Divesting control by demerger

Author: | Published: 1 Apr 2007
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Owed in part to the strength of equity capital markets, the last 12 months or so have seen demergers coming back into favour with UK listed companies. Demergers, which typically involve the spin-off by a company to its shareholders of certain of its activities and a listing on public markets of the separated business, provide a means to enhance shareholder value, focus business activities and/or divest control of non-core assets, often in preference to a sale of the relevant assets to a third party (see table showing selected recent demergers). This article examines some of the reasons why UK listed companies have chosen to demerge parts of their business and the principal legal issues that have arisen in structuring and implementing them.

Reasons for implementing a demerger

Unlocking shareholder value

Unsurprisingly, unlocking or enhancing shareholder value is the most commonly cited reason for implementing a demerger; companies that choose to implement a demerger believe for one reason or another that the value of their businesses when separated will exceed the value of the group as a whole (for example where the market fails to fully recognise the value of a non-core business). Unlocking or enhancing shareholder value is a recurring theme in a number of the other reasons for implementing a demerger, listed below.

Focus activities and management

Demergers can be employed by a group with diverse businesses as a means to focus the activities of its various divisions and to allow these divisions to benefit from greater management focus on their respective strategies as independent businesses. The completion in 2006 of the break up of GUS is a good example of this. What was previously Great Universal Stores is now represented on the Official List of the FSA (the Official List) by three very different listed companies: Burberry (the luxury brand), Experian (the credit agency) and Home Retail Group (comprising the catalogue store Argos and DIY chain Homebase). Focussing activities and management was also a key driver behind the Severn Trent/Biffa, Collins Stewart Tullett and WH Smith demergers. A demerger can also align management's rewards more directly with the separated business and its stock market performance.

Relief from regulatory constraints

The demerger route has been used to free a business from regulatory restrictions which apply to other businesses within the group. A key reason for the Collins Stewart Tullett demerger was to relieve its Tullett Prebon inter-dealer broking business from regulatory and capital maintenance requirements which applied to the group as a whole as a result of the group's stock broking business. This then allowed Tullett Prebon to return approximately £300 million ($579.9 million) excess capital to its shareholders.

Establishing appropriate ratings and capital structures

A demerger can also be used to establish ratings and capital structures suited to the specific businesses being separated. The demerger by Severn Trent of its waste management business, Biffa, enabled Severn Trent to increase its gearing in line with other listed water companies, allowing Severn Trent to return almost £600m to shareholders.

Other commercial reasons

There can be a range of other sensible business reasons for implementing a demerger. The separation in 2006 of WH Smith's news distribution and high street retail businesses allowed the newspaper and magazine wholesale distribution business greater access to other high street retailers that had previously viewed it as being part of a competitor's group. A demerger of a business can also act as a precursor to a sale or merger of that business with a third party.

Pre-demerger structuring issues

Recent demergers have commonly been preceded by a group restructuring, often for one or more of the following purposes:

  • To separate the business to be demerged from the remaining business and in a tax efficient manner;
  • To create reserves within the remaining group to give effect to the demerger by dividend (see demerger structures below) or to ensure that the remaining group has sufficient reserves following the demerger to support its dividend policy going forward;
  • To create reserves within the entity to be demerged to support its own dividend policy as a newly listed business following demerger;
  • To extract surplus cash from the business to be demerged; and
  • To establish appropriate new capital structures for the remaining and the demerged businesses.

Demerger structures

A number of considerations will drive the choice of demerger structure, such as the availability of reserves within the parent group, complexity, timing and, importantly, tax (as to which, see tax considerations below). The most frequently employed structures over the last year or so have been the following:

