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Your Guide to Understanding Regulatory Developments to Navigate the Capital Markets

Opinion of the European Data Protection Supervisor — Bridging EU Data Protection with Competition Law?

Posted in Compliance

On March 26, the European Data Protection Supervisor (“the Supervisor”) issued a preliminary opinion (“the opinion”) on the interplay between data protection, competition law and consumer protection in the Digital Economy. The opinion reflects the convergence of underlying rationales and policy objectives of these different fields of EU law and analyzes the need for EU regulators to enhance their cooperation not only to aid enforcement of competition and consumer protection rules but also to stimulate the market for privacy enhancing purposes.

The opinion addresses first the issue of big data, outlining the value of big personal data for the digital economy. The Supervisor explains why digital services such as e-mail or search engines, although advertised to be provided for free, in fact are not because individuals are required to provide valuable personal data to access them. This turns data into what is, in essence, a currency for the provision of online services. The industry has developed sophisticated business models for capturing big personal data, making it available for sale, creating efficient economies of scale and putting into play the potential application of a number of legal provisions of EU law.

An overview of each individual piece of EU legislation concerned is followed by a substantive analysis of their interfaces. In particular, the Supervisor points out that competition law analysis with respect to market definition supports potential violations in the digital market, when few digital services providers collect and process personal data in one market for use in another (as “input” to “supply” in competition law terms). At the same time, infringements of EU data protection law are also possible because the data subjects have not provided their consent for the use of their data to types of services which not only are perceived of but are also in fact different. In many cases, complex algorithms are used to codify data that is afterwards used for business purposes, having thus been transformed into a commodity.

In addition, the entire approach to market concentration under the Merger Regulation could change if the European Commission took into consideration the enhanced capabilities of combined undertaking that in turn manage to achieve more substantial control of personal data of commercial value. The opinion underlines also potential “tying” of services when for instance digital companies offering services “for free” engage in the collection of personal data coupled with online provisional behavioral advertising. Even more importantly, dominant undertakings can effectively restrict market entry to competitors that lack the access to the required data collection and processing for digital service development. Even if access to personal data was granted on a remedial basis, this would not be acceptable from a data protection perspective because the required consent of the data subject would be lacking.

Whereas competition and data protection law depart from the same point, namely the protection of the consumer, the argument of the Supervisor on fostering privacy as a competitive advantage, resembling a similar argument of the Commission with respect to the Proposal for a Data Protection Regulation and the recent case law of the Court of Justice of the EU, is not convincing. Indeed effective competition can be restricted as big personal data grows bigger to drive more forces in the digital economy, however it is difficult to see how an in parallel non liberal approach to the existing and future data protection framework, on which the institutions and the data protection authorities seem to agree, could help the market economy.

The opinion of the Supervisor signifies the beginning of an era of enhanced regulatory cooperation affecting different fields of EU law that could compromise even further the operational freedom of U.S. corporations that operate in the EU digital market. These corporations need to closely monitor the new developments, while in parallel continue receiving effective advice by experienced counsel on both EU competition and data protection law, whose infringements entail considerable financial and reputational risks.

Chinese Units of Big 4 Accounting Firms Barred for Six Months from Auditing Chinese Companies Listed in U.S.

Posted in Accounting, Federal Securities

 

In a decision sure to be challenged by the defendants, the Chinese units of the Big Four accounting firms (Ernst & Young, KPMG, Deloitte Touche Tohmatsu and PricewaterhouseCoopers) have been barred for six months from auditing companies that are reporting with the SEC.  If the decision stands, it will have far-reaching implications not only on Chinese companies listed in the U.S., but on U.S. multinational corporations with major operations in China.

ALJ Initial Decision

It could have been worse, as the SEC staff initially requested that the Chinese units of the Big Four accounting firms be permanently barred from these audits.  While the Administrative Law Judge rejected this request, she did find that because of the Big Four’s unwillingness to turn over records in connection with ongoing SEC enforcement investigations, a six month bar was warranted.  This despite the arguments of the Big Four accounting firms that, under Chinese state secrecy laws, they are prohibited from turning over the information to the SEC.

