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How GM's use of tracking stock is complicating a tax-free divestiture of its DirecTV business.

1Jan

Judging from all the hoopla, one would expect General Motors Corp. to have divested itself of Hughes Electronics Corp.by now. After all, the subsidiary, which consists mainly of the satellite television business known as DirecTV Inc., was recently valued at $40 billion by analysts, compared with $28 billion for GM. If GM doesn't act soon, it could find itself subject to a hostile takeover by a bidder primarily interested in Hughes. In fact, its attractions drew the interest of corporate raider Carl Icahn, who took a big stake in GM last August, only to sell it a month later, evidently because he was unable to force faster action.


Yet a host of companies, including Comcast, Disney, General Electric, News Corp., Sony, Viacom, and Vivendi, were all considered possible partners for Hughes, at least until recently. One of the most eager, reportedly, is News Corp., which has a satellite TV business of its own called Sky Global Networks Inc., in which Microsoft Corp. is said to be interested in investing. While Sky Global has no tracking stock that could serve as currency for such an acquisition, John Malone of Liberty Media Group, a large investor in News Corp., recently directed his company to contribute assets to News Corp., which could help the latter do the deal.


So what's holding things up? The basic problem is that GM carries Hughes on its books for only $5 billion, so divesting it would create a huge tax liability for its shareholders--a problem heightened by GM's use of tracking stock in connection with Hughes. That's because the interests of tracking-stock holders conflict to some degree with those of GM shareholders. Meanwhile, the stocks of both companies are heading south, even as some potential Hughes buyers appear to be getting cold feet. So, the longer GM takes to resolve the conflict, the more difficult it may be to extract maximum value for Hughes. "GM is between a rock and a hard place," says Jeffrey Wlodarczak, an analyst at CIBC World Markets Corp. GM's dilemma suggests that companies may want to think twice about trying to unlock the value of coveted assets through tracking stocks.


To be sure, the potential tax liability involved in the Hughes divestiture is substantial enough to present formidable problems, regardless of the issues posed by the tracking stock and declining share prices. About the only way around the tax issue, say analysts, is through a variation on a byzantine but widely used scheme known as a Morris Trust transaction. Named after a bank that was the defendant in a 1966 tax case, the scheme, in effect, blurs the line between a tax-free corporate restructuring — a spin-off or merger — and a taxable divestiture of a business.


However, "Morris Trusts are very complex," says Daniel Van Riper, CFO of Sealed Air Corp. "You really need competent corporate counsel to pull it off." Van Riper notes that his company announced a deal based on a reverse Morris Trust — which involves debt — in August 1997. But the deal, which merged the old Sealed Air with W.R. Grace & Co.'s Cryovac food packaging business, was not consummated until March 1998, even though the reverse Morris Trust structure was fully anticipated at the time of the announcement.


GM's divestiture of Hughes, however, is further complicated by the stock that GM issued back in 1985 to track the performance of the electronics business. Since tracking stock does not confer actual ownership of a business's assets, GM's shareholders still own Hughes's assets, so they're the ones on the hook for any tax. But holders of GMH shares, as the tracking stock is known, can claim dividends reflecting the earnings those assets generate. What's more, GM, like most tracking-stock issuers these days, granted holders the right to be compensated in full for the divestiture of those assets. For that reason, GM itself initially retained 70 percent of the GMH shares, though it reduced its position to 32 percent last summer.


But GM, also like other issuers, retains the right to decide whether to give GMH shareholders cash or stock in GM. Typically, says Robert Willens, a tax and accounting specialist at Lehman Brothers, compensation in the form of stock includes a premium of about 15 percent over the assets' market value. In this case, GM agreed to offer GMH shareholders a 20 percent conversion premium. But GM's board cannot force a conversion before the end of 2002. So GM would have to offer GMH stockholders cash if it wants to shed Hughes soon.


To compensate its own shareholders for their retained interest, the company would either have to distribute GMH stock to them or extract a dividend from Hughes to pay for retiring it. The trouble with the first option is that Hughes's stock is down roughly 50 percent since its high of $46.67 last March, thanks at least in part to the general sell-off in communications stocks. So GM shareholders may not want GMH shares. And with GM's credit rating under pressure because of the company's own underperformance, its board probably would not accept a dividend in the form of another company's stock. "To shore up its credit standing, GM may choose to monetize its retained interest," says Willens.


Based on Hughes's recent value, GM can expect a dividend of roughly $15 billion for its share of the tracking stock. Of course, such a dividend would reduce Hughes's value in the eyes of a potential buyer. But as Willens sees it, GM could get around that by borrowing the money to pay a big cash dividend to its shareholders, then spin off everything except Hughes and the debt into a new company. Then the old company — effectively Hughes--would merge with a suitor to form still another company.



