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Chapter 8 Corporate Combinations: Corporate Law Aspects

Copyright 2013, Stanley Siegel

NOTE: Corporate Law in this draft reflects developments only as of 2000 I. INTRODUCTION A.The Importance of Form. This chapter examines the formal requirements, imposed primarily by state corporation law, for effectuating corporate combinations. Perhaps surprisingly, these requirements vary widely not only among jurisdictions, but also between the forms of corporate combination. Any of numerous structures may be devised to carry out a corporate combination, all with essentially or exactly the same economic and substantive end results. However, the legal rules applicable to these structures, including approval and disclosure formalities as well as shareholder and creditor protections, will often vary widely. From the planning perspective, therefore, form may be all important. Business combinations are referred to by many names -- merger, combination, acquisition, purchase, pooling, etc. -- which have varying and often ambiguous meanings, dependent upon the context in which they are used. In the literature and in practice, the two sides of the transaction are also referred to by a variety of terms, including the buying and selling corporations, the surviving and disappearing corporations, or the acquirer and the target. The corporate laws impose occasionally similar, but more often different, requirements on the two sides of the combination transaction. The choice of the form of combination, and in many instances of some of the economic and substantive terms, will be affected by the likelihood of satisfying these requirements and the costs that must be incurred to do so. For example, when one

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form of transaction (such as a statutory merger) requires the vote of stockholders of both corporations, while an equivalent alternative (such as a sale of assets) requires the vote of the stockholders of only one, the choice of the latter may result in significant savings of time and money. That two transactions which are economically and functionally equivalent are treated differently by the law poses important questions for the legal system, but leaves little choice for the business planner who is intent upon carrying out the interests of his or her client. The choice of form will not turn entirely on the corporate law formalities and protections examined in this chapter. Additional issues, including accounting treatment, disclosure and reporting requirements imposed by the Securities and Exchange Commission or by state law, federal and state income tax treatment, and the requirements of loan agreements or other contractual commitments, may significantly affect the form and substance of the transaction. However, the corporate law requirements come first, both logically and operationally: if the transaction cannot be approved pursuant to state law, it obviously cannot be implemented. B.Voting. The first line of legal protection for stockholders is ordinarily the right to vote on a transaction, the requirement that the transaction be approved by a stated proportion of the shares as a condition to its implementation. As applied to corporate combinations, this requirement generally consists of three parts: approval of the transaction by the board of directors, notice and disclosure of the transaction to the stockholders, and approval by stockholder vote.1 The important issues of which transactions require stockholder approval, and which corporation's stockholders are enfranchised are discussed further below. Most state corporation laws now require only a majority vote of stockholders to approve a corporate combination or other major corporate transaction, but that majority is measured by the number of shares entitled to vote,2 not merely by the number present at the meeting or actually voting. Some state laws retain larger majority requirements for certain transactions, typically 2/3 1..Model Bus. Corp. Act § 11.03.

2..Model Bus. Corp. Act § 11.03(e) (merger); § 12.02(e) (sale of assets); § 14.02(e) (dissolution); § 10.03(e) (amendment of articles of incorporation).

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majority for approval of a merger,3 and all permit the articles of incorporation to provide for a greater than majority voting requirement.4 An additional issue is posed when, by the terms of the articles of incorporation5 or the state corporation law,6 the shares of a particular class of stock are entitled to vote separately on a transaction. Typically, class voting rights are imposed by statute when the transaction affects, normally adversely, the rights of a particular class of shares; this issue is discussed further later in this chapter. Counting of votes can be illustrated by example: Example 1: The boards of directors of Apex, Inc. and Boulder Corp. have approved a plan of

merger providing for Boulder to be merged into Apex. The 10,000 outstanding shares of voting common stock of Apex will remain outstanding without change. Each of Boulder's 5,000 outstanding shares of voting common stock will be exchanged for one share of Apex common stock; and each of Boulder's 200 outstanding shares of non-voting preferred stock will be exchanged for 10 shares of Apex common stock. Under the Model Business Corporation Act, what votes will be required to approve the plan?

Approval of the Apex-Boulder merger requires a majority of the votes of each voting group entitled to be cast on the plan.7 Apex has only one voting group, common stock, and the required vote will therefore be 5,001 shares in favor. Note that since the statute requires an affirmative vote of a majority of those entitled to vote, failure to appear at the meeting or by proxy, or failure to vote altogether, is the equivalent of a negative vote on the plan. Boulder Corp. has two classes of stock outstanding, and therefore has two voting groups within the contemplation of the Model Business Corporation Act. If the preferred stock had by its

3..E.g., N.Y. Bus. Corp. L. § 903.

4..Model Bus. Corp. Act § 7.27.

5..Model Bus. Corp. Act §§ 7.25, 7.27.

6..Model Bus. Corp. Act § 11.03(f) (merger); § 10.04 (amendment of articles of incorporation).

7..Model Bus. Corp. Act § 11.03(e).

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own terms been entitled to a class vote on the merger, the statute would have enforced that right.8 Absent such a provision, the preferred stock would appear to have no voting rights. However, the statute grants a class voting right when a provision in the plan of merger would trigger class voting if contained in an amendment to the articles of incorporation.9 A change of preferred stock into common stock, as provided by the Apex-Boulder merger plan, would require such a class vote if contained in an articles amendment,10 and therefore a class vote is required on the merger itself. The approval requirement for the Boulder stockholders is a majority affirmative vote of each class: 2501 common shares and 101 preferred shares. This conclusion, in the Apex-Boulder merger and most similar transactions, appears obvious and is supported by the Official Comment to the Model Business Corporation Act.11 However, had the Boulder preferred stock been voting stock ab initio, both the statute and its commentary would support a critically different conclusion. In that instance, the required vote would have been a majority of all voting shares counted in the aggregate, plus a majority of the preferred stock counted separately.12 Apart from problems of determining the necessary majority, the Apex-Boulder example illustrates a recurring planning issue common to all the forms of business combination. When a corporation has multiple classes of stock outstanding, the class voting requirement creates the potential for a veto power by one group of stockholders. Often, the affected class may be convinced to vote in favor of the transaction by offering a favorable exchange rate. (If the Boulder preferred indicates dissatisfaction with the merger, perhaps an exchange ration of 11 or 12 to 1 will

8..Model Bus. Corp. Act § 11.03(e). This section similarly enforces greater-than-majority voting

provisions included in the articles of incorporation.

9..Model Bus. Corp. Act § 11.03(f)(1).

10..Model Bus. Corp. Act § 10.04(a)(2).

11..Model Bus. Corp. Act § 7.26 (official comment).

12..Thus, if the Boulder preferred had been voting stock, the required vote could have been satisfied by a favorable vote of 2401 common and 200 preferred. The total favorable vote (2,601) is a majority of all voting stock (5,200 shares), and the preferred favorable vote (200) is a majority of the class entitled to a separate class vote. See Model Bus. Corp. Act § 7.26 (official comment).

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achieve their favorable vote.) In some instances, the extra price is too great, and in others the class may simply vote "no" on any transaction. An alternate solution to the problem, discussed below, is to restructure the plan so that the Boulder preferred, and perhaps even the Boulder common, is denied the right to vote altogether. A variation on the voting process, allowed by every corporation statute, is approval by unanimous consent of the stockholders.13 Particularly when a corporation has relatively few stockholders, and when notice and a meeting would be inconvenient or impracticable, written consents may be distributed and collected to obtain and document the required stockholder approval. A few states have extended the consent procedure to non-unanimous approval. For example, in Delaware a transaction may be approved by majority consent and in fact implemented prior to notifying the non-consenting stockholders.14 In most instances, the questions of voting will relate only to stock, but this is not invariably the case. The Model Business Corporation Act does not allow bonds to vote,15 but voting debt is not unknown in many states.16 Moreover, even though debt generally carries no formal voting power, covenants limiting mergers, asset sales and other major corporate transactions are normally included in bond trust indentures and bank loan agreements. The effects of these contractual limitations are the same as a class vote: unless the bank or the bond trustee agrees with the merger, it cannot go through. The remedy of the ignored creditor in this situation is drastic, since breach of the bond covenant or the loan agreement normally allows the creditor to demand immediate payment of the entire debt. Therefore, the consent of major creditors will normally be required as a precondition to a corporate combination, whether or not they hold the formal right to vote. II. FORMS OF COMBINATION 13..See Model Bus. Corp. Act § 7.04.

14..Del. Gen. Corp. Law § 228.

15..Model Bus. Corp. Act § 7.21(a); see Official Comment.

16..See, e.g., Del. Gen. Corp. Law § 221.

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A. The Nature of the Combination: Corporate combinations differ in both form and substance. The first step in analysis of a proposed business combination is determination of its substantive character: the economic, financial, control and other business aspects of the transaction. Important legal, tax and financial considerations turn on whether the combination is in the nature of an acquisition, purchase or buyout or, alternatively, whether it represents the combination or pooling of continuing businesses under combined ownership. Like many other dichotomies in law and finance, this distinction is sharp at the extremes and blurred at the borders. Compare the facts of Example 1 (page 3, above), involving the Apex-Boulder combination, with the following illustration: Example 2: The boards of directors of Cory, Inc. and Darwin Corp. have approved a plan of merger

providing for Darwin to be merged into Cory. The 250,000 outstanding shares of voting common stock of Cory (which trades publicly at about $25 per share) will remain outstanding without change. Each of Darwin's 20,000 outstanding shares of voting common stock will be exchanged for $8.50 cash. An alternative plan is under consideration pursuant to which each share of voting common stock would be exchanged for $10 face amount of 11% subordinated debentures.

It will be seen in the discussion below that both examples are true mergers, in the legal sense. But they are more different than similar. The Apex-Boulder combination of Example 1 involves the combination of two businesses of roughly similar size, in which stockholders of each will remain as stockholders of the combined enterprise. The Cory-Darwin combination of Example 2 represents, in substance, the buy-out of a small corporation by a much larger corporation. The former stockholders of Darwin receive only cash, and have no continuing interest in the combined enterprise. Even in the alternative plan, former Darwin stockholders become only creditors, rather than equity participants, in the surviving company. We may for ease of reference refer to the Apex-Boulder transaction as a true business combination or pooling of interests, by contrast with the Cory-Darwin transaction, which we may refer to as a purchase or buy-out. Many business combinations can readily be categorized as one or the other. However, a variety of more complex transactions pose difficult questions of characterization. How does one characterize an Apex-Boulder combination when the Boulder

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stockholders immediately sell their newly-received Apex stock? What is the character of a transaction in which part of the consideration is stock and part is cash or debt? What importance should be attached to the relative sizes of the combining enterprises? These questions are not academic. The discussion in this and succeeding chapters will demonstrate that characterization of the transaction will determine the nature of the legal safeguards associated with it, the tax consequences to the parties to the transaction, and the nature of the financial reporting of the transaction. To complicate matters further, the characterization will vary in each context: legal, tax and financial reporting. B.Combinations in the Nature of Acquisition or Purchase: 1.Factors favoring purchase-type acquisitions. A variety of considerations may weigh in favor of a purchase-type acquisition, any one or several of which may be definitive: (a) Excess cash or inadequate leverage. A cash rich corporation will seek investment prospects for its excess funds, as opposed to seeking acquisitions in which further equity securities will be issued. Similarly, a corporation whose management seeks additional leverage might look for acquisitions funded by the issuance of debt, whether that debt is issued directly to the stockholders of the acquired company or is issued publicly to raise cash for acquisitions. The tender offer boom of the 1980's was financed largely with debt, with the direct effect of dramatically increasing the leverage of the acquiring companies. (b) Avoidance of equity dilution. Acquisitions in the nature of pooling invariably require the issuance of stock. To the extent that the newly-issued stock is voting, the result is dilution of the voting control of the stockholders of the acquiring company. And if the newly-issued stock participates fully in combined earnings (e.g., common stock), the additional issuance has a dilutive effect on earnings-per-share of the acquired company.17

17..This point is somewhat oversimplified. In fact, if the ratio of the earnings of the acquired

corporation to the number of shares issued in the acquisition exceeds the earnings-per-share of the acquiring corporation, then the post-acquisition earnings-per-share of the

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(c) Presence of favorable market conditions for issuance of new debt. When market interest rates are low, and similarly when unsecured or subordinated corporate debt is readily marketable, it may be to the advantage of an acquisition-minded company to issue long-term low-interest debt for acquisition purposes. The low fixed charge represented by low interest rates has the combined effect of minimizing the company's risk and maximizing the advantages of leverage.18 (d) Simplified acquisition structure. The discussion below will demonstrate that cash and debt financed acquisitions tend to avoid most compliance requirements (vote, appraisal remedy, etc.) under state corporate law, at least with respect to the acquiring corporation. (e) Minimize of SEC and state disclosure and filing requirements. Similarly, negotiated (as opposed to hostile) cash or debt financed acquisitions may minimize, or in some instances avoid entirely, certain SEC and state registration, filing and disclosure requirements, at least with respect to the acquiring corporation. (f) Tax advantages to one or both corporations. It is possible, though not common, that a purchase-type transaction might produce tax advantages in the form of higher basis for depreciable assets or inventories, without any adverse tax consequences. It is more likely that the parties will find no major tax disadvantages to the purchase-type acquisition in certain circumstances. (g) Desire of one group of stockholders to sell out. Commonly, a major reason for the purchase-type acquisition is that all or a substantial portion of the stockholders of the selling

company will actually increase. However, had the acquisition been financed with cash or debt, the increase in earnings-per-share would normally have been greater.

