Topic D-14 and EITF 90-15. In particular, they pointed to the existence of an independent substantive equity capital investment in excess of the minimum 3% required by EITF 90-15.1
The staff advised Company A that the consolidation analysis would have to consider the guidance set forth in ARB 51 and Statement 94. That guidance states as follows: "The usual condition for a controlling financial interest is ownership of a majority voting interest, and, therefore, as a general rule ownership by one company, directly or indirectly, of over fifty percent of the outstanding voting shares of another company is a condition pointing toward consolidation."2In this transaction, there are no significant participating rights as specified in EITF 96-16.3As a consequence, Company A controlled the majority of the equity and voting rights. The staff therefore advised Company A to consolidate the SPE.
II. Business Combination Issues — Other than Pooling
A. COMMON CONTROL TRANSACTIONS (COALLIER, 1997)
Another frequent question in registrant submissions over the last year is: How to account for combinations of, or transfers or exchanges between, entities with a high degree of common ownership? Specifically, the staff is asked to concur that these transactions should be accounted for at historical cost. In assessing whether to account for these transactions at historical cost or fair value, two questions are relevant:
Are the entities under common control as described in AIN 394and does the transfer lack substance as described in FTB 85-5?5
When there is a transfer or an exchange between companies under common control, AIN 39 states that "assets and liabilities so transferred would be accounted for at historical cost in a manner similar to that in pooling-of-interests accounting".6Registrants have asserted that common control exists between different companies when there is common majority ownership by an individual, a family, or a group affiliated in some other way.
Common control between different companies often exists when one shareholder holds more than 50% of the voting ownership of each company. Common control may also exist when a group of shareholders holds more than 50% of the voting ownership of each company, and all members of the group agree to vote those shares in concert.
The staff generally does not object to assertions that immediate family members vote their shares in concert absent evidence contradicting those assertions. The staff believes immediate family members include a married couple and their children, but not the married couple's grandchildren. Businesses owned in varying combinations by a married couple and their children or among living siblings and their children may be viewed by the staff to be under common control.
However, the staff has objected to assertions that different companies owned by individuals that are not members of an immediate family are under common control unless there is contemporaneous written evidence of an agreement to vote a majority of an entity's shares in concert. The staff has not accepted oral agreements as evidence of common control outside of an immediate family. Nor has the staff accepted new agreements as evidence that the companies were operated under common control in the past.
B. JOINT VENTURES — GAIN RECOGNITION UPON FORMATION (BOOK, 1993)
Another aspect of accounting by the investor involves the propriety of gain recognition upon the contribution of assets to a joint venture. The staff's position has been, and continues to be, that contributing assets to a joint venture is not the culmination of the earnings process — it is an exchange of a portion of operating assets for a 50% interest in a larger pool of operating assets. The staff has modified its position when cash is received for the contribution of assets, and certain other conditions are met. This is similar to the guidance provided in SOP 78-9, Accounting for Investments in Real Estate Ventures. Sometimes, cash is paid to balance the fair market values of the contributed assets.
For example, Company A contributes a business with a book value of $30 and a fair value of $100. Company B contributes a business with a book value of $20 and a fair value of $70, plus cash of $30. The joint venture then pays the $30 to Company A. The staff would not object to recognition of up to 50% of the indicated gain by Company A, limited to the amount of cash received. (Thus the calculated $35 gain would be limited to $30).
This assumes that Company A has no obligation to refund the cash to the joint venture or to Company B. The staff has also allowed gain recognition to the extent that other near-cash, monetary assets or traded, marketable securities are part of the settlement.
C. LBO — DEFINITION OF "HIGHLY LEVERAGED" IN THE CONTEXT OF EITF 88-16 (SEC STAFF, 1992)
One of the criteria for the application of EITF 88-16, "Basis in Leveraged Buyout Transactions", to a purchase transaction is that the acquisition be highly leveraged. The SEC staff believes that a 60 percent or greater debt financed transaction would meet the highly leveraged test. If the transaction is 50 percent or more debt financed it is probably highly leveraged. Acquisitions involving leverage of significantly less than 50 percent would not meet the criteria for following EITF Issue 88-16 accounting.
D. PUSH DOWN ACCOUNTING WHERE PUBLIC DEBT IS NOT SIGNIFICANT (CASEY, 1999)
In a recent registrant matter, a parent entity proposed buying out the minority interest in its majority owned subsidiary. The subsidiary had convertible debt outstanding that traded on a foreign exchange. The question posed to the staff was whether the parent, after buying out the minority interest, was required to push its basis down to the subsidiary's financial statements for purposes of any separate issuance of the subsidiary's financial statements. The parent intended to effect an IPO of the subsidiary shortly after the minority interest buyout.
The interpretive response to Question 2 in SAB 547states, "The staff recognizes that the existence of outstanding public debt, preferred stock, or a significant minority interest in a subsidiary might impact the parent's ability to control the form of ownership. Although encouraging its use, the staff generally does not insist on the application of push down accounting in these circumstances"
The registrant argued that SAB 54 refers to significance only in the context of minority interest, not public debt, indicating that push down accounting is not required where any public debt is outstanding at the subsidiary level. Because its subsidiary had convertible public debt outstanding, the registrant believed that it was not required to push its basis down to the subsidiary's stand alone financial statements that would be filed with the subsequent planned public offering of subsidiary shares.
The staff objected to the registrant's conclusions.
The staff believes that fair value information may generally be more relevant or meaningful to financial statement users than historical cost information. Furthermore, the staff believes that SAB 54 recognizes that as the population of investors or users of financial statements decreases and the majority investor's ability to control the subsidiary's form of ownership increases, fair value information prevails over continuity of the subsidiary's historical cost financial information. So, while SAB 54 does not explicitly refer to significance of public debt, the staff believes that it is reasonable and consistent with the general principles in SAB 54 to consider the significance of public debt in assessing the applicability of push down accounting. To do otherwise would also appear to establish a different threshold for investors in public debt than for minority interest holders without an obvious conceptual basis for creating such a distinction.
In evaluating the significance of public debt, the staff believes that it is reasonable and appropriate to consider both the quantitative and qualitative significance of the public debt. In this specific registrant's fact pattern, the staff concluded that the public debt was neither quantitatively nor qualitatively significant. Quantitatively, the debt amounted to approximately 5 percent of the subsidiary's net book value and less than 1 percent of the subsidiary's fair value. The debt holders, in the aggregate, would hold an approximately 1 percent interest in the subsidiary on an as-if-converted basis. Qualitatively, the debt holders had virtually no ability to control or influence the form of the parent's ownership of its subsidiary, nor did the debtholders have any consent rights regarding the buying out of the existing minority interests, issuing subsidiary equity, or the subsidiary paying dividends.
Because the outstanding public debt was neither quantitatively nor qualitatively significant, the staff believes the parent is required to apply pushdown accounting.
1. Reverse Spin-Off Accounting (Blackley, 2000)
The staff has received questions about whether a spin-off must be accounted for in accordance with the legal form or if it may be accounted for in accordance with its substance, often referred to as a "reverse spin-off." Let me provide an example; assume Oldco distributed the stock of a subsidiary, ABC Company, to its shareholders. As part of a planned transaction, immediately following the spin-off, Oldco is acquired by another entity. The intent of the series of transactions is for Oldco to dispose of all of its operations except ABC Company.