Direct Demergers

  • A direct demerger involves a dividend in specie, by the parent company to its shareholders, of shares in the subsidiary to be demerged (commonly referred to as a demerger dividend). Severn Trent implemented the demerger of Biffa using this structure.
  • A direct demerger by dividend is only viable if the parent company has distributable reserves at least equal to the book value of the assets being distributed to pay the demerger dividend.
  • This tends to be the simplest and quickest demerger structure to implement. Shareholder approval of the demerger dividend will typically be required (but this will depend on the company's constitution, which usually requires a majority of those attending and voting at the relevant shareholder meeting to vote in favour) and in terms of public documents, the production and publication of a circular convening a shareholders' meeting to obtain that approval and an appropriate listing document (see securities law issues below).
  • If there are insufficient reserves to pay a demerger dividend, it may be possible to implement a direct demerger by means of a court approved reduction of capital instead. However, these structures are rare in practice for a number of reasons. In particular, before providing its consent to a reduction of capital, a court will want to ensure that creditors of the parent company are adequately protected and frequently creditor consent will be required. Reductions of capital are, however, not uncommon in the context of demergers involving a scheme of arrangement for reasons discussed below (see schemes of arrangement below).
Severn Trent/Biffa – Direct demerger

Indirect demergers

  • The typical indirect or so called three-cornered demerger is very similar to a direct demerger, with one key structural difference. It also involves the payment of a dividend in specie to shareholders; however, here the parent company declares a dividend which is satisfied by the transfer of the subsidiary to be demerged to a newly formed company (Newco), in consideration for which Newco issues shares directly to the parent company's shareholders. Bunzl employed a simple three-cornered structure to demerge its plastics and fibres business, Filtrona.
Bunzl/Filtrona – Indirect demerger

A three-cornered demerger is frequently combined with a scheme of arrangement.

  • When not combined with a scheme of arrangement, an indirect demerger is also a relatively simple structure to implement, involving the production of the same public documents required on a direct demerger. If the parent company does not have sufficient reserves to pay the demerger dividend, an indirect demerger can also be implemented by means of a three-cornered reduction of capital (where the business to be demerged is transferred to the Newco pursuant to a reduction of capital, in consideration for the issue by the Newco of shares to the parent company's shareholders) although these structures are also rare in practice for the reasons mentioned above.
  • An indirect demerger can provide slightly more structural flexibility than a direct demerger (eg it involves a new, clean company whose share capital can be constructed to suit the commercial requirements of the parties) and the scope of tax reliefs available are broader than on a direct demerger (see tax considerations below).

Schemes of arrangement

  • A scheme of arrangement is a court approved procedure under section 425 of the Companies Act 1985 which enables a company to make a compromise or arrangement with its members or creditors. The most common form of scheme of arrangement in the context of a demerger involves the insertion of a new holding company (New Holdco) between the listed parent company and its shareholders. This type of scheme is commonly used in tandem with a reduction of capital of New Holdco to implement the demerger. Unlike the structures described above, it involves two listings: (i) a fresh listing of New Holdco and the remaining business; and (ii) a listing of the business being demerged. Both the Collins Stewart Tullett and WH Smith demergers employed New Holdco schemes combined with a reduction of capital.
  • These structures are the most complex and time consuming of the structures described in this article so far. They require court approval in relation to the scheme and reduction of capital as well as shareholder approval of the scheme (comprising a majority in number and at least 75 per cent. in value of shareholders who vote at a court meeting convened to sanction the scheme and 75 per cent. of those voting at a shareholder meeting called for the same purpose). There is also significantly more documentation required, including a scheme circular to shareholders, court documents relating to the scheme and the reduction and two listing documents: one for the company to be demerged and the other for New Holdco and the remaining business.
  • An advantage of a scheme combined with a reduction of capital is that it can be used to affect a demerger when the company does not have sufficient distributable reserves to affect a demerger by dividend. In addition, a New Holdco reduction of capital is typically much simpler than a reduction of capital of the parent company on a direct or indirect demerger scenario, on the basis that New Holdco will not have any creditors. This is one reason why it is not uncommon for companies to go down the New Holdco scheme route if there are insufficient reserves to implement a demerger by dividend.
  • In addition to the structures mentioned above, it is also worth mentioning liquidation schemes, which involve the liquidation (under section 110 of the Insolvency Act 1986) of the parent company of the group and the transfer of its assets typically to two newly formed companies. For various reasons, including difficulties associated with liquidating an operating company, these structures are now rarely used in practice.
WH Smith – Scheme of Arrangement

