Subsidiary Spin-Off Considerations

Care must be taken when a U.S. entity spins off assets to a newly formed wholly-owned subsidiary so that the legal protections offered by the desired separation are realized. This article presents a few high-level issues to consider.

Fraudulent Conveyance Risks Associated with the Separation. A conveyance would be deemed fraudulent by a court of law if a company transfers assets for less than reasonably equivalent value while the company was insolvent. A board of directors cannot approve a spin-off of assets if the board’s intention is to hinder, delay or defraud creditors of the company. This solvency concern arises under federal bankruptcy laws and state fraudulent conveyance laws. The board could face lawsuits for breach of fiduciary duty if it approved a fraudulent conveyance. To mitigate this risk, the board may consider obtaining solvency opinions from financial advisors.

Thinly Capitalized. Directors must carefully allocate debt and liabilities in the spin-off to ensure that the newly formed subsidiary (and the parent) are viable and that any solvency risks relating to either entity have been considered. In performing such allocation, consideration will also need to be given to the allocation of cash, cash equivalents and financial instruments.

Anti-Takeover. Care must be taken to ensure that the subsidiary’s takeover defense profile is adequate. Key provisions to include in governing documents include a classified board structure, no right for shareholders to call a special meeting or to act by written consent, a blank check preferred stock authorization, inclusion of “fair price” provisions, advance notice provisions for shareholders who seek to make director nominations or otherwise bring business before a meeting, and a limitation on shareholders’ ability to amend bylaws.

Asset Shielding. Directors must be aware of six factors that courts commonly look to in determining whether an entity is sufficiently standalone to justify shielding its assets from creditors of its affiliates. These factors are (i) the entity must be a single-purpose entity, (ii) it should incur no additional debt beyond what is needed for its routine business purposes, (iii) it should covenant not to merge or consolidate with a lower-rated entity, (iv) it should observe various separateness covenants in order to avoid being substantively consolidate, including maintaining separate offices, books and bank accounts, (v) it should obtain a non-consolidation opinion from counsel, and (vi) it should provide in its charter for either an independent director or a special class of stock.

Corporate Veil Piercing. If the new entity’s separate identity is disregarded by its parent and their two enterprises are effectively commingled, there is a risk the corporate veil will be pierced, in particular if it has acted as the “alter ego” of the parent, if the parent exerts more control over it than would be expected of a normal investor, or if the actions of the parent directly cause it to incur a liability.

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