In my example, assume that ABC Company was larger than the post spin-off Oldco based on estimated fair value, total historical assets and net assets, revenue and net income. On that basis, some believe that the accounting for the transaction should be that of a reverse spin-off that does not follow the legal form, instead reflecting the substance of the transaction. In a reverse spinoff, the financial statements of each entity are presented as if the legal spinee, ABC Company, had spun-off the legal spinnor, Oldco.
Some accountants believe that from the perspective of the shareholders of ABC Company, the transaction was the sale of all of the Oldco operations other than ABC Company and the continuation of ABC Company's operations. Frequently in these types of transactions, the legal form of the spin-off is based on tax consequences and has little to do with the substance of the transaction. In my example, had Oldco sold all of its operations except ABC Company and then distributed the resulting cash or equity proceeds as a dividend to shareholders, the sale would have been taxable to Oldco and the dividend would have been taxable to the shareholders.
The staff believes that reverse spin-off accounting is permitted only when it is the most relevant presentation and clearly is a faithful representation of the transaction. Accordingly, evaluating when reverse spin-off accounting is appropriate requires the use of sound professional judgment and consideration of whether shareholders are best served by a presentation that differs from the legal form. The staff has considered the following indicators of when reverse spin-off accounting is appropriate:
- Which company retained the executive management and officers of the formerly combined enterprise?
- Is the entity to be treated as the continuing enterprise for accounting purposes larger than the entity being spun-off? All relevant factors should be considered in measuring relative size such as revenue, operating earnings and net income as well as both book value and fair value of total and net assets.
- Did tax-planning consequences have a significant impact on the legal form?
In regards to the presentation of a reverse spin-off, the staff has also considered if the sale of Oldco must be presented as a distribution of the legal spinnor to the shareholders. Some have asked if the transaction may be presented as the sale of the legal spinnor followed by a distribution of the proceeds, resulting in the recognition of a gain or loss on disposal. This question arises since Oldco was sold immediately following the spin-off of ABC Company.
The staff believes the provisions of APB 298indicate that the spin-off transaction should be reflected as a distribution of Oldco, recorded at net book value. In addition, APB 29 requires that prior to the spin-off the net book value of Oldco must be reduced for impairment, when indicated.
In the example of Oldco and ABC Company, the staff observes that neither company would receive the proceeds from the sale of Oldco. Rather, in the example the proceeds from the sale of Oldco would go directly to the shareholders. In addition, had the company received the proceeds, an additional tax liability would have been incurred. These substantive factors indicate that reflecting the distribution of Oldco at net book reflects the substance of the transaction.
2. Leveraged Recapitalization of a Division (Casey, 1998)
The staff recently considered a transaction where a parent and a new financial investor entered into a planned series of integrated transactions in order to transfer control of a division. The staff concluded that the transactions could notbe separated but rather should be viewed as a single transaction.
As background assume a Parent wanted to dispose of a division within one of its wholly owned subsidiaries. In order to accomplish this, Parent and financial investor negotiated the following series of transactions. First, Parent formed Newco, a wholly owned subsidiary, immediately transferring the net assets and business operations of the division to it. Second, Newco issued shares to a financial investor and incurred debt. Third, using the proceeds from the sale of shares and the debt, Newco repurchased Parent's shares in Newco. Upon completion of the transactions Parent's ownership interest in Newco was diluted down to 6%, with the financial investor owning the remaining 94%.
The formation of surviving Newco and the transfer of net assets and business operations of the division into surviving Newco were integral conditions of the transaction. The steps were necessary in order to accommodate investment by new investors and facilitate the financing and collateralization of the debt incurred in the recapitalization. The issue presented to the staff was whether the planned subsequent steps, which resulted in a change in control of Newco, should result in a change in basis of the net assets of Newco at the Newco level. The registrant analogized to EITF Issue 94-29and SAB 4710in arguing that the change in control should not result in a new basis of accounting at the Newco level.
The staff objected to this conclusion. In the staff s view, this was an integrated, planned series of transactions negotiated by the parent and a new financial investor or collaborative group in conjunction with transferring control of the division to the new investor or collaborative group. That is, the parent participated with a known counterparty to establish the structure and order of transactions so as to facilitate the transfer of control of the business to the counterparty. Therefore, in the facts and circumstances presented, the two steps (transferring assets and obtaining control) could not be separated. The staff believed that they should be viewed as a single transaction.
Furthermore, if this integrated, planned series of transactions had been structured such that the financial investor had formed the surviving Newco, this transaction would have been within the scope of EITF Issue 88-1611and partial step up at the Newco level would have been required. The staff did not believe the negotiated form of the transaction between parent and financial investor should yield a different accounting conclusion. The staff therefore concluded that the basis of the division's net assets transferred to Newco should be recorded at fair value as specified by EITF Issue 88-16.
III. Business Combination Issues — Pooling-of-Interests
A. ATTRIBUTES OF COMBINING ENTERPRISES — AUTONOMY CONDITION
1. Personal Holding Company (Smith, 1997)
Frequently, the staff is asked questions about how personal holding companies affect pooling-of-interests accounting. Paragraph 46(a) of Opinion 16 requires that each of the combining companies be autonomous and not have been a subsidiary or division of another corporation within the two-year period before a plan of combination is initiated in order for the combination to be accounted for as a pooling of interests. AIN-APBl6 28, "Pooling By Subsidiary of Personal Holding Company," allows an exception to a technical violation of paragraph 46(a) when the "parent" is a personal holding company established for federal income tax reasons and the "subsidiaries" are in fact operated by the owners as if the personal holding company did not exist. The interpretation does note, however, that in many cases a parent-subsidiary relationship does in fact exist ant should be considered as such in applying paragraph 46(a) if the personal holding company or any of its subsidiaries is involved in a business combination. The staff is often asked if and when an analogy can be made to this narrow interpretation in situations other than personal holding companies.
To determine whether a parent entity is similar to a personal holding company and meets the assertion that the entity is not substantive, the staff looks to all aspects of the holding company-investment relationship to determine whether it has substance beyond a mere tax convenience. In past inquiries, the staff has considered, among other things, (1) the number of holding company shareholders, (2) the number of holding company employees and their functions, (3) the assets and liabilities of the holding company other than its investment(s) in the subsidiary(s) involved in the instant pooling, and (4) the nature and amount of any transactions between the holding company and the subsidiary(s). The staff has not concurred with registrants' conclusions that pooling-of-interests accounting by a subsidiary(s) is appropriate when the shareholders of the holding company have numbered more than a few, or the holding company has provided services to the subsidiary(s) such as management, financial, legal, accounting or employee benefits activities In addition, any assets or liabilities at the holding company level other than the investment in the subsidiary(s) involved in the pooling would be evidence that a substantive holding company does in fact exist which would preclude pooling-of-interests accounting by the subsidiary(s).
In the circumstance where a holding company was otherwise able to meet the personal holding company exemption except that the number of shareholders of the holding company was more than a few, the staff has not objected to pooling-of-interests accounting by the subsidiary(s) under certain circumstances. In those cases, registrants have liquidated the holding company contemporaneously with the consummation of the business combination such that the holding company's investment in the combined entity is immediately distributed to the holding company's shareholders. In addition, any minority interest previously outstanding in the subsidiary(s) was accounted for as the acquisition of minority interest in accordance with AIN-APB16 26, "Acquisition of Minority Interest," and any basis difference between the holding company's investment in the subsidiary(s) and the underlying assets and liabilities recorded in the subsidiary(s)' accounts has been considered by recording the holding company's basis in the combined financial statements. Such an approach presented in the combined financial statements as if the holding company was the combining entity in the pooling-of-interests combination.
