The following article is adapted and reprinted from the M&A Tax Report, Vol. 8, No. 6, January 2000, Panel Publishers, New York, NY.


By Robert W. Wood

The battle being waged between Pfizer and American Home Products, for control of Warner-Lambert has thrust into prominence so-called lock-up options and termination fees as defense mechanisms. American Home Products and Warner-Lambert exchanged options that permit the optionee to purchase up to 19.9% of the grantor's stock upon the occurrence of specified events. Should the deal not be completed, the jilted party will be entitled to receive, as salve for its wounds, some $2.5 billion. (Not a bad salve!) Pfizer has filed suit to have these provisions rendered null and void. One of the primary objectives of the suit is Pfizer's desire to account for the acquisition of Warner-Lambert as a pooling of interests, a goal that these options might thwart.

Pooling, as we have noted previously in these pages, is scheduled to affect transactions initiated on or after January 1, 2001. Until then, pooling remains desirable because of its capacity to minimize the earnings dilution resulting from an acquisition. To qualify a transaction for pooling, neither party to the transaction can have changed its voting common equity interests in contemplation of the pooling. Generally, changes occurring during the two-year period preceding its initiation (the date on which the major terms of the plan, including the exchange ratio, are publicly announced) are presumed to be in contemplation of the deal. But in many cases, the parties are able to rebut this presumption by demonstrating that the changes were undertaken for independent business reasons (that is, unconnected with the pooling).

Lock-Up Options

A grant of lock-up options may muddy the waters. In EITF Issue No. 97-9, it is acknowledged that the parties to a business combination will often exchange options. If the merger is consummated, these options will expire unexercised. Yet, if a specified event occurs that interferes with the planned transaction (such as an interloper obtaining a controlling interest in one of the participants), the options become exercisable. EITF No. 97-9 then concludes that the lock-up options would not preclude the use of pooling for the business combination that gave rise to the granting of the options, but would preclude the use of pooling for any business combination that would trigger the ability to exercise options.

On the surface, Pfizer's goal to pool Warner-Lambert seems likely to fail. Pfizer, on the other hand, is seeking to have the options (as well as the termination fee) set aside in court. If the court strikes down the options as if they never existed, the options will be regarded as never issued. That means Pfizer's pooling ambitions will not be adversely affected. Such suits don't always work though. Crane was unsuccessful in getting a Pennsylvania court to set aside the lock-up options that were exchanged in the Coltec/BF Goodrich deal.

What happens if Warner-Lambert and American Home Products voluntarily rescind the options? While this seems unlikely, too, rescission would presumably work where the pooling rules are potentially violated by a grant of employee options (or an alteration of the terms of existing options) in close proximity to the initiation of a pooling. Indeed,it is well-accepted that the damage can be undone if the option grant is canceled or otherwise rescinded prior to the time the offending options are exercised.

It would seem that a voluntary rescission of lock-up options, which restores the status quo prior to the time they become exercisable, should have a similar impact. How about a payment to American Home Products for the purpose of inducing it to terminate its option? That probably would not work. The only effective avenues seem to be a voluntary rescission or a finding by a court that the options should be set aside.

Termination Fees

The presence of a termination fee provision does not by itself preclude the use of pooling. Thus, Topic D-59 says the SEC will not find that a termination fee has a fatal impact on pooling where: (1) the parties to the previous merger agreement (in connection with which the fee arose) were unrelated; (2) the fee was negotiated at arm's length and was paid pursuant to the terms of the previous merger agreement; and (3) a termination fee is customary in merger agreements, and the amount of the fee is within the range of fees customarily negotiated. Here, the termination fee is less than 3% of the deal value and, thus, seems to be within the permissible range. The payment of the termination fee, while loathsome to Pfizer, at least would not preclude pooling with Warner-Lambert.

Deductible is Good

As we all know, the payment of a termination fee will be much less painful if it is deductible by Warner-Lambert. In the Federated Department Stores case, Federated paid a break-up fee to two "white knights" (including the DeBartolo interests) whose efforts were thwarted when Federated was ultimately acquired by the Campeau interests. The court concluded that the fees were deductible under Section 162. However, the decision, may have been influenced by the fact that the Campeau acquisition was an unmitigated disaster. The court stated that Campeau's takeover did not provide the type of synergy found in INDOPCO because, among other things, Campeau was inexperienced in Federated's business and did not have resources available to improve Federated's business.

Perhaps it was difficult to find that the Campeau acquisition resulted in long-term benefits to Federated, the amorphous INDOPCO legal standard for classifying an expenditure as capital rather than deductible. Some observers feel that Federated is not persuasive precedent for concluding that all termination fees are automatically deductible. However, the Federated court also concluded that the fees were deductible under Section 165. This provision allows a deduction for losses. The court stated that the failed merger (with the white knight) and the ultimate merger were separate and distinct transactions.

Thus, the break-up fee in Federated related to an abandoned transaction. It is reasonably clear that expenses incurred in connection with abandoned transactions are deductible. (See Revenue Rulings 73-580, 1973-2 C.B. 86, and 79-2, 1979-1 C.B. 98.) The lesson of Federated is that while an IRS challenge to termination fees can be expected, the alternative Section 165 holding by the Federated court provides nice support for claiming a current deduction for the payment of a termination fee.

Two arrows are always better than one!

More Pooling Points

To qualify for pooling, the voting common shareholders of the acquired corporation must all be offered and receive only voting common stock of the issuing corporation. However, the issuing corporation may pay cash (or other property) for less than 10 percent of the stock, provided that the cash is paid only to dissenting shareholders (and entails the purchase of all of their stock), or is used to pay cash in lieu of issuing fractional shares. In the latter case, the payment must represent a mere mechanical rounding off of the fractions and not be separately bargained for consideration.

Careful, though. This 10 percent basket is reduced if either corporation holds "tainted" treasury shares or an intercorporate investment in the other corporation. With respect to the former, neither corporation can have reacquired shares of its voting common stock during the period beginning two years prior to the initiation of the pooling, and extending through the date of its consummation. Because the prohibition regarding reacquisitions has always been considered together with the other items that comprise this 10% basket, this rule is relaxed in cases where the number of such shares is not material in relation to the total number of shares issued in the deal.

This would limit tainted shares to a maximum of 10 percent of the total number of shares to be so issued. Still, this potential pooling violation can be cured. In effect, the taint can be removed if the offending shares are issued at any time prior to consummation. The taint may be curable by issuing the shares for fair value to an independent third party (or into the market) prior to consummation.

Pooling Perambulations: Lock-Up Options and Termination Fees, Vol. 8, No. 6, The M&A Tax Report (January 2000), p. 6.