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Peckar & Abramson

Consolidation of the Civilian Boards of Contract Appeals
Section 847 of the FY 2006 Defense Authorization Act (Pub. L. No. 109-63) consolidated the eight existing boards of contract appeals for the civilian agencies.

08-04-2006

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Weil, Gotshal & Manges, LLP

SEC Adopts Sweeping Changes to Executive Compensation and Other Disclosures - Time to Get Ready For the 2007 Proxy Season
On July 26, 2006, the U.S. Securities and Exchange Commission adopted amendments to the disclosure requirements for executive and director compensation, related person transactions, director independence and other corporate governance matters, and securities ownership of officers and directors. The disclosure requirements for Form 8-K regarding employment and compensation arrangements have also been modified. These sweeping changes represent the first overhaul of executive and director compensation disclosure in over 14 years, with the aim of providing to shareholders and investors "comprehensive but also comprehensible information," mainly in plain English.

08-04-2006

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Watson, Farley & Williams, LLP

Anti-Doping Rules, a Barrier to Competition? Maybe . . .
In 1999, two professional long distance swimmers each received four year suspensions for testing positive for nandrolone, a prohibited anabolic substance. This was reduced to two years in 2001 by the Court of Appeal for Sport, in light of new scientific evidence. Still unsatisfied, the swimmers filed a complaint with the European Commission (the “Commission”). The applicants challenged the compatibility of certain anti-doping regulations, adopted by the International Olympic Committee (“IOC”) and implemented by the International Swimming Federation (“FINA”), with the EC Treaty rules on competition and freedom to provide services. The Commission rejected the complaint. An appeal to the Court of First Instance (“CFI”) to have the Commission’s decision set aside was unsuccessful. The CFI concluded that as the prohibition of doping is based on purely sporting considerations, and not any economic considerations, the anti-doping rules fall outside the operation of the EC Treaty provisions relating to the freedom to provide services and competition. The swimmers appealed to the European Court of Justice (“ECJ”). Importantly, the ECJ held that the CFI had made an error of law in deciding that “purely sporting” rules are automatically excluded from the operation of Articles 81 and 82 of the EC Treaty. The ECJ stated that it must, instead, be determined whether the rules in question fulfil the specific requirements of the prohibitions set out in Articles 81 and 82. In applying those provisions, account can be taken of the objectives of the rules, whether the consequential anti-competitive effects are inherent in the pursuit of those objectives, and whether they are proportionate. The restrictions inherent in the anti-doping rules can be considered to be justified by the legitimate objective of protecting competitive sport. The ECJ clearly stated, however, that the nature of penalties under the anti-doping rules (i.e. lengthy suspensions), means that they could have adverse effects on competition. For such rules not to fall within Article 81, therefore, it is crucial that those restrictions of competition be limited to “what is necessary to ensure the proper conduct of competitive sport”. Unfortunately for the swimmers, they were unable to establish that the nandrolone-related anti-doping rules are disproportionately restrictive, and their challenge was dismissed.

To borrow from a famously long list of sporting clichés this was never about the result but about the performance. These two swimmers may have lost but they have shown future aggrieved sports people the route to goal. For sports governing bodies, the ECJ’s ruling will doubtless have come as a bit of a shock. In short, their word is no longer final when it comes to bans, suspensions, etc., and that goes for performance enhancement as well as any other similar infractions (e.g. bribing match officials - as it that would ever happen!). Prevent an individual and/or a team from competing and you can confidently expect to be going twelve rounds with a heavyweight competition lawyer from now on.

08-04-2006

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Pepper Hamilton, L.L.P.

Pennsylvania Uniform Trust Act: New Duties and New Benefits
On July 7, 2006, Gov. Rendell signed the Pennsylvania Uniform Trust Act into law. The UTA, which becomes effective in Pennsylvania on November 4, 2006, is closely modeled on the Uniform Trust Code, which has been enacted in similar versions in 18 states and the District of Columbia and is pending in many others.

In general, the UTA is designed to encourage and facilitate communication among trustees and beneficiaries. It specifically provides that “a trustee shall promptly respond to a beneficiary’s reasonable request for information related to the trust administration.” While we at Pepper believe that a trustee always has been obligated to respond to reasonable requests for information from a beneficiary, this obligation was never specifically stated – until now.