2. Autonomy of Spun-Off Entity (Heckler, 1996)
Generally, each of the combining companies in a pooling must be autonomous and cannot have been a subsidiary or division of another corporation for two years prior to the date the combination is initiated.12
The staff often is asked to concur with a registrant's conclusion that unique facts and circumstances exist supporting the use of pooling-of-interests accounting notwithstanding a technical violation of this requirement. Issues regarding this requirement arise when an entity that formerly was a subsidiary or division of another entity was spun-off within the two-year period prior to the initiation of a business combination.
In fact, there have been a limited number of exceptional cases where the staff has not objected to a registrant's conclusion that a subsidiary spun-off within two years prior to initiation could meet the autonomy condition. In these cases, registrants asserted that the legal form was structured for reasons unrelated to the business combination and the substance of the arrangement was that the spun-off entity was the continuing former "parent" entity. Registrants frequently represent that the form of the transaction was created for reasons other than the combination, often related to achieving a desired tax outcome.
The staff previously has concluded that to overcome the presumption that the legally spun-off entity lacks autonomy until the passage of two years from the date of the spin-off, the circumstances would require persuasive, objective evidence that the "legal spinee" was indeed the "accounting spinner." In the past, evidence that the staff considered was based upon the relative size of the two entities taking into consideration a variety of size tests. In these exceptional cases where the staff did not object to the application of pooling-of-interests accounting notwithstanding a technical violation of the autonomy requirement, the subsidiary clearly has been dominant i.e., greater than 75 to 80 percent of the combined entity prior to the spin-off based upon fair value and all of the following historical GAAP measures: total assets, net assets, revenues, operating income.
Let me give you an example of a recent registrant question involving this concept. A company that was established over 100 years ago formed a subsidiary 10 years ago to pursue a new line of business. The subsidiary's business experienced significant growth and quickly approached the size of the parent on a variety of measures. The businesses of the parent and the subsidiary differed significantly and involved different relative relationships between revenues, capital assets, equity, total assets, etc.
The parent spun-off the subsidiary and presented the subsidiary as a discontinued operation. About a year later, the subsidiary entered into a business combination with a registrant. The proposed combination was expected to meet all of the conditions for pooling except for the autonomy condition. If one were to exclude certain nonoperating monetary assets of the parent and compare the estimated market capitalization of the two entities, one would conclude that the subsidiary was slightly larger than the parent. The registrant concluded that the subsidiary met the autonomy condition based on this analysis. They believed that the entity that was larger should be considered autonomous without regard to the fact that it legally may have been a subsidiary. In making this analysis, the registrant believed that the other historical GAAP measures of relative significance were not meaningful given the disparity of the two businesses and should be ignored when determining whether the entity was autonomous.
The staff objected to the registrant's conclusion because it was not clear that the subsidiary was the continuing former "parent." In this case, the subsidiary was not predominately and consistently larger on the historical GAAP measures the staff traditionally has considered. The staff did not believe it was appropriate to assess autonomy based on a simple majority of total fair value, ignoring the other contradictory evidence.
In another example, three registrants that were created or survived the break up of an entity about a year earlier collectively requested the staff's concurrence with their conclusion that each of the entities could meet the autonomy condition prior to the passage of two years from the date of the break up. Even though two of the entities previously were subsidiaries of the third, the registrants and their auditors believed that this was a unique situation where the combined company started the process of segregating these businesses several years ago. They asserted that the entities had been operated "highly autonomously" for at least the past two years with separate management teams, no significant intergroup transactions, and no overlapping operations, markets, financing, customers, competitors.
The staff objected to the conclusion that each of the three post-split-up companies were autonomous prior to the passage of two years from the date of the split-up. In addition, the staff was skeptical about their ability to identify the former "autonomous parent" in this situation since there was not persuasive evidence that identified one of three entities as clearly dominant and the "continuing parent." In previous cases involving true split-ups, the staff has concluded that all of the surviving entities lacked autonomy until after the passage of two years following the split-up.
B. MANNER OF COMBINING INTERESTS — COMMON-STOCK-FOR-COMMON-STOCK CONDITION
1. Common Stock With Graduated Voting Rights (Rodgers, 1999)
The staff recently considered the application of the pooling criteria to a registrant that had a single legal class of common stock outstanding, but that class had graduating voting rights. The number of votes attributable to an individual share of common stock increased from one vote to five votes when that share had been held for four or more years without a change in beneficial ownership. If the holder of a five-vote share later sold the share, the share reverted to a single-vote status. The registrant's charter established this right. All other rights of the registrant's common stock were identical, and all holders voted as a single class on all matters.
As a condition for pooling, paragraph 47(b) of APB 1613requires that "a corporation offers and issues only common stock with rights identical to those of the majority of its outstanding voting common stock in exchange for substantially all of the voting common stock interest of another company at the date the plan of combination is consummated." Because of the supervoting rights attributable to shares held for at least four years without a change in beneficial ownership, the staff viewed the registrant as essentially having two classes of common stock for purposes of applying paragraph 47(b). In other words, the staff viewed the one-vote shares as one class and the five-vote shares as another class. Accordingly, if the registrant was the issuer in a pooling transaction, the registrant must issue the "class" of stock that had voting control of the registrant. Because the registrant's charter did not provide for the issuance of shares that would immediately entitle the holder to five votes, the registrant would be precluded from being the issuer if the five-vote shares held voting control of the registrant. Further, changing the registrant's charter to eliminate the graduating voting rights in contemplation of a business combination would be an alteration of equity interests in violation of paragraph 47(c) of APB 16.
The staff also considered the implications of the graduating voting rights assuming the registrant was the combining company. Paragraph 47 of APB 16 states that "exchanges of common stock that alter relative voting rights, that result in preferential claims to distributions or profits or assets for some common stockholders groups, or that leave significant minority interests in combining companies are incompatible with the idea of mutual sharing." Paragraph 47(e) of APB 16 requires that "the ratio of the interest of an individual common stockholder to those of other common stockholders in a combining company remains the same as a result of the exchange of stock to effect the combination." This condition appears to indicate that all common shareholders of a combining company maintain their relative voting interests after a pooling. However, paragraph 47(b) is clear that holders of "other outstanding equity and debt securities" in a combining company may receive voting common stock of the issuer in exchange for those securities. When this occurs, the relative voting rights of the holders of common stock in the combining corporation do not remain the same.
In reconciling this seeming conflict between paragraphs 47(b) and 47(e), the staff interprets paragraph 47(e) to mean that the relative voting interests of individual shareholders within a class of stock must remain the same, not that the relative voting interests among all shareholders must remain the same. Applying this rationale, the staff did not object to the registrant being a combining company because the relative voting interests within the one-vote class of shares and within the five-vote class of shares remained the same. In addition, the exchange ratio represented the fair value for each class of combining company shares exchanged and did not cause an alteration of equity interests in violation of paragraph 47(c). However, consistent with current practice, the staff required that the issuing company obtain at least 90% of the fair value and 90% of the votes of the aggregate of the one-vote shares and five-vote shares outstanding in the exchange transaction. Furthermore, all of the other criteria for pooling of interests were required to be met.