Tax considerations

A key advantage of a demerger compared with a sale to a third party is that a demerger enables the business to be split without a tax charge for the participants. Although it may be possible to effect a tax efficient sale, there are demerger reliefs which are specifically designed to avoid tax leakage. The key tax consideration underlying the choice of a demerger structure will be to utilise available reliefs to avoid tax leakage. The following is a brief outline of principal tax points which may influence the choice of demerger structure:

  • The three main tax charges which are normally considered are: (i) tax in the hands of shareholders; (ii) tax in the hands of the parent company or group; (iii) a degrouping tax charge in the hands of the demerged company or group.
  • An indirect demerger by dividend benefits from reliefs which will generally protect from all of these tax charges. However, these reliefs are subject to stringent conditions, in particular: (i) they only apply to trading groups; and (ii) it is not possible for the demerger to include arrangements for shareholders to dispose of their shares in the demerged company (eg an on-sale to a third party). It is possible though to apply for clearance that the conditions are met and the main reliefs will apply.
  • A direct demerger by way of dividend benefits from similar reliefs and is subject to the same stringent conditions. However, the parent will need to rely on either a sufficient base cost in the demerged company or the availability of the substantial shareholdings exemption (SSE) to avoid a taxable disposal by the parent of the demerged company. The SSE exempts, subject to conditions, disposals of trading companies by trading groups from tax. It is not possible to apply for clearance that the SSE will be available, and testing the availability of the exemption can be a painful process for groups with some investment (as opposed to trading) activity.
  • Demergers by way of scheme of arrangement or liquidation do not require compliance with the stringent conditions mentioned above, and in particular it is possible to carry out a demerger using one of these methods as part of arrangements under which the shareholders will dispose of their shares in the demerged company. However, there is no statutory protection from a degrouping charge in a demerged company for these types of demerger. A degrouping charge can arise where the demerged group takes with it an asset acquired on a tax free basis from the parent group. It has generally been considered possible to plan around a possible degrouping charge. However, this is currently the subject of litigation, and an unfavourable outcome may mean that such planning techniques may not be effective in all cases in future.

Securities law issues

A feature that distinguishes a demerger from other forms of disposal is that it involves a listing of the demerging business and sometimes (in the case of a New Holdco scheme of arrangement) a new listing of the remaining business. These are a selection of securities law issues that are of particular relevance in the context of demergers:

UK

  • The Prospectus Rules, which implemented the EU Prospectus Directive in the UK, provide that, subject to certain exemptions, an issuer may not: (i) offer transferable securities, whether listed or unlisted, to the public in the UK; or (ii) admit transferable securities to trading on a regulated market (which is defined to include the Official List but not AIM) in the UK unless a prospectus has been made available.
  • The transfer or issue by a parent company to its shareholders of shares in the demerging company will not generally constitute an offer to the public for Prospectus Rules purposes.
  • However, if a listing of those shares on a regulated market is sought (for example, the Official List) a prospectus containing detailed information relating to the demerging company will need to be prepared.
  • If the shares are to be listed on AIM, the AIM Rules require the preparation of an AIM admission document (with contents similar to a prospectus).
  • If the demerger involves a New Holdco scheme of arrangement, depending on where the New Holdco is to be listed, a prospectus or AIM admission document for New Holdco and the remaining business will also be required.

Other jurisdictions

If the parent company has a significant shareholder base in any overseas jurisdiction then it may be appropriate to analyse the impact of the demerger under local securities laws. This article does not deal with those issues except to mention the following general points on EU and US securities laws which are worth noting:

EU: Although the Prospectus Directive has effect across the EU, the treatment of demergers in other EU states will not necessarily follow the UK analysis that a demerger does not constitute a "public offer". Local advice on this and the availability of exemptions from the requirement to produce a prospectus may be required.

