By: David J. Herzig
I remember one of my first days at GT we were advising on a corporate merger. At the end of the process (of course), the M&A group asked tax to sign off on the deal. Everything was done and this was supposed to be a rubber stamp. Well, as you can guess by now, the tax consequences of the deal as structure were disastrous and the whole deal had to be restructured. I remember vividly the corporate lawyers saying as they walked out the door, this is why we never ask tax anything!
Today, a judge killed the proposed $38 billion merger between Energy Transfer Equity (“ETE”) and the Williams Companies. Chancery Court Vice Chancellor Sam Glasscock ruled that ETE could back out of the deal because of taxes. [UPDATE: The link is not consistently working so here is the web link to the court: http://courts.delaware.gov/opinions/list.aspx?ag=court%20of%20chancery%5D Latham & Watkins, actually, tax lawyers at three top firms (L&W, Gibson Dunn and Morgan Lewis and one law professor) could not opine that the deal was tax neutral under 721 despite one law professor and Cravath saying the deal worked. This opinion is a rather big deal for M&A lawyers. Usually, conditions precedent like this won’t allow one side to back out of a transaction.
This is a tax blog not a M&A blog, so, I thought I could show how a $38 billion deal was structured and some lessons that could be learned by examining the deal post-mortem. The post is rather long but I hope super interesting to partnership tax people.
As a total aside, the tax side sounds to me like cover. The $6B payout to Williams shareholders as part of the deal was bridge financing. This bridge financing dried up when the value of the assets dropped to about half after the agreement because of a drop in energy prices. From the opinion, “In light of its obligation to deliver $6.05 billion in cash, the Partnership and its Chairman Kelcy Warren have become increasingly troubled with its potential overall debt levels.” But failure to conduct a proper thought experiment regarding the guaranteed payment by the tax lawyers created the controversy.
According to the ruling, “The Proposed Transaction is an unusual structure, accommodating Williams’ desire for its stockholders to continue to be holders of publicly traded common stock (as opposed to partnership units) and to receive a substantial cash payment, in return for Williams’ assets being acquired by the Partnership.”
L&W was asked by ETE to issue a should opinion that “ETC and the Partnership “should” be treated by the tax authorities as a tax-free exchange under Section 721(a) of the Internal Revenue Code (the “721 Opinion”).” L&W could not issue the opinion and the Chancellor allowed, quite unusually, ETE to pull out of the deal.
Now, it was not like Williams was without adequate counsel. Cravath, Swaine & Moore LLP was deal and tax counsel to them and Gibson, Dunn & Crutcher LLP was additional deal counsel. For that matter, Morgan, Lewis & Bockius LLP (tax counsel) and Wachtell, Lipton, Rosen & Katz (deal counsel) also served as counsel to to ETE.
According to the opinion here was the proposed deal:
Step One: “the Partnership will transfer $6.05 billion to ETC in exchange for ETC shares (the “Hook Stock”) representing approximately 19% of ETC (the “Cash Transaction”). ETC is then required to distribute the $6.05 billion directly to the former Williams stockholders.”
Step Two: “ETC will transfer, or “contribute,” the Williams Assets to the Partnership in exchange for newly issued Class E partnership units from the Partnership (the “Class E Units”) (the “Contribution Transaction”). The number of Class E Units issued to ETC will equal the aggregate number of ETC shares held by the Partnership and the former stockholders of Williams.”
At the end of the deal “ETC will own Class E Units representing approximately 57% of the limited partner interest of the Partnership. The Partnership will own the Williams Assets, as well as 19% of the outstanding ETC shares. Finally, the former Williams stockholders will own 81% of the outstanding ETC shares and will have received $6.05 billion in cash.”
There are great pictures of the deal in the opinion.
THE TAX SIDE
“Section 721(a) provides that “[n]o gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.” Again, the Contribution Transaction is the exchange in which ETC will transfer, or “contribute,” the Williams Assets to the Partnership in exchange for Class E Units. It was the parties’ intention that the Contribution Transaction would qualify as a tax-free contribution pursuant to Section 721(a).”
