THE INVERSION SUBVERSION: IS WALL STREET BERMUDA-BOUND?

2002.09.06

By Fernando Carneiro and Shirley Westcott

One of the most contentious issues to come out of Proxy Season 2002 has been that surrounding "inversion" or "flip" transactions. The term "inversion" refers to the reincorporation of U.S. companies into tax havens, particularly Bermuda. A U.S. company forms a subsidiary in a foreign tax haven, then the subsidiary becomes the parent, thereby "inverting" the ownership.¹

After the pounding the markets have taken recently, coupled with—and perhaps fueled by—depressed earnings, some companies have started looking at alternatives to address their overall cost of operations. And taxes, unlike death, are perhaps no longer a certainty anymore. Seeking to increase shareholder value, some companies put a move to Bermuda before shareholders this season, and the battle over inversions started in earnest.

ISS analyzed seven companies that proposed a move to tax havens this season. Five of them (The Stanley Works, Nabors Industries, Leucadia National Corp., Weatherford International Inc., and Coopers Industries) proposed a move to Bermuda. One of them, Noble Corp., was seeking a move to the Cayman Islands. Finally, Patagonia Gold Corp. is reincorporating in the British Virgin Islands (BVI). (See Sidebar 1). ISS recommended a vote for all of the proposals, with the exception of Leucadia. Others that may soon be considering island emigration include Veritas DGC, Inc., and Ensco International, Inc.

Perhaps due to the charged climate after the terrorist attacks on Sept. 11, a coalition of labor funds, led by the AFL-CIO, found a friendly ear in some congressional quarters and raised some legitimate questions about inversions and the long-term impact such transactions would have on shareholders and other constituencies.

Though the Star-Spangled Banner was waved, the critics’ central argument was based on the lack of a treaty between Bermuda and the U.S. concerning the enforcement of civil judgments and limitations on derivative actions (the ability to sue directors and officers). Critics argued that the dearth of Bermudan legal precedent could make it hard to ascertain how courts would rule on some issues, potentially leading to the trampling of shareholder rights in the future.

Bill Patterson, director of the AFL-CIO’s Office of Investments, was quoted by the Dow Jones Newswires as saying that "the reincorporation issue is the latest round of efforts by companies to weaken shareholder accountability by moving to legal systems with weaker systems of shareholder rights…. It has to do with giving away your corporate governance rights for a tax benefit, which we think has not been factored in the analysis to date."

Also disturbing to critics was the possibility that Bermuda-reincorporating companies could be tarnished by their association with meltdowns at other Bermudan-domiciled companies such as Tyco, Inc., and Global Crossing, two companies that have been pilloried for their failings in the past year.

Opponents of inversions point to the fact that most of these transactions are taxable events to shareholders. Inspired by Helen of Troy Ltd.’s move to the Cayman Islands, the U.S. Treasury Department enacted a "toll charge" in 1994 (Section 367 of the IRS Code) imposing either a shareholder- or company-level capital gains tax on most corporate inversions. However, the depressed state of the current markets has significantly shrunk any gains that might be taxed in inversions. And in any case, such gains would not apply to the tax-exempt pension funds, which constitute most of the shareholder base of public U.S. companies.

Of greater concern to critics is the possibility that Congress could pass a "blanket ban" against inversions that would nullify the tax benefits of a move offshore. Several bills have been introduced in Congress in recent months targeting expatriations (see Table 1). The proposed bills, such as the Neal Bill and the Grassley-Baucus Bill, could be retroactive as far back as Sept. 11, 2001, and would tax U.S. companies that reincorporate offshore as domestic corporations.

However, an outright ban from Congress continues to appear unlikely due to a fierce corporate lobby. Some Republican leaders are advocating a temporary moratorium, but most of the proposed legislation only attacks the problem on a piecemeal basis. A preliminary study by the Treasury Department advocates a comprehensive examination of U.S. international tax rules, noting that a complete ban on inversions would not stop multinationals from finding loopholes that would reduce their U.S. tax liabilities. Among other technical changes, the Treasury proposes restricting companies from transferring untaxed U.S. income to an offshore parent, generally through interest payments on intercompany debt (a technique known as "earnings stripping" or "asset stripping").