2. Determination of Residual Equity Interests (Holmes, 1993)
A difficult issue in business combinations is determining compliance with paragraph 47(b) when classes of a combining company's securities are acquired by the issuing company for cash or redeemable securities.
EITF Issue 85-14 considered whether options, warrants, or convertible securities of a combining company must be exchanged for similar securities or voting common stock of the issuing company in order for the business combination to qualify as a pooling of interests. The Task Force concluded that not all convertible securities must be so exchanged and that a case-by-case evaluation must be made. The staff believes that securities must be evaluated to assess whether they are essentially residual equity interests.
Recently, the staff addressed whether a security that was not convertible into common stock represented a residual equity interest. The staff does not believe that convertibility is a necessary attribute for a security to be essentially a residual equity interest. For example, holding a class of voting, nonconvertible preferred stock, in combination with holdings of voting common stock, could give a shareholder or group of shareholders majority voting control of a company. In this circumstance, the staff would consider the acquisition of the preferred stock for cash in a business combination to violate the pooling criteria.
The staff also has addressed whether a class of nonvoting common stock that was not convertible to shares of the voting class of common stock could be acquired for cash in a business combination intended to qualify as a pooling of interests. The terms of the nonvoting common provided participation on an equivalent share basis with voting common in dividends and upon liquidation. Further, the nonvoting common was not subject to any put or call provisions. In other words, the nonvoting common stock had rights identical to those of the voting common stock, except that it lacked the right to vote. Therefore, the staff concluded that the nonvoting common stock was essentially a residual equity interest, and acquisition of such a security for cash would violate the conditions of a pooling of interests.
3. Stock for Net Assets (Book, 1993)
I'd like to start by addressing a situation that the staff has considered several times within the last year — that is, whether certain business combinations that are effected in the form of stock for net assets qualify for pooling of interests accounting. APB 16 (paragraph 47b) states that "a transfer of the net assets of a combining company to effect a business combination satisfies condition 47b provided all net assets of the company at the date the plan is consummated are transferred in exchange for stock of the issuing company." An exception to that provision allows the combining company "to retain temporarily cash, receivables, or marketable securities to settle liabilities, contingencies, or items in dispute if the plan provides that the assets remaining after settlement are to be transferred to the corporation issuing the stock to effect the combination."
The staff has addressed a situation in which the issuing company proposed to exchange shares for all of the net assets, except for an operating facility. The reason for excluding the operating facility was the existence of an environmental contingency. Under the proposed scenario, the ultimate resolution of the environmental problem would be assumed by the target shareholders. The target would maintain the building and the contingent liability, along with any insurance, within the target's corporate structure. Although the book value of the operating asset was less than 10% of the Target's assets and the fair market value of the operating facility was arguably less than book value, the staff concluded that leaving behind an operating asset did not meet the basic test of paragraph 47b that "all the net assets" be transferred, nor did it meet the exception that permits temporarily leaving certain monetary assets in the target company to settle disputed liabilities.
What situations are conducive to a stock-for-net-assets pooling? The staff reviewed a transaction that was originally structured as an exchange of shares and was modified to a stock for net assets arrangement because of litigation filed shortly before the planned business combination. The target believed the claim was frivolous but would require time and resources to defend. The combining parties believed the stock for net assets structure facilitated the merger in light of the contingency associated with the ultimate settlement of the lawsuit. The arrangement eliminated the need to place shares in escrow for some unknown period of time.
The stock for net assets structure also raised another pooling issue. In the particular fact pattern addressed, the Target shell would receive the shares and place them in a liquidating trust. The staff was concerned that if the shares were to remain in the trust and voted by the trustee, that the stockholders might be deprived of their individual voting rights. Paragraph 47f requires that stockholders are neither deprived of, nor restricted in, exercising their voting rights, even for a temporary period. The trustee, in this case, voted proportionately in accordance with the wishes of the beneficial owners; thus paragraph 47f was not violated.
C. MANNER OF COMBINING INTERESTS — CHANGE IN EQUITY INTERESTS CONDITION
1. Curing Alterations of Equity Interests (Adams, 1997)
An issue that the staff addresses repeatedly is whether specific alterations of equity interests were made in contemplation of a business combination. Paragraph 47c of Opinion 16 requires that "none of the combining companies changes the equity interest ... in contemplation of effecting the combination" within two years of initiation of the combination. Any change in equity interests that occurs within two years of initiation of a business combination is presumed to have been made in contemplation of the combination — just as any acquisition of treasury stock made within two years of initiation is presumed to have been made in contemplation of the transaction.
In several recent transactions, the staff has objected to registrants' conclusions that it overcame the presumption that the change was in contemplation of the business combination. As a result, the registrants proposed rescinding the transactions that violated paragraph 47c, which in the cases reviewed were grants of stock options. In evaluating these proposals, the staff has learned that there is diversity in practice in permitting rescissions of such grants as effective "cures" of the alterations. Some practitioners believe that a "no harm/no foul" analysis can be applied so long as an alteration is canceled or rescinded for no consideration and the equity holders are returned to the same equity position held before the alteration. Other practitioners believe that to be an effective cure, rescissions also must occur shortly after an alteration occurs — usually not more than a few months. Others question whether a cure can be effected at all in circumstances where the equity position in question has value — for example, an in-the-money option. There does seem to be agreement, however, that application of the "no harm, no foul" approach requires that any such rescission be made for no consideration.
The staff has not objected to cures that put the shareholders back in the same position as before the alteration, based on analogies to the guidance in Interpretations 19and 20 of APB 16 regarding other alterations of equity interests. The staff has taken this position, however, only when no consideration is paid to the counterparty — otherwise the shareholders would not be restored to their former position. The staff has informed registrants that consideration includes any promise made to counterparties — either written or unwritten — to provide any form of additional compensation at the time of the rescission or at any time in the future.
The staff is concerned that some rescissions of alterations of equity interests have been effected that do not restore the shareholders to their former positions, as would be the case if the rescissions had been done for consideration. As a result, the staff is reconsidering its views on cures to determine the circumstances and conditions where cures should be permitted. When that process is completed, the staff will determine if there is a need to issue guidance in this area.
2. S-Corp Distributions (Holmes, 1993)
Unique considerations may arise when a Subchapter S corporation participates in a business combination. Paragraph 47(c) of APB 16 prohibits any combining company from changing the equity interest of its voting common stock in contemplation of the business combination. A question frequently arises regarding whether distributions to the Subchapter S corporation's shareholders comply with paragraph 47(c).
Paragraph 47(c) provides that distributions to stockholders that are no greater than normal, based on earnings and past dividend policy and pattern, would not violate this condition. The staff believes this provision is generally appropriate to the evaluation of distributions to stockholders of Subchapter S corporations. However, because of the unique tax status of Subchapter S corporations, the staff has not objected to distributions by a Subchapter S corporation prior to the business combination in an amount sufficient to meet its shareholders' current tax obligations, despite the past pattern of distributions.
3. Acceleration and Termination of Stock Options (Holmes, 1993)
A related issue under paragraph 47 involves the treatment of outstanding stock options in a business combination. Two years ago, the staff addressed provisions of a company's stock option plan that trigger the acceleration of the options' vesting upon a change in control of the company. As we stated then, the staff would not object to the acceleration of vesting of outstanding options in a merger to be accounted for as a pooling, provided the contractual acceleration provision was not adopted in contemplation of the subsequent business combination.