The ALJ Initial Decision will become a final decision of the SEC unless one or more of the parties files a petition for review of the Initial Decision (deadline of 21 days from the date of the Initial Decision) or files a motion to correct a manifest error of fact (deadline of 11 days from the date of the Initial Decision, with an additional 21 days from the date any correcting order is issued to file a petition for review).

Implications of ALJ Initial Decision

If the ALJ’s Initial Decision remains intact, Chinese companies that are listed in the U.S. and whose financial statements have historically been audited by the Chinese units of one of the Big Four accounting firms will be unable to comply with U.S. securities laws requiring that they file audited financial statements with the SEC.  Those companies will be forced to scramble to retain other auditors to conduct an audit of their financial statements.  With a looming deadline for filing audited fiscal year end financial statements (assuming a calendar year end fiscal year), this is not an insignificant hurdle.

The Initial Decision also could implicate the audits of financial statements of U.S. multinational companies with a significant presence in China, as the Big Four accounting firms will often collaborate with their Chinese units to have a portion of the overall audit completed.

European Commission Launches Consultation on Crowdfunding: A Gateway to Alternative Project Financing in Europe

Posted in Capital Markets

On October 3, 2013, the European Commission launched a consultation inviting stakeholders to share their views on crowdfunding. Considered as a rapidly emerging alternative source of financing involving open calls to the public, generally via the internet, to finance a project through either a donation, a monetary contribution in exchange for a reward, product pre-ordering, lending, or investment, crowdfunding is thought to demonstrate potential considerable benefits for EU economies, leading the European Commission to explore future regulation possibilities. This is also indicated by the estimated 65% growth that crowdfunding experienced in 2012 compared to 2011 reaching EUR 735 million. The consultation is due to terminate on December 31, 2013.

One of the most important benefits of crowdfunding appears to be the financial support provided to many small start-ups and medium sized enterprises that do not manage to access mainstream financial markets. In this way, crowdfunding can help facilitate technological research and development and secure the efficient execution of innovative projects, thus contributing to growth and job creation at the macroeconomic level, according to the European Commission.

In addition, benefits can be found on the contributors side, as crowdfunding constitutes a complementary investment tool that could lead to the generation of profits through the conclusion of further cooperation agreements between the project creators and the contributors.   To contributors, crowdfunding generally offers the possibility of greater understanding of the projects they finance since, in principle, there is more efficient communication with the project’s founders. In addition, one could add to the benefits the broadening of the concept of project ownership due to the extensive pool from which the required funding is derived and the promotion of popular legitimization of research and social solidarity.

The consultation paper addresses a number of issues concerning crowdfunding, ranging from the benefits and risks associated with this form of finance to the adequate safeguards for the avoidance of illegal practices and the required actions to exploit the potential of crowdfunding. The consultation participants are asked to complete a questionnaire referring to all of these issues, the compilation of answers to which is thought to provide the Commission with a preliminary understanding on whether crowdfunding markets require proper regulation or some type of soft law instead. Certain concerns could be raised about the failure of the European Commission to mention the implications of the call on the public that crowdfunding involves on the regulatory level and the prohibition of canvassing and hawking in financial products that exists in the national legislations of some EU Member States. It  remains to be seen whether the historically uniform license requirements for calls on the public in the finance sphere will be decided to apply to crowfunding as well or whether a de minimis exception will be provided.

U.S. investors who already operate in the EU or who are considering becoming involved in the EU financial markets need to watch closely for new developments and should take advantage of the current opportunity to complete the questionnaire and influence the process, contributing thus to the added value that flexible and efficient regulation would entail for crowdfunding. Financial models of crowdfunding can create a complementary investment opportunity, where investors can develop direct communication channels with project creators and  benefit from the future success of the project.