Most of the UTA is a restatement of current trust law in Pennsylvania; however, new notice requirements to beneficiaries and changes in trustee liability for the administration of a trust impact both trustees and beneficiaries.

Notice

The UTA requires trustees to give notice of the existence of an irrevocable trust to any beneficiary over 25 who currently may or might be entitled to receive income or principal. In Pennsylvania, unlike many jurisdictions, the administration of an estate or trust is subject to court supervision only when the executor, trustee or a beneficiary requests the court’s assistance. In this sense, Pennsylvania is a ""beneficiary monitored"" – rather than a ""court monitored"" – system, which benefits all those concerned by keeping down unnecessary costs, filings and time expenditures. To work properly, however, beneficiaries of an estate or trust need to know that they are beneficiaries.

The notice itself, while not complicated, must disclose the following:

the fact of the trust’s existence
the identity of the settlor (the person who created the trust)
contact information for the trustee
a statement of the beneficiary’s right to receive a copy of the trust and some form of annual report if desired.
This requirement is similar to the notice that must be given to all beneficiaries at the beginning of an estate administration.

Certain trusts are exempt from the notice requirement. No notice is required for any trust that is currently revocable, nor for any trust (revocable or irrevocable) where the settlor is still living and has not been declared incapacitated by a court. Once the settlor dies and the trust becomes irrevocable, notice must be provided within 30 days. Other events occurring during the administration of the trust – such as a change of trustee – will require further notice.

If you are a trustee of a trust, you may need to give this notice and should consult with trust counsel concerning whether the notice is required, to whom it must be given and when. The answers to these questions may vary but, in general, a trustee of an existing irrevocable trust has until November 4, 2008, to send the notice.

Release of Trustee from Liability

The UTA provides greater protection from liability for a trustee’s administration of a trust. Currently, absent a written release from all present and future beneficiaries, a trustee remains liable for his or her administration of the trust until that release is obtained or until an accounting is filed with the court. This liability may cover many years and may even extend beyond the death of a trustee. Under the UTA, a trustee may be relieved of liability for the administration of the trust by providing certain annual reports to beneficiaries and having specified periods of time expire without the beneficiaries objecting to the reports.

If you are a trustee of a trust, particularly if there is no corporate trustee, you should consult with trust counsel concerning the benefits, costs and need to provide some form of annual report to beneficiaries.

Other UTA Provisions of Note

Until the enactment of the UTA, there was no statutory guidance concerning an individual’s capacity to write a trust or the rights of creditors in revocable trust assets at the death of the settlor. The UTA provides that the mental capacity to write a trust is the same as that needed to write a Will. It also limits the ability of creditors to reach the assets of a revocable trust at the death of the settlor, tracking the ability of creditors to reach estate assets, including extending to trusts the protection of a specific statute of limitations for claims against trust assets.

Revocation of the Rule Against Perpetuities

The same bill that enacted the UTA repealed the Pennsylvania Rule Against Perpetuities for all interests created after December 31, 2006. This means that beginning January 1, 2006, anyone who wishes to create a long-term trust will not need to go to Delaware, New Jersey, South Dakota or any other jurisdiction that has previously repealed this rule. While it now will be possible to create such a trust in Pennsylvania, we encourage clients to continue to build in as much flexibility as possible when creating long-term trusts to allow for the reality of changing circumstances many years in the future.

08-04-2006

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Pepper Hamilton, L.L.P.

SEC and DOJ File First Civil and Criminal Charges Involving Stock Option Backdating
On July 20, 2006, the Securities and Exchange Commission and federal prosecutors in San Francisco filed civil and criminal charges against the former CEO of Brocade Communications, Gregory Reyes, and Brocade’s former vice president for human resources, Stephanie Jensen, in one of the first cases involving the alleged backdating of stock option grants in violation of federal securities laws. The criminal charges carry a penalty of as much as 20 years in prison and a fine of up to $5 million. The SEC also filed a civil complaint against Antonia Canova, Brocade’s former CFO.

The director of the SEC’s Enforcement Division, Linda Chatman Thomsen, stated that “this case will not be the last” involving the arguably widespread practice of backdating stock options.

