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The following discussion thread excerpt is from a recent law.com online seminar, “Mergers and Acquisitions 2001,” moderated by Professor Jeffrey Gordon of Columbia Law School. For more information on this program, other law.com seminar offerings and our upcoming seminars please visit www.law.com/seminars PROFESSOR JEFFREY GORDON, COLUMBIA LAW SCHOOL, NEW YORK, N.Y. To Jacqueline Daunt (and others): The Financial Accounting Standards Board (FASB) seems to have won the battle but lost the war in its recent pronouncements on eliminating pooling: Pooling will go but goodwill will stay, except when it won’t. Could you please summarize where things are now in the FASB process and the prospects for final action, finally. JACQUELINE DAUNT, FENWICK & WEST, PALO ALTO, CALIF. The Financial Accounting Standards Board expects to issue the new merger accounting standard by June 2001. It is likely to eliminate pooling accounting for mergers. Pooling has been popular because it allowed companies to gross up their revenues via acquisitions without recognizing the implicit premium over the target’s balance sheet assets as a financial charge against the buyer’s earnings. Purchase accounting forces the buyer to recognize the goodwill and amortize it over time, creating a “hit to earnings.” FASB prefers the purchase accounting method because it believes it more accurately reflects the economics of acquisitions and has been trying to eliminate pooling for years. Unlike other pronouncements from FASB on this subject, however, this one is likely to come to fruition. FASB is offering to revise the purchase accounting rules to eliminate the standard amortization of goodwill, thus eliminating the “hit to earnings.” Instead, the goodwill would stay on the books of the buyer until the goodwill is impaired and it becomes written down at that time. The key open question is how you will value the goodwill to determine when the write-off is required. PROFESSOR JEFFREY GORDON So under the new FASB proposal, is the case that the acquirer will have to mark-to-market the target’s balance sheet assets and then carry the difference between acquisition price and the revalued assets as “goodwill?” If so, there is some disadvantage vs. pooling, which contemplates accounting for the target’s assets at book value (i.e., value on target’s balance sheet). A hit to earnings because of the need to take higher depreciation, even if no amortization of goodwill. CRAIG WASSERMAN, WACHTELL LIPTON ROSEN & KATZ, NEW YORK, N.Y. The developments here will be very interesting to watch — especially in industries like financial services where most deals have historically been structured as poolings. There are several significant aspects to the FASB’s recent pronouncements on this topic (which can all be found at FASB.org — see discussion of business combinations project). First, the decision to stop the amortization of goodwill will apply to both new and old goodwill on the books — so that if the new rules go into effect (as is currently expected — with the anticipated adoption date being around June 30, 2001), companies that currently have a high level of amortization will get an immediate boost to earnings. As the prior comment notes, the big question is when will companies be required to write down goodwill for impairment — the test is supposed to be when the fair market value of the business suggests that the goodwill is overvalued (but the guidance from the FASB to date suggests that this analysis will only need to be done when there are significant changed circumstances suggesting this might be the case — as opposed to a true mark-to-market analysis on a regular periodic basis). What is less clear is whether the changed circumstances are meant to be problems with the acquired business or whether a general decline in market prices or acquisition premiums would be sufficient changed circumstances to prompt an impairment inquiry. Also of note is the fact that even with this new, more favorable treatment of goodwill, there will be many categories of assets (both tangible and intangible) that will need to be written up in a purchase transaction and then depreciated or amortized going forward. So the ability to capitalize goodwill, so to speak, does not mean that a purchase acquisition will result in the same level of future earnings as would under a comparable pooling transaction. For example, in an acquisition of a bank holding company, a portion of the purchase price would likely need to be attributed to the core deposit intangible, which would still be required to be amortized under the new proposed rules. However, even if there are additional charges to earnings resulting from the write-up of certain classes of assets, the ability to avoid goodwill amortization will clearly be a big plus. And, the ability to avoid the strict limitations under the old pooling rules (very limited flexibility on buy-backs, mix of acquisition currency, asset dispositions) will mean that acquirers can take significant steps to improve the pro forma earnings picture for the combined companies. Net/net the new rules should be a significant plus to active acquirers and a big plus to takeover specialists who will now have a much greater role to play in helping structure the optimal transaction. For more on this topic — take a look at the memoranda that are included in the Seminar Library (and as I indicated in a prior response you can also check out the official FASB web site at FASB.org) PROFESSOR JEFFREY GORDON Could the elimination of pooling possibly disadvantage the interests of the selling shareholders, in two respects? First, pooling in effect imposed a “plain vanilla rule” on the form of consideration — common stock — that was relatively easy to value. Indeed, the daily stock tables provided a running tally on what the deal was worth and placed significant constraints on the board, especially if another bidder came along offering consideration that was demonstrably higher. Think of the contest between Pfizer and American Home for Warner-Lambert. The momentum really swung Pfizer’s way as the gap grew between AHP and Pfizer stock, notwithstanding the W-L management/board preferences. But suppose pooling is eliminated, and W-L and AHP were free to devise a consideration package that contained a substantial portion of new equity and debt securities with specific conversion rights, call provisions, etc. Much harder to value. Much less obviously inferior to a competitive bid. This gives the board a lot more discretion, in a practical sense at least, adding to the discretion they already have in a legal sense to protect a merger of