As taxation is the central issue, most of the companies seeking to incorporate in Bermuda register as external companies under Barbados law and are licensed as international business companies (IBCs). Companies reincorporating offshore often create this type of triangular structure, which includes setting up a paper company in a third country, such as Barbados or Luxembourg, that has a tax treaty with the United States. Without this arrangement, any funds sent outside of the United States would be subject to 30-percent withholding taxes. Although Barbados levies income taxes on non-Barbados source income, the maximum rate is 2.5 percent, falling to 1 percent as income increases.

Another governance trap facing these companies, according to the contrarians, is that executive compensation could nullify half of the company’s tax savings or more. As many executives link pay with certain performance measures such as cash flow, there could be meaningful rises in overall compensation, particularly for CEOs, following an inversion.

Silver Lining?

Proponents of inversions claim that the reincorporations create a more flexible corporate structure that is ideal for growing the foreign operations of U.S. companies. Inversions allow for easier business combinations with non-U.S. entities, access to international capital markets, and expansion of the investor base to non-U.S. shareholders. Yet operationally, nothing changes for the corporation because the offshore parent is a mere shell company. Even large firms such as Ingersoll-Rand, Tyco, and Cooper Industries continue to be included in the S&P 500 Index, despite Standard & Poor’s recent decision to eliminate "foreign" companies.

More importantly, companies expect to enjoy greater cash flow and profitability because of the reduction in their overall effective tax rate on worldwide income. Bermuda has no income tax, capital gains tax, withholding tax, estate duty, or inheritance tax. Thus, a Bermuda company will only be subject to U.S. federal income taxes on income derived from business or trade within the United States. Its non-U.S. operations will not be subject to U.S. corporate income tax other than withholding taxes imposed on certain U.S. source income.

As noted in the Treasury Department report, the difference in tax treatment enables foreign firms to increase market share by potentially passing the tax savings on to customers through reduced prices or to pay more for acquisitions because of the post-acquisition tax savings.

Proponents of inversions also dismiss legal fears about an alleged lack of judicial precedent and dicta as it pertains to corporate disputes in Bermuda. Bermuda law is based on English common law and looks to British legal precedent. Furthermore, the companies that reincorporate will still be subject to U.S. securities laws should they still be listed on a U.S. exchange, which happens to be the case almost exclusively. And only those that are designated foreign private issuers under the 1934 Securities Exchange Act would be exempt from the exchange’s corporate governance requirements.²

As it pertains to congressional battles between what some in Congress call the "Benedict Arnold companies" and inversion opponents, tax haven enthusiasts seem to have the upper hand. On June 13, the Senate Finance Committee postponed indefinitely action on legislation seeking to curb or restrict inversion transactions. The new argument claims that curbing inversions could put some firms at a competitive disadvantage or lead to more takeovers by foreign corporations, which could have an impact on U.S. jobs.

More than likely, the legislative fate of inversions will be tied to an overall omnibus bill that would address a rewriting of the whole corporate tax law code. Rep. Bill Thomas (R-Ca.), chairman of the tax-writing Ways and Means Committee, is trying to steer this grandiose opus through the House. This Herculean task makes it a good bet that inversions will not go away by legislative fiat anytime soon. Nonetheless, the Senate and House have already approved separate measures banning inverted firms from receiving military contracts or contracts with the Homeland Security Department.

What Next?

Even if Congress or others are ultimately able to prevent companies from setting up maildrops in tax havens, opponents of such moves will have to contend with new wrinkles and variations on the theme. Companies are now transferring intellectual property abroad, including trademark and patents, to keep income from overseas sales as tax-free as possible. The companies turn over the patents’ rights to a subsidiary offshore, keeping the revenue stream away from the Internal Revenue Service.

Although past Bermuda incorporations have been heavily tilted towards the insurance industry, and more recently energy and drilling companies, this new trend features pharmaceutical firms. According to a Wall Street Journal report, "more than two dozen pharmaceutical and computer companies have set up subsidiaries in Bermuda in recent years." The royalties of foreign sales of the parent company go to the offshore subsidiary. They need to be reported to the IRS, but not all of it is repatriated.