Client Alert on Pay Ratio Rules

Posted in Disclosure, Dodd-Frank Act, Federal Securities

My colleague, Ellen “Nell” Czura Schiller, and I recently penned a more detailed memorandum explaining the new proposed pay ratio rules and next steps for those companies who will be subject to the final rules (when adopted).  The memorandum can be accessed here: Corporate Advisory SEC Proposes Pay Ratio Rules.

SEC Proposes Pay Ratio Rules

Posted in Disclosure, Dodd-Frank Act, Federal Securities

After years of delay, the SEC finally proposed pay ratio rules (as required by the Dodd-Frank Act) requiring, among other things, disclosure of the ratio of the median of the compensation of all employees (other than the CEO) to the total compensation of the CEO.  Comments are due 60 days from publication of the proposed rule in the Federal Register (as of the date of this post, this has not occurred) and can be submitted here.

How to Calculate the Median of Employee Pay

As proposed, the rules would permit companies to use various alternatives to calculate the median of employee pay, including

  • by calculating the compensation of each employee in accordance with the executive compensation disclosure requirement (i.e., the same method that is used to calculate compensation of each named executive officer);
  • by using reasonable estimates of employee pay; and/or
  • by using statistical sampling.

Because of the complexity of calculating every employee’s pay based on the executive compensation disclosure requirements, the SEC confirmed in the proposing release that the median employee could be determined using a direct pay method of analysis, i.e., by determining the median employee based on compensation as reflected in the company’s payroll systems, and then determine the compensation of that median employee based on the executive compensation disclosure requirements.

How to Disclose the Pay Ratio

The proposing release provides that the ratio of the median of the annual total compensation of all employees to the annual total compensation of the CEO can be disclosed in one of two ways:

  • as a ratio in which the median of the annual total compensation of all employees is equal to one; or
  • in narrative form in terms of the multiple that the CEO’s total compensation amount bears to the median.

For example, if the median annual total compensation is $60,000 and the annual total compensation of the company’s CEO is $14,000,000, then the pay ratio would be 1 to 233. This could also be expressed narratively along the lines of: “the CEO’s annual total compensation for the fiscal year ended [YEAR] is 233 times the median of the annual total compensation of all employees.”

How to Determine Which Employees to Include in the Calculation

When determining the median annual total compensation of all employees of the company, the company must include all employees of the reporting company and all of its subsidiaries, including all full-time, part-time, seasonal, non-U.S., and temporary employees.  Notably, the company should also include executive officers (including named executive officers other than the CEO) in this calculation.  However, independent contractors or other temporary workers employed by a third party are not covered.

Next Steps

As noted above, comments on the proposing release are due 60 days from publication of the release in the Federal Register.  Because two Commissioners dissented (which can be found here and here), and because I expect to see a fair bit of resistance to implementation of the rules, I would not be surprised if one of the usual suspects (such as the U.S. Chamber of Commerce) challenges the adopted rules in the D.C. Federal Circuit courts.

In addition, even if (and when) the rules become effective, I would not be surprised to see further controversy arise based on ISS interpretations of how companies should calculate, and disclose, the pay ratio in annual meeting proxy statements.  The SEC acknowledged, in the proposing release, that because of its concerns about competitive harm if all companies were forced to use the same methodology for calculating median employee pay, the SEC would allow companies to take a flexible approach to determining the median.  As a result, the SEC further acknowledged that this would have the effect of diminishing, if not eliminating, the comparability of the median measure across companies.  It will be interesting to see whether ISS views this as an opportunity to step in and create a policy that encourages companies to use a specific calculation method that aids in determining the comparability of the pay ratio to other pay ratios of the company’s competitors.

The European Commission’s Communication on Shadow Banking: A Coordinated Effort to Avoid Contagion of Regulated Markets

Posted in Commercial Lending, Financing & Lending

On September 4,2013 the European Commission (“ the Commission”) issued a Communication to the Council and the European Parliament on shadow banking with a view to address new sources of risk in the Financial Sector. The Communications sets out the roadmap which aims at limiting the emergence of risks in the unregulated systems with a focus on risks of a systematic nature and is an additional step, following the 2012 Commission’s Green Paper, towards the adoption of unified EU wide legislation in order strengthen market integrity and transparency  and increase the confidence of savers and consumers.