According to the SEC’s civil complaint, Reyes and Jensen routinely granted in-the-money stock options from 2000 to 2004 to enable Brocade to hire or retain certain employees, but in doing so, they modified documents to make it appear that the options had been granted on earlier dates with exercise prices equal to the closing market prices on such earlier dates.

The SEC alleges that during that period, when Reyes, the sole member of the company’s compensation committee, distributed stock options to new or current employees, Jensen and others had previously supplied him with Brocade’s stock-price history, highlighting the lowest closing price during recent months. When the compensation committee granted options, according to the SEC, Reyes backdated offer letters and minutes of compensation committee meetings, so that the options would appear to have been granted on dates when the price of Brocade’s stock was low, with the exercise prices equal to the market prices at the close of trading on such dates. In certain instances, Reyes’ scheme allegedly resulted in options having been granted to certain persons before they had been hired by Brocade.

Because Reyes and Jensen are charged with having created documentation that falsely represented that the options had been granted on an earlier date, which often corresponded with quarterly lows, Brocade is said to have violated generally accepted accounting principles by failing to properly record options-related expenses in its income statements.

After discovering the backdating practice, Brocade was obligated to restate its prior financial statements by increasing its net loss from $2 million to $32 million in 2004, and by reducing net income by $304 million for the three-year period 1999 to 2001.

According to various newspaper reports and statements from the SEC, numerous other companies are already under investigation for actions similar to those alleged to have occurred at Brocade. Federal prosecutors in California and New York have initiated investigations of at least several dozen companies that may have accounting problems associated with option backdating, and the SEC is investigating at least 80 companies.

There are tax implications, as well, when an option is awarded at a price below the market price on the date of the grant. According to a press report, the Internal Revenue Service is now auditing the returns of several dozen companies and their top officers to determine whether there are additional income tax liabilities arising from the improper reporting of option grants.

The interest that the SEC, federal prosecutors and the IRS are showing in the issue should be a strong warning to directors, officers and counsel to review their companies’ policies with regard to the granting and dating of stock options. It would appear to be nearly inevitable that stockholder class actions will follow soon.

When handled properly, it is perfectly legal and appropriate to grant stock options to directors, officers and employees, but the intricate set of accounting and tax rules governing the granting of options must be followed very strictly. Backdating of option grants should be avoided in all circumstances. Moreover, the SEC voted on July 26 to adopt rules requiring that public companies disclose any executive compensation programs or practices that award stock options and set the exercise price based on the stock’s price on a date other than the actual grant date.

The interest shown by federal prosecutors demonstrates that backdating and other improprieties involving the granting of options may create risks that are far greater than even having to restate the corporation’s prior years’ financial statements.

08-04-2006

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Pepper Hamilton, L.L.P.

Selling and Buying From Yourself - Negative Tax Results of Related Party Transactions
The notion that transactions between affiliated corporations filing consolidated returns are subject to a series of complex rules that may defer or disallow the recognition of related items of deduction or loss (among other items) is generally familiar to many taxpayers. Perhaps slightly less well known is the notion that transactions between “related” taxpayers are subject to a similar series of complex rules that may defer or disallow the recognition of related items of deduction or loss (among other items).

A recent Chief Counsel Advice Memorandum, 200617036 (January 12, 2006), highlights a case where the purported loss that was generated by sales and transfers between certain related parties was disallowed by the Internal Revenue Service (IRS) under Section 267 and Treas. Reg. Section 1502-13.

In General

Section 267 of the Internal Revenue Code generally provides that no deduction shall be allowed in respect of any loss from the sale or exchange of property between certain related parties. Related parties include, but are not limited to, two corporations that are members of the same “controlled group.”

In an exception to the general disallowance rule of Section 267(a), Section 267(f) provides that, with respect to any loss from the sale or exchange of property between members of the same “controlled group,” such loss shall not be disallowed, but shall generally be deferred until the property is transferred outside such controlled group. However, to the extent the buying member transfers the property to a related nonmember, the loss or deduction is taken into account only to the extent of any income or gain taken into account as a result of the transfer. The balance is treated as a loss that can only be used to offset gain on a later disposition of such property.