Royalty profits also played a pivotal role in the tax haven triads set up by the consulting arms of Arthur Andersen LLP and PricewaterhouseCoopers LLP, both of which based themselves in Bermuda in the past year as they geared up to go public. By setting up operating companies in tax-friendly Luxembourg and Switzerland, Accenture Ltd. and Monday Ltd. can whittle down their overall tax rates to as low as 10 percent by shifting U.S.-source income overseas through internal borrowings or trademark licensing. Critics mocked the irony of the Big Five passing themselves off as "reformists" by separating their accounting and consulting practices while devising complex corporate structures designed to escape U.S. taxes—including the tax penalties currently under consideration on Capitol Hill. PricewaterhouseCoopers has since abandoned the Bermuda locale after agreeing to sell its consulting business to International Business Machines Corp.

Several Fortune 500 companies have set up subsidiaries in tax havens with an eye on maximizing their tax savings one way or another. However, the transactions have garnered heightened scrutiny in recent months, and regardless of the ultimate result, the added scrutiny will be beneficial to all.

Endnotes

1. There are two primary types of corporate inversion. An asset inversion occurs when a U.S. company transfers its assets to a shell foreign corporation. The more prevalent stock inversion takes place when a foreign parent holding company is created that acquires the stock of the U.S. firm. In both cases shareholders exchange their stock for shares of the foreign company. However, in an asset inversion, the corporation must pay taxes on the appreciation of its assets, while in a stock inversion shareholders face a taxable gain on the stock they exchange.
   
2. On the New York Stock Exchange, Cooper Industries, Ingersoll-Rand, GlobalSantaFe Corp., and Noble are among offshore firms considered to be non-U.S. companies. Tyco, Foster-Wheeler Ltd., and Weatherford are designated as U.S. issuers.

Table 1: Congressional bills

*Tests applied:

Neal bill: The new offshore parent would be taxed in the United States if it ends up with substantially all of the assets of the inverted company and former shareholders own more than 80 percent of the stock. A lower stock threshold would apply (50 percent) if the principal market where the shares are traded is the United States and the foreign parent does not have substantial business activities in the tax haven where it is organized.

McInnis bill: Same, but the circumstances for applying the 50-percent threshold are more defined: The shares must be publicly traded on a U.S. exchange, less than ten percent of gross income comes from the tax haven, and fewer than ten percent of employees are permanently based in the tax haven.

Baucus-Grassley bill: Distinguishes between pure inversions and limited inversions. In a pure inversion, the new foreign parent ends up with substantially all of the company’s assets and former shareholders own at least 80 percent of the stock. The company would continue to be taxed as a U.S. firm. In a limited inversion, former shareholders end up with more than 50 percent of the stock. A full toll tax will be collected on the appreciation in value of the assets shifted out of the United States, and the IRS must give advance approval for all transactions with affiliates for ten years after the inversion.

Sidebar 1: Don’t Stop the Carnival

Although the exodus to tax havens has taken place for decades—including more than 20 firms since 1994—the recent spate of island hopping has been prompted by low stock values, thereby reducing any capital gains tax payable by shareholders. On the heels of Ingersoll-Rand’s flight to Bermuda in December 2001, ISS tracked seven offshore reincorporations during the 2002 proxy season.

In the spotlight were Stanley Works and Nabors Industries, which faced protest campaigns by Connecticut’s state pension fund and organized labor. (Coincident to the targeting were ongoing labor disputes at those two firms.) Citing the migrations as a "flight from accountability," the detractors churned the murky waters of Bermudian law and challenged its ability to protect shareholder interests on a number of fronts: the discharge of fiduciary duties, the availability of derivative actions, the enforceability of judgments under U.S. securities laws, prohibitions on director and officer self-dealing, and the ability of boards to adopt defensive measures to thwart a takeover.

The labor funds also questioned the economic benefits of the moves, namely tax savings, particularly if the company (in this case Nabors) failed to quantify them. Interestingly, until this year, few issuers ever went to the length of presenting dollar savings figures. But the tax motivation is genuine (see Table 3). The U.S. tax laws were written in the 1960s, when U.S. firms generated most of their sales domestically. As a result, the United States is one of the few countries in the world to tax both domestic and nondomestic source income. Such double taxation gives foreign multinationals a competitive edge. And as more industry players move offshore, the incentive for the remaining U.S. firms to make the switch increases.

Notwithstanding potential sanctions by Congressional grim reapers, the labor groups concluded that no amount of tax savings could justify a deleterious governance trade-off.

