Question: Why do businesses that have been spun off from their parent often immediately put antitakeover defenses in place?

Why would the U.S. Internal