Controlled Groups

Section 267(f) also provides that the term “controlled group” generally refers to corporations that would meet the requirements of a controlled group under the consolidated return regulations if the threshold ownership requirements were reduced from “at least 80 percent of the total combined voting power of all classes of stock entitled to vote or at least 80 percent of the total value of shares of all classes of stock” to “more than 50 percent of the total combined voting power of all classes of stock entitled to vote or more than 50 percent of the total value of shares of all classes of stock.”

While fairly simple on its face, in application this rule can be quite complex. For example, in Turner Broadcasting Systems, Inc. v. Commissioner, 111 T.C. 315 (1998), the court examined the issue of when the determination must be made as to whether the corporations involved in the transaction were members of a “controlled group.” In that case, pursuant to a plan, the shareholders of MGM (including Tracinda) sold their MGM shares to TBS; MGM sold the shares of its wholly-owned subsidiary, UA, to Tracinda at a loss; and Tracinda sold some of the UA shares received to certain public shareholders. The parties stipulated that prior to the UA sale, Tracinda, MGM and UA were all members of a controlled group; after completion of the UA sale, MGM was no longer part of such controlled group. The court, following an evaluation of the legislative history of Section 267 and the consolidated return regulations, concluded that the appropriate time to determine whether corporations are part of a controlled group is “immediately after” the transaction and not the time the parties enter into a “binding commitment” to undertake such transaction. As a result, MGM was entitled to deduct its loss on its sale of UA shares to Tracinda since MGM and Tracinda were not members of a controlled group immediately after the sale of the UA shares.

Chief Counsel Advice 200617036

In Chief Counsel Advice 200617036, the IRS evaluated a similar issue and took the position that the purpose of Section 267 prevented a taxpayer from structuring a transaction in order to claim a loss on a sale of distressed securities where such taxpayer effectively retained control over such distressed securities. The IRS and the taxpayer agreed that the transactions at issue in that case should be viewed for tax purposes as follows: 1) Parent sold its distressed securities to Subsidiary (a wholly-owned subsidiary) in exchange for Subsidiary Class A and Subsidiary Class B stock; 2) Subsidiary contributed the distressed securities to Partnership (a partnership wholly-owned by members of Parent’s consolidated group) under Section 721; and 3) Parent sold the Subsidiary Class A stock to Bank Sub. Parent and Bank also agreed that so long as Bank held stock in Subsidiary, Parent would control Partnership.

Basis of Disallowing the Loss

In arguing that the loss purportedly generated by the sale of distressed securities between related parties could not be taken into account by the taxpayer, the IRS argued that immediately after the sale of distressed securities to Subsidiary and before the sale of the Subsidiary Class A stock, Subsidiary was a member of the controlled group of corporations that included Parent (Parent Controlled Group), and as a result, the loss on the sale should be deferred. To reach this result, the IRS disregarded the remaining steps of the transaction and simply looked to the relationship of the parties immediately after the sale of the distressed securities to Subsidiary. The IRS then examined the consequence of the transfer of the distressed securities to Partnership and concluded that such transfer was a transfer to a related party that should be disallowed because the taxpayer still retained effective control over the property “transferred.” Thus, the transaction should be viewed as merely an intercompany transaction under Treas. Reg. Section 1.1502-13.

In addition, the IRS argued that, even if the Subsidiary was not a member of the Parent Controlled Group immediately after the sale, the transaction fell under the anti-avoidance rules of the regulations because of the mechanical attempts to remove the transaction from the literal language of the disallowance provisions. In making this argument, the IRS asserted that because of the dominion and control by the taxpayer over the partnership and the reversion rights under the agreements, the facts of this case were even stronger than those set forth under an example in the regulations to which the anti-avoidance rules were applicable.

Finally, the IRS disagreed with the taxpayer’s selective application of the step transaction doctrine, and concluded that the appropriate application of the step transaction doctrine would be a deemed sale by Parent of the distressed securities to Partnership. In taking this approach, the IRS argued that the anti-avoidance rules were intended to apply to disallow the loss as it applies to sales between a corporation and a related partnership. In addition, the IRS concluded that the taxpayer’s attempts to interpose a non-consolidated corporation as an interim holder of the property at issue had no economic significance, and thus, must be disregarded for federal income tax purposes.