Last year, the staff addressed provisions of residual equity securities that trigger a cash redemption upon a change in control. As we stated then, the staff would object to pooling accounting when residual equity interests are redeemed for cash in the merger, other than pursuant to dissenter's rights or as fractional shares. The staff believes that a contractual provision that contemplates the intentional termination of a residual equity interest contradicts the basic concept that there is a uniting and continuation of equity interests in the business combination.
The staff recently considered provisions of a stock option plan that would trigger both accelerated vesting and the termination of any unexercised options upon a change in control. Consistent with our prior position, the staff would not object to the contractual acceleration of vesting of outstanding options, provided the acceleration provision was not adopted in contemplation of the subsequent business combination. The staff would object, however, to pooling accounting based on the termination of unexercised stock options in the merger. Stock options are a residual equity interest. The staff believes that the termination of a residual equity interest, whether for monetary consideration or no consideration, is inconsistent with a uniting and continuation of equity interests. As residual equity interests, employee stock options must be exchanged for either similar options of the issuing company or common stock of the issuing company based on the fair value of the options.
4. Option Repricing (Book, 1993)
The staff recently considered a repricing of stock options by one of the combining companies that occurred in close proximity to the initiation date.
A repricing of stock options may occur when the market value of the stock has experienced a significant, prolonged decline due to various market forces and the Company believes a repricing to the then-fair value is necessary to continue to provide the intended incentive to the employee.
The threshold question is, of course, whether the repricing is an alteration of equity interests in contemplation of a business combination. It depends on the weight of evidence.
In the fact pattern addressed, the staff did accept the representation that a repricing was not in contemplation of a business combination because of the prolonged decline in price and the competitive concerns presented by the company. In addition, the options subject to repricing were held by a large employee base and, in fact, EXCLUDED selected senior management; the affirmative vote of a majority of the independent, outside board members was required to approve the repricing; and, the company extracted a "quid pro quo" from its employees that required them to hold such repriced shares for a year. And, In this case, it was the issuing company repricing the options and there did not appear to be any embedded premium based upon the expected merger.
5. Acceleration of Vesting at Discretion of Board (SEC staff, 1991)
Paragraph 47c of APB Opinion No. 16, "Business Combinations" provides that a change in the equity interest of the voting common stock in contemplation of effecting a pooling-of-interests business combination within two years before the combination is initiated will void pooling accounting. The SEC staff has concluded that the acceleration of the vesting date of stock options at the discretion of the Board of Directors, previously provided for in the option arrangement and not in contemplation of a pooling at that time, would be considered a change in equity interests.
6. Target Dividend Equalization (SEC Staff, 1991)
Paragraph 47c of APB Opinion No. 16, "Business Combinations" provides that "dividend distributions on stock of a combining company that are equivalent to normal dividends on the stock to be issued in exchange in the combination" will not affect pooling accounting treatment. The SEC staff interprets this provision to permit a target company to increase its dividend rate to that of the "acquirer" adjusted for the exchange rate to be used in the business combination transaction.
D. MANNER OF COMBINING INTERESTS — TREASURY STOCK CONDITION
1. Repurchase of Shares to Settle Litigation — ASR 146-A (Casey, 1998)
Let me begin with treasury stock acquisitions and ASR 146-A.14Generally, the issue of whether treasury shares are tainted focuses on the intended subsequent reissuance of the shares. Exceptions to this general rule include shares repurchased pursuant to a systematic pattern for which there is a reasonable expectation of reissuance and shares to be reissued in a specific purchase business combination. In addition, the Commission indicated an additional type of exception in ASR 146-A when it stated "circumstances may exist where a company is obliged by contract to reacquire specific shares or must reacquire specific shares to settle outstanding claims (emphasis added)." That is, shares reacquired pursuant to those circumstances may not be viewed as tainted, despite the fact that there is no specific intent to reissue the shares, unless it appears that the rights or obligations are contrived to circumvent the pooling requirements.
A recent registrant matter involved a situation where two partners formed a new company, with each receiving 50% of the shares. Several months later each partner hired an employee, with the respective partner orally promising the respective employee an undefined equity interest in the company to be received at an unspecified future date. The grants required the approval of the board of directors (the two partners). Subsequent to formation, the two partners began disagreeing over the future direction and control of the company. One partner, Partner A, wanted to retain at least a 50% voting interest in the company in order to have veto power. Due to the dispute, and in order to avoid being diluted below 50%, Partner A refused to approve granting a voting equity interest to the employees.
Approximately nine months later, the two employees filed lawsuits against the company seeking to compel it to grant them equity interests. The parties ultimately negotiated a settlement which included the company repurchasing virtually all of Partner A's shares. Six months after settlement the company initiated merger discussions with another company.
The company argued that the shares it repurchased from Partner A pursuant to the litigation settlement should not be considered tainted treasury stock for two reasons. First, they were repurchased pursuant to litigation arising from alleged misrepresentation relating to their original issuance. That is, the shares were repurchased because of a dispute between the two founding partners as to whether or not Partner A, from the date of formation, had the right to retain a 50% voting interest in the company, irrespective of any other equity transactions. Second, the company argued that even if the litigation were unrelated to the original issuance of the shares, the shares were repurchased pursuant to litigation that was unrelated to the business combination. They believed that ASR 146-A merely provides some examples of situations where the Commission believed there could be persuasive evidence to overcome the presumption that shares were repurchased for a business combination.
The staff objected to the registrant's conclusions. ASR 146-A provides that shares repurchased to "settle a claim or lawsuit involving alleged misrepresentation or other acts relating to the original issuance of stock" would not be tainted. However, the staff did not believe this registrant met the conditions for that example because:
- The repurchase of shares was not required pursuant to a preexisting contractual obligation. The reacquisition was part of a negotiated settlement — the litigation itself did not involve Partner A's shares or ownership. Thus the settlement could have taken alternative forms.
- The company did not provide any objective, contemporaneous evidence to support the assertion that there was an understanding between the partners as to whether Partner A would or would not be permitted to retain a 50% voting interest in the company.
- Partner A's oral promise to grant an equity interest to the new employee was inconsistent with such an assertion.
A distinguishing characteristic described in the lead-in sentence to the four examples cited in ASR 146-A is that a company has no discretion as to whether shares will be repurchased. Since this company was not obligated to repurchase the shares, any shares repurchased were subject to the intended subsequent reissuance test for treasury shares referred to above. As a result, all the shares repurchased by the company from Partner A were presumed to be tainted.
2. Share Exchange With Shareholder (Jones, 1998)
The staff has addressed certain pooling issues relating to variations of a share exchange transaction with a major shareholder. In the specific fact patterns the staff considered, one of the significant (but not controlling) shareholders in the registrant was a holding company that was owned by an officer/director and members of his family. That holding company had no significant assets other than the investment in the registrant. In the proposed transaction, the registrant would merge with the holding company by issuing shares to the shareholders of the holding company. In some of the transactions the staff considered, the registrant expected to issue slightly fewer shares than it would receive in the merger transaction. In others, the registrants would receive exactly the same number of shares that would be issued. Generally, the business reason cited for this transaction was to eliminate the potential of double taxation of shareholders in the holding company by having the holding company shareholders have a direct, rather than indirect, interest in the registrant.