18..Suppose that the assets to be acquired have an expected long-term return of 14% based on their purchase price, and the acquiring company can publicly issue long-term bonds with an effective interest rate of 8.5% to finance the entire acquisition. Purchase-type acquisition in this instance provides the company with a 5.5% "free" return (14% - 8.5%), with relatively low risk, since the return on the assets would have to drop dramatically before the interest on the debt was not covered. In periods of low market interest rates, corporate debt financing tends to increase dramatically.

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corporation wish to discontinue their association, as both management and owners, with the enterprise. (h) Hostile acquisition. It is possible to structure a hostile takeover in the form of either a purchase or a pooling type acquisition, but the pooling is both economically and tactically impracticable in such acquisitions. Moreover, since most hostile acquisitions look to removal of the management of the target, stock ownership by the target stockholders in the acquiring company would be at least undesirable if not dangerous. Hostile acquisitions are almost invariably for cash, debt or a combination thereof. The discussion below, illustrating the forms of purchase-type acquisitions, will be based on a variation of the facts of the Cory-Darwin acquisition, discussed earlier, as follows: Example 3: The presidents of Cory, Inc. and Darwin Corp. have agreed in principle to a plan of

acquisition providing for Cory to acquire Darwin, or alternatively to acquire all the assets and assume all the liabilities of Darwin. The purchase price will be either $170,000 cash, or $200,000 of 11% subordinated debentures, or some combination thereof. Cory has outstanding 250,000 shares of common stock, which trade publicly at about $25 per share. Darwin has outstanding 20,000 shares of voting common stock, which is closely held.

2.Asset Purchase. The simplest form of acquisition, asset purchase for cash, debt, or a combination thereof, may be diagrammed as follows:

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Cash & Debt Assets & Liabilities (a)The buying corporation. From the viewpoint of Cory, the transaction involves acquisition of assets and assumption of liabilities in return for cash, debt or a combination thereof. Every element of the transaction is within the authority of the board of directors. Therefore, no part of this transaction will require notice, meeting or vote of the stockholders of Cory, Inc. (b)The selling corporation. Since the transaction involves Darwin's disposition of all its assets and liabilities, it has two steps: (i) Sale by Darwin to Cory of the assets, coupled with assumption by Cory of the liabilities, in exchange for stock, debt or a combination thereof; and (2) Probably, dissolution of Darwin and distribution of the proceeds of sale to its stockholders. The second step might not be part of the plan were Darwin to dispose of only a portion of its assets (such as an unwanted plant) and reinvest the proceeds. When the disposition involves all the assets, however, it is likely that the selling corporation will dissolve and distribute its assets. A corporation may normally dispose of a portion of its assets, even if the disposition is extraordinary, on the basis of approval by the board of directors. Corporation laws requiring

Cory, Inc.

Darwin Corp.

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stockholder approval of sales of assets are invariably limited to those outside the normal course of business and comprising substantially all the assets. For example, the Model Business Corporation Act explicitly grants the board of directors, without stockholder approval, the authority to sell or otherwise dispose of all assets within the usual and regular course of business and to mortgage all assets whether or not in the usual and regular course of business.19 Moreover, the Model Act by both explicit statutory inclusion and negative implication excludes from the stockholder approval requirement sales of less than substantially all the assets.20 The Delaware decision excerpted below indicates, however, that the determination of "substantially all" may not always be a simple question. In any event Darwin's asset sale would under most state corporation statutes require board approval, notice to stockholders, and a majority vote of the stockholders entitled to vote,21 for approval of the transaction.22 Moreover, most states grant the right of appraisal to voting stockholders who elect to dissent from the transaction, although the Model Act denies appraisal when the sale is entirely for cash and the proceeds of sale are distributed within one year after the date of the sale.23 The operations of the appraisal remedy, and the problems occasioned by its application, are discussed later in this chapter. KATZ v. BREGMAN Delaware Court of Chancery 431 A.2d 1274 (c)Dissolution following the sale. 19..Model Bus. Corp. Act § 12.01. Provisions of this general substantive import are to be found

in nearly all contemporary state corporation statutes.

20..Model Bus. Corp. Act § 12.01 (official comment), § 12.02.

21..See the discussion of voting, earlier in this chapter, for discussion of how the majority is calculated.

22..Model Bus. Corp. Act § 12.02.

23..Model Bus. Corp. Act § 13.02 (a)(3).

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Should Darwin elect to dissolve, it will be required to follow the statutory dissolution procedure, which invariably requires resolution of the board of directors, notice to stockholders, and majority affirmative vote of the voting stockholders.24 An interesting question is occasionally posed: does a stockholder vote authorizing dissolution automatically authorize sale of all assets? The Model Business Corporation Act appears to answer the question in the affirmative,25 but nevertheless preserves the appraisal remedy for dissenting stockholders unless the asset sale is for cash and the proceeds are distributed within one year.26 Dissolution is not a mere mechanical process. The Model Business Corporation Act, like all other corporation statutes, requires that claims against the corporation be discharged or that provision be made for their discharge.27 Failure to do so will occasion director and potential stockholder liability.28 Normally, in a Cory-Darwin type of acquisition, when the liabilities of a small corporation are assumed by a larger (and presumably more credit-worthy) corporation, creditors will accept assumption of their obligations as satisfactory provision. But this is not inevitable, and in some instances (including bank loans and mortgages), separate assumption provisions or even discharge of the debt may be required.

24..This procedure is detailed in Model Bus. Corp. Act § 14.02. Note that no class vote is

required for dissolution, since it is assumed that each class will receive its portion of the proceeds of liquidation in accordance with its interests. See Model Bus. Corp. Act § 14.05 (a)(4). If the plan of dissolution calls for a class of stock (e.g., preferred) to receive anything other than its rights as set forth in its terms, the plan will be treated as including an amendment of the articles of incorporation changing the rights, preferences or limitations of such shares. Such an amendment requires a class vote of the affected shares. Model Bus. Corp. Act § 10.04(a)(4).

25..Model Bus. Corp. Act § 14.05(a)(2) authorizes "disposing of its properties that will not be distributed in kind to its shareholders."

26..Model Bus. Corp. Act § 13.02(a)(4) extends the appraisal remedy to sales of all or substantially all the assets other than in the usual and regular course of business "including a sale in dissolution."

27..Model Bus. Corp. Act §§ 14.05(a)(3), 14.06 (known claims), 14.07 (unknown claims).

28..See Model Bus. Corp. Act §§ 6.40, 8.33.

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In summary: (i) The purchase by Cory requires only board approval, whatever the terms of the transaction; (ii) The sale by Darwin will require majority stockholder approval, whether solely as a sale or as a sale coupled with dissolution. If the sale is for cash alone, and the cash is distributed within one year, no appraisal remedy will apply. But if all or part of the consideration consists of debt or other consideration, the appraisal procedure will be applicable. 3. Stock Purchase. The purchase of stock often has quite different effects from the purchase of assets. The transaction can be diagrammed as follows: Step 1 Step 2 Darwin Corp. 100% Stock Cash & Debt Stock Ownership Darwin Corp. Stockholders

(a)The buying corporation. From the viewpoint of Cory, the stock acquisition (like the asset acquisition discussed above) involves only the acquisition of assets (in this case, stock of another corporation) in return for cash, debt or a combination thereof. Every element of the transaction is within the authority of the board of directors. Therefore, no part of this transaction will require notice, meeting or vote of the

Cory, Inc.

Cory, Inc.

Darwin Corp.

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stockholders of Cory, Inc. (b)The acquired corporation. From the viewpoint of Darwin, the transaction is a non-event. The Darwin Corp. takes no action to effect this transaction. Rather, the Darwin Corp. stockholders choose to give up their shares of stock in return for cash or debt. Thus, no vote or appraisal remedy is applicable. However, the Darwin Corp. stockholders must "vote with their feet," by electing to exchange their shares in return for the proffered consideration. If some of the stockholders are unwilling to accept, or are too lazy to send in their shares, or cannot be found, Cory might find itself owning less than all of the stock of Darwin. That result might be acceptable, or if unacceptable might be remediable by one of the techniques to be discussed later in this chapter.29 But the risk of an unacceptable result, and the potential costs of remedying it, render the stock-purchase transaction less desirable except in situations where the stock is held by few owners and all have evidenced in advance the desire to accept the deal. In some states, this difficulty in the stock-purchase transaction has been eliminated by the adoption of "share exchange" provisions in the state corporation law. These provisions, generally designed for share exchange mergers, are discussed in detail later in this chapter. At least some statutory provisions of this type would also be usable to achieve a stockholder-voted mandatory share purchase.30 After the first step in the transaction, assuming complete success, Darwin will be a wholly-owned subsidiary of Cory, as shown in step 2 of the diagram. An optional third step is available: dissolution of the acquired subsidiary. Although dissolution must be authorized by stockholder vote, Cory as the only stockholder of Darwin will be able to assure a favorable outcome of that vote should it desire to cause Darwin's dissolution.

29..These include short merger and freeze-out merger.

30..See Model Bus. Corp. Act § 11.02, which in subsection (b) permits the consideration for the share exchange to be cash or other property. Under this provision, a majority vote of the stockholders of Darwin could authorize a mandatory exchange of all Darwin stock for cash to be paid by Cory. See Model Bus. Corp. Act § 11.03(b).

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In many if not most instances of stock acquisition, however, the wholly-owned subsidiary will not be dissolved, since there will be several important business advantages to retaining the separate subsidiary. Indeed, a principal reason for undertaking a stock acquisition (as opposed to an asset acquisition or a merger) is to assure retention of the acquired subsidiary. Primary among the advantages are the insulation of the acquiring corporation from the debts of the subsidiary. In only the rarest of cases will courts apply the doctrine of "lifting the corporate veil" to hold an acquiring parent corporation liable for the debts of an acquired subsidiary. Particularly when the subsidiary is engaged in liability-intensive activities (involving, for example, the risk of environmental disaster or product liability), retention of the subsidiary may be a critical element of the acquisition plan. Similarly, if the acquired corporation has significant contingent liabilities, the acquiring corporation can be most effectively protected against them by retaining the subsidiary. Retention of the subsidiary may also avoid the need to retitle property, pay various transfer taxes, renegotiate contracts and franchises and obtain new licenses, all of which would likely be attendant upon an asset acquisition or merger. Of course, there can be no assurance that some or all of these procedures will not be required; in any acquisition, the process of due diligence examination will unearth contract, filing or compliance problems that may or may not be avoided by choice of form. A further and not insignificant virtue of retention of the subsidiary may be preservation of certain favorable tax attributes. This issue is discussed in the next chapter. In summary: (i) The stock purchase plan has the considerable advantage of retaining the separate corporate structure of the acquired corporation; (ii) The stock purchase by Cory requires only board approval, whatever the terms of the transaction; (iii) The sale by Darwin stockholders requires no stockholder vote as such, but requires the more unwieldy process of convincing the Darwin stockholders to turn in their shares in return for cash; (iv) In some states, the problem of convincing the stockholders to turn in their shares has been statutorily solved by enactment of mandatory share exchange statutes. 4.Cash Merger.

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Earlier in this chapter, an example was given in which a statutory merger was effected, but the former stockholders of the merged-out corporation received cash instead of shares of stock of the surviving corporation. Corporation statutes now nearly universally authorize the exchange of any form of consideration for the stock of the acquired or merged-out corporation, including cash. The cash merger may be diagrammed as follows: Assets and Liabilities Cash Darwin Corp. Disappears in Stockholders Merger The cash merger, like mergers involving other forms of consideration, generally requires approval by affirmative vote of the stockholders of both corporations.31 Barring exceptions to this rule, which will be explored further below, the cash merger would therefore require approval of the boards of both Cory and Darwin, notice to the stockholders of both corporations, and a majority affirmative vote of the stockholders of both corporations at duly held stockholders' meetings. Moreover, the appraisal remedy would ordinarily be available to the stockholders of each corpora-

31..Model Bus. Corp. Act § 11.03(a).