Pepper Perspective

The rules characterizing the tax consequences of transactions between “related” taxpayers are numerous. Section 267 and Treas. Reg. Section 1.1502-13 include just a few examples of these rules, and when viewed in light of the IRS’s willingness to invoke its authority under the anti-avoidance rules provided by the regulations, caution is warranted when structuring exchanges between related parties. Thus, a company involved in transactions with related parties should evaluate these and other rules to determine the impact of such rules before taking into account items of income, gain, deduction and loss on their tax return. In addition, when evaluating a potential target company for acquisition, purported losses should be evaluated carefully to ensure that these related party provisions were not implicated in generating losses on the target company’s books.

08-04-2006

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Pepper Hamilton, L.L.P.

To Step or Not to Step
One of the most vexing issues in structuring acquisitions is whether the steps of the acquisition will be collapsed with the resulting tax treatment being other than what was expected. On July 5, 2006, the IRS released regulations under §338(h)(10) that provide helpful guidance in the area.

In Rev. Rul. 90-95, the IRS advised that if an acquisition is a “qualified stock purchase,” it would be treated as independent from subsequent events, even if they were pre-planned. A QSP is a purchase by a corporation of more than 80 percent of the stock of the target in a transaction that does not give the buyer a carryover basis. For example, if Company T bought all of the stock of Company A for cash and immediately liquidated A into T, the independence of the steps would be respected, and there would be (1) a purchase of the A stock and (2) a liquidation of A into T, pursuant to §332. The goal was to provide that the only way to get into deemed asset sale treatment was through the making of an election under §338.

Rev. Rul. 90-95 dealt solely with transactions that could not have been reorganizations governed by §368 even if they were stepped together, because they would not have met the continuity of proprietary interest test.

A healthy debate developed over the impact of Rev. Rul. 90-95 on the use of the step transaction doctrine to determine if a multi-step structure resulted in a tax free reorganization and the potential impact on the ability to make a §338 election. For example: T acquires 100 percent of A’s stock for T stock worth $100 and cash of $1.00. T immediately liquidates A into T pursuant to a prearranged plan. If the steps were respected, the first step results in a taxable stock purchase (the cash blows the “B” reorganization), and the second step is a tax free liquidation under §332. But, if the steps are collapsed, the overall transaction may well qualify as a “C” reorganization under §368(a)(1)(C). Thus the question: was the acquisition of the A stock a QSP? If the transaction were a reorganization, there would be a carryover basis in the stock, which would preclude QSP status.

Rev. Rul. 2001-46 settled this issue by providing that if the steps were collapsed and the overall transaction meet the tests of §368, it would be a reorganization and Rev. Rul. 90-95 would not prevent such a conclusion. As a result, a §338(h)(10) election could not be made for the target because there would not have been a QSP. Tax professionals were quick to ask for a middle ground and the IRS responded with Treas. Reg. §1.338(h)(10)-1(c)(2).

Under the regulations, a taxpayer may choose to effectively apply Rev. Rul. 90-95 to separate two steps in a transaction if it wishes to make the election under §338(h)(10) with respect to the stock acquisition, even if the overall transaction would otherwise qualify as a reorganization if the steps were collapsed.

Example: P owns 100 percent of the stock of Y. A owns 100 percent of the stock of T. P wants to acquire the stock of T. Y merges with and into T, T survives and A receives P stock and cash of equal value. Immediately thereafter, T merges into P.

The first step is a QSP, if viewed independently, because there is too much cash to qualify as a reorganization under §368(a)(2)(E). But, if the transaction is viewed as one integrated transaction, it qualifies as a reorganization under §368(a)(1)(A), and thus there is no QSP.

If both of T and A agree to make an election pursuant to §338(h)(10) as to the first step, the regulations provide that the acquisition of the T stock will be a QSP. If no election is filed, the transaction will be a reorganization pursuant to §368(a)(1)(A).

It’s important to note that these rules apply solely to elections made pursuant to §338(h)(10). They do not apply to §338(g) elections. Thus, acquisitions in which a §338(h)(10) election cannot be made are still governed by Rev. Rul. 90-95 and Rev. Rul. 2001-46.

Pepper Perspective

The benefit of a §338(h)(10) election can be quite substantial and frequently impacts the sales price of a company. The ability to make the election and not worry about it being tainted by subsequent events is welcome relief.

08-04-2006

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