US investors and market participants  that have frequently resorted to the different segments of the shadow banking sector need to monitor closely the developments in the European Union and become aware of the new regime which will include enhanced supervision in order to avoid regulatory arbitrage.

I. DEFINITION OF SHADOW BANKING

The Communication follows the definition adopted by regulators in both sides of the Atlantic, who define shadow banking as a system of credit intermediation that involves entities and activities outside the regular banking system, including but not limited to entities that:

(i)  raise funding with deposit-like characteristics;

(ii) perform maturity and/or liquidity transformation;

(iii) allow credit risk transfer;

(iv) use direct or indirect leverage, including securitization vehicles or conduits, money market funds, investment funds that provide credit or are leveraged and financial entities that provide credit or credit guarantees.

II. MEASURES FOR FINANCIAL ENTITIES

The most important measures that aim at tackling the risks to which financial entities such as banks, insurance companies and investment funds, are subject include: (i) the strengthening of requirements imposed on banks in expectation of the Basel Committee’s review of prudential consolidation practices in the end of 2014; (ii) the reinforcement of requirements imposed on insurance companies, including the risk based approach adopted by the Solvency II Directive; and (iii) new rules for all hedge funds, private equity and real-estate funds with a focus on the new Alternative Investment Fund Managers Directive.

III. MEASURES FOR MARKET INTEGRITY

Suggested measures to secure market stability and reliability are also provided in the Communication. They include: (i) regularization of risk transfer instruments  to prevent contagion of regulated markets by shadow banking activities especially with regard to  OTC derivatives, central counterparties and trade repositories  where applicable legislation provides for central clearing of all standardized derivative contracts, as well as margin calls for non standardized contracts; (ii) more robust securitization arrangements especially with a view toward  increasing transparency and reinforcing the standardization of disclosure; and (iii) rationalization of credit rating agencies’ role in the financial system in order to avoid overreliance on such rating, improve their reliability and increase their liabilities under applicable legislation.

IV. ADDITIONAL MEASURES

The Communication sets out a number of additional measures that are deemed necessary to minimize the risks posed by shadow banking for the stability of the financial system. Enhanced transparency via central repositories or the implementation of the Legal Entity Identifier (LEI) (the new standard ensuring a unique identifier for each legal entity that is party to a financial transaction) is particularly worth mentioning while the Commission stresses its attention in the need to reconsider the risks posed by money market funds formerly considered as a relatively stable form of investment and UCITS. Securities financing transactions are also targeted as a potential source of arbitrage and thus the Commission also calls for special attention to such transactions via the establishment of a central repository to collect detailed data on repurchase transactions in the EU, as recently proposed by the European Central Bank (“ECB”).

V. ASSESSMENT

The Commission’s Communication on shadow banking is a multi-level plan that operates in different regulatory stages and aims at tackling the risks posed by the shadow banking sector which, although remaining heavily unregulated, accounted for EUR 51,000 billion of asset worth worldwide. The strong connections between the shadow banking system and the rest of the financial sector create severe risks of contagion and market failures that need to be avoided. Prudent foreign investors operating in the EU need to become familiar with the Commission’s initiatives and be ready to adapt to a new regulatory era.

Auditor Independence and Objectivity – A Continuing Story

Posted in Accounting, Compliance

In several prior posts, we have followed the continuing developments and activity, from the PCAOB “Concept Release” in August of 2011, comments and round table discussions, and similar actions taken in other parts of the globe, all dealing with auditor independence.  Previously, the U.K. Competition Commission, an independent body charged with investigating mergers, markets and regulated industries in the U.K., had considered issuing guidance regarding auditor independence and methods to promote competition among audit firms, including mandatory rotation.  In late July, the Competition Commission issued draft guidance, to be codified later in the year, which did not mandate auditor rotation.  Instead, the guidance will require all FTSE 350 firms to solicit or retender for engagement of an audit firm every five years, allowing the current independent auditor to be part of the competition.  The argument before the Commission has been that competition in the U.K. audit market is very limited, given replacement of auditors will be costly, and the incentive an incumbent audit firm may have to focus on satisfying management rather than focusing on stockholders.