The registrants considered the guidance in ASR No. 146 that indicates that tainted treasury shares can be cured if they are reissued. The registrants acknowledged that implicit in that guidance is the notion that the taint on treasury shares cannot be cured before it exists. These proposed transactions raised an interesting question in that shares were being received from and issued to the same counterparty in one exchange transaction whereas the guidance in ASR No. 146 contemplates separate exchange transactions with different counterparties. The registrants did not believe it was appropriate to consider all of the shares acquired from the holding company to be tainted treasury shares that were not cured by the issuance of shares to the holding company's shareholders. The staff did not object to the registrants' conclusions that since the exchange was part of one transaction, only any net contraction in the number of outstanding shares should be considered tainted treasury shares. However, there were certain caveats. First, the staff pointed out that this transaction structure results in certain tax benefits being provided to shareholders. Accordingly, this transaction would be viewed as an alteration of equity interests that would need to be evaluated in the context of any future pooling transactions the registrant might enter into. Finally, the staff pointed out that if this transaction were effected after a pooling transaction and the holding company were deemed to be an affiliate for purposes of the risk sharing rules, any shares distributed to shareholders of the holding company would continue to be subject to those rules.
3. Leveraged Recapitalization — Computation of Tainted Treasury Shares (Jones, 1997)
The first item I will discuss illustrates how to compute the number of tainted treasury shares following a leveraged recapitalization transaction. Opinion 16 and its interpretations provide that treasury shares purchased within a restricted period preceding a business combination are presumed to have been purchased in contemplation of that business combination. Those shares are considered tainted treasury shares unless the presumption that the shares were purchased in contemplation of the business combination was overcome or the shares were reissued prior to consummation. The number of tainted treasury shares at consummation are added to other pooling violations to demonstrate that substantially all of the voting common shares of the combining companies have been included in the exchange, as required by paragraph 47b of Opinion 16.
Over the past several years, many companies had a change in control effected through a series of equity transactions, a transaction structure often referred to as a leveraged recapitalization. A typical leveraged recap transaction generally is effected through two or three integrated steps. In the first step, new investors put in cash for common and preferred shares of the company. In some transactions there is an intermediate step where additional cash is obtained from debt financing. In the final step, the cash proceeds from the first two steps are used to purchase a portion of the company's shares from existing shareholders. However, because the transaction is not effected as a leveraged buyout where a Newco acquires 100% of Oldco as described in EITF Issue 88-16, that guidance does not apply. Instead, the transaction is accounted for as a series of equity transactions and generally, there is no change in the accounting basis of the company's recorded assets and liabilities.
The staff recently addressed a situation where a company that was party to a recapitalization transaction about one and a half years ago was considering a business combination that it expected to account for as a pooling of interests. A family controlled the Company — the parents controlled the majority of the shares and their adult children held the remaining shares. In the recapitalization transaction the parents sold all of their interests in the company and the children sold 95% of their interests in the company. However, because of the leverage in the company's new capital structure, the children retained approximately the same voting percentage interest in the company after the transactions as they had held before the transactions. The company believed that because both the parents and the children redeemed a portion of their interests in the company, the cash payments to the family should be accounted for as a dividend to the extent both groups of shareholders received pro rata distributions. In other words, the company interpreted the transactions to consist of a 95% redemption of all shareholders' interests followed by a repurchase of the parents' remaining 5% interest in the company. Therefore, the company believed that only the non pro rata portion of the cash distribution, or the 5% redemption of the parents' interest in the company, gave rise to tainted treasury shares. In addition, the company argued that the shares issued to the new investors in the first step of the recapitalization transactions cured an equivalent number of tainted shares.
The staff objected to the company's treatment of substantially all of the cash payments made to the family members as a substantive dividend. The staff noted that the cash payments were structured legally as stock redemptions and not as dividends declared by the company's board of directors. As a result, the staff concluded that all of the cash payments to the family members gave rise to tainted treasury shares.
The next question the staff addressed was whether the taint on any of those treasury shares was removed when shares were issued to new investors. The staff considered Interpretation 20 to Opinion 16 which provides that to the extent treasury shares reacquired during the restricted period "... have not been issued ... an equivalent number of shares of treasury stock may be sold prior to consummation to 'cure' the presumed violation of paragraphs 47c and 47d." The staff believes that there is an implicit principle in that guidance that the issuance of shares cures taint on treasury shares only if tainted treasury shares exist at the time of reissuance; that is, taint cannot be cured before it exists. The form of the transaction evaluated by the staff, which is typical of leveraged recap transactions, is that the new money was injected into the company first and the proceeds were used to purchase treasury shares from the family members. As a result, the staff objected to the company's conclusion that the sale of shares to new investors cured taint on subsequent purchases of treasury shares.
4. Curing Tainted Treasury Shares (Holmes, 1993)
The relevant accounting literature regarding the effect of treasury stock transactions on accounting for business combinations is paragraph 47(d) and Interpretation 20 of APB 16. In addition, Accounting Series Releases 146 and 146A set forth the Commission's conclusions regarding treasury stock transactions. The staff generally scrutinizes carefully treasury share purchases during the two year period before initiation of a business combination to determine whether persuasive evidence exists that would support a conclusion that such shares were repurchased for purposes other than the business combination.
The literature acknowledges a combining company's ability to cure tainted treasury shares by first, selling common stock, second, issuing common stock in a business combination, or third, issuing common stock upon the exercise or conversion of other securities, provided untainted shares are not held for those purposes already. Under the third scenario, the securities that are exercised or converted likely would be considered essentially residual equity interests. Given that securities that are essentially residual equity interests cannot be acquired for cash in a pooling combination, and tainted treasury shares have been acquired for cash, the staff considered whether it was acceptable to cure tainted treasury shares through the exercise or conversion of such securities. Consistent with our prior position on treasury stock issuances, the staff will not object to the cure of tainted treasury shares by issuing common stock upon the exercise or conversion of securities that are essentially residual equity interests, provided that the transaction was not arranged to circumvent the requirements of Opinion 16.
E. MANNER OF COMBINING INTERESTS — CONTINGENCY CONDITION
1. Calculation of 10% Limitation for General Management Representations (Smith, 1997)
Paragraph 47(g) of APB Opinion No. 16, Business Combinations (Opinion 16), requires that the combination be resolved at the date the plan is consummated and no provisions to issue securities or other consideration remain pending. Paragraph 47(g) does allow for an agreement to revise the number of shares issued to effect a combination for the later settlement of a contingency know at the combination date at an amount different from that recorded by a combining company. AICPA Accounting Interpretations (AIN-APB 16) 30 of Opinion 16, "Representations in a Pooling," clarifies that the most common type of contingency agreement not prohibited in a pooling by paragraph 47(g) is the "general management representation," and states that a portion of the shares issued to effect the combination may be placed with an escrow agent until the contingency is resolved. The staff has previously stated that the maximum number of shares that can be placed in escrow for a "general management representation" clause is ten percent of the shares issued to effect the combination. The staff has recently received questions regarding how to calculate the ten percent limit.
For example, a technology company proposed issuing its common shares for the common shares of a target, and issuing like stock options for the deep-in-the-money options of the target. Under the terms of the combination, the issuing company would issue two million of its common shares in exchange for the outstanding common stock of the target, and issue options to purchase 200,000 shares of its common stock with terms similar to the outstanding options of the target company in exchange for the target's options. The registrant believed that since the target's options to purchase common shares were deep in the money, their exercise was virtually assured and should be considered equivalent to outstanding common shares when calculating the number of shares available for escrow under the "general management representation" clause. The merger agreement called for 220,000 common shares (10% of 2,200,000) to be placed in escrow.