Out of Control?

Here the rules governing Morris Trust deals create a catch: The company that then owned Hughes would have to refrain from issuing a lot of stock for any reason. That's because the rules say shareholders of GM common stock would have to retain majority control of the company for at least six months, and in most instances for two years. If the company wanted to make an acquisition for stock or raise equity capital (say, from Microsoft), it would have to be very careful not to dilute the GM shareholders out of their majority control. If it did, there would suddenly be penance to pay, in the form of a capital gains tax on something like $35 billion.


The rules also make it difficult for a company much larger than Hughes to acquire the assets in this manner, and the decline in Hughes's value adds to the problem. No wonder GM has yet to come to terms with any of Hughes's supposedly numerous potential takers.


Some analysts say the time is right for a deal despite all the complications. Cai von Rumohr, managing director of SG Cowen Securities Corp. in Boston, for one, contends that buyers are likely to pay a bigger premium for Hughes now, with the telecom sector consolidating, rather than after consolidation.


Granted, with Hughes's value down as far as it is, one might think that GM would be better off waiting to see if it rebounds. After all, Hughes is trading at only $1,800 to $2,000 per subscriber, compared with $3,200 for EchoStar Communications Corp., a competitor with far fewer takers and about half of the multiple of cable stocks. Trouble is, says Wlodarczak of CIBC, investors expect Hughes to be divested, and absent prospects for a deal, "there's nothing to make the stock go up." In addition, he suggests that GM's fiduciary obligations to Hughes's shareholders may not be as serious as they seem. If a deal gives them short shrift, however, don't be surprised if they challenge it in court.



Emily S. Plishner is a freelance writer in Brooklyn, New York.



In Morris We Trust


In the mid-1990s, a slew of heavily debt-burdened Morris Trust deals — including transfers of Times Mirror's cable division to Cox Communications, Viacom's cable assets to TCI Communications, Rockwell's aerospace assets to Boeing, Tenneco's gas pipeline business to El Paso Energy, and Morton International's air bag business to Autoliv AB--prompted Congress to look at the gambit. Not coincidentally, the biggest proposed deal at the time was GM's disposition of Hughes's defense assets to Raytheon Co., a deal that was not, technically, a reverse Morris Trust, but very much like one. When Congress passed the 1997 Tax Reform Act, it included a provision to severely restrict the use of Morris Trusts. By closing the loophole, the Joint Committee on Taxation expected the U.S. Treasury to generate $280 million in new tax revenues.


However, as written, the modifications to Section 355 of the Internal Revenue Code missed their target. "It was like hitting a gnat with a sledgehammer," says Laura Watts, an attorney with Pillsbury Winthrop LLP, in San Francisco. Of course, what Congress was really aiming at was a larger animal — the tax on the capital gain GM is likely to reap on its investment in Hughes Electronics Corp. (currently about $35 million). But the legislation barely grazed the target.


The statutory language of the new Section 355(e) of the Code bans a shift in majority control of a spin-off for two years before and after the deal. The Treasury recommendations as currently proposed state that if such a change occurs within six months of a deal, it becomes retroactively taxable to the parent. If it happens after six months but within two years, there could be a rebuttable presumption that a plan to sell the business was in place at the time of the spin-off, and the parent would have to pay tax on capital gains, dividends, or both.


Strapped with an opaque statute, the Treasury and the Internal Revenue Service have proposed guideline regulations under Section 355(e) that have proved very controversial and have never been finalized, although many lawyers have published papers discussing hypothetical defenses under the rebuttable presumption language. These defenses can resemble scholastic arguments about how many angels can dance on the head of a pin, because companies doing Morris Trust deals must prove in advance that they did not know of plans for events that they have no control over and have no way of predicting. This awkward position has caused some in the corporate tax bar to speculate about the potential for a new class of investment banking opinions — the Morris Trust equivalent of fairness opinions — that assert that no one has any plans to buy a proposed spin-off.



Legal Limbo


The fact that the proposed 355(e) regulations haven't been finalized leaves Morris Trust deals in legal limbo, with no assurance for CFOs that even an innocent spin-off will be able to muster a successful rebuttal to the presumption of a nefarious tax-avoidance plan. Ironically, the result of this legal limbo has been that the big, tax-free deals involving mounds of debt--reverse Morris Trusts and their close kin--continue, but the smaller, more straightforward Morris Trust deals without debt aren't viable, because the level of risk is too great. All told, at least five Morris Trust transactions of one type or another have been completed since the regulations were proposed. —E.S.P.

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