Upon signing the merger agreement, “In addition, Latham believed that it could deliver the 721 Opinion and considered the Section 721(a) issue “fairly straightforward.” Cravath likewise had no concern about the delivery of the 721 Opinion. Therefore, at the time the Merger Agreement was executed, the parties and their tax advisors understood that the Contribution Transaction should qualify as a tax-free contribution under Section 721(a)”
RE-EVALUATION OF OPINION
Then the market crashed and according to the opinion, “the Partnership and its tax counsel Latham began to reevaluate the two legs between the Partnership and ETC. Following the decline in energy markets, Whitehurst, the Partnership’s Head of Tax, began evaluating the tax implications of potential actions that the Partnership might take in response to the distress in the energy sector.” Whitehurst (looking for a way out maybe for ETE?) “discovered an aspect of the Cash Transaction that—according to Whitehurst—he had not before considered. To reiterate, the Cash Transaction is the leg in which the Partnership will transfer to ETC $6 billion in cash in exchange for 19% of ETC’s stock.”
“Whitehurst testified that the ETC shares were worth approximately $2 billion, creating a $4 billion delta. Based on that oversight, Whitehurst worried that the IRS could attribute the excess cash to the other leg (the Contribution Transaction) and thus trigger taxable gain.”
Whitehurst then calls L&W and it looks like all hell broke loose. According to the opinion, “Indeed, Latham had previously never considered how any movement in the Partnership’s unit price might affect Latham’s ability to give the 721 Opinion. Following the conversation with Whitehurst, Fenn was initially skeptical that any problem existed. He and other attorneys at Latham, including tax partner Larry Stein, began analyzing the transaction, paying close attention to the decrease in value of the Partnership’s units. During this time, Latham held multiple discussions with the Partnership, Wachtell, the Partnership’s deal counsel, and V&E, the Partnership’s litigation counsel, and consulted six other tax partners at Latham.”
Amazingly, it was not until that point that “Latham had discovered for the first time that the complex interactions between the Contribution and Cash Transactions could have significant tax implications under Section 721(a).” Then Whitehurst asked Morgan Lewis “to analyze the tax implications of the Proposed Transaction, hoping to get a “fresh look,” and expressed specific concerns about the change in the Partnership’s unit price.”
As a result of the “fresh look” L&W “was concerned that the IRS, under the disguised sale rules in Section 707, could attribute the cash exchanged in excess of the value of the Hook Stock to the Williams Assets contributed in the Contribution Transaction.”
The Morgan & Lewis tried to see if it could issue the opinion. “McKee [of Morgan & Lewis] concluded—independent of and without consulting with Latham—that he would be unable to render the 721 Opinion if asked. McKee’s conclusion, however, was based on a theory somewhat different from Latham’s analysis—McKee explained that he has never understood Latham’s “perfect hedge” theory, and that the decline in the Partnership’s unit price is not legally relevant in his view. McKee concluded that he was concerned that the IRS may conclude that the parties had specifically allocated the cash to the Hook Stock (and not the Williams Assets) for tax purposes—a practice commonly referred to as “cherry picking”—and that the Contribution Transaction was likely taxable under Section 707 as a disguised sale.”
Then Cravath got involved. According to the opinion, Cravath, “disagreed fervently with Latham’s conclusion, and strongly stated its belief that the Contribution Transaction was tax free under Section 721(a), on April 14, 2016, Cravath proposed two potential solutions to the Section 721(a) issue, which it referred to as Proposal A and Proposal B.”
Proposal A -Proposal A envisioned a modification of the Merger Agreement calling for creation of a new ephemeral entity to receive the cash payment and distribute it to Williams’ shareholders, which entity would then be dissolved. According to attorneys at Cravath, this structure would insulate ETC from the cash payment, and tax authorities would thus not consider the asset exchange between ETC and the Partnership as a hidden transaction for cash. The parties here agree that Proposal A, while it would employ a different structure, would have the same economic result as the Proposed Transaction.”
Proposal B – “Proposal B,” which had a somewhat different structure.