US: Companies which have a substantial number of US shareholders need to be aware of restrictions contained in the Securities Act of 1933, as amended (the Securities Act). The staff of the Division of Corporate Finance of the Securities and Exchange Commission has issued guidance stating that a demerger and attendant distribution of a subsidiary's shares to holders of the parent company's shares generally do not need to be registered under the Securities Act if certain conditions are met, whilst, if a demerger is structured as a scheme of arrangement, it is likely to be exempt from the registration requirements of Section 5 of the Securities Act if it meets the requirements of Section 3(a)(10) of the Securities Act. US securities law advice will need to be taken to ensure that these conditions and requirements and other relevant US issues such as the anti-fraud provisions are complied with.

Selected other issues

Because of the nature of a demerger (effectively a disposal combined with a listing) many of the issues that arise are similar to those that typically arise either on a sale or on an IPO, in some cases with differences reflecting the particular characteristics of a demerger. This article does not seek to go through these in detail, other than to highlight some selected points of particular interest:

Due diligence

It is not uncommon for the parent company to undertake due diligence on the demerging business for reasons associated both with a disposal process (for example, identifying consents required under banking facilities, change of control clauses in key contracts, shared contracts and services, cross-group guarantees and other separation issues) and a listing process (for example, the production of a long form report and identifying items for disclosure in the listing document).

Financial/accounting

As with an IPO process, there is usually a significant amount of work undertaken to support the financial information included in the listing document (for example, long and short form reports and working capital and significant change work).

Class tests

The listing rules applicable to companies listed on the Official List and the equivalent rules under AIM rules require specific prior shareholder approval to large acquisitions and disposals. As with any disposal by a listed company it will be necessary to check whether class tests are triggered under Listing Rules or AIM rules, and which mean the demerger will require specific shareholder approval. If such specific approval is required, this will increase the required content of the public documentation and produced in relation to the transaction.

Preparation for listing

As on an IPO, the demerging company will need to take steps to prepare itself for listing, for example:

  • putting in place a suitable listed company board. This will sometimes involve the introduction of new board members who are unfamiliar with the demerging business and who need to be brought up to speed quickly, particularly as they will share responsibility for the contents of the listing document; and
  • establishing listed company policies, procedures and controls.

Pensions

  • Where the demerging entity participates in a pension scheme which will remain with the parent company's group, the commercial rationale of the demerger may mean that the assets and liabilities of that scheme are divided so that they can be transferred to a scheme within the demerged company's group. Consideration will need to be given to the terms of the transfer of the pension liabilities and the method for calculating the amount of assets to be transferred. There may also be a need to "top up" the transfer if the liabilities exceed the assets.
  • Consideration should also be given to seeking clearance from the Pensions Regulator (the UK regulator of work-based pension schemes). Without clearance there remains a risk that, as a result of the way in which the demerger is structured, the Pensions Regulator may impose a contribution notice (e.g. if he considers that steps are being taken to avoid pension liabilities). There is also a risk that he may impose a financial support direction requiring one group to support a scheme in the other group in the future. The Pensions Regulator will expect the trustees to be in agreement with any application for clearance. This affords the trustees the opportunity to negotiate with the employers, and brings the risk of the employer being required to top up funding as a result. This risk should be weighed against the benefits of obtaining clearance.

Employees Share Schemes

  • Employees in the demerged company may hold share options and awards in the parent company's share schemes. Often these schemes will provide for the shares to be released immediately or, sometimes, at the end of any relevant performance period. Therefore, the rights of participants who leave the parent company's group on the demerger will need to be examined in order to ensure the shares are released at the appropiate time and all applicable tax paid on the gains made on release.
  • Employees in the demerged company will cease to be eligible to participate in the parent company's schemes following demerger and new schemes therefore need to be established by the demerging company. Although new schemes are commonly established in advance of a demerger, it is considered best practice to obtain the approval of the parent company's shareholders to their operation at the same time as approval to the demerger is obtained (WH Smith).