equals. So? Second, the end of pooling also may open the way to much richer payoffs to target managers. My understanding is that the pooling rules effectively limit managers to the options already issued (including any accelerated vesting in accordance with the original grant). Thus the pooling rules constrained target managers’ efforts to bargain for a higher payoff as the price of a “friendly” merger. Won’t this change now? Do you foresee an impact? CRAIG WASSERMAN Your points are all valid, but this is nothing new — we have had plenty of deals with complex forms of consideration and the market and boards and their advisors do their best to value them. The Paramount/Viacom/Diller transaction is a good example of competing cvr structures. Besides adding fixed-income securities into the mix as opposed to common equity — which has been talked about in the financial services context — serves to reduce the potential volatility in value of the total acquisition package — and nothing is less volatile than cash, which can be added to the mix in a purchase transaction but can not be included in a pooling transaction. PROFESSOR JEFFREY GORDON But wasn’t Paramount from an era in which judicial deference to deal-protection of mergers of equals was much less developed? Can you think of a recent large transaction which used complex consideration? Obviously not for pooling deals, which are most of the large ones. But even in the case of Time/AOL, a purchase, I would argue that the “plain vanilla” culture left them constrained on consideration. Once pooling goes, the culture will change, too. I bet we will see calls for a more vigorous review role in the Del. courts. CRAIG WASSERMAN To the extent you move away from 100 percent common stock for common stock transactions — you do begin to raise questions under Delaware law as to when you enter Revlon land (although some people think that the Delaware court cares less about the Revlon/Unocal distinction than it did in the past — and has implicitly adopted a more pragmatic “do the facts suggest that the board acted in good faith to pursue the best transaction available all things considered” type of analysis). When you have mixed cash, common stock and other forms of consideration it is less clear as to which transactions fall under Revlon (although strong arguments can be made that you’re not in Revlon land as long as 50 percent of the total consideration is in the form of common stock of an acquirer that does not have a controlling shareholder). JACQUELINE DAUNT Pooling does limit the target’s and acquirer’s ability to do something out of the ordinary for the target’s executives. You can’t change the equity structure in contemplation of the deal, so no new acceleration of vesting on options. The deal must be a stock one — so no new, out of the ordinary cash payments to make the executives happy. These limitations don’t exist under purchase accounting, so I predict more executive greed and demands to be the result. The only real limit will be the 280G limits and bargaining leverage. PROFESSOR JEFFREY GORDON Academics continued to be bemused by the purchase/pooling battle, on the view (supported by empirical work) that our reasonably efficient markets see through the accounting conventions to the underlying economic reality. So in the effort to assume that managers are nonetheless acting rationally in caring, academics look to (i) the form of management compensation, (ii) debt covenants tied to accounting conventions, and (iii) regulatory constraints tied to accounting conventions. A recent addition to this literature is David Aboody, Ron Kasznik & Michael Williams, “Purchase versus Pooling in Stock-for-Stock Acquisitions: Why Do Firms Care?” 29 J. Acctng & Econ. 261-286 (2000). The abstract reads: “We investigate firms’ choices between purchase and pooling methods in stock-for-stock acquisitions. We find that in acquisitions with large step-ups in targets’ net assets, CEOs with earnings-based compensation are more likely to choose pooling and avoid the earnings ‘penalty’ associated with purchases. We find no association between stock-based compensation and the purchase-pooling choice, suggesting that managers are not concerned about implications of large step-ups for firms’ equity values. We also find that the likelihood of purchase increases with debt contracting costs, consistent with its favorable balance sheet effects, and with costs of qualifying for pooling, particularly the restriction of share repurchases.” There are, of course, famous poster children for the alleged absurdity of caring about pooling, most particularly ATT’s acquisition of NCR, where ATT paid approximately $700 million extra to obtain pooling treatment. The merger failed, leading to a massive write-off, leading some to associate the irrationality of paying such a huge premium for favored accounting treatment with the faulty judgment that led to the transaction in the first place. Note also, however, that a major element in the contest between Pfizer and American Home Products for Warner-Lambert turned on W-L’s grant of pool-killing options to AHP. In the final settlement, AHP was induced to surrender the options without any consideration to save Pfizer’s pooling (though AHP did get to hold onto its $1.8 billion breakup fee!). Note also that Time Warner and AOL is going forward as a purchase, though I bet AOL is the survivor because the goodwill is [a] huge amount less than if Time-Warner were the survivor. CRAIG WASSERMAN Whether or not it makes intuitive sense, boards and market analysts still care. People do not want to announce dilutive deals and the companies that have tried to get the market to look at cash earnings have had only limited success doing so. Part of the problem gets into the ease of comparing comparable companies and the difficultly of completely rewriting the accounts of all competitors in an industry to get a true apples-to-apples comparison. Until the accounting profession comes up with a perfect way of describing true economic earnings (which is likely neither captured by current GAAP earnings or cash eps) — people will worry about the accounting treatment that applies in a particular merger. Note the new proposed rules will add plenty of tough new issues: What is goodwill versus what in an intangible that is distinguishable from goodwill (such as a write-up in the value of contracts) will be a hot topic to watch as acquirers hope to avoid allocating too high a portion of their purchase price premium to categories of assets other than goodwill (including many other types of intangibles) that will still need to be depreciated/amortized.

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