Debt Load Is a Growing Concern in Spin-Offs

Cendant’s easing of spun-off companies’ debt spotlights the legal uncertainties of heaping financial burdens on former units Before splintering into four parts at the end of July, Cendant Corp. apparently took considerable pains to ensure that the breakup did not come back to haunt the company and its directors in the courts. Instead of spinning off three segments as originally planned, Cendant sold one for a whopping $4.3 billion and earmarked the proceeds for lightening up the debt load of the two that were cut loose through tax-free distributions to shareholders. According to financial and legal commentators, the unusual move resembled an effort to dodge potential accusations, if something went sour, that Cendant had strapped the newly independent companies with so much debt that survival would have been tough. Cendant didn’t put it that way, although it revealed pretty good detail on how it was parceling out the money from the sale of its Travelport travel services subsidiary to Blackstone Group. The debt at real estate broker Realogy Corp. was chopped to $750 million from nearly $2.3 billion, and at hotelier Wyndham Worldwide Corp. to $600 million from $1.36 billion. Cendant, which is to be renamed Avis Budget Group, concentrates on auto rentals. Cendant’s preventative actions pointed up the growing concern among experts about how restructuring companies are extracting cash from, or piling debt on, subsidiaries spun off to shareholders in tax-free deals. The issue is when practices once applauded as smart financial engineering are milking the businesses to enrich the parent. At least part of the conflict grew out of the creditors suit filed in Delaware federal court in connection with the bankruptcy of the former Vlasic Foods, which had been spun off by Campbell Soup Co. Although the plaintiffs, who charged that Campbell loaded too much debt on Vlasic, lost the case, the specter of litigation and liability hasn’t disappeared as the fiscal practices continue and key legal elements are unsettled. Sara Lee Corp., for example, drew heavy analyst comment when it disclosed in July that its apparel operation, being spun off as HanesBrands Inc., would borrow $2.6 billion and pay $2.4 billion to the parent. Upstream dividends of that nature enjoy tax-favored status, and Sara Lee says HanesBrands’ cash flow will be strong enough to handle the debt. Automatic Data Processing Inc. is getting a more modest $500 million to $700 million from the spin-off of its brokerage services group. Sally Beauty Co., which is being divested in a sponsored spin-off by Alberto-Culver Co., is expected to be in debt because of borrowing by Clayton Dubilier & Rice that will be transferred to the parent to pay a $25-a-share dividend to stockholders. A $2.5 billion stock buyback by Alltel Corp. is being funded by money from its former landline business that was spun off and merged to form Windstream Corp. in a reverse Morris Trust transaction. William Schoenholz, an expert in financial services at the Los Angeles firm of Buchalter Nemer Fields & Younger, says, “The issues in a spin-off are what kind of debt the spin-off is burdened with, when the debt arose, and who got the benefit of the debt.” If spun-off companies get into trouble in a down economy, “there has to be some nervousness over the way the courts are going to interpret these transactions.” He notes that the California law test on business transfers is whether the company “has reasonably sufficient capital to meet the obligations that are likely to be incurred.” Schoenholz advises firms doing spin-offs to project pro forma financials for the divested business that adequately account for the debt burden. “You should have realistic, perhaps conservative, assumptions about the business going forward,” he says. Bolstering CFIUS Is a Long Process Congress appears basically committed to tightening CFIUS monitoring of inbound acquisitions involving targets owning “critical infrastructure” important to national security, although exactly what that consists of remains open to debate. Among the components currently featured in proposed legislation are major energy assets, important technologies, and production capacity needed for national defense. That’s a general commonality in bills reported from committees to the House and Senate floors and awaiting action when Congress began its summer recess in early August. The two versions also mandate an investigation of buyers controlled by foreign governments and create systems for reviewing compliance of agreements between CFIUS and the inbound buyer. However, the bills diverge on many other provisions, and it was unclear whether the differences could be resolved in this session. The legislative ball began rolling after a huge controversy erupted earlier in 2006 over the Dubai Ports World acquisition of U.K.-based Peninsular & Oriental Steam Navigation Co., which managed several ports in the U.S. The U.S. ports later were removed from the deal. Court Decisions Trump Accounting Rule Who wins in a tug-of-war between accounting rules and legal precedent? Don’t bet on the FASB, says the Delaware Chancery Court. In a late June decision, Vice Chancellor Stephen Lamb ruled that an owner of redeemable preferred stock was not entitled to be designated a creditor so that it could block an asset sale. The plaintiff, Harbinger Capital Partners, was trying to stop financially pressured Granite Broadcasting Corp. from selling two TV stations and could succeed only if it were named a creditor. Harbinger’s plea was based on FASB Statement 150 issued in 2003, which requires redeemable preferred stock to be classified on a company’s books as debt. However, Lamb said that an accounting rule could not overcome a long line of court decisions that ran counter to it. Robert Willens, a Managing Director at Lehman Brothers, says he’s not surprised by the decision and notes that accountants are used to different treatments of financial matters. “The purpose of accounting rules is to present fairly a financial picture of a company, but other forums have different objectives,” he says. “Litigation couldn’t possibly be bound by accounting classifications.” (c) 2006 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com