Share consolidation

As demergers involve the disposal by a company of valuable assets they can lead to a significant drop in the share price of the parent company following the demerger. It is not uncommon for the parent company to carry out a consolidation of its share capital to ensure that it share price is approximately the same before and after the demerger and in order to preserve the comparability of per share data before and after demerger and the value of share options under the parent company's share schemes. Severn Trent carried out a share capital consolidation to reflect the demerger of Biffa and related return of cash to shareholders by way of special dividend.

Selected recent demergers
Company Event Date
Bunzl Demerger of plastics and fibres business June 2005
WH Smith Separation of retail and newspaper and magazine distribution businesses September 2006
GUS Demergers of:
(i) Remaining stake in Burberry
(ii) Home Retail Group (Argos/Homebase)
(iii) Experian

December 2005
October 2006
October 2006
Severn Trent Demerger of Biffa October 2006
Collins Stewart Tullett Separation of stock broking and inter-dealing broker businesses December 2006
Proposed/contemplated demergers
Georgica Separation of snooker and ten-pin bowling businesses Ongoing
Provident Financial Demerger of international businesses Ongoing
Chrysalis Group Potential demerger of radio and music businesses Strategic review announced February 2007
Author biographies

Alan Montgomery

Herbert Smith

Alan is a corporate partner who specializes in M&A, ECM and other securities work as well as restructurings. He advises corporations and investment banks.

Selected transactions include advising:

  • Central SAFE Investments, a state-owned Chinese company and sole shareholder of Bank of China, on the sale of a 10% strategic interest in the bank to a group of investors led by Royal Bank of Scotland for $3.1 billion, and the sale of further stakes to Temasek, UBS and Asian Development Bank;
  • Heath Lambert on its innovative restructuring;
  • Lazard on its $800 million initial public offering;
  • Hollinger International on the £700 million ($1.2 billion) sale of the Telegraph Group; and
  • BP on the sale of its 2% stake in PetroChina by way of accelerated bookbuilt placing on public markets for HK$13 billion ($1.65 billion).

Derek Hill

Herbert Smith

Derek Hill is a tax partner in the corporate group in Herbert Smith's London office.

He has a broad-based corporate tax practice, with experience in domestic and cross-border tax planning and structuring, mergers and acquisitions, and company reorganizations. His practice also includes asset and unusual finance structures and securitizations, disputes with HMRC and all tax aspects of energy transactions, including CHP and renewable tax issues.

Selected transactions include:

  • IRC v Rafferty (an Allied Dunbar sales associate) in a successful appeal to the Special Commissioners overturning a pre-existing adverse precedent in the anti-avoidance context;
  • various corporate and banking clients in relation to the successful resolution of high-value tax disputes in respect of both direct and indirect taxation;
  • various corporate clients in relation to a number of tax-structured asset finance matters in relation to real estate, moveable assets and intellectual property;
  • Macquarie on the purchase of the Wales & West Gas Distribution Network;
  • TXU on the sale of its £1.37 billion gas and power supply business to E.ON/Powergen;
  • Amerada Hess on the restructuring of its interests in Premier Oil;
  • various clients in relation to taxation issues in the Renewable Energy industry, including in relation to Climate Change Levy;
  • Hollinger International on the £729.5 million sale of the Telegraph Group, the publisher of the Daily Telegraph, Sunday Telegraph and Spectator; and
  • Time Warner on various matters, including its £1.15 billion acquisition of IPC Media.

Robert Moore

Herbert Smith

Bob specializes in a wide range of general corporate, corporate finance, and mergers and acquisitions transactions. His experience includes both recommended and hostile public company takeovers, private company acquisitions and disposals, demergers and returning value to shareholders.

Selected transactions include:

  • Severn Trent in relation to the demerger of Biffa and advising Biffa on its listing on the London Stock Exchange;
  • Signet Group on the redenomination of its share capital from sterling to US dollars;
  • West Ham Unitedon its recommended takeover by an Icelandic consortium;
  • RAC on its recommended takeover by Aviva for £1.1 billion;
  • Roger De Haan on the sale of Saga for £1.35 billion to a management buyout team supported by Charterhouse; and
  • Bristol Water on a return of capital to shareholders.