Where Ford Motor Co. and The Limited Inc. have feared to tread, Torchmark Inc., headquartered in Birmingham, Alabama, is preparing to go. If the $2.3 billion insurance and financial services combine stays the course, it will become the first company to exploit a tax-code provision that permits a company to sell up to half of a subsidiary without generating a tax bill.
"No one has pulled the trigger," says Robert Willens, managing director of Lehman Brothers Inc. "There were companies that set up to do this transaction. Each had capitalized a sub with two classes of stock, but they never issued enough to bring them below 80 percent."
A successful outcome will trigger more such deals, Willens predicts. For now, companies are focused on acquisition and consolidation. Eventually, though, eyes may turn to prospects for divesting some of the assets gobbled up in the current binge. At that point, tax- advantaged spin-offs will supply a lucrative way to backpedal. But if one more large company gets cold feet, it could put a chill not only on this structure, but possibly on other tax-advantaged spin-offs as well.
Torchmark announced its plan last March. On May 13, Republic Industries Inc., in Ft. Lauderdale, Florida, unveiled a similar plan. Both will take advantage of the definition of control for the purposes of conducting a tax- free spin-off. For the purpose of filing a consolidated tax return, a company must control 80 percent of the value and 80 percent of the voting shares of a subsidiary. To allow a tax-free spin-off, it must control 80 percent of the voting shares and 80.1 percent of shares in the nonvoting class, but only 50.1 percent of the value of all the subsidiary's stock.
By spinning off Waddell & Reed Financial Inc., in Overland Park, Kansas, Torchmark expects to capture the higher market premium that asset management companies, as opposed to insurance companies, enjoy. As a publicly traded company, Waddell & Reed should also gain access to capital markets on its own merits. Fresh capital can finance growth without exhausting Torchmark's credit quality, which is crucial to insurers.
In the best part of the bargain, Torchmark can sell up to half of Waddell & Reed and still retain 80 percent of the voting rights. Before Torchmark can proceed, however, it must disentangle Waddell & Reed from another subsidiary, Liberty National Life Insurance. Capital requirements in the insurance industry compel Torchmark to restore about $200 million, or 30 percent of the value of Waddell & Reed, to Liberty National.
To accomplish this feat, Torchmark created two classes of Waddell & Reed stock: 31.8 million Class A shares with one vote per share and 34.3 million Class B shares with five votes each. Then it raised $516 million by selling a third of the Waddell & Reed shares. Torchmark retained all of the Class B shares and 8 million of the Class A shares, giving it 88 percent of the votes and 64 percent of the value of Waddell & Reed stock.
Mum's the Word
It is not clear why other companies have considered the strategy and then shied away from it. The Limited, both when it took public its Intimate Brands subsidiary in October 1995, and again with its Abercrombie & Fitch subsidiary in September 1996, created two classes of stock with unequal voting rights. The Limited's Class A shares in both Intimate Brands and Abercrombie & Fitch had one vote each and Class B shares had three votes each. Ford also created two classes--one with five votes, the other with one vote--when it took its Associates First Capital Corp. subsidiary public in May 1996. But, The Limited offered only 17 percent of Intimate Brands to the public and 16 percent of Abercrombie. Ford offered just 19.3 percent of Associates.
The Limited, in May, declined to explain why it had created the two classes of shares, saying that it could not make public statements regarding the transactions since it was in the midst of spinning off Abercrombie & Fitch. Mel Stephens, director of business news and financial information in Ford's corporate finance department, said only that Ford created the two classes to give Associates the flexibility to make acquisitions by issuing more stock or to issue stock options. He did not explain why it had not opted to take advantage of the flexibility by selling off more than 20 percent of Associates.
One reason not to take advantage of the strategy may be concern about the market's response to two classes of shares, analysts say. In the cases of both Abercrombie & Fitch and Associates, the high-vote shares reverted to common shares in anticipation of the subsidiaries' spin-offs. The companies would not have been able to do tax-free spin-offs if the shares had converted and more than 20 percent of the value of the subsidiaries had been sold.
"People may scratch their heads" about two classes of stock, says one tax consultant. "It is one thing to do two classes so that a family can control a company. But, there are very few [other] cases of two classes with different voting power. It's odd. Investment bankers and market makers will wring their hands."
That is what happened when Eaton Vance Corp., an investment management firm in Boston, created two classes of shares--one with 10 votes and the other with 1 vote--in its Investors Financial Services Corp. subsidiary, in a November 1995 recapitalization. The two classes were created to bring Eaton Vance's voting control of the subsidiary up to a minimum of 80 percent so that Investors Financial Services could be spun off tax- free.
Some of the high-votes shares were valued lower than the common shares, and some were valued the same, says William Steul, CFO of Eaton Vance. The problem was short-lived because in order to protect the company from a hostile takeover, the high-votes shares were designed to revert to common shares after two years or once they were sold.
"The market does have an aversion to this feature," says Steul. "It does have trouble valuing these shares. You need to make them liquid by converting them."
Another reason The Limited, Ford, and other companies may not have followed through with the strategy is that a company can no longer consolidate tax returns when it sells off more than 20 percent of the value of its subsidiary. For firms like Torchmark that plan to spin-off their subsidiaries within months of taking them public, the drawbacks are negligible. But, it was 21 months between Abercrombie & Fitch's IPO and its spin-off, and it was nearly two years between Associates's IPO and its April 1998 spin-off. The ability to consolidate tax returns was definitely a consideration for Ford, says Louis Ghilardi, a Ford lawyer. It may well have been a consideration for The Limited, says Mark Friedman, an analyst with Merrill Lynch.
Keith Tucker, Waddell & Reed's chairman and the CFO of Torchmark until last March, declined to discuss the company's Waddell & Reed transaction until after the company received an Internal Revenue Service ruling on its plans. However, companies should have little doubt about the legality of the strategy, say many tax consultants. The IRS has granted approval letters for comparable transactions at least five times previously. "I don't think it's risky at all on a tax basis," says one consultant of the transaction.
Until a company goes through with it, however, there will be an edge of uncertainty. "If a reputable company does it, it will go a long way toward acceptance," says Willens. "The fact that a company like Torchmark will do it will help get others to do it."