“After reviewing Cravath’s proposals, Latham concluded that neither proposal would allow the firm to issue the 721 Opinion.” “Under the doctrine announced in Commissioner v. Court Holding Co., tax authorities would disregard this late modification to the deal, and that it would be unable to issue the 721 Opinion even if either proposal were in place.” Then on April 29, 2016, Latham conveyed its conclusion on the proposed modifications to both Williams and Cravath.”
Finally, Cravath pitched Gibson Dunn. “Cravath contacted Gibson, Williams’ deal counsel, to review the Section 721(a) issue. Although Gibson ultimately concluded that it could give a “weak-should” opinion if asked, it initially determined that it was “tough to get to a should.””
SHOULD A SHOULD OPINION BE ISSUED?
The Court then continues later to discuss why L&W could miss such an obvious problem. There the court states, “The testimony indicates to me that Latham took this responsibility seriously. It devoted considerable effort in this endeavor, ultimately investing over 1,000 hours of attorney time in the process. It marshalled its tax attorneys and extensively analyzed the regulations and case law regarding the issue. Latham reached the following conclusion: There was some risk as the deal was initially constituted that, given the cash component of the transfers between ETC and the Partnership, tax authorities could consider this a hidden transaction for cash, triggering tax liability. Nonetheless, given that at the time the deal was struck, the Cash Transaction involved assets of equivalent value, Latham was able, under those conditions, to issue an opinion that the transaction should be considered a tax-free event.”
“The tax lawyers at Morgan Lewis, hired by the Partnership to analyze the same situation, came to a similar conclusion based on a somewhat different premise; Bill McKee of Morgan Lewis testified that in the opinion of his firm, even if the Cash Transaction was for assets of equivalent value, the tax authorities would be sufficiently likely to consider the cash component of the overall asset transfer between ETC and the Partnership as a hidden asset purchase, so that his firm could not have issued an opinion that the transfer “should” be tax free. In other words, a non-trivial risk exists that the tax authorities would look at both “legs” as a single transaction.”
“In addition, the Partnership’s expert, Professor Ethan Yale, reached a similar conclusion and explained that the Proposed Transaction was flawed from inception”
Yet, on the other side is Cravath and Professor Howard Abrams—to assert that ETC is merely a conduit for the passage of cash to Williams’ stockholders, that tax authorities would so regard it, and that the Contribution Transaction thus should be deemed tax free. Professor Abrams went so far as to testify that no reasonable tax attorney could opine otherwise, and that therefore Latham must be acting in bad faith, suppressing its true opinion.
WHO WAS RIGHT?
The Chancellor ultimately believe L&W for two reasons: (1) it is not clear because no two parties could agree on the type of opinion – from should to would to maybe. This meant in the court’s eyes that there was not clear cut; and (2) “Particularly convincing was the testimony of Stein, who testified forcefully that his firm’s opinion was not influenced by the (concededly manifest) interests of its client, the Partnership. I credit this testimony as truthful based on the demeanor of the witness, and this belief is buttressed by the fact that Latham reversing itself in the manner it has is not in the reputational interest of the individual tax attorneys at Latham, nor the interest of the firm generally. It is, in fact, a substantial embarrassment to Latham and its tax partners.” (I guess an embarrassment that cost a client 1,000 hours at probably over $1,000/hr.; just wondering if they are refunding the fee.)
I would love to hear others opinions here. But some off the cuff reactions I had were:
- As I tell my partnership class, subchapter K is hard. Here we had Cravath, L&W, Gibson Dunn, and Morgan Lewis reviewing a deal in real-time and no consensus of opinion. That alone should be a signal that there is no such thing as a simple transaction.
- In partnership class, we do a lot of thought experiments looking at a transaction. We examine what happens if the property goes up or down and the effects of the movement. Now here, it seems like that step was missed. It is important (and I’m sure L&W won’t forget for a while) to work through a transaction.
- Don’t issue tax opinions. Skadden got off the hook for its Yahoo! Alibaba tax opinion when Yahoo! decided to not spin-off the shares. Now, L&W would have been on the hook (if the merger had gone through and then L&W ultimate theory was correct) for a potential $4,000,000,000 (yes that is billion with a b) mistake. Maybe the $1,000,000 + fee is not worth it.