Are Spinoffs Being Used to Eliminate Corporate Liabilities?

Time Warner has recently made news for planning the spinoff of its struggling Time magazine division.  A spinoff is a transaction in which a parent corporation distributes the stock of its subsidiary to the parent’s shareholders.  In accordance with Internal Revenue Code Sections 355 and 361, spinoffs can often be executed without the involved parties incurring any federal income tax.  A corporation may have a variety of business reasons to carry out a spinoff, which is important because the IRS requires a spinoff to have a valid business purpose.  Perhaps the most common is to streamline the parent’s business and allow it to focus on its core competencies (often referred to as “fit and focus”).  A parent may also use a spinoff to rid itself of an unprofitable or struggling subsidiary.  Prior to a spinoff, a parent may “load up” its subsidiary with debt, or it may transfer liabilities- such as pension obligations or contingent environmental liabilities- to the subsidiary.  Once the spinoff is executed, the parent sheds such the subsidiary’s liabilities and debt.

If a subsidiary goes bankrupt shortly after it is spun off from the parent, creditors of the subsidiary often sue the parent and argue that the parent acted in bad faith by trying to avoid its obligations through the spinoff.  For example, creditors of Patriot Coal Corporation are pursuing legal action against its former parent, Peabody Coal Corporation, on the ground it was done to defraud creditors.  In addition, shareholders in the parent who receive the stock of the subsidiary may be upset that that they received stock of a struggling company.  Depending on state law and the percentage of the parent’s assets that the subsidiary comprises, shareholder approval of a spinoff may not be required.  If no shareholder approval is required, it may be particularly tempting for the parent’s management to jettison a subsidiary after weighing it down with liabilities.