The staff did not concur with the registrant's conclusion that the shares to be issued upon option exercise could be used in determining the maximum number of shares available to be placed into the escrow. The staff believed that only the number of common shares issued to effect the combination should be used to determine the maximum number of shares which could be placed in escrow for a "general management representation" clause. In this fact pattern, the staff believed the maximum number of shares that could be placed in escrow was 200,000.
2. Settlement Contingency in Excess of 10% (Holmes, 1993)
The last issue under paragraph 47 involves the settlement of contingencies in a pooling of interests. Paragraph 47(g) of APB 16 allows revision of the number of shares issued in the business combination for the settlement of a contingency at a different amount than that recorded by a combining company. As discussed in Interpretation 30 to APB 16, merger agreements commonly include general management representations warranting the existence and value of assets and the amounts of liabilities. An issuing company may escrow shares, limited to ten percent of the shares issued in the business combination, to simplify any settlement in the unlikely event of a breach of the general management representations. The staff has been asked, if ten percent of the shares issued in the business combination are escrowed for general management representations, do the conditions of a pooling of interests limit the actual settlement of a breach of those representations to the shares in escrow?
The staff observes that when an escrow is not established for general management representations, an adjustment of the shares issued to resolve a breach would not be limited legally to ten percent of the shares issued. Similarly, the staff believes that establishing an escrow does not limit the settlement of a breach of the general management representations to the number of shares in escrow, unless of course, the merger agreement so provides.
Nevertheless, when a business combination has been accounted for as a pooling of interests, any subsequent adjustment in the exchange ratio related to contingencies, whether through an escrow arrangement or otherwise, should reflect conditions determined to have existed at the date of combination and should not relate to developments occurring after the combination date. The staff believes that any adjustment of the shares issued in the combination must be evaluated to determine whether such an adjustment is consistent with the required sharing of risks from the date of combination forward.
3. Noncompete and Other Compensation Arrangements (Book, 1993)
Payments of cash to executives or shareholders in a merger transaction are subject to a high level of scrutiny by the staff. These types of payments frequently include employment contracts, golden parachute arrangements, consulting agreements and covenants not to compete.
Interpretation 31 of APB 16, dealing with employment contingencies in a pooling addresses whether the granting of an employment contract or a deferred compensation plan by the combined corporation to former stockholders of a target company cause a violation of paragraph 47g. 47g stipulates that there can be no agreement for contingent issuance of additional shares of stock or distribution of other consideration to the former stockholders of a target company. The interpretation indicates that the critical factors in the evaluation would be the reasonableness of the arrangement and the restriction of the arrangement to continuing management personnel. Further, the interpretation indicates that plans entered into by a target company between the initiation and consummation date would be presumed in contemplation, thus a pooling violation.
The staff recently addressed a situation involving a covenant not to compete for the president of the target enterprise. Based upon the fair market value of the stock to be exchanged in the merger transaction, which for argument sake was $6,000,000, the cash covenant not to compete was $2,000,000. The recipient was also the majority shareholder in the target company. The covenant not to compete was also in addition to a multi-year employment agreement and a seat on the Board. While the staff acknowledged that covenants not to compete may serve a valid business purpose and do not, conceptually, invalidate a pooling, the staff did not believe that this arrangement was reasonable in this fact pattern. In addition, the staff was troubled by the fact that the payment could not be reasonably separated from the recipient and his position as the majority shareholder and primary negotiator of the merger transaction.
In another fact pattern, a large cash bonus plan was initiated in anticipation of the "sale" of the target. Approximately 85% of the target was held by outside venture capital-type interests. The remaining 15% was held by employees — with virtually all employees holding some shares. The company was in the development stage.
The 85% shareholders agreed to provide a large cash bonus payment to virtually all the employees in order to obtain the assistance of management and others in selling the target. The staff objected to the existence of the cash bonus arrangement because it was tantamount to a part cash — part stock for the 15% minority shareholders. Particularly troubling was the timing of the bonus plan inception and the inclusion of all minority shareholders, not just those who presumably would be assisting in the merger negotiations. The registrant noted that the cash payments were not to be based upon the relative shareholdings of the employees but were to be based upon their employment positions within the company, thus the arrangement could be viewed as reasonable and compensatory. The staff did not find this argument persuasive.
4. Extension of One Year Limit for Settlement of Environmental Liabilities (SEC Staff, 1991)
Consistent with existing guidance under APB Opinion No. 16, no extension of the one year time limitation for resolving a general management representation for environmental liabilities will be entertained by the staff. They did point out that some environmental liability contingencies may qualify as a specific contingency which contain no time limitation for resolution. The staff would expect that the nature of the contingency be specific, such as the nature and type of containments and the specific location, etc.
G. ABSENCE OF PLANNED TRANSACTIONS — FINANCIAL ARRANGEMENTS — UNDERWRITING FEES (HOLMES, 1993)
I will complete the discussion of pooling of interests accounting by addressing two matters that relate to paragraph 48 of APB 16, which precludes certain planned transactions in a pooling of interests. Paragraph 48(b) of APB 16 prohibits a combined corporation from entering financial arrangements that benefit the former stockholders of a combining company. However, Interpretation 21 of APB 16 does allow the combined corporation to agree to pay the "costs of initial registration" when unregistered stock is issued to effect the combination. Payment of the costs of initial registration is not considered a "bailout" of the former stockholders that would violate paragraph 48(b).
The staff has been asked whether underwriting fees are a cost of initial registration that could be paid by the combined corporation. The staff distinguishes costs of registration and costs of disposition. In the staff's view, costs of registration would include legal, accounting, printing, filing and related fees associated with having a registration statement declared effective. Costs of disposition, on the other hand, would include underwriter's or broker's fees, discounts, commissions, marketing and distribution fees and similar transaction costs. Whether registered or unregistered stock is issued in the business combination, the staff believes that an agreement by the combined corporation to bear a shareholder's costs of disposing shares violates paragraph 48(b) of APB 16.
H. ABSENCE OF PLANNED TRANSACTIONS — PLANNED DISPOSITIONS
1. Transfer or Sale of Held-to-Maturity Securities (Desroches, 1998)
The staff recently dealt with a transaction where a registrant transferred securities out of the held-to-maturity category for reasons other than the exceptions permitted under paragraph 8 of FASB Statement No. 115. As a result of that transfer, the registrant agreed to reclassify all held-to-maturity securities into the available-for-sale category and it further agreed that it would not use the held-to-maturity category for the next two years. Nine months after the transfer of the held-to-maturity securities, the registrant consummated a business combination with Company B which was accounted for using the pooling-of-interests method of accounting. Company B had a fairly large held-to-maturity portfolio as of the date the business combination was consummated. The staff was asked its views regarding the appropriate accounting by the combined company for the held-to-maturity securities formerly held by Company B.
The staff concluded that the combined company would not be permitted to transfer or sell the securities classified as held-to-maturity by Company B as of the consummation date unless one of the exceptions in paragraph 8 of FASB Statement No. 115 had been satisfied. The staff further advised the combined company that it would not be permitted to add any additional held-to-maturity securities to its portfolio for the remaining fifteen months of the two-year period in which Company B was restricted from classifying securities as held-to-maturity.