Cory, Inc.

Darwin Corp.

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tion who are entitled to vote on the plan of merger.32 The immediate question is then why such a plan would be considered, if its substantive effects can so readily be achieved by other plans not requiring a vote of both corporation's stockholders. The answer to this question lies in the mechanical operation of the statutory merger. First, it should be noted that when the constituent corporations are both closely held, it is often a minor matter to obtain approval of both groups of stockholders. Second, although the process of approval may be rendered more complex as a result of two stockholder votes, the implementation of a statutory merger is often simpler than the other acquisition or combination methods. A statutory merger automatically transfers title to all assets, and obligations on all liabilities, to the surviving corporation.33 No conveyances, title changes, notices to creditors or similar documents are necessary. Generally, the statutory merger form is more advantageous in pooling-type mergers as opposed to cash mergers. In practice, the statutory authorization to use cash as consideration in a merger is most widely used in two settings: (i) Cash is occasionally used either as partial consideration or as optional consideration for the shares of the merged-out corporation; (ii) The cash merger is widely used as a squeeze-out device in hostile acquisitions. Both of these uses are further described later in this chapter. In summary: (i) A cash merger of Darwin into Cory would normally require board approval, notice and stockholder vote by the stockholders of both corporations; (ii) The appraisal remedy would normally be available to the stockholders of both corporations; (iii) In return for these approval formalities, the merger offers considerably simplified implementation of the actual acquisition. 5.Multi-corporate variations: triangles and drop-downs. Mergers, like many other corporate transactions, may be used as components of larger multi-part business plans. In its simplest form, the multi-party merger involves the merger of the 32..Model Bus. Corp. Act § 13.02(a)(1). The appraisal remedy is discussed further later in this

chapter.

33..Model Bus. Corp. Act § 11.06(a)(2), (3).

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acquired corporation into an existing or newly-created subsidiary of the acquiring corporation. Such a "triangular" cash merger may be diagrammed as follows:

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Step 1 100% Stock Ownership Cash Assets and Liabilities Darwin Corp. Stockholders Merged into Cory Acquisition, Inc. Step 2 100% Stock Ownership

Cory, Inc.

Cory Acquisition, Inc.

Darwin Corp.

Cory, Inc.

Cory Acquisition, Inc.

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The use of multi-party mergers (in both purchase and pooling type transactions) developed in response to the need to achieve certain results not obtainable by traditional combination or acquisition forms.34 Suppose that in the Darwin-Cory example it were essential to insulate Darwin from Cory's contingent product liabilities. Neither an asset acquisition nor a merger of Cory into Darwin would achieve this result. Suppose, too, that a significant minority of Cory's stockholders would simply not turn in their stock if offered cash in exchange. Therefore, Darwin would be faced with the Hobson's choice of either assuming all contingent liabilities or acquiring less than 100% of Cory.35 Use of the triangular cash merger in this setting would effectively satisfy all of Darwin's objectives. Since the transaction would take the form of a merger, a majority vote of Cory's stockholders would bind all of them. And since Cory would merge not into Darwin, but into a newly-formed subsidiary, its liabilities would never attach to Darwin. Authority to effectuate multi-party mergers appears in most state corporation laws in the description of the consideration permitted to be exchanged for the acquired corporation's stock. For example, the Model Business Corporation Act states that the plan of merger must set forth: "the manner and basis of converting the shares of each corporation into shares, obligations, or other

securities of the surviving or any other corporation or into cash or other property in whole or in part."36

The consideration, whether cash, shares or other property, may therefore flow from any corporation.

34..Asset acquisitions and stock acquisitions can similarly be effected through subsidiary

corporations. All of these forms can, as well, involve more than three corporations. To set some practical limits on the discussion, only three-party ("triangular") mergers are diagrammed and evaluated. Similar considerations apply to multi-party asset and stock acquisitions and to transactions involving additional entities.

35..This dilemma no longer exists in states that have adopted mandatory share-exchange provisions. See, e.g., Model Bus. Corp. Act § 11.02, discussed later in this chapter.

36..Model Bus. Corp. Act § 11.01(b)(3).

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In the diagram, the merger occurs between Darwin Corp. and Cory Acquisition, Inc., the latter having been formed by Cory, Inc. for the specific purpose of the acquisition. And though Darwin is merged into Cory Acquisition, Inc. the consideration flows from Cory, Inc. An interesting side-effect of the triangular merger is that in most states it effectively eliminates the voting rights and the appraisal remedy of the parent corporation's stockholders (Cory, Inc., in the diagram). Note that the required stockholder vote is of the merging corporations, and in the diagram those are Darwin and Cory Acquisition. Since Cory Acquisition is a wholly-owned subsidiary of Cory, Inc., its shares are voted by Cory, Inc. And since Cory, Inc. is not merging with another corporation, its stockholders do not vote on the transaction.37 Moreover, since the appraisal remedy with respect to corporate mergers is in most states granted only to stockholders entitled to vote on the transaction,38 it is also denied to the stockholders of Cory, Inc. in the triangular merger. A variation on the theme of the triangular merger is the corporate acquisition followed by a "drop down" into a newly-formed or existing subsidiary of the acquiring corporation. The acquisition can take any form, asset acquisition, stock acquisition39 or statutory merger. Immediately following the acquisition, all or part of the acquired assets and liabilities are transferred to the subsidiary in exchange for all or a part of the subsidiary's stock.40 37..A few states by statute reject this analysis, and provide voting rights and the appraisal

remedy to the stockholders of a parent corporation whose subsidiary is a party to a triangular merger. See Cal. Gen. Corp. Law §§ 1200, 1201, requiring board and shareholder approval by the corporation in control of any constituent or acquiring corporation, the "parent party."

38..See Model Bus. Corp. Act § 13.02(a)(1). The appraisal remedy is discussed further later in this chapter.

39..Normally, a drop down is not required following a stock acquisition, since the acquired assets remain in a separate corporation. However, in some instances a portion of the assets of the newly-acquired corporation may be dropped down to yet another corporation to achieve further separation of ownership and liabilities.

40..This "drop down" of assets and liabilities will ordinarily be a tax-free transfer pursuant to IRC § 351(a). Details of the tax aspects of this transaction are discussed in the next chapter.

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The drop-down has the advantage of insulating the acquiring corporation from future liabilities of the subsidiary. It has the disadvantage, relative to the triangular merger, that preexisting liabilities (including contingent and unasserted claims) attach to the acquiring corporation as of the acquisition. The subsequent dropping down of the assets does not relieve the acquiring company of ultimate liability on those claims. In summary: (i) Preservation of the separate corporate status of the acquired corporation, particularly when the share exchange cannot be effectively carried out, can be achieved by means of a triangular merger; (ii) A triangular merger of Darwin into a subsidiary of Cory would normally require stockholder vote only by the stockholders of Darwin; (iii) The appraisal remedy would normally be available only to the stockholders of Darwin; (iv) An alternative to the triangular merger, offering insulation only with respect to post-acquisition liabilities, is the asset purchase or cash merger followed by a drop-down of the acquired business or assets into a newly-formed subsidiary. 6. Hostile acquisition: the freeze-out merger. The preceding section illustrated the use of the multi-corporate (triangular) merger to achieve the results of a 100% stock acquisition while avoiding vote and appraisal by the acquiring corporation's stockholders. The same mechanism and the same diagram demonstrate that the multi-corporate merger can be used effectively as part of a plan to achieve a hostile takeover. Example 4: Suppose that Cory, Inc. decides to acquire all the stock of Darwin Corp., but that a

significant minority (40%) of the Darwin stockholders are unwilling to part with their shares at any price. Cory purchases 60% of the Darwin stock for cash from those stockholders who are willing to sell. What should be the next step?

One approach to the problem is a statutory merger of Darwin Corp. into Cory, Inc. As noted earlier in this chapter, the merger would require a majority vote of the stockholders of both corporations, and the appraisal remedy would be available to both groups of stockholders. Since Cory now owns a majority of the stock of Darwin, a favorable vote by the Darwin stockholders on the merger is a foregone conclusion.41 And the appraisal remedy results only in payment of cash to 41..Issues of fairness and business purpose, which may affect the terms of the merger, are

discussed later in this chapter.

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dissenting stockholders, a result that was desired by Cory from the beginning. The statutory merger may not be the ideal answer to the problem, for the reasons discussed earlier in this chapter. It may be essential, for liability protection and other business purposes, to preserve the separate corporate status of Darwin following the acquisition. An alternative mechanism that achieves this objective would be the triangular merger. As step 1, Cory would establish a new subsidiary, Cory Acquisition, Inc., and transfer to it the previously acquired 60% of the stock of Darwin in return for 100% of the Cory Acquisition stock. Step 2 would be a cash merger of Darwin into Cory Acquisition, Inc., under the terms of which all remaining outstanding shares of Darwin Corp. would receive cash. The freeze-out is complete: Cory, Inc. now owns 100% of the stock of Cory Acquisition, Inc., which in turn is (as a result of the merger) the successor to all the assets and liabilities of Darwin. An important added virtue of the triangular merger, in this as in other settings, is that it can be achieved in most states without the vote or appraisal remedy of the stockholders of the parent corporation. An elegant variation on the freeze-out theme, the freeze-in merger, has been used to solve the problem of the reluctant preferred stockholders. This subject is discussed and illustrated in the section of this chapter on fairness. 7.Partial acquisitions: "thinning down" the acquired corporation. Not infrequently, the acquiring corporation wishes to obtain some, but not all, of the assets or business of another corporation. The simplest method of achieving this goal in many instances is to acquire a portion of the assets for cash. If the acquired business or assets pose potential liability problems, the acquisition can be made by a newly-created subsidiary of the acquiring corporation, into which sufficient cash has been transferred to finance the transaction. Alternatively, the transaction may be structured as a stock acquisition or as a triangular merger. The unwanted assets or business must then be disposed of, either before, concurrent with or after the acquisition. The process of "thinning down" the acquired corporation poses no unique corporate problems, since the sale or disposition of a portion of the corporation's assets will generally be within the discretion of the board of directors.42 The transaction may, however, pose 42..Model Bus. Corp. Act § 12.01.

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interesting tax questions, which are discussed in the next chapter. C.Combinations in the Nature of Pooling: 1. Factors favoring pooling-type combinations. A variety of considerations may weigh in favor of a pooling-type combination, any one or several of which may be definitive: (a) Minimizing of cash drain. Pooling-type combinations are invariably effected through issuance of all or a substantial part of the consideration in the form of stock of the surviving corporation. Cash drain in the transaction is therefore limited to the legal, accounting and other costs of effecting the arrangement, plus any periodic dividend payments the board may make on the newly-issued stock after the acquisition. By contrast, the purchase acquisition will normally involve either direct cash payment for the acquired assets or stock, or mandatory dividend and principal payments on debt issued as part of the acquisition price. (b) Continuation of both managements and ownership interests. It is often in the interests of the parties to retain all or part of the existing management and ownership structure of the combining companies. Under these circumstances, combination by issuance of stock is generally the preferred approach. (c) Tax advantages. In many, if not most, instances, important tax advantages can be secured by using the pooling-type acquisition. These include avoidance of tax on the gain resulting from exchange of stock and securities in the transaction, as well as retention of certain desirable tax attributes of the constituent corporations. These tax considerations are discussed in the next chapter. (d) Accounting and reporting issues. Prior to revision of the accounting standards for business combinations, the required accounting disclosure for purchase-type transactions was considered undesirable by the business community. Under current standards, acquisition accounting requires that the acquirer restate the value of acquired assets and liabilities. The restatement of asset values often results in the creation of a substantial goodwill account on is

25

books. Details of this accounting treatment are discussed in the next chapter.43 (e) Creation of a broader public market for corporate securities. Quite commonly, a small publicly- or privately-held corporation merges with a larger publicly-held corporation with a major objective being to achieve broader public ownership and a more readily ascertainable market value for the shares held by the owners of the smaller company. (f) Presence of favorable market conditions for issuance of new stock. A strong stock-market condition for equity securities means that newly-issued stock will have maximum value (and therefore minimum dilutive effect). In such circumstances, particularly when coupled with high interest rates (rendering issuance of debt undesirable), stock-financed combinations tend to be favorable. The discussion below, illustrating the forms of pooling-type combinations, will be based on a variation of the facts of the Apex-Boulder combination, discussed earlier in this chapter, as follows: Example 5: The presidents of Apex, Inc. and Boulder Corp. have agreed in principle to a plan of

combination pursuant to which Boulder's assets and liabilities, or Boulder's stock, will be acquired by Apex; alternatively Boulder will be merged into Apex. The plan provides for the 10,000 outstanding shares of voting common stock of Apex to remain outstanding unchanged. Each of Boulder's 5,000 outstanding shares of voting common stock will receive one share of Apex voting common stock; and each of Boulder's 200 outstanding shares of non-voting preferred stock ($100 per share liquidation preference) will receive 10 shares of Apex voting common stock.

