Since January 1, 2019 there have been approximately 20 spinoff transactions announced. And to date there have been a number of instances of litigation arising out of spinoffs, some of which have insurance-related issues in dispute. This blog post will provide a brief summary of spinoff transactions and will highlight certain insurance-related considerations that practitioners, boards of directors and insurers should consider as they navigate their way through a spinoff transaction.
In a typical spinoff transaction a public company (Parent) creates a subsidiary (SpinCo) and contributes to it assets and liabilities. The subsidiary may sell up to 20% of its stock in an initial public offering. Parent then distributes all SpinCo’s stock that it holds to Parent’s stockholders. Thereafter, both Parent and SpinCo have separate and independent existences, with the stockholders of Parent owning the stock of Parent and, at least initially, the stock of SpinCo.
The reasons to effect a spinoff are varied. Some of the more common ones are (a) the parts are worth more independently than the whole, (b) the desire to shed non-core or under-performing businesses, (c) the need to incentivize employees of disparate business lines without creating friction due to having differing compensation metrics within the same organization, and/or (d) to eliminate conflicts between business lines.
Select Insurance Considerations in a Spinoff Transaction.
While there are a plethora of issues that lurk in a spinoff transaction, the issues noted below may provide an unpleasant surprise for Parent, SpinCo and their respective insurers if they are not prepared.
- Claims of Breach of Fiduciary Duty or Fraud by Parent’s Board.
Claims are often brought on the basis that either Parent or SpinCo was damaged by the transaction. While Delaware courts have ruled that the fiduciary duties owed by Parent’s and (pre-spin) SpinCo’s board of directors are owed only to Parent’s stockholders and not to the future stockholders of SpinCo, it is not unusual to see claims of breach of fiduciary duties being made against Parent’s board of directors by parties related to SpinCo.
Breach of duty claims are particularly likely where Parent’s directors wear two hats, also serving as post-spin SpinCo’s directors (who do have fiduciary duties to the SpinCo stockholders) or have consulting contracts with the other entity, and where Parent and SpinCo remain engaged in similar businesses that may present corporate opportunity issues. Accordingly, one should ensure that the approval process is free of conflicts and that the directors fulfill their duty of care.
Parent and its insurers should be prepared for claims of breach of fiduciary duty by Parent’s directors since the risk of such a claim is heightened, in part, because the distribution of SpinCo’s stock constitutes a dividend under corporate law. The threat of personal liability of Parent’s directors for an alleged improper declaration of a dividend can be an effective way to seek leverage in a negotiation over a fiduciary duty claim. Parent should carefully analyze its compliance with the requirements for declaring a dividend, which may involve an asset valuation, to be prepared to validate the dividend.
Securities fraud suits are also common, based on claims that disclosures made to the public markets were misleading.
- Fraudulent Transfer.
Related to the potential for breach of fiduciary duty claims is the potential for claims of fraudulent transfers. When either Parent or SpinCo, as an independent company, is left with insufficient assets to meet its obligations, it is not unusual to see third parties alleging that the distribution of SpinCo stock to Parent’s stockholders was a fraudulent conveyance.
Given that in a typical spinoff transaction there is no arms-length negotiation with a third party, the context of such a transaction is ripe for claims like fraudulent conveyance and self-dealing. For these reasons, parties are strongly encouraged to obtain solvency and fairness opinions from qualified third parties in an effort to bolster Parent’s chances of ensuring that Parent’s board’s actions are analyzed under the business judgment rule.
- Change of Control or Sale of Substantially All the Assets.
A spinoff transaction can lead to unintentional changes of control or sales of substantially all the assets, especially if there are a series of transactions at or around the same time as the spinoff. The question of whether a change of control or a sale of substantially all the assets has transpired is highly fact-specific. As a result, the parties and the insurers should be cognizant of this risk and should review the insurance policies and other material agreements of the parties in light of that potential risk. For instance, the D&O policy of Parent should be reviewed to ascertain whether the transaction will constitute a change of control because D&O policies normally provide coverage only for wrongful acts that occurred before the change of control. Further, if a change of control or sale of substantially all the assets is determined to have occurred, that could put D&O and other insurance policies into runoff, which would limit the time for making claims and could reduce coverage amounts. An additional concern is the possible acceleration of rights (e.g., employee bonuses or vesting) or the triggering of a default under a material agreement (e.g., a senior credit facility) if an unintended change of control or sale of substantially all the assets of a company results from a spinoff.
- Allocation of Risk of the Unknown.
Because SpinCo’s business was part of Parent prior to the spinoff and because Parent will continue to exist post spinoff (and thus will likely be the recipient of any third party claim relating to the pre-closing period for the spinoff business), the parties should consider how to allocate the risk of unknown claims. This task can be especially challenging because the risk of the unknown may not be clearly 100% attributable to Parent or SpinCo. For instance, both federal and state laws can impose joint and several liability for the cost of remediation on a party that sent waste to a contaminated disposal site. The difficulty in properly allocating responsibility between Parent and SpinCo for such risk can be exacerbated given the long gestation periods that can exist for environmental liabilities and the fact that Parent’s board may be incented to allocate a disproportionate amount of risk to SpinCo.
While many of the issues highlighted above may be found in many M&A transactions, the context of a spinoff transaction can increase the likelihood or magnitude of one or more of the noted issues above. Accordingly, we encourage Parent and SpinCo to consult with both their legal advisors and their risk management professionals as early as possible in the planning stages for any spinoff transaction.
 This post assumes that the companies involved in the spinoff transaction are all US entities; issues associated with foreign subsidiaries are beyond the scope of this post.