The draft guidance issued by the Competition Commission also contains several recommendations, including a requirement that the Financial Reporting Council (FRC) Audit Quality Review team examine each audit engagement for FTSE 350 firms, at least every five years, with a companion requirement that the audit committee for those firms report to stockholders any findings of the FRC; a prohibition against loan documentation providing a restriction for limiting a company’s choice of auditor to a preselected list or to “big 4 only”; a requirement for a stockholder vote on whether audit committee reports contained in a company’s annual report contain sufficient information for the benefit of stockholders; consideration of measures to be implemented to strengthen the accountability of the independent auditor directly to the audit committee, to reduce the influence of management in the audit process, and require solely the audit committee (not management) to negotiate and agree upon auditor engagement terms, audit fees, scope of the audit and to initiate the retendering process for independent auditors.

In commenting on the draft guidance, the Chair of the Competition Commission noted that stockholders are better served when a more competitive market exists, and that frequent retendering will ensure that companies will make regular and well informed assessments that their incumbent auditor is competitive and will open more opportunities for other firms to compete.  The Competition Commission noted that the European Union is actively considering similar issues but it nevertheless chose to publish its guidance, in the absence of any definitive proposals.

Of particular significance, in the Competition Commission’s draft guidance, the proposed stockholder vote on the sufficiency of the audit committee’s annual report is an expansion of the duties and responsibilities of the audit committee.  Much like the vote required under the Dodd-Frank Act on executive compensation (“say on pay”), functions and responsibilities for an audit committee are clearly increased  by requiring stockholder approval as well as the mandate of full responsibility for the audit process.  Once again, it appears that focus on the duties and responsibilities of the audit committee is increasing as we have predicted.  Meanwhile, the PCAOB continues to review the auditor independence issues raised in the “Concept Release,” and there has been no indication whether the action of the U.K. Competition Commission will be part of any proposal.

FASB Raises a Red Flag–Going Concern Disclosures

Posted in Accounting, Compliance

In late June 2013, the Financial Accounting Standards Board (FASB) proposed for comment an update to accounting standards involving disclosure of uncertainties about an entity’s going concern, more specifically, the ability of a reporting entity to continue as a going concern.  Under current GAAP, only the external auditors are required to state in an audit report its opinion regarding the ability of the entity being audited to remain a “going concern” for the next twelve months.  In the proposed accounting standards update, issued June 26, 2013, the FASB recognizes that under current GAAP requirements, there is no available guidance regarding the responsibility of management in evaluating or disclosing uncertainties that the entity will be able to continue operation as a going concern.  Currently, financial statements are prepared with a presumption of going concern, until such time as liquidation appears eminent, at which time the liquidation basis of accounting is initiated.

Current Standards

Under current auditing standards, an auditor is required to evaluate in connection with its audit report whether there is substantial doubt about an entity’s ability to continue as a going concern, for the next twelve months, or until the following year audit.  For reporting entities under U.S. securities laws, the auditor must also consider possible financial statement effects, including the adequacy of disclosure.  In addition, disclosure rules implemented by the SEC require a reporting company to disclose in management’s discussion and analysis (MD&A) information regarding trends and uncertainties that are reasonably likely to have a material effect on liquidity, capital resources and the results of operation.  However, there is no current guidance under U.S. GAAP regarding disclosure of going concern uncertainties in financial statement footnotes.

Proposed Update

The proposed accounting standards update would modify U.S. GAAP and require management to evaluate going concern uncertainties by assessing the likelihood that the entity would be unable to meet its obligations, as they become due, within 24 months after the date of the financial statements.  This disclosure would be undertaken and evaluated at each annual and interim reporting period, initially with footnote disclosure, when it is either:  (1) more likely than not that the entity will be unable to meet its obligations within 12 months after the financial statement date, without taking actions outside the ordinary course of business; or (2) known or probable that the entity will be unable to meet its obligations within 24 months after the financial statement date, without taking actions outside the ordinary course of business.  It should be noted that the footnote disclosure would not have the safe-harbor protections that are generally available for MD&A disclosures.