2. Extraordinary Treatment of Impairment of Assets Identified as Held for Sale (Coallier, 1996)
I'd like to address a question related to the application of paragraph 60 of APB Opinion 16. Paragraph 60 addresses the rare circumstance of a significant disposal of assets within two years after consummation of a business combination accounted for using the pooling-of-interests method. Paragraph 60 requires that material profit or loss resulting from such a disposal be reported separately as an extraordinary item. Extraordinary treatment is warranted because under paragraph 48c, the pooling-of-interests method would have been inappropriate if the combined company planned the disposal as part of the plan of combination.
In a submission, a registrant asked whether paragraph 60 applies to an asset impairment recognized after a pooling-of- interests transaction, in connection with selected assets identified as held for sale. The registrant expected to dispose of the assets within the two years following the business combination. Specifically, the registrant questioned whether extraordinary treatment under paragraph 60 was appropriate since the asset disposal had not yet occurred. The staff concluded that impairment losses are similar to a loss on disposal and are within the scope of paragraph 60. As such, they should be classified as an extraordinary item when the paragraph 60 conditions are met.
1. Rule 10b5-1 Sales by Insiders During Risk Sharing Period (Blackley, 2000)
Accounting Series Release (ASR) No. 135, as interpreted by SAB 65, Risk Sharing in Pooling of Interests, established that risk sharing must occur for no less than the period beginning 30 days prior to consummation and ending after 30 days of post-merger combined operating results have been published. This period is commonly referred to as the risk sharing period.
Recently, the SEC adopted Rule 10b5-119, which addressed the issue of when insider-trading liability arises in connection with a trader's "use" or "knowing possession" of material nonpublic information. The staff has been asked whether the sale of stock by an affiliate that occurs during the risk sharing period, pursuant to the newly adopted rules on insider trading, would violate the pooling-of-interests rules.
Rule 10b5-1 sets forth affirmative defenses that allow persons, including corporate officers and directors, to buy or sell the issuer's securities without Section 10(b) liability while aware of material nonpublic information if the transaction was arranged before the person became aware of the information. To claim an affirmative defense, before becoming aware of such information a person must:
- enter into a binding contract to buy or sell;
- instruct another person to buy or sell for him or her; or
- adopt a written trading plan.
For an affirmative defense to apply, the purchase or sale must occur pursuant to the contract, instruction or plan.
In applying the risk sharing rules, the staff believes that stock sales made pursuant to a program designed to provide an affirmative defense under Rule 10b5-1 are no different than any other sale of stock by an affiliate. Accordingly, the risk sharing guidelines should be applied to all transactions of affiliates regardless of the circumstances giving rise to the trade.
The staff cautions registrants that a careful evaluation of the facts and circumstances is required to determine if the provisions of ASR 135 and SAB 65 have been met. Accordingly, registrants may wish to consult with the staff on a prefiling basis.
2. Cashless Exercise of Options During Risk-Sharing Period (Holmes, 1993)
The staff recently addressed the implication of stock option pyramiding and "phantom" stock-for-stock exercises of options to pooling of interests accounting. In these transactions, an employee exchanges or tenders shares held, rather than cash, for the exercise price of stock options. I will refer to stock option pyramiding and "phantom" stock-for-stock exercises of options as "cashless exercises."
EITF Issues 84-18 and 87-6 discuss the compensation aspect of cashless exercises. When an employee has held shares for at least six months, those shares generally are considered "mature" shares. The Task Force reached consensus that a cashless exercise does not result in a new measurement date for the exercised stock options, provided the employee tenders mature shares for the option exercise price.
Accounting Series Releases 130 and 135 set forth the Commission's position on risk-sharing in business combinations accounted for as pooling of interests. Staff Accounting Bulletins 65 and 76 provide further interpretation of the risk-sharing criterion. The staff considered whether an affiliate's cashless exercise of stock options represents a disposition of shares that would be contrary to risk-sharing. In the staff's view, an affiliate's cashless exercise would not preclude a business combination from being accounted for as a pooling of interests. The staff observes that the intrinsic value of the affiliate's holdings after a cashless exercise remains the same as immediately before exercise. Also, unlike the effect of selling stock, the affiliate has not reduced its investment in those holdings.
3. Actions of Controlling Shareholder(s) (Book, 1993)
Another aspect of pooling which requires registrants and their auditors to be particularly vigilant is the actions of certain controlling shareholders. Sometimes controlling shareholders will undertake a transaction that may be attributed to the combining companies, or the controlling shareholders may enter into a "side" deal that would be prohibited if entered into by the combining company. The staff has taken the position in these cases that control-group shareholders generally cannot do what the company is precluded from doing. For example, we have objected to control group shareholders of a Target entering into a side transaction that would give a disproportionate interest to certain shareholders as a means of encouraging them to accept the offer.
As stated in EITF 90-15, "the SEC staff believes that a greater investment may be necessary depending on the facts and circumstances, including the credit risk associated with the lessee and the market risk factors associated with the leased property."
See Statement 94, paragraph 13.
EITF Issue No. 96-16, Investor's Accounting for an Investee When the Investor Has a Majority of the Voting Interest but the Minority Shareholder or Shareholders Have Certain Approval or Veto Rights (EITF 96-16). Also see Regulation S-X, Article 3A-02.
AICPA Accounting Interpretation 39 to APB Opinion No. 16, Business Combinations (AIN 39), addresses transfers and exchanges between entities under common control.
FASB Technical Bulletin No. 85-5 (FTB 85-5) addresses issues relating to accounting for business combinations, including stock transactions between companies under common control.
AIN 39 also states that "purchase accounting applies when the effect of a transfer or exchange is to acquire all or part of the outstanding shares held by the minority interest of a subsidiary". FTB 85-5 provides guidance on determining whether a minority interest is acquired.
Staff Accounting Bulletin No. 54, Application of "Pushdown" Basis of Accounting in Financial Statements of Subsidiaries Acquired by Purchase (SAB 54).
See paragraph 23 of Accounting Principles Board (APB) Opinion No. 29, Accounting for Nonmonetary Transactions.
EITF Issue No. 94-2, Treatment of Minority Interests in Certain Real Estate Investment Trusts.
Staff Accounting Bulletin No. 47, Financial Statements of Oil And Gas Producers, Exchange Offers.
EITF Issue 88-16, Basis in Leveraged Buyout Transactions.
See APB Opinion 16, paragraph 46a.
Accounting Principles Board Opinion No. 16, Business Combinations.
ASR 146-A, Statement of Policy and Interpretation in Regard to Accounting Series Release No. 146, Effect of Treasury Stock Transactions on Accounting for Business Combinations.
Staff Accounting Bulletin No. 96, Treasury Stock Acquisitions Following a Business Combination Accounted for as a Pooling-of-Interest.
Remarks by Donna Coallier 1997 Twenty-Fifth Annual National Conference on Current SEC Developments, December 9, 1997.
Accounting Principles Board Opinion No. 16, Business Combinations paragraph 47(b) common-stock-for-common-stock condition.
As interpreted by EITF Issue 87-16, Whether the 90 Percent Test for a Pooling of Interests Is Applied Separately to Each Company or on a Combined Basis.
Rule 10b5-1: Trading "On the Basis Of" Material Nonpublic Information.