So just how deficient is Bermuda’s legal system? The principal law governing corporate affairs is the 1981 Companies Act, which is patterned after the U.K. Companies Act of 1948. Bermuda cases are binding precedents, and English or other Commonwealth decisions are persuasive on the Bermuda courts. In the absence of specific Bermuda authority, the local courts typically follow English or Canadian law. Most U.S. issuers stipulate in their proxies that Bermuda’s corporate legal system is such that shareholder rights will be "substantially similar" or "essentially unchanged"—a claim being disputed by Connecticut officials. While there are certainly meaningful differences in corporate law, the disparities may be overblown:

• Standards of conduct: Officers and directors of Bermuda companies must abide by a statutory duty of good faith and duty of care, which are similar to the duties of loyalty and care in states such as Delaware. They owe their duties directly to the corporation, which under Bermuda law is defined by reference to the shareholders as a group. Hence, they must act in the best interests of both the company and its shareholders.
• Shareholder suits: A shareholder may seek redress in a personal capacity for a breach of a director’s duty if the resulting injury is to the shareholder individually. Derivative claims can be asserted under Bermuda law if the alleged transgression was ultra vires, contrary to statutory law, or constituted a fraud upon or was otherwise prejudicial to minority shareholders. A derivative action would generally not be allowed if there is an alternative action available that would provide an adequate remedy.
• Enforcement of civil liabilities: There is no loss of protection under U.S. federal securities laws if the corporation remains a registered 1934 Exchange Act company with its shares listed on a U.S. exchange. Judgments arising from securities-related claims brought in the United States would generally be enforceable in Bermuda. Actions that constitute violations of the U.S. securities laws would also give rise to a cause of action under Bermuda law, resulting in civil liability on the company or its directors or officers.
• Antitakeover provisions: Bermuda does not have any statutory takeover protections, though companies are not circumscribed from adopting defensive mechanisms such as poison pills.

As Nabors argued, the underlying U.K. law is as established as Delaware’s, though not as litigious in philosophy. One could even argue that there are a number of states, such as Pennsylvania, Maryland, and Ohio, where the rights of shareholders could be significantly more impaired than in Bermuda. The opposition’s concerns, however, are more suppositional in nature. The true mettle of the law may very well be tested by any malfeasance claims brought against the likes of Tyco and Global Crossing. In other respects, Bermuda companies have not historically been apathetic to shareholder interests (see Sidebar 2).

In ISS’s estimation, Bermuda law contains sufficient protections to preserve director and officer accountability and provide mechanisms for redress. For this reason, ISS generally supported offshore reincorporations during the 2002 proxy season because of the overriding economic benefits, though this balance may shift if the tax laws change or if companies that move offshore are penalized via the loss of government contracts, etc. Typically, the governance falls short in instances where the inverting firm tacks on charter and bylaw changes that significantly detract from shareholder rights (see Leucadia below).

Shareholders apparently agreed. Nabors’ reincorporation was approved by 83 percent of the votes cast despite last minute efforts by Steven Rosenberg and the AFL-CIO to block the vote in a U.S. district court.

Similarly, Stanley Works’ shareholders supported its relocation, albeit by a slim margin (67.2 percent versus two-thirds of all shares needed for approval). Even so, the vote was immediately challenged by Connecticut Attorney General Richard Blumenthal and Treasurer Denise Nappier, along with union leaders, due to misleading ballot instructions. Holders of 401(k) plan shares were told that unvoted shares would count as "no" votes, when in fact they were voted by a trust in proportion to all votes, thereby providing the winning margin. The company was going to submit the reorganization to a revote, but ultimately succumbed to the pressure and announced that it will not pursue a move at this juncture. The revised prospectus, which included additional bylaw changes (eliminating the fair price provision and requiring shareholder approval for major asset sales) was attacked by Blumenthal et al for conflicting statements regarding the impact on shareholder rights.

For Stanley Works, the political pressure came from all corners, including the House race in Connecticut, where expatriations have become a featured issue. One of the main opponents of inversions is Rep. Jim Maloney (D-Conn.), who has co-sponsored legislation to that end. Due to redistricting, Maloney is facing off with Rep. Nancy Johnson (R-Conn.) in the fight for votes in New Britain, Connecticut, where Stanley Works is based.

Other offshore relocations in 2002 met with little resistance. Oil and gas drillers Weatherford International and Noble Drilling jumped ship to Bermuda and the Caymans with overwhelming shareholder support (93 and 96.4 percent of the votes cast, respectively). Likewise, Canadian-based Patagonia Gold’s plan to redomicile in the BVI this summer should pass easily.