The proposed accounting standards update is open for comments until September 24, 2013.  Needless to say, this “red flag” type of disclosure is highly controversial and as an accounting standard, would become part of a company’s internal control mechanisms, and another function or duty of an audit committee for public companies.  The sensitivity of the disclosure could have a significantly deleterious effect on companies and their operations if it were to originate with management rather than initiated by auditors (as is the case under the current standard); in fact, one key concern is the disclosure by management itself may give rise to the very condition being disclosed.

Stay tuned, as this is likely to be a very controversial proposal.

SEC’s Resource Extraction Rule Vacated by Federal Court

Posted in Disclosure, Dodd-Frank Act, Federal Securities

In a decision filed on July 2, 2013, the U.S. District Court for the District of Columbia vacated the SEC’s resource extraction disclosure rules, which had been promulgated under Section 1504 of the Dodd-Frank Act (adding a new Section 13(q) to the Exchange Act).  The resource extraction disclosure rules, other things, would have required that resource extraction issuers publicly disclose any payment made by the issuer, a subsidiary of the issuer, or an entity under the control of the issuer, to a foreign government or the Federal Government for the purpose of the commercial development of oil, natural gas, or minerals.

While the plaintiffs asserted a number of challenges to the rules, including one under the First Amendment, the court was ultimately convinced by two arguments in favor of vacating the rules: (1) the SEC misread the Dodd-Frank Act to require public disclosure of the covered payments; and (2) the SEC’s failure to craft an exemption from the rule with respect to payments to certain foreign governments that prohibit such disclosure was a violation of the Administrative Procedures Act.

Analysis

Ultimately, what was most fatal to the SEC was the plain language of the statutory provisions in Section 13(q).  In particular, the court noted the following:

  • Plain Language Definition of “Report”: The key operative language in Section 13(q) requires the SEC to “issue final rules that require each resource extraction issuer to include in an annual report of the resource extraction issuer” the resource extraction payment disclosure.  The court held that the plain language of “report”, using definitions of the word in the Oxford English Dictionary and the American Heritage Dictionary, does not dictate any requirement that the report be made publicly available.  Ultimately, this is probably the weakest argument in support of the decision, as the court completely ignores the fact that the term “annual report”, though not defined, is used throughout Section 13 of the Exchange Act to refer to a document that, in its plain meaning, refers to a document that is publicly available.  The court, by focusing on the definition of “report” rather than “annual report” successfully  glossed over this flaw in its argument.
  • Structure of Section 13(q): More compelling, however, was the court’s reference to the structure of Section 13(q) itself.  Even if we admit that the language above is ambiguous at best, there is language elsewhere in Section 13(q) that is fatal to the SEC’s argument that the annual report must be publicly disclosed without exception.  As noted by the court, in Section 13(q)(3) (labeled, remarkably enough, “Public Availability of Information”), the SEC is directed, “to the extent practicable [to] make available online, to the public, a compilation of the information required to be submitted under the rules issued under” the operative provision highlighted in the above bullet point.  In other words, Section 13(q)(3) essentially assumes that the “annual report” in Section 13(q) is not to be public, with a requirement that a compilation (not a full-blown dissemination of the entire annual report) be made public “to the extent practicable.”  In other words, the court viewed this language as not only permitting the SEC to implement exemptions to the disclosure requirements based on local law requirements, but to also not require public disclosure of the entire annual report submitted to the SEC pursuant to the rules under Section 13(q).

