When Dual-Class Stock Met Corporate Spin-Offs

A corporate spin-off creates a new spun-off public company (“SpinCo”) by distributing the new company’s stock to the shareholders of a parent company (“ParentCo”) in the form of dividends proportional to their stock ownership. In this process of dividing one company into two or more stand-alone companies, the corporate spin-off offers potentially unchecked discretion for managers over corporate governance. First, because the SpinCo stock is internally distributed to ParentCo’s shareholders, the SpinCo’s various features including governance arrangements are not subject to market-pricing checks as in an Initial Public Offering (“IPO”). Second, current corporate law consistently treats a spin-off as a way to distribute dividends falling within managers’ discretion. ParentCo’s managers can solely decide whether, when, and how to make dividends through the form of a spin-off without shareholder approval. An important assumption for the lack of shareholder approval in a spin-off is that there are no fundamental changes to shareholder rights before and after the spin-off. Furthermore, the same assumption of mere change in forms of ownership also functions as a basis for tax-free benefit for spin-offs.

Our forthcoming article, Insulation by Separation: When Dual-Class Stock Met Corporate Spin-off, claims that the assumption for the special treatment of spin-offs is under attack. Recent practice suggests that ParentCo’s managers tend to stretch their discretion to add a new provision affecting the allocation of power between shareholders and managers to a SpinCo’s charter in a way to empower themselves over shareholders and to make them less accountable to shareholders (e.g., new antitakeover provisions). Such governance changes through SpinCo’s corporate charters are considered fundamental changes to the companies, which in principle require shareholder approval. The consequences of a spin-off may be far more transformative than those of a simple dividend distribution, but neither corporate law nor tax law properly addresses the problem arising from corporate spin-offs: stock that is proportional in numbers but differential in rights. Both areas of law have rarely considered the differences in rights attached to stock as long as the number of stock distributed is “pro-rata” to stock ownership. The article argues that the rights attached to stock should be taken into account in evaluating spin-offs in order to prevent opportunistic management insulation from shareholder intervention.

The potential agency problem inherent in the managers’ unilateral governance changes described above can be significantly compounded when ParentCo’s managers adopt a dual-class stock structure in SpinCo’s charter without shareholder approval. Dual-class stock, which involves two or more classes of common stock with unequal voting rights, has been on the rise. By adopting a dual-class stock structure, one class of shareholders receives a higher voting right per share than the others. Often times, corporate charters even prohibit trading high-vote stock on the market. Thus, dual-class stock is one of the most effective tactics for a small number of insiders to retain corporate control without corresponding equity interests. As shareholder voting remains the primary tool for incorporating shareholders’ voice into corporate decisions, any deviation from the one-share-one-vote standard (e.g., by adopting dual-class stock structure) must be explicitly set forth in the company’s charter. Nevertheless, as this Article reveals, a spin-off offers leeway for managers to switch to the dual-class structure in the post-IPO stage. The adoption of dual-class stock through a spin-off not only bypasses the shareholder approval requirement for a charter amendment under corporate law, but it also has the effect of overriding the rules of the major stock exchanges that prohibit a post-IPO switch from a one-share-one-vote principle to dual-class stock except through IPOs.

The deviation from the assumption of no fundamental changes before and after the spin-off also has significant implications for the tax law treatment of spin-offs. The reason that tax law offers a tax-free benefit to certain spin-offs is that if a corporate reorganization through spin-off is a mere change in form yet more efficient for the business, tax law will facilitate the transaction by deferring tax liability that should have been imposed on the separating transaction. The tax benefit is so attractive that the popularity of corporate spin-offs largely derives directly from the tax-free benefit status of the spin-off. However, if the governance changes during spin-offs are considered to be fundamental changes to the company, it is hard to justify tax-free status of those transactions. Nonetheless, current tax law, especially the “continuity of interest” doctrine, fails to scrutinize the problem. The requirements for tax-free spin-offs are supposed to guarantee that the spin-off is a mere change in corporate forms. In particular, the continuity of interest doctrine requires that shareholders of ParentCo continue their proprietary interest in SpinCo more than at a certain level. However, the doctrine does not consider qualitative differences in stock due to governance changes as long as historic shareholders of ParentCo receive an instrument labeled “equity.” Thus, tax law fails to determine whether spin-offs with significant governance changes could still be viewed as mere changes in form and thus deserving of tax-free benefits.

Rather than recommending constraints on managers’ discretion on corporate spin-off transactions in general, this article focuses on the potential risks of unconstrained managerial discretion over “governance arrangements” during spin-offs, which deviates from the initial intent of both corporate and tax legislation on the issue. Given the increasing popularity of both corporate spin-offs and dual-class stock issuances in recent years, the adoption of dual-class stock through corporate spin-offs seems likely to expand, and with the rise of the trend, the following contributions of the article will become increasingly pertinent. First, it adds another important but underdiscussed situation that expands the managers’ tendency to exercise their discretion to advance their own benefits over shareholders’. Second, it engages the current debate on whether dual-class stock is conducive to shareholder value. Both advocates and opponents of dual-class stock, however, pay little attention to the further possibility that managers can unilaterally rearrange the initial allocation of voting rights through spin-offs and/or subsequent transactions. Such possibility should be considered in evaluating the advantages and disadvantages of dual-class stock. Third, this article updates the tax law literature on the continuity of interest requirement in spin-offs by offering critiques from a policy and legal perspective. Furthermore, this article advances the debate on the efficacy and merit of current tax law influencing corporate governance and agency costs.

The article makes various policy proposals in both corporate and tax law to address the potential agency problems discussed above. Corporate law should consider a shareholder approval requirement for spin-offs that are sizable, or that substantially amend a SpinCo charter. At the same time, tax law needs to revisit the continuity of interest requirement to evaluate to what extent a spin-off involving governance changes can be treated as a tax-free (or tax-deferred) transaction. The IRS Pilot Program to examine broader issues in spin-offs has just become permanent in March 2019, which we hope will work as a good platform to review the eligibility of tax-free benefits for spin-offs accompanied by significant governance disparity.

The complete article is available here.