Dr. Jekyll meets Mr. Hyde: dealer buy-sells in the M & A world
NOTE: The following article is from the collection of articles in our Automobile Dealership Buy/Sell Newsletters. The newsletter deals with the complex area of buying and selling automobile dealerships. Some of the material may not be up to date because of changes in the law from the date shown at the end of the article. This article is not to be taken as legal, accounting, tax, or other advice. You should consult your own professionals for such advice and for any updating of the information provided.
Suddenly new language has taken hold in the automobile dealership world. Where the term “buy-sell” used to describe the sale and purchase of a dealership, today that transaction might well be called an acquisition–as in mergers and acquisitions, or “M & A.”
Thanks to the emergence of dealer ownership by publicly traded companies–Republic Industries, Circuit City, United Auto, Lithia, Rush, et al.–the dealer’s buy-sell agreement has met the investment community’s M & A agreement. In this article, we discuss some of the differences between the typical buy-sell agreement and M & A agreements that could be used when a publicly traded company acquires a dealership.
The primary difference between the buy-sell and M & A is diversity. While there exists a somewhat predictable pattern to the typical dealer buy-sell, M & A agreements change radically from one transaction to another, depending on a number of key deal points, such as whether the transaction will be a tax free reorganization; what method of accounting will be used; whether the purchase price will be paid in cash or stock and, if stock is given, whether it is registered or restricted.
Tax Free Reorganization
When is a sale not a sale? When it is a reorganization. If the original owners receive only voting stock upon conveying the business to its new corporate owner, the original owners do not recognize capital gains (or losses). Instead, the old owner’s basis in the business is carried over to the stock received. The theory behind this has to do with continuity of ownership: the dealership’s assets or stock continue to be owned by the original owners, only now in the form of shares held in the acquiring company. Although “tax deferred” would be more accurate, the shorthand term for this situation has come to be called a “tax free exchange.”
Tax free exchanges work whether the buyer purchases stock or assets. A stock-for-stock acquisition is sometimes called a Type B reorganization, and a stock-for-assets reorganization is sometimes called a Type C reorganization (Type A refers to a true corporate merger).
The M & A agreement diverges sharply from the typical buy-sell if the parties decide on a tax free exchange. First, such a decision automatically forces the seller to accept the buyer’s stock in lieu of cash, a deal point in its own right. In addition, several tax free exchange issues must be addressed in the agreement. For example, provisions relating to ancillary transactions, like leases and employment agreements, must be carefully scrutinized to ensure that there are no problems with “boot”–non-stock consideration paid to the sellers. If a stock-for-asset deal is involved, the M & A agreement must be structured to call for the purchase of all of the assets of the seller, because less than all will not suffice.
Many rules and nuances exist in this area, such as the extent to which boot may be received, the percentages of shareholders of the target company that must receive stock in lieu of other consideration, and whether the assets being acquired satisfy various tests relative to tax free exchange treatment. These matters must be carefully reviewed by attorneys and accountants for both buyer and seller, often to the extent of opinion letters wherein the attorney, accountant, or both, formally confirm that the transaction complies with and will be afforded the tax treatment which the parties expect.
Accounting Method: Pooling vs. Purchase
Independent of the firmly established and highly regarded rules governing tax free exchanges, there exists another major tax issue: pooling of interests. If a tax free exchange is elected, the acquiring company must decide if it wishes to account for the acquisition as a purchase or as a pooling of interests. If pooling is desired, the acquiring company will have to obtain the seller’s consent.
Although having less than a stellar reputation in accounting, pooling, among other things, relieves the buyer of the burden of showing any charge on its income statement relative to the amount it paid as goodwill to acquire a dealership. If the purchase method were used, accounting rules would require the goodwill paid to be amortized-and charged against income-over a period of no more than 40 years. Once more, pooling allows the buyer to include in its income statement some or all of the income reflected on the acquired company’s books, even for periods taking place prior to the acquisition.
Many argue that pooling paints too rosy a picture of the acquiring company’s costs and income. Its future is currently being examined by the Financial Accounting Standards Board (FASB). For years, however, the FASB and Securities and Exchange Commission (SEC) have imposed strict rules intended to protect the securities markets from any adverse impact that might result from the pooling method.
Included among the SEC’s rules is a requirement that the former owners, now shareholders in the acquiring company, remain “at risk” as to their shares in the acquiring company. The at risk period starts on closing and lasts until publication of financial statements by the company covering at least 30 days of combined operations.
Since financials are issued quarterly almost universally, and take at least 15 days following the close of the quarter to be published, pooling will, at a minimum, require an at risk period of 45 days, and, at worst, up to 4 months. Being at risk requires the shareholder to not only refrain from selling the shares, but also prohibits the use of financial products, like put options, that would serve as a hedge or insurance against a drop in the stock’s value. Pooling also generally prevents the seller from retaining assets, even if kept in separate corporations, that could somehow be characterized as part of a common enterprise. For example, a dealer having multiple stores could not sell some, and keep others under pooling.
Pooling rules also exist that favor the sellers at the expense of the acquiring company. For example, pooling forces the acquiring company to assume virtually all of the liabilities of the acquired company, and, subject to very limited exceptions, the acquiring company cannot hedge its exposure as respects contingent liabilities, nor seek guarantees from the sellers regarding future financial performance. Pooling rules even limit (but do not entirely eliminate) the acquiring company’s right make a breach of warranty claim against the sellers. Generally, such a claim must be made no later than one year after closing or publication of the first audit report covering consolidated financial statements, whichever comes first. Although pooling is far more common in stock-for-stock deals, it can, subject to even more rules, be used in stock-for-assets transactions as well.