Takeaways

This marks another demoralizing defeat for the hard-working staff at the SEC, which was simply trying to implement the poorly drafted, and poorly thought-through, statutory provisions presented to them via the Dodd-Frank Act.  While this case can be viewed as a positive development for resource extraction issuers, it also casts a further pall on the Conflict Minerals requirements under Dodd-Frank and the other rules that have yet to be proposed by the SEC’s staff (including the requirement in the Act that issuers disclose the ratio of the median of compensation of all employees to the total compensation of the CEO).  It also demonstrates that issuers face a great deal of uncertainty as a result of these cases; issuers are left with costs incurred to comply with the original phase-in dates, not knowing when or what the final rules will look like, and not knowing if other Dodd-Frank rules will ever be implemented.

The Supercharged IPO: A New Twist on the Traditional IPO Illustrates the Evolution of the Corporate Finance Landscape

Posted in Capital Markets

Initial Public Offering (IPO) Market: Favorable Pricing Trend

Investor confidence in the U.S. public capital markets is continuing to trend upwards. According to a recent report by Renaissance Capital, an IPO-focused research and investment management firm, in the first quarter of 2013, 36% of  IPOs were ultimately priced above the price range previously disclosed in Securities and Exchange Commission (SEC) filings, the highest percentage since 2004. As a result, not surprisingly, there has been a significant uptick in the number of IPO related prospectuses/registration statements that have been filed with the SEC in recent weeks.

Traditional IPOs vs. Supercharged IPOs: Exit Strategy

Defined as the first capital raise (i.e. offer and sale of securities) engaged in by a private firm to the investing public, an IPO provides liquidity and a financially lucrative exit strategy for the existing owners (founders, private equity/venture capital investors, etc.), and, in the event that an existing owner elects to sell all, or a portion, of his, her or its holdings, in connection with or after the IPO, the selling equity owner  is typically required to pay taxes at the long-term capital gain rate. That said, notwithstanding the tax consequences realized upon an actual sale, from a tax perspective, the traditional IPO structure is a non-event (i.e., the event itself does not generate tax costs for any of the parties).

As examined and outlined by an excellent, highly recommended article (accessible by clicking here) by Victor Fleischer and Nancy Staudt titled “The Supercharged IPO” (publication forthcoming in the Vanderbilt Law Review), a number of private equity firms have recently utilized an innovative, supercharged IPO structure that has yielded increased investment returns, as a result of collecting significant post-IPO payments from former (now publicly traded) portfolio companies (e.g., Bloomberg Group, Graham Packaging Company, Emdeon and National CineMedia).

The supercharged IPO structure – “supercharged” with post-IPO payments –  allows pre-IPO owners to generate and subsequently share in the value of various tax benefits (e.g., tax deductions and tax credits). The supercharged IPO structure is a complex, tax driven structure that requires extensive analysis and the consideration of a number of factors. Essentially, through a series of taxable steps/transactions (including having the owners of the private firm contribute their ownership interests to a newly public corporation in exchange for shares of the newly public corporation), new tax assets are generated that can be used to offset future state and federal income taxes, and a “tax receivable agreement” is entered into that apportions the newly created tax assets pursuant to a pre-negotiated formula. The “twist” is that the exchange of stock noted above is intentionally structured as a taxable transaction (so that the public corporation can take a “stepped up” basis in the private firm’s assets), despite the ability to structure the transaction tax-free under IRC Section 351. The supercharged IPO structure does require the pre-IPO owners to take an immediate tax hit; however, this is generally more than offset by the post-IPO payments received pursuant to the tax receivable agreement (reported to be $864 million – the Bloomberg Group, $200 million – Graham Packaging Company, $151 million – Emdeon and $196 million – National CineMedia).

Bottom Line

Application of the supercharged IPO structure is facts and circumstances specific, and it is not a suitable approach for all entities contemplating an IPO. However, the supercharged IPO, on a macro level, represents another example of the type of sophisticated corporate finance legal structures that are helping to shape an ever-evolving, ever competitive industry and, more importantly, serves as an important reminder that proper planning, and the implementation of legal structures and processes that are aligned with your strategic business objectives, on the front-end, gives you the best chance of realizing a more favorable outcome on the back-end.