Even Cooper Industries saw strong support (68.3 percent) for a revived plan to shift its legal residence to Bermuda. Last year, the company’s proposed reincorporation was interrupted by a $5.5 billion unsolicited bid by rival toolmaker Danaher Corp., which threatened to launch a "vote no" campaign against any move offshore. Although Cooper’s resident state of Ohio offers protections against takeovers, hostile bids are largely untested in Bermuda. Danaher eventually dropped its offer over concerns with asbestos liabilities, and Cooper now joins the ranks of 13,000 other international firms registered in the Atlantic Ocean archipelago.

In fact, only one offshore reincorporation failed to pass muster with ISS this season, though it received approval from shareholders: diversified financial services firm Leucadia, which is 35-percent owned by Chairman Ian Cumming and President Joseph Steinberg. As with several earlier firms, (White Mountains Insurance Group, Inc., and Arch Capital Group Ltd.), the inverted Leucadia will impose tough new share ownership restrictions: 1 percent of the stock or 9.9 percent of the total voting power, with Cumming and Steinberg exempted. Such rigid provisions are designed to prevent the company from constituting a controlled foreign corporation or a foreign personal holding company and are enforceable by the board through mandatory stock redemption or a refusal to register a transfer of shares. Unfortunately, Leucadia could not counter its harsh charter amendments with any defined tax benefits, which the company was unable to project due to the nature of its business (buying and selling distressed firms).

Management, meanwhile, took a coercive approach to the deal by trying to reduce the supermajority vote requirement in a separate ballot item. With only a simple majority threshold, the high insider ownership effectively ensured support. So far, Leucadia is the only one of this season’s island-bound firms to postpone implementation, because the company rather than shareholders will take the tax bite, currently estimated at $315 million. The company will only effect the move if it can reduce the one-time tax hit on the asset transfer to $100 million.

Notwithstanding ISS’s general support for these transactions during the 2002 season, developments of the past few months may already be changing the balance of pros versus cons. Stanley Works’ retreat reflects the growing public and political opposition to offshore reincorporations, and as opposition gains steam, it is quite possible that others could join Stanley Works in deciding that offshore is not the place to go.

Table 2: 2002 vote results

Table 3: Gimme shelter: projected tax savings

*Market analyst projections

Tyco tax savings

Sidebar 2: Shutting out shareholders?

Although the Companies Act of 1981 has stricter requirements for submitting shareholder proposals (100 sponsors or holders of 5 percent of the shares), most U.S. expatriate firms are still subject to the Securities Exchange Act of 1934. Hence, bringing resolutions is still feasible if an investor owns 1 percent or $2,000 worth of company stock. And shareholders of Bermuda firms have not been shy.

This spring, Bermuda reinsurer ESG Re Ltd. faced a "vote no" campaign by New York investment firm Vicuna Advisors LLC, which railed against excessive executive compensation and severance benefits as company performance dimmed. The initiative evoked shareholder rejection of the company’s highly dilutive 2002 stock incentive plan and approval of Vicuna’s proposal asking the company to adopt a performance-based pay system. Such votes of no confidence on stock option plans are rare even in the United States, where a year ago only one plan (at Synopsys, Inc.) was actually voted down by shareholders. ESG, however, has faced investor criticism since 2000, when a private investment firm chastised Chairman John Head’s exorbitant pay package for serving as interim CEO while the stock price plummeted 80 percent. A related shareholder proposal at that year’s annual meeting seeking a sale of the company won the support of 55.7 percent of the votes cast. ISS supported the recent initiatives by Vicuna, and ESG management intends to implement the proponent’s recommendations.

Even Tyco, a frequent recipient of shareholder resolutions, has demonstrated responsiveness to investor issues. A 1999 majority-supported pill proposal, sponsored by the U.A. Local 343 Pension Trust Fund, prompted the company to accelerate the pill’s expiration from 1999 to 2005. Similarly, consecutive proposals in 1998 and 1999 by the International Brotherhood of Electrical Workers (IBEW) sought a majority of independent directors on the Tyco board. Although neither received majority support, the company adopted a formal policy, based on the Business Roundtable’s criteria for independence, that a substantial majority of the board comprise independent directors.