As can be seen, pooling adds many provisions to the M & A agreement which are totally foreign to the typical buy-sell, and forces many provisions that are found in buy sells to be modified dramatically, such as treatment of the LIFO reserve.
Stock in Lieu of Cash
Tax free exchange status and pooling treatment are not the only driving forces for the use of stock in lieu of cash. If the selling dealer is to have a continuing employment or consulting relationship with the buyer, stock provides a sense of ownership and incentive that cash cannot.
Cash availability is certainly another factor. However, the more the lack of cash is stressed by a supposedly established public company, the more cautious one must be. If the stock were truly “hot,” or if the company truly can register the shares “quickly,” then cash could also quickly be generated by retaining an underwriter to do a general stock offering. The issue of timing can, however, be a legitimate issue in assessing whether it is appropriate to accept stock in lieu of cash. An offering to the public can raise the needed cash, but it might take too long. Generally, lack of a registration statement filed with and declared effective by the SEC is why the underwriting would take too long. Under this scenario, the seller will be asked to accept “unregistered” stock, also known as “restricted” or “legend” stock.
Generally, before stock may be sold by a company to the public, the shares must be registered with the SEC. Certain exemptions allow companies to issue unregistered shares in private transactions, such as in connection with acquisition of a dealership. For example, a public company could acquire a dealership in exchange for unregistered stock issued to the former owner, all in full compliance with securities laws. But the law requires these unregistered shares, now in the hands of the former owner, to be considered “restricted securities,” meaning they may not be sold absent registration with the SEC, or pursuant to very narrow exemptions. The securities laws of California and other states (“blue sky laws”) further restrict the ability to dispose of restricted securities, although the present discussion is limited to federal law.
For the most part, the holder of restricted securities is limited to two alternatives for selling the stock on the open market: SEC registration or Rule 144.
SEC Registration can realistically be accomplished only by the company filling out a registration statement with the SEC, and sheparding it through until it is declared effective. The particular shares owned by the dealer must be mentioned by name–for purposes of these rules, it is shares, not the company, that is being registered. The time, cost, and difficulty involved in obtaining an effective registration statement varies widely, based upon the whether the company is already public, whether it is listed on an exchange, the size of the company, and its recent activity and “record” with the SEC.
Rule 144, in general, allows restricted securities to be sold if they have been held for two years, subject to restrictions such as limits on the volume of shares being sold. Three years after acquiring the shares, most of those limitations lapse.
A dealer who does not want to wait two or three years before selling unregistered stock must obtain registration rights or some other way to ensure a measure of liquidity. A typical approach is a registration rights agreement. The types and varieties of registration rights agreements are limitless, although several generic patterns are common: continuous, demand, and piggyback.
Continuous registration rights are the next best thing to taking registered stock in the first instance. Here, the company agrees to register the shares, and keep the registration statement effective continually until the dealer sells all of the shares or until Rule 144 becomes available.
Demand registration rights entitle the dealer to ask the company to register his shares when he gets ready to sell them, and generally require the registration statement to be kept effective for six months or some longer period within which the shareholder must sell his shares. Some demand registration agreements permit the demanding shareholder only to make only one demand, while others permit multiple demands over time.
Piggyback registration rights generally require the company to register the shareholder’s shares whenever the company is registering any other shares. For example, although the shareholder could not force the company to register his shares at any particular time, as soon as the company decides to issue an new offering to raise capital, piggyback rights would require the company to include the shareholder’s shares as part of the registration statement.
All forms of registration rights are affected by two key issues: the level of assurance that registration will become effective, and timing of effectiveness. Companies are reluctant to unconditionally guarantee that registration will become effective, let alone an exact date for effectiveness; they favor “best efforts” assurances instead. Generally a compromise approach is taken, such as where the company gives an unconditional promise to file the registration statement by a certain date, and for best efforts thereafter to be exercised to have the statement declared effective by the SEC. Nevertheless, some shareholders have sufficient leverage to demand a registration rights agreement coupled with a put option or other term which would guarantee the shareholder that registration will be effective on a date certain and, if not, the shareholder could sell the shares back to the company.
Representations and Warranties
While no solid rule of thumb exists, it is generally the case in the M & A world that representations and warranties by the seller are significantly more elaborate than those found in the typical asset buy-sell agreement, especially as respects the seller’s past financial statements and performance. This holds true even where the M & A agreement is for the acquisition of assets. Acquiring companies attempt to justify elaborate warranties on the premise that more assets are being acquired than in the typical asset buy-sell, or that liabilities are being assumed. Sometimes warranties are claimed as necessary to avoid the possibility of shareholder class action suits against the public company’s board of directors for failing to obtain sufficient proof that the business being acquired is sound. But, as in typical buy-sells, representations and warranties are always negotiable. In the M & A world, however, much more ground must be plowed before both sides agree on a final form of agreement.
Only a few fundamental differences between buy-sell and M & A agreements are discussed here. These, and many other differences flow not only from securities law and tax issues, but also from a different perspective on what benefits are truly being acquired in the purchase or acquisition of business.
This article was written in 1997.