43..Much was made in the financial press about the relative advantages of pooling accounting

over purchase accounting. Whether the accounting differences were so consequential as to affect the form of the deal was never clear. Contemporary financial theorists are in agreement that the differences have no effect on the stock market.

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2.Stock-for-Assets: The stock-for-assets combination involves the issuance by the acquiring corporation of stock (or a combination of stock and other consideration) in return for the assets of another corporation. In most instances, the liabilities of the other corporation are assumed in the same transaction, and in most instances the newly-issued stock and other consideration is distributed in liquidation of the selling corporation. This combination, like others to be discussed in this section of this chapter, is often referred to by reference to the section of the Internal Revenue Code that governs qualification for tax-free reorganization status. The stock-for-assets combination is governed by section 368(a)(1)(C), and is commonly known as a "C Reorganization." It can be diagrammed as follows: Step 1 Step 2 Apex Assets and Dissolved Stock Liabilities Apex Stock Boulder Corp. Stockholders

Apex, Inc.

Apex, Inc.

Boulder Corp.

Boulder Corp.

27

(a) The buying corporation. From the viewpoint of Apex, the transaction involves acquisition of assets and assumption of liabilities in return for newly-issued stock and -- possibly -- other consideration. If the articles of incorporation of Apex authorize a sufficient number of shares of the appropriate class or classes, the transaction on its face will be entirely within the authority of the board of directors and will not require notice, meeting or vote of the stockholders of Apex. Often, corporations in the position of Apex do not have sufficient authorized shares. Moreover, if a portion of the consideration is to be other than common stock, it may be necessary to authorize the additional class unless series authorization is already included in the articles of incor-poration.44 Authorization of additional shares, or of a new class of shares, requires amendment of the articles of incorporation, a process that will require resolution of the board of directors, notice to stockholders, and an affirmative majority vote on the amendment at a stockholders' meeting.45 Additionally, if the shares to be authorized carry rights or preferences with respect to distribution or dissolution that are prior, superior or substantially equal to those of an already outstanding class, that class will be entitled to vote separately on the transaction,46 pursuant to the procedure outlined earlier in this chapter. The notice to stockholders and the request for their vote on the amendment will clearly be proxy materials within the meaning of Section 14 of the Securities Exchange Act and the regulations thereunder. Among the material items required to be disclosed in the notice, apart from the terms of 44..The Model Business Corporation Act, like many recently revised corporation statutes, allows

inclusion in the articles of incorporation of a provision permitting the board of directors to designate the rights, preferences and limitations of any class or series before issuance thereof. See Model Bus. Corp. Act § 6.02. Acquisition minded corporations often include such a provision in their articles of incorporation, coupled with an ample authorization of preferred stock, to provide flexibility in future acquisitions or stock flotations.

45..Model Bus. Corp. Act §§ 6.01, 10.03.

46..Model Bus. Corp. Act § 10.04(a)(6).

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the proposed amendment, will be any plans that the corporation is presently considering for issuance of the newly-authorized stock. In other words, if Apex must seek stockholder approval for authorization of additional shares, the required approval will in practical effect be not only of the authorization, but also of the acquisition in which the shares are to be issued. All of these considerations suggest strongly the importance of advance planning in the drafting of the articles of incorporation. Sufficient authorization of shares, together with series preferred authorization, will eliminate the need for any stockholder vote by Apex, except in the unlikely event of the application of the de facto merger doctrine, discussed further below. (b)The selling corporation. The procedures that must be followed by Boulder as the selling corporation are similar to those that were described earlier (with respect to Darwin Corp.) to authorize an asset sale for cash. The rights available to Boulder's stockholders and creditors may be somewhat different. The sale will be a disposition of all or substantially all the assets of Boulder, and will therefore require board approval, notice to stockholders, and a majority vote of the stockholders entitled to vote.47 Although Boulder has two classes of stock outstanding, the preferred stock is by its terms non-voting, and state corporation laws generally do not grant a statutory class vote on sale of assets. However, the Model Business Corporation Act, like many but not all state corporation laws, grants the appraisal remedy to stockholders dissenting from the sale.48 And in the case of the sale for stock, as opposed to a sale for cash followed by prompt distribution thereof,49 no exception to the appraisal remedy is granted. Boulder will also require authorization of dissolution and distribution of the stock received as consideration for the sale. The required procedure for dissolution -- board approval, notice to stockholders, and majority affirmative vote of the voting stockholders50 -- can be combined with the 47..Model Bus. Corp. Act § 12.02.

48..Model Bus. Corp. Act § 13.02(a)(3).

49..Ibid.

50..Model Bus. Corp. Act § 14.02.

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vote to approve the asset sale. Again, no class vote is granted by statute to the Boulder preferred stockholders. In dissolution, however, each class of stock is entitled to receive proceeds in accordance with its terms.51 Therefore, upon dissolution the Boulder preferred stock would be entitled to $20,000 cash (200 shares x $100 per share liquidation preference). However, the proposed terms of the transaction call for Boulder to receive 7,000 shares of Cory common stock, and no cash, in exchange for its assets.52 It will therefore be necessary, as part of the plan, for Boulder to amend its articles of incorporation, changing the liquidation preference of the outstanding preferred stock from $100 cash per share to the sale consideration that will be distributed in liquidation: 10 shares of Apex common stock. This amendment will require a class vote of the Boulder preferred stock, since it changes the "designation, rights, preferences, or limitations" of the preferred stock.53 Thus, the stock-for-assets plan requires of the selling corporation three votes: (i) approval of the sale; (2) amendment of the articles changing the preferred stock liquidation preference; and (iii) approval of dissolution. The votes may, and should, be combined and made contingent upon approval of all simultaneously.54 The result of the combined votes will be that the Boulder stockholders will effectively have a class vote on the transaction, plus an appraisal remedy. (c)The problem of reluctant preferred stockholders. The preferred stockholders of Boulder may be unwilling to vote in favor of the plan. This problem may be solved in several ways. The most obvious and simple solution is to offer the preferred stock greater consideration, perhaps 11 or 12 shares of Apex common stock in return for 51..See Model Bus. Corp. Act § 14.05(a)(4).

52..The amount of stock to be issued by Cory in the acquisition can be calculated from the exchange ratios agreed to by the presidents of the two corporations, as follows:

5,000 common x 1 share each = 5,000 shares 200 preferred x 10 shares each = 2,000 shares Total 7,000 shares

53..Model Bus. Corp. Act § 10.04(a)(4).

54..See Goldman v. Postal Telegraph, Inc., 52 F. Supp. 763 (D.C. Del. 1943) (Delaware law), in which these three steps were combined successfully and were upheld by the court.

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each preferred share. The plan might, however, still be unacceptable to the preferred stockholders. Moreover, the shifting of consideration to the preferred stockholders might be so great as to make the plan unacceptable to the common stockholders.55 It may in some instances be feasible to adopt a plan under which the common stock receives new common stock of the acquiring corporation, while the preferred stock receives cash equal to its liquidation preference. Since this plan would not change the liquidation preference of the preferred stock, they would have no vote on the plan whatever. But this plan has a number of serious problems, one of which is that the entire plan almost certainly will not qualify for advantageous tax-free reorganization treatment.56 Moreover, this plan calls for the preferred stock to be paid its full liquidation preference, which may in fact be greater than its value.57 Finally, in some instances the required cash payment may strain the cash resources of the acquiring company. Alternatively, the acquisition may be modified to provide that the preferred stock of Boulder will receive in the exchange identical preferred stock of Apex. Since in that case the terms of the preferred stock would be unchanged (though it would be stock in a different corporation) it might be possible to avoid a preferred stock class vote on the transaction.58 This approach has the possibly

55..The total consideration to be issued to Boulder (in Apex stock, cash or any other form) is a

function Apex's view of the value of Boulder. That value is independent of allocation of the consideration among the classes of Boulder stock. Therefore, increasing the consideration to one class of Boulder stock will correspondingly decrease the consideration to the other.

56..See Internal Revenue Code §§ 368(a)(1)(c), 368(a)(2)(B). This issue is discussed in detail in the next chapter.

57..On the other hand, particularly if the preferred stock carries a high dividend rate, its liquidation preference may be lower than its value. Indeed, in some instances it will be desirable to cash-out the preferred stock (possibly by pre-acquisition redemption by the issuing corporation) before the plan is implemented.

58..This point is not perfectly clear, and is not addressed directly by any corporation statute. For example, none of the statutory grants of class voting in Model Bus. Corp. Act § 10.04(a) applies to exchange of preferred stock for identical preferred stock of another corpora-tion. Moreover, if the stock issued in exchange is stock of a corporation with a greater asset base -- normally the case following a corporate combination -- the rights of the new

31

undesirable feature of leaving the Boulder preferred stock outstanding, retaining its full liquidation preference and its priority in dividends. Yet another alternative is to stand the transaction on its head: let Apex sell its assets to Boulder. Since the purchasing corporation requires no stockholder approval of the transaction (unless approval is required to authorize the stock to be issued), no vote will be required of any Boulder stock, common or preferred. This "reverse sale" strategy is also useful when it is difficult to obtain approval by the common stockholders of one of the combining corporations. Like other strategies, it too is not without problems. One difficulty is that the Boulder preferred stock remain outstanding under this plan. Another is that the reverse sale is a prime candidate for "de facto merger" treatment, as discussed below. (d)The de facto merger doctrine. The stock-for-assets combination, coupled as it almost invariably is with dissolution of the selling corporation, generally has exactly the same effects as a statutory merger. However, both voting procedures and appraisal rights are more extensive in mergers than in stock-for-assets combinations. The most important distinction is, in general, the denial of voting rights and the appraisal remedy to stockholders of the surviving corporation in a stock-for-assets combination. Another difference present in some jurisdictions is a lower vote requirement (generally majority) for authorization of sale of assets than for a merger (often two-thirds). The reasons underlying these statutory distinctions are unclear. They may, indeed, have had their origins in a drafting oversight, failure to foresee the use of the asset-sale authorization to achieve the results of a merger. Whatever the reasons for the differences, they led to widespread use of the stock-for-assets combination as a device to avoid the need for a stockholder vote and appraisal remedy for one group of stockholders. And, as suggested earlier in this chapter, occasionally the sale was reversed, so that the actual selling corporation became the putative purchasing corporation, and its stockholders were denied the vote.59

preferred stock are likely effectively superior to those of the stock it replaced. Cf. Dalton v. American Investment Co., 490 A.2d 574 (Del. Ch.), aff'd, 501 A.2d 1238 (Del. 1985), excerpted later in this chapter.

59..The most famous instance of such a transaction, and possibly the impetus for creation of the

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The status of these transactions was occasionally contested by disenfranchised stockholders of the "buying" corporation. They sought, and occasionally obtained, voting and appraisal rights based on the theory that the transaction was, in fact, a merger. The "de facto merger" doctrine has been accepted in some cases60 and a few statutes, but rejected by many jurisdictions either in litigation or in legislation. In many jurisdictions, its status remains unclear. The Delaware and Pennsylvania decisions excerpted below demonstrate both judicial and legislative grounds for rejection of the doctrine. The excerpts of the California General Corporation Law represent the most expansive statutory enactment of the doctrine's underlying theory: that all reorganizations in whatever form should be subject to the same statutory requirements and protections. In summary: (i) The purchase by Apex requires only board approval, unless Apex has insufficient authorized shares; (ii) If Apex has insufficient authorized shares, or if the de facto merger doctrine is applicable by statute or case law, the full transaction will require board resolution, notice to stockholders, and majority stockholder approval; (iii) The sale, dissolution and distribution by Boulder will require majority stockholder approval and a class vote of the preferred stock, and will create an appraisal remedy for dissenting stockholders; (iv) A variety of techniques, with varying degrees of desirability, may be utilized to avoid a class vote or, if necessary, to disenfranchise the Boulder shareholders entirely. HARITON v. ARCO ELECTRONICS, INC. Delaware Court of Chancery, 1982 40 Del.Ch. 326, 182 A.2d 22 affirmed 41 Del.Ch. 74, 188 A.2d 123(1963) TERRY v. PENN CENTRAL CORP. United States Court of Appeals, Third Circuit, 1981

doctrine at least as it applies to stockholder rights, is Farris v. Glen Alden Corp., 393 Pa. 427, 143 A.2d 25 (1958). The subsequent history of the Farris doctrine in Pennsylvania is discussed in Terry, excerpted below.

60..See, e.g., Rath v. Rath Packing Co., 257 Iowa 1277, 136 N.W.2d 410 (1965).

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668 F.2d 188 3.Stock-for-stock; share exchange: The stock-for-stock combination involves the issuance by the acquiring corporation of stock (or a combination of stock and other consideration) in return for the stock of another corporation. Since stock, rather than corporate assets, is acquired, the transaction takes place between the acquiring corporation and the stockholders of the acquired corporation. This combination is often referred to by reference to the section of the Internal Revenue Code that governs its qualification for tax-free reorganization, section 368(a)(1)(B). The transaction is therefore commonly known as a "B Reorganization." It can be diagrammed as follows: Step 1 Step 2 Apex Boulder 100% Stock Stock Stock Ownership Boulder Corp. Stockholders

Apex, Inc.

Apex, Inc.

Boulder Corp.

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(a)The buying corporation. From the viewpoint of Apex, the stock-for-stock combination bears strong similarities to the stock-for-assets combination discussed above. Thus, if Apex has sufficient authorized shares of the necessary classes, and if the de facto merger doctrine is not applied to the transaction,61 the entire transaction can be effected solely on the basis of approval by the Apex board of directors. Two important differences distinguish the process of acquisition of stock the process of acquisition of assets. The first is that since the acquisition of shares is made from individual stockholders rather than the corporation, the acquisition can -- and in many instances must -- be made piecemeal by individual negotiations and purchases.62 The timing, as well as the price and other purchase terms, may vary among stockholders. The second difference turns on the requirements for qualification of the transaction as a tax-free reorganization. Central to these qualifications, which will be discussed in detail in the next chapter, is acquisition of "control" by means of the exchange solely of voting stock.63 Thus, if reorganization qualification is desired, as it often will be, the form of consideration permissible in the acquisition will be sharply limited. Issuance of non-voting stock, debt, cash or other consideration will disqualify the transaction for reorganization treatment. Moreover, the "control" test is severe: it requires ownership of 80% of the voting stock plus 80% of all other shares of stock of the acquired corporation.64 Therefore, in the Apex-Boulder transaction, Apex would be required to own 80% of both the common and the preferred stock of Boulder to meet the control test. (b)The exchanging shareholders. 61..For an example of application of the de facto merger doctrine to a stock-for-stock

acquisition, see Applestein v. United Board & Carton Corp., 60 N.J. Super 333, 159 A.2d 146 (Ch.), aff'd per curiam, 33 N.J. 72, 161 A.2d 474 (1960).

62..The strategy of slowly aggregating the controlling shares of stock by piecemeal acquisition is frequently referred to as a "creeping B reorganization."

63..Internal Revenue Code § 368(a)(1)(B).

64..Internal Revenue Code § 368(c).

35

From the viewpoint of Boulder, the transaction -- like the cash acquisition of shares discussed earlier in this chapter -- is a non-event. It is the Boulder Corp. stockholders who choose to give up their shares of stock in return for Apex common stock. Thus, no vote or appraisal remedy is applicable. However, if qualification of the transaction for reorganization status is to be achieved, 80% of both the common and the preferred stockholders of Boulder must elect to exchange their shares in return for Apex common stock. While partial success in the analogous cash acquisition of shares might be acceptable, the threshold for partial success in the share-for-share exchange will therefore ordinarily be 80%. (c)The statutory share exchange. It was noted earlier in this chapter that this difficulty in the stock-purchase transaction has in some states largely been eliminated by the adoption of "share exchange" provisions in the state corporation laws. These provisions operate similarly to state law requirements for sale of assets. Thus, under the Model Business Corporation Act a share exchange must be approved by the boards of directors of both corporations, but approved by an affirmative majority vote of the shareholders of only the corporation the shares of which will be exchanged in the transaction.65 A class vote by each class of shares exchanged is mandatory.66 As applied to the Apex-Boulder transaction, the Model Act provision would require majority approval of both the Boulder common stock and the Boulder preferred stock, since the plan calls for both classes to be exchanged for Apex common stock. The requirement of class voting, which grants an effective veto power to the preferred stockholders, poses familiar problems. Achieving the required class vote may require advance discussion and negotiation with the preferred stockholders. It may be necessary to offer them a more favorable exchange ratio in order to obtain their vote. It may, in some instances, simply be impossible to obtain their vote, in which case an alternative plan of combination may have to be considered.

65..Model Bus. Corp. Act §§ 11.02, 11.03(a).

66..Model Bus. Corp. Act § 11.03(f)(2).

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Following stockholder approval, the statutory share exchange is self-executing. The shares are deemed exchanged whether or not they are in fact tendered in return for new certificates, and they are treated thereafter as though they are the shares which were approved for exchange pursuant to the plan.67 The Model Business Corporation Act also grants appraisal to shareholders dissenting from the share exchange,68 thereby granting them effectively the option to receive cash in the exchange.69 (d)Dissolution or merger of the acquired corporation. Earlier in this chapter, the reasons for retention of the acquired corporation as a wholly-owned subsidiary were detailed. These included protection against existing and contingent liabilities, minimization of transfer formalities, and preservation of desirable tax attributes. Despite these advantages of maintaining the separate corporate status of the acquired corporation, there may be instances when dissolution of the acquired corporation -- or merger of that corporation into the parent or a subsidiary of the parent -- may be desirable.70 One such situation results from the acquisition (obviously not by means of statutory share exchange) of less than all the stock of the subsidiary. If it is undesirable or unacceptable to leave a minority outside interest in the subsidiary outstanding,71 a further step will be required.

67..Model Bus. Corp. Act § 11.06(b).

68..Model Bus. Corp. Act § 13.02(a)(2).

69..The exercise of the appraisal remedy may threaten qualification of the transaction as a reorganization under Internal Revenue Code § 368(a)(1)(B). This problem will be discussed in the next chapter.

70..A stock acquisition followed by a dissolution or a merger of the acquired subsidiary is likely to be characterized for tax purposes as an acquisition of assets; the implications of this recharacterization are discussed in the next chapter.

71..Among the reasons why the minority interest might be unacceptable are the following: (i) sufficient minority ownership to require continued compliance with the reporting requirements of the 1934 Securities Exchange Act; (ii) minority shareholder rights of inspection of corporate books under state law; (iii) minority objections to, and possible litigation over, corporate transaction that favor the parent.

37

The further step would normally have as its objective cashing out the minority stockholders. Dissolution of the subsidiary corporation probably cannot achieve this objective, since the minority shareholders may properly complain that it is impermissible in dissolution to convey the business to one group of shareholders (the majority, parent corporation) and cash to another.72 Merger of the subsidiary in any of various forms, including short merger and triangular merger, will however effectively eliminate the minority and generally be immune from judicial attack except on grounds of fairness. These techniques are discussed below. In summary: (i) The stock-for-stock exchange has the considerable advantage of retaining the separate corporate structure of the acquired corporation; (ii) The exchange by Apex requires only board approval, unless Apex has insufficient authorized shares; (iii) If Apex has insufficient authorized shares, or if the de facto merger doctrine is applicable by statute or case law, the full transaction will require board resolution, notice to stockholders, and majority stockholder approval; (iv) The exchange of shares by Boulder stockholders requires no stockholder vote as such, but requires the more unwieldy process of convincing them Darwin stockholders to turn in their shares in return for Apex stock; (v) In some states, the problem of convincing the stockholders to exchange their shares has been statutorily addressed by enactment of mandatory share exchange statutes, but these will generally require a class vote and grant appraisal remedies to the Boulder stockholders. 4.Statutory Merger: The statutory merger, which qualifies for reorganization treatment in accordance with § 368(a)(1)(A) of the Internal Revenue Code, is widely known as an "A" Reorganization. It can be diagrammed as follows:

72..See, e.g., Kellogg v. Georgia-Pacific Paper Corp., 227 F. Supp. 719 (W.D. Ark., 1964).

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Apex All Assets and Stock & Bonds Liabilities Boulder Corp. Stockholders & Bondholders Disappears in Merger

(a)General statutory provisions applicable to the stockholders of the merging corporations. The statutory merger generally requires resolution of the boards of directors, notice to the stockholders, and approval by affirmative vote of the stockholders of both corporations.73 A class vote will be required on the plan of merger if it contains a provision that, if contained in an amendment to the articles of incorporation, would require a class vote.74 The term of the proposed Apex-Boulder merger calling for the exchange of Boulder preferred stock for Apex common stock would be such an amendment,75 and therefore a class vote of the Boulder preferred stock will be required to authorize the merger. Moreover, the appraisal remedy will ordinarily be available to the

73..Model Bus. Corp. Act § 11.03(a).

74..Model Bus. Corp. Act § 11.03(f)(1).

75..See Model Bus. Corp. Act § 10.04(a)(2) -- exchange of the shares of one class into shares of another class.

Apex, Inc.

Boulder Corp.

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stockholders of each corporation who are entitled to vote on the plan of merger.76 The formal aspects of merger approval appear more onerous than the procedures required for other functionally equivalent forms of corporate combination. As a result, some corporate combinations have been, and continue to be, implemented by means of these alternative forms. However, a number of arguments may be made in favor of the statutory merger. It was noted earlier in this chapter that when the merging corporations are both closely held, obtaining approval of both groups of stockholders often presents no problem. And, since the statutory merger automatically transfers title to all assets, and obligations on all liabilities, to the surviving corpora-tion,77 no conveyances, title changes, notices to creditors or similar documents are necessary to implement the plan. More importantly, qualification of a statutory merger for reorganization treatment for tax purposes is considerably easier than qualification of the alternative forms of corporate combination. The statutory merger allows the surviving corporation to issue a broader range of permissible consideration (such as nonvoting stock, debt and other consideration) while preserving reorganization treatment. These advantages are further discussed in the next chapter. (b)Statutory elimination of the vote of stockholders of the surviving corporation. Despite its advantages, the statutory merger would likely have remained an unfavored form of corporate combination were it not for two relatively recent developments. The first has already been introduced in this chapter, and is discussed further below: the triangular or multi-party merger. The second, also of great importance, is statutory enactment of the no-vote merger. The no-vote merger, now part of the corporation statutes of many states, reflects what a reading of this chapter should make obvious: parties considering a corporate combination are not limited to the often onerous voting and appraisal requirements of a statutory merge. The same or equivalent results can be achieved by asset and stock acquisitions, for cash, stock or other consideration. And nearly all of these alternative approaches can be implemented without a vote of the stockholders of the surviving corporation. 76..Model Bus. Corp. Act § 13.02(a)(1). The appraisal remedy is discussed further later in this

chapter.

77..Model Bus. Corp. Act § 11.06(a)(2), (3).

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The general approach of these statutes is to eliminate the need for a vote by the stockholders of the surviving corporation if their stock and rights remain unchanged, and if the merger involves issuance of no more than a stated maximum percentage of additional shares. The underlying theory of these provisions is that shareholder protection by voting and appraisal is not necessary when the shareholder rights remain unchanged and the dilution resulting from issuance of additional shares in the merger is not substantial. The Model Business Corporation Act contains a typical provision, eliminating the need for a vote of the stockholders of the surviving corporation if four conditions are satisfied by the plan of merger: (i) the plan calls for no amendment to the articles of incorporation; (ii) there is no change in the previously outstanding shares of the surviving corporation; (iii) the number of voting shares outstanding immediately after the merger (plus any such shares issuable by virtue of conversion of securities or exercise of rights or warrants issued in the merger) will be no more than 120% of the number of voting shares outstanding immediately prior to the merger; and (iv) the number of participating shares outstanding immediately after the merger (plus any such shares issuable by virtue of conversion of securities or exercise of rights or warrants issued in the merger) will be no more than 120% of the number of participating shares outstanding immediately prior to the merger.78 The percentage test of the Model Business Corporation Act and most enacted state statutes assures that the no-vote merger will extend only to transactions where the surviving corporation is several times larger than the merged-out corporation. In effect, the statute treats such a merger -- for stockholder approval purposes -- as a purchase by the surviving corporation not justifying a stockholder vote. Similarly, most such statutes deny the appraisal remedy to stockholders of the acquiring corporation.79 The Apex-Boulder merger will not qualify for no-vote

78..Model Bus. Corp. Act § 11.03(g). Voting shares are defined as those that vote

unconditionally in election of directors, and participating shares as those that entitle the holders to participate without limitation in distributions. Model Bus. Corp. Act § 11.03(h).

79..Model Bus. Corp. Act § 13.02(a) extends the appraisal remedy "if shareholder approval is required for the merger . . . "

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treatment under the Model Business Corporation Act formulation, since the stock to be issued by Apex will not meet the 120% test.80 Since the laws of most jurisdictions require no vote by the stockholders of the acquiring or surviving corporation in a stock-for-assets, share-exchange, or triangular merger combination (irrespective of the number of shares that may be issued), the no-vote merger procedures have no application to those transactions. However, in the few jurisdictions, like California, that have applied unified voting requirements to all forms of corporate combinations, the no-vote merger procedure has been extended to all corporate combinations that might otherwise require a vote of stockholders of the acquiring corporation.81 In summary: (i) A merger of Boulder into Apex would normally require board approval, notice and stockholder vote by the stockholders of both corporations; (ii) The appraisal remedy would normally be available to the stockholders of both corporations; (iii) In return for these approval formalities, the merger offers considerably simplified implementation of the actual acquisition, as well as tax advantages to be discussed in the next chapter; (iv) The no-vote merger provisions of many states will allow statutory mergers with stated qualifications to be effected without vote or appraisal by the stockholders of the surviving corporation. (c)The short merger. Nearly every state corporation statute contains a provision allowing the merger of an existing subsidiary corporation into its parent without the vote of the stockholders of either. In most states, the condition for application of the "short merger" procedure is ownership by the parent of 90% of the outstanding shares of each class of the subsidiary stock.82 Additionally, nearly all such 80..Apex will issue 7,000 shares of common stock in the merger (5,000 shares to Boulder

common stockholders plus 2,000 shares to Boulder preferred stockholders). Therefore, following the merger, Apex will have 17,000 shares of stock outstanding, represented 170% of the 10,000 shares originally outstanding. This number substantially exceeds the 120% of the Model Business Corporation Act and most enacted statutes.

81..See Cal. Gen. Corp. Law § 1201(b), (c), reproduced earlier in this chapter.

82..Model Bus. Corp. Act § 11.04(a).

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statutes provide that the plan of merger may contain no amendment to the articles of incorporation of the parent corporation.83 Most such statutes also provide that, despite the absence of a right to vote on the merger, stockholders of the merged-out subsidiary are entitled to the appraisal remedy.84 Though by its terms it applies to a very limited category of mergers, the short merger is an extremely useful and simple procedure. Ordinarily, it will be implemented when the parent corporation wishes to cash out an undesired (but relatively small) minority shareholder group. Note that while minority blocks substantially greater than 10% can in fact be cashed out, as described earlier in the discussion of cash mergers, a greater than 10% cash-out will require the formalities of a vote of the subsidiary corporation stockholders and, in some instances, also of the parent corporation stockholders. 5.Multiple corporate variations: triangles, drop-downs: The use of multiple corporations to achieve a merger was discussed earlier in this chapter, together with the substantial virtues of that tactic: (i) The triangular merger achieves the results of a 100% share exchange, not otherwise feasible except in the few states that have enacted mandatory share exchange procedures; (ii) Preservation of the separate corporate existence of the subsidiary provides insulation against subsidiary liabilities and, in some instances, continuation of desirable tax attributes; and (iii) In most states, though not all, the triangular merger effectively denies the stockholders of the parent corporation both the vote and the appraisal remedy. The triangular merger can take either of two basic forms. In the first, which may be called the forward triangular merger, the acquired corporation is merged into a subsidiary of the surviving corporation. This form is expressly recognized as a reorganization for tax purposes under § 368(a)(2)(D) of the Internal Revenue Code. It can be diagrammed as follows:

83..Model Bus. Corp. Act § 11.04(e).

84..Model Bus. Corp. Act § 13.02(a)(1).

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Step 1 100% Stock Ownership Apex Stock & Bonds Assets and Liabilities Boulder Corp. Stockholders and Bondholders Merged into Apex Acquisition, Inc. Step 2 100% Stock Ownership

Apex, Inc.

Apex Acquisition, Inc.

Boulder Corp.

Apex, Inc.

Apex Acquisition, Inc.

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In some instances, even the notable advantages of the forward triangular merger will not suffice. It may be necessary not simply to preserve separate corporate status for the acquired corporation, but actually to preserve the acquired corporation intact and unchanged in its original corporate form. The mandatory share exchange, discussed earlier, achieves precisely this goal: Boulder Corp. is retained not only as an intact corporate subsidiary, but as Boulder Corp. (not as Apex Acquisition, Inc.). The reasons for the desirability of an unchanged subsidiary generally have to do with loan agreements, contracts and franchises. In a literal sense, when Boulder Corp. merges into Apex Acquisition, Inc. pursuant to the forward triangular merger, Boulder ceases to exist. Some loan agreements might thereby be accelerated, some franchises and licenses might therefore expire, and some contracts might be rendered in default. However, if Boulder Corp. remains unchanged as a corporation, many of these results will not occur.85 The device developed to achieve these results is the reverse triangular merger, a merger of a subsidiary of the parent corporation into the acquired corporation. The acquired corporation survives the merger and becomes a wholly-owned subsidiary of the parent. This form of merger is expressly recognized as a reorganization by § 368(a)(2)(E) of the Internal Revenue Code. It can be diagrammed as shown on the following page, but no diagram of the transaction is intuitively clear. It is tempting to redraw the diagram so that it demonstrates the "actual" flow of stock in the trans-action, but this is a frustrating and essentially meaningless exercise since there are in fact no actual transfers of shares other than those shown below. The intuitive problems with the diagram stem from the ambiguous and unusual function of Apex Acquisition, Inc., the newly-created corporation that is merged out.

85..This conclusion is not universally true. Many contemporary loan agreements require creditor

consent (or result in a default acceleration of the loan) when the corporation is "a party" to a merger, stock acquisition, or other major change in control, whether or not the corpo-ration technically continues to exist. The same kinds of provisions can be found in some contracts, franchises and licenses. Nevertheless, it is often the case that avoidance of a change to the technical corporate status will avoid default, breach or termination of some of these relationships.

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Step 1 100% Stock Ownership Apex Merged into Stock & Boulder Corp. Bonds Boulder Corp. Stockholders and Assets and Liabilities Bondholders remain in Boulder Corp. Step 2 100% Stock Ownership

Apex, Inc.

Apex Acquisition, Inc.

Boulder Corp.

Apex, Inc.

Boulder Corp.

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The reverse triangular merger "works" not because of a diagrammable flow of shares, but because of the statutory definition of a merger. That definition, in most state corporation laws, allows either of the two corporations to be the survivor and permits the consideration for the merger to be stock of any corporation (or any other consideration) to be exchanged for the stock of each corporation that is a party to the merger.86 The broad statutory authority clearly includes a plan providing as follows: (i) Apex Acquisition will be merged into Boulder Corp. and the surviving corporation (Boulder) will remain a wholly-owned subsidiary of Apex, Inc.; (2) Former stockholders of Boulder Corp. will receive stock of Apex, Inc. in exchange for their Boulder shares. In effect, Apex Acquisition, Inc. plays a role analogous to that of a chemical catalyst: it facilitates the combination of Apex and Boulder but never becomes part of that combination. It is created and eliminated in the same transaction, its ephemeral existence justified only by the end result that it assists in bringing about. Although the reverse triangular merger therefore has exactly the same effects as the mandatory share exchange, discussed earlier, two differences of considerable importance separate the transactions. The first is that the merger can be effected by stockholder vote in jurisdictions that have not enacted share exchange provisions.87 The second is that the status of the merger for tax purposes is beyond cavil, while the tax status of the mandatory share exchange - discussed further in the next chapter - may remain ambiguous.

86..Model Bus. Corp. Act § 11.01(b): "The plan of merger must set forth: (1)the name of each corporation planning to merge and the name of the surviving corporation

into which each other corporation plans to merge; (2)the terms and conditions of the merger; and (3)the manner and basis of converting the shares of each corporation into shares, obligations, or

other securities of the surviving or any other corporation or into cash or other property in whole or part."

87..As of this writing, most of the major corporate jurisdictions have not enacted such provisions and have no published plans to do so.

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It has already been noted that some of the advantages of the triangular merger or share exchange can be achieved by combining either a merger or a stock-for-assets combination with a "drop down" of some or all of the acquired assets and liabilities into a newly-formed or existing subsidiary of the acquiring corporation. If the first step in the drop-down transaction is a merger, however, it will normally require stockholder votes by both corporations. Moreover, while the drop-down has the advantage of insulating the acquiring corporation from future liabilities of the subsidiary, it provides no insulation from pre-acquisition liabilities (including contingent and unasserted claims). Finally, the drop-down does not achieve the admirable simplicity of the reverse triangular merger, which generally avoids asset retitling, loan renegotiation, and contract and franchise problems. In summary: (i) Preservation of the separate corporate status of the acquired corporation, particularly when the share exchange cannot be effectively carried out, can be achieved by means of a triangular merger; (ii) Further virtues, including avoidance of defaults or terminations under loan agreements, contracts and franchises, can often be obtained by utilizing the reverse triangular merger; (iii) A triangular merger of Boulder into a subsidiary of Apex, or a reverse triangular merger in which Boulder survives as a wholly-owned subsidiary of Apex, would normally require stockholder vote only by the stockholders of Boulder; (iv) The appraisal remedy would normally be available only to the stockholders of Boulder; (v) An alternative method of preserving separate corporate status is asset acquisition or merger followed by drop-down into a new or existing subsidiary of the acquiring corporation. This approach offers some, but not most, of the advantages of the triangular merger. 6.Partial acquisitions: "thinning down" the acquired corporation. When the acquiring corporation wishes to obtain some, but not all, of the assets or business of another corporation, the most common method is a purchase type acquisition, as discussed earlier in this chapter. However, it may be desirable to structure the transaction as a pooling-type combination, in order to achieve tax advantages, or to secure insulation from liabilities or protection of contract rights. Disposition of the unwanted assets or business may in these circumstances some compli-cated mixed problems of corporate and tax law. The combination may be effected by any of the techniques described above, and then followed by a disposition of the unwanted assets. This

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approach, as discussed further in the next chapter, may threaten the reorganization status of the combination, particularly if it takes the form of a acquisition of assets for stock. Also, if the undesired portion of the business consists not only of unwanted assets but also of undesired (and possibly unknown) liabilities, it is considerably safer never to acquire that business segment. Moreover, acquisition of the entire business by issuance of stock, followed by disposition of a portion of the business for cash, may result in both excess stock issuance and excess cash proceeds. Finally, the cash proceeds may be received with attendant tax liability for gains on the sale of the unwanted assets. Normally, the preferred alternative will be thinning down of the acquired corporation prior to acquisition. As noted earlier, the process of thinning down the acquired corporation poses no unique corporate problems, since the sale or disposition of a portion of the corporation's assets will generally be within the discretion of the board of directors.88 However, if the pre-combination disposition of assets is in fact part of the plan of combination (or is so deemed by the Internal Revenue Service), qualification of the transaction for tax-free reorganization treatment may be threatened. Though this issue is discussed in detail in the next chapter, it is worth noting here that a pre-combination asset disposition poses fewer problems for tax qualification of mergers (including triangular mergers) than it does for the other forms of combination. 7.Consideration for the acquired corporation's stock and debt: It might at first seem that the form of the combination -- asset or share acquisition or merger -- will not affect the nature or the amount of the consideration for the acquired corporation. The acquired corporation should be worth whatever it is worth, irrespective of acquisition form, and the holders of stocks and bonds should accept or reject the acquisition terms based on the consideration offered, also irrespective of acquisition form. A number of factors conspire to destroy this clear and simple picture. Taxation will play an important role in determining both the character and value of the consideration because (i) the tax character of the combination may be determined by the nature of the consideration used, and the permissible consideration varies among the

88..Model Bus. Corp. Act § 12.01. Avoidance of liability related to the assets or business not

acquired may, however, not be so simple. See the discussion of product liabilities later in this chapter.

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different forms of combination; (ii) the consideration itself (e.g., common stock, preferred stock, bonds, notes) may have differing tax attributes depending on the form of the combination; and (iii) the tax attributes of the acquired corporation may be affected by the form of the transaction and the character of the consideration. These issues are discussed in greater detail in the following chapter. Market conditions, trends and fads will also affect the mix, character and relative value of the consideration. The acceptability of the consideration may vary depending on whether the combination requires a stockholder vote, a stockholder exchange, or neither. The purest form of pooling type combination would provide for issuance to the holders of stock and debt of the acquired corporation of identical, or nearly identical, stock and debt of the acquiring corporation. In Example 5, common stockholders of Boulder Corp. would receive common stock of Apex Inc.; holders of Boulder's preferred stock ($100 liquidation preference) would receive preferred stock of Apex with identical liquidation preference, dividend rights, and voting rights; Boulder bondholders would receive bonds of equal principal amount, interest rate, and remaining maturity; and other Boulder creditors would become creditors of Apex. The apparent simplicity of this approach is deceptive. The first problem is value. It is unlikely that the common stock of the two corporations will be identical in value (as it apparently is in Example 5), and therefore while shares of identical terms may be issued, the number of shares is likely to be different. Problems of value are commonly solved by adjusting the exchange ratio of shares. If the common stock of Boulder were worth $4 per share and the common stock of Apex were worth $10 per share, the terms of combination would provide for one share of Apex common stock to be exchanged for each 2 1/2 shares of Boulder common stock. When the exchange involves identical shares of common stock, the issue normally is the familiar one of relative value of each of the combining companies. When the issue involves stock of different classes, or debt with different terms, the valuation problems center on relative values of the particular securities. These issues were detailed in earlier chapters. The second problem is that the economics of the combination (including not only the financial and control structure of the acquiring corporation, but the nature of the outstanding stock and debt of the acquired company) often call for different stock or debt instruments to be issued in exchange for those of the acquired corporation that were previously outstanding. The reasons for this conclusion are many, and may include the following:

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(i)The need or desire of the acquiring corporation to reduce or eliminate fixed charges, represented

by bonds or preferred stock. (ii) The need to reduce overall debt of the combined enterprise. (iii) The desire to accelerate the elimination (by repurchase or redemption) of outstanding preferred

stock or bonds. (iv) The necessity of eliminating preferred stock dividend arrearages. (v) The desire to minimize common stock dilution. (vi) The requirement to adjust dividend and interest rates to reflect changes in market conditions. The corporate law problems of non-identical exchanges in corporate combinations are relatively few. It was earlier noted that alteration of the rights, preferences or privileges of preferred stock by means of an exchange in a corporate combination will normally require a class vote of the affected preferred stock. Alteration of bondholder rights by vote is impossible, since the rights are contractual in nature. The bonds can be eliminated involuntarily if they are callable and by purchase on the market if they are not, and new bonds of the desired terms issued by the acquiring corporation. Alternatively, they may be left outstanding as an obligation of the surviving corporation. The tax law problems of alteration of stock and bond structure incident to a combination may be significant, and while they will be detailed in the next chapter, they are previewed here. The tax issues revolve about two principal questions: (i) whether the nature of the exchange will pre-clude tax-free reorganization treatment of the entire transaction, and (ii) whether the exchange by some or all of the stockholders and security-holders will be fully or partially taxable. The answer to the first question turns not only on the nature of the exchange, but also on the form of the combi-nation. When the combination is structured as a share exchange (whether statutory or otherwise) or a stock-for-asset exchange, assurance of reorganization status will generally require that only stock be issued in exchange for stock.89 By contrast, considerable leeway is permitted in the nature 89..IRC § 368(a)(1)(C) and (B). Moreover, in the case of the stock-for-stock exchange, only

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of the consideration in a statutory merger, and in a more limited sense, in the triangular variations thereof.90 Therefore, in some forms of reorganization an exchange of bonds for stock, or the payment of other consideration, will be absolutely precluded, while in others such an exchange will within some limits be permissible. The second question concerns the tax effects of an exchange (when permitted) in which former stockholders of the acquired corporation receive something other than identical stock in acquiring corporation. Receipt of a different class of stock, or of stock with different dividend, voting or liquidation rights, will not render the transaction taxable to the exchanging shareholders, except in the case noted above of the disqualified "B" reorganization. Also, an exchange by a preexisting bondholder in return for stock is generally not an event giving rise to taxable gain. However, when bonds or other consideration are given in exchange for stock, the exchange is treated as giving rise to "boot", or potentially taxable other consideration. If there is gain on the exchange, the effect of the receipt of boot is to render the gain taxable to extent of the value of the boot received.91 Non-identical exchanges may also give rise to variations in the accounting treatment of the combination. These questions are considered in detail in the next chapter. III. SHAREHOLDER PROTECTION A.Disclosure. 1.State and federal disclosure requirements.

voting stock must be issued. Normally, preexisting debt may be exchanged for new debt of the acquiring corporation without threatening reorganization status, but issuance of debt in a greater principal amount will generally result in the recognition of gain based on "boot." See the detailed discussion of IRC § 356 in the next chapter.

90..See IRC §§ 368(a)(1)(A) (statutory merger), 368(a)(2)(D) (forward triangular merger), and 368(a)(2)(E) (reverse triangular merger), discussed in detail in the next chapter.

91..See IRC § 356, discussed in the next chapter. In some instances, the boot will be given dividend treatment.

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The first line of shareholder protection associated with corporate combinations and other major corporate changes is stockholder voting. If the vote is to be meaningful, and if other stockholder rights are to be adequately secured, it must be reinforced by a requirement of full disclosure. The disclosure requirement has roots in both state corporate law and federal securities legislation. The notice and disclosure requirements of state corporate law apply whenever a stockholder vote is required. Generally, they will require full disclosure of the terms of a proposed amendment to the articles of incorporation,92 the terms of a proposed sale of assets,93 or the plan of a proposed merger.94 Nondisclosure or inadequate disclosure generally provide a basis in state corporate law for finding that the required stockholder vote is invalid, and therefore for enjoining the transaction. Recent decisions on the issue of fairness, discussed and excerpted below, also apply a threshold requirement of full disclosure. If the corporation is within the regulatory regime of the 1934 Securities Exchange Act, the notices and disclosures made in connection with obtaining required stockholder votes will clearly be proxy material, subject to the requirements of Section 14 and the regulations thereunder.95 Moreover, pursuant to Rule 145, the exchange of securities in a corporate combination is a "sale" within the contemplation of the 1933 Securities Act,96 and will therefore require compliance with the 92..Most statutes require that a copy or a summary of the proposed amendment accompany the

notice to stockholders of the vote thereon. Model Bus. Corp. Act § 10.03(d). As a practical matter, the notice should generally include both the text of the amendment and an explanation.

93..The notice invariably must state that a purpose of the stockholders' meeting is to consider the sale of assets; most statutes also require that the transaction be described. Model Bus. Corp. Act § 12.02(d).

94..Most statutes require that a copy or summary of the plan of merger accompany the notice to stockholders. As a practical matter, the notice ordinarily should contain a copy of the plan as well as an explanation or summary of its terms.

95..See Regulation 14A, 17 CFR 240.14a-1 et seq. Schedule 14A, Item 14, lists the disclosures that will be required in the proxy statement.

96..Rule 145 (17 CFR 230.145) provides that a sale or offer to sell is involved when there is

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prospectus requirement.97 Where both requirements apply, the corporations will issue a combined proxy statement and prospectus for the transaction. 2.Letters of intent, formal merger agreement. Negotiated corporate combinations rarely proceed directly from preliminary negotiations to signing of a definitive merger agreement. More commonly, preliminary negotiations end with the signing of one or more letters of intent stating the general terms and structure of the proposed combination, subject to negotiation of a definitive agreement and (when applicable) stockholder approval. Letters of intent usually contain binding confidentiality provisions, prohibiting disclosure of information exchanged during the negotiations. They often contain non-shopping covenants, prohibiting the proposed acquired corporation from seeking other offers.98 The signing of letters of intent is almost invariably a material event requiring prompt public disclosure. In some instances, the disclosure will attract competing offers for the proposed acquired corporation or will provoke a tender offer for its stock. Several tactics have been developed by potential acquiring corporations to preclude such interference with their plans, including rapid negotiation of a formal merger agreement. If tax-free reorganization is not essential, the acquiring corporation may acquire a substantial block of stock on the market prior to initiation of merger negotiations, or may make a friendly tender offer (with the support of the proposed acquired corporation) for the stock of the corporation it wishes to acquire. When a significant portion of a corporation's stock is already in the hands of an intended acquirer, acquisition attempts by other corporations will be less common and less likely to succeed. The formal merger agreement, or plan of merger,99 is a lengthy document containing not

submitted to a vote or consent of security holders a plan for (1) reclassification involving the substitution of one security for another, (2) merger or consolidation, or (3) corporate sale of assets in consideration for securities providing for distribution of the securities to security-holders of the corporation.

97..Rule 153a (17 CFR 230.153a). The prospectus will normally be on Form S-4.

98..The validity and effect of these and similar provisions, including "lock-ups" and binding options, are discussed later in this chapter.

99..A similar document, but for the form of the combination, will normally be executed by the

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only the terms of the combination but also the representations, warranties and covenants of the parties and provisions as to applicable laws, dispute resolution and remedies. The agreement will usually contain extensive exhibits and appendices, including financial statements; detailed lists of assets and liabilities; copies of loan agreements, pension plans, and insurance policies; details of pending litigation; customer and backlog lists; and other business documents. Typically, the acquired corporation will represent and warrant the completeness and accuracy of the items in the exhibits and appendices, including at least the following items: (i) valid corporate organization and corporate powers to effect the transaction; (ii) fully paid and legally outstanding shares of stock; (iii) fair and complete presentation of its balance sheets, income statements and statements of cash flows; (iv) absence of undisclosed or contingent liabilities, claims, tax assessments and legal violations; and (v) absence of any adverse change in the character or prospects of its business. Some, but generally not all, of these warranties will continue through the date of closing of the combination. For example, the warranty of absence of any adverse change in the business often extends to the date of the closing. The representations, warranties and covenants of the acquiring corporation are sometimes, but not always, similar to those of the acquired corporation. When the transaction calls for acquiring corporation stock is to be issued, the representations, warranties and covenants of both corpora-tions are generally parallel.100 In cash acquisitions, however, the acquiring corporation's representations and warranties are often limited to valid organization and legal ability to carry out the transaction. 3.The merger timetable; due diligence. After execution of the definitive agreement and its approval by the boards of directors, the notice to stockholders is prepared and distributed.101 Following the notice, the stockholder meeting

constituent corporations as part of a stock-for-assets or share-exchange combination, as well as for any of the multi-party mergers.

100..In a triangular merger, representations, warranties and covenants will generally be required of the parent of the acquiring corporation.

101..When the notice is subject to either or both of the proxy rules under the l934 Securities Exchange Act or the prospectus requirements of the 1933 Securities Act, it will be submitted for prior review by the SEC.

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or meetings are held, and following stockholder approval, the merger (or other form of combination) is implemented on the closing date. In most cases, at least 30 days will be required to prepare and distribute the notice of meeting and perhaps another 30 days will elapse before the meeting or meetings are held. Closing generally follows within a few days of stockholder approval. The 60 or so days that pass between execution of the definitive agreement and closing of the transaction are not a time of rest. During that time, experts for each corporation (including accountants, investment bankers, lawyers, appraisers and others) investigate the business of the other to provide reasonable assurance that the representations are true and that no undisclosed facts or circumstances render the combination undesirable. This "due diligence" examination will often present the first occasion for the parties to learn the important facts about their respective potential merger partners. B.The appraisal remedy. There is no agreement on the origin of the appraisal remedy. Some early commentators and cases viewed the cash-out right as an alternative to a constitutional right to prevent alteration of the nature of the stockholders' expected investment except by unanimous vote. Later commentators consider the appraisal remedy as being rooted in fundamental notions of fairness. This latter view gains considerable support from recent decisions on fairness, excerpted and discussed below, holding that a principal element of the fairness test in a reorganization or freeze-out is whether the consideration paid would meet the value test of the appraisal remedy. The appraisal remedy extends in most states to dissenting stockholders of both corporations that are parties to a merger, and in many states to dissenting stockholders of corporations that have approved a sale of substantially all assets not in the usual course of business.102 Several states extend the appraisal remedy to stockholders who dissent from articles amendments that adversely affect the rights, preferences or privileges of their shares.103 Other 102..See the discussion earlier in this chapter. Appraisal is often, but not always, denied to

stockholders who have no right to vote on the transaction.

103..See Model Bus. Corp. Act § 13.02(a)(4). The Model Business Corporation Act also contains statutory authorization for the grant of additional appraisal rights pursuant to the articles, the bylaws or a board resolution. Model Bus. Corp. Act § 13.02(a)(5).

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major corporate events, including amendments of the articles (in most states) and dissolution, do not give rise to an appraisal remedy. In its operation, the appraisal remedy has been (and in many jurisdictions remains) unwieldy, slow and expensive for both the dissenting stockholder and the corporation. The mechanical operation of the remedy varies widely among jurisdictions, but in general obtaining the remedy requires that the dissenting shareholder vote against the transaction, file his dissent with the corporation, and await a cash offer of fair value for his shares. If the offer is satisfactory, the corporation then purchases the shares at the stated price. When the offer is unsatisfactory, full litigation over the value ensues. The litigation in many jurisdictions is long and expensive; during its pendency, the dissenting stockholder in most jurisdictions retains his shares and receives no payment. Costs of the proceedings, with some exceptions, are borne separately by each of the parties. The costs of the proceedings, in substantial part borne by the corporation, led some commentators of the 1970's and early 1980's to conclude that the appraisal process was often utilized by minority dissenting stockholders in an effort to prevent implementation of a transaction that they could not otherwise stop by securing the necessary majority of negative votes. There was, and is, reason to believe that this criticism of the appraisal proceeding has merit. The required purchase of minority shares plus the costs of the appraisal proceeding can aggregate an amount sufficient to threaten the solvency or effective operations of the corporation following the transaction. Since exposure to the appraisal remedy follows stockholder approval of the transaction, it is essential that the board of directors have authority to abandon the transaction if the appraisal demand (or other post-approval events) render it inadvisable. This authority is often contained in the corporation statute itself, and when it is not it should be contained in the plan approved by the stockholders. Criticisms of the appraisal remedy led to widely-adopted exceptions to the appraisal right. In many states, the "market out" exception makes the remedy unavailable to stockholders who hold exchange-traded or widely-held stock. The theory of this exception is that the affected stockholders in this situation can obtain full value for their shares by simply selling their stock. A major defect in this theory is that the market provides less than ideal protection when the market price drops in contemplation of the proposed transaction or because large numbers of stockholders wish to sell.

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In at least one jurisdiction, there is an exception to the "market out" exception when a significant block of stockholders demand appraisal. The latest version of the Model Business Corporation Act dropped the "market out" exception entirely. More recent appraisal provisions, typified by the revised Model Business Corporation Act formulation, have attempted to simplify the procedure and to facilitate resolution of the difficult valuation issue. The new provisions require that the corporation promptly pay to the dissenter the amount that the corporation estimates to be the fair value of the dissenter's shares, and provide financial information and an explanation of the basis for the valuation.104 The dissenter is not bound by the corporation's valuation,105 and costs of the appraisal proceeding are normally borne by the corporation,106 but the court may assess costs against the complaining stockholder if the stockholder acted arbitrarily, vexatiously or not in good faith in demanding additional payment.107 The complex problem of valuation is nevertheless not easy to resolve. The Delaware Supreme Court took a major step in the direction of simplification as well as greater sophistication of value determination -- at least in cases when the stock is publicly traded -- in Weinberger v. UOP, excerpted below. Weinberger is important for a number of additional reasons, including its acceptance of the appraisal value approach in determining fairness. It serves as an appropriate introduction to the discussion of fairness in corporate combinations. Delaware's rejection of the rigidity of the "Delaware block approach" to valuation is not universal, and other courts may continue to insist upon averaging multiple values based on assets, earnings and market.108 Moreover, when the stock involved is not traded, complex valuation 104..Model Bus. Corp. Act § 13.25.

105..Model Bus. Corp. Act § 13.28.

106..Model Bus. Corp. Act § 13.31(a).

107..Ibid.

108..See, e.g., Piemonte v. New Boston Garden Corp., 377 Mass. 719, 387 N.E.2d 1145 (1979) (pre-Weinberger case applying the "Delaware block approach"); Leader v. Hycor, Inc., 395 Mass. 215, 479 N.E.2d 173 (1985) (reaffirming that the "Delaware block approach," as applied in Piemonte, continues to be one of the acceptable methods of appraisal valuation, despite Weinberger).

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problems requiring expert testimony will be inevitable. WEINBERGER v. UOP, INC. Supreme Court of Delaware, 1983. 457 A.2d 701 C.Fairness. A threshold question, addressed in part by Weinberger, is whether appraisal is the exclusive source of protection and remedies for stockholders unhappy with the proposed trans-action. Appraisal statutes often provide that they are the exclusive remedy for dissenting stockholders. When, as in the case of freeze-out mergers in some jurisdictions, the statutory appraisal remedy is unavailable, alternative forms of judicial scrutiny are clearly not precluded.109 Moreover, even when appraisal is statutorily provided, alternative judicial examination has been extended in some circumstances. Without exception courts have entertained actions claiming fraud,110 violation of fiduciary duty, and non-disclosure or mis-disclosure in the transaction or its approval.111 A more difficult question is posed by a stockholder claim that the transaction is unfair. Historically, the claim of unfairness was judicially recognizable despite availability of appraisal, but in most arms'-length transactions the terms, negotiated in good faith by the parties, were generally beyond attack. The growing body of fairness decisions in the last decade concerns, almost invariably, freeze-out mergers or other non-arms'-length transactions. In these decisions, including Weinberger and the cases excerpted below, both the standard of judicial examination and the substantive standard of fairness are different. These decisions typify recent judicial analysis that 109..Typical appraisal exclusivity provisions apply by their terms only when appraisal is in fact

provided. See, e.g., Model Bus. Corp. Act § 13.02(b).

110..Model Bus. Corp. Act § 13.02(b) allows a shareholder to challenge the corporate action, despite the availability of appraisal, when the action is "unlawful or fraudulent with respect to the shareholder or the corporation."

111..See Vorenberg, Exclusiveness of the Dissenting Stockholders' Appraisal Right, 77 Harv. L. Rev. 1189 (1964).

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divides fairness into two aspects: fairness in the procedures for evaluation and approval of the transaction, and fairness in the relative values realized by the groups of stockholders affected by it. Dalton involves the further problem of inter-class fairness in the unique situation of a freeze-in merger. A further question is what form of relief should be granted. Relief against fraud, or against violation of applicable state or federal disclosure requirements, often takes the form of injunction when the transaction has not already been implemented. Similarly, a claim of substantive unfairness may justify injunctive relief. In either case, subsequent unscrambling of the merger after it has been concluded is impracticable and unlikely. Moreover, as the recent Delaware cases illustrate, unfairness in some jurisdictions has been equated with fair value, with the result that the remedy is monetary, and is measured by standards derived from the statutory appraisal right. D. Business Purpose. It is rare that a true corporate combination, negotiated at arms' length, is attacked based on absence of a business purpose. Indeed, the business purpose requirement for corporate reorganizations appears to have originated in the tax law, rather than in corporate law. There, its function has been to distinguish transactions undertaken solely for tax-saving purposes, as opposed to those with a corporate or business purpose.112 The recent growth, and partial withering, of the business purpose test for corporate law purposes has been exclusively in the area of freeze-out mergers. There, the test has been applied to distinguish between (i) transactions the sole purpose of which is to cash out an unwanted minority, and (ii) mergers justified by some corporate or business purpose. In Delaware, the business purpose test appeared in a pair of celebrated 1977 decisions,113 was subsequently refined and narrowed,114 and was ultimately abandoned entirely in 112..See Gregory v. Helvering, 293 U.S. 465 (1935), in which the business or corporate purpose

test was applied to disqualify a recapitalization from tax-free reorganization status when there was no corporate or business purpose for the transaction. The operation of the business purpose test in the tax context is discussed in the next chapter.

113..Singer v. Magnavox Co., 380 A.2d 969 (Del. Supr. 1977); Tanzer v. Int'l General Industries, Inc., 379 A.2d 1121 (Del. Supr. 1977).

114..Roland Int'l. Corp. v. Najjar, 407 A.2d 1032 (Del. Supr. 1979).

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Weinberger, excerpted above. In New York, as evidenced by the Alpert decision excerpted below, the business purpose requirement remains. It is extremely unlikely that the business purpose test will threaten the effectuation of an arms'-length merger even in those jurisdictions where it continues to apply. Moreover, its scope and meaning as applied to freeze-out mergers remain unclear. ALPERT v. 28 WILLIAMS ST. CORP. New York Court of Appeals, 1984 63 N.Y.2d 557, 483 N.Y.S.2d 667, 473 N.E.2d 19 DALTON v. AMERICAN INVESTMENT CO. Delaware Chancery Court, 1985 490 A.2d 574, affirmed 501 A.2d 1238 (1985) E.The business judgment rule. That the freeze-out merger boom of the 1970's and 1980's was a rich source of decisional law on corporate law generally (as well as the law of corporate mergers) is further illustrated by the celebrated decision of Smith v. Van Gorkom, excerpted below. Normally, the business judgment rule provides the standard for imposing or denying monetary liability on directors or officers based on the fidelity and care with which they carried out the duties of their office. In Van Gorkom, liability was imposed based on a finding of gross negligence in the effectuation of a cash-out merger. This fact alone renders the business judgment rule an important desideratum in the planning of a merger, although in the wake of Van Gorkom Delaware (and a substantial majority of the other states) enacted statutory provisions allowing shareholder-approved limitation of director liability.115 It is also important to note that while Van Gorkom ultimately found director liability, it was originally an action to rescind the merger based on violation of the business judgment rule. Thus, there remains the possibility that the rule may be used as a basis for injunctive or rescissionary relief. SMITH v. VAN GORKOM Supreme Court of Delaware, 1985 488 A.2d 858, 46 A.L.R.4th 821 115..See Del. Gen. Corp. Law § 102(b)(7).

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IV. CREDITOR PROTECTION A.The effects of variations in form. The discussion earlier in this chapter noted that the surviving corporation in a statutory merger succeeds as a matter of law to all liabilities of the constituent corporations.116 The extent of this successor liability, including punitive damages and extending beyond the value of the assets transferred, is dramatically illustrated in Schmidt, excerpted below. SCHMIDT v. FINANCIAL RESOURCES CORP. Arizona Court of Appeals, 1984 140 Ariz. 135, 680 P.2d 845 At least three formal solutions to Schmidt have been explored earlier in this chapter: (i) stock acquisition leaves the liabilities of the acquired corporation in the acquired corporation; (ii) forward or reverse triangular merger similarly assures retention of the liabilities in separate corporate solution; (iii) to some degree, liabilities may be cut off in the asset acquisition. The first two of these formal solutions do not, in any sense, cut off liabilities. Instead, they limit the recovery of claimants to the same asset base that existed as of the time of the corporate combination. Although this appears to be a satisfactory resolution from the viewpoint of both the acquiring corporation and the existing or potential creditors, it poses several problems. Most of these problems have to do with contingent or potential claims, rather than matured liabilities. For example, contingent claims (such as unknown product liabilities) of the corporation to be acquired may potentially be so great that the acquisition may not be desirable.117 And while stock acquisition or a triangular merger may limit these claims to the acquired corporation, claimants would also benefit from injections of assets and management skill by the parent. 116..Model Bus. Corp. Act § 11.06(a)(3).

117..To the extent that these claims can be readily quantified, or that insurance can be obtained to cover them, the issue of liability simply becomes an issue of price. In some instances, however, the claims are neither quantifiable nor insurable.

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The third formal solution is asset acquisition. It was once thought that asset acquisition, coupled with full notice to creditors as required by the dissolution provisions of state corporate law, would cut off such contingent liabilities. This appeared particularly appropriate when the acquisition represented part, but not all, of the assets of the disposing corporation. State courts and legislatures, particularly in the area of products liability, have sharply divided in their view of these transactions. The two case excerpts reproduced below provide several bases for continued liability.118 RAY v. ALAD CORP. Supreme Court of California, 1977 19 Cal.3d 22, 136 Cal.Rptr. 574, 560 P.2d 3 SCHUMACHER v. RICHARDS SHEAR COMPANY, INC. New York Court of Appeals, 1983 59 N.Y.2d 239, 464 N.Y.S.2d 437, 451 N.E.2d 195

118..See Juenger & Schulman, Asset Sales and Products Liability, 22 Wayne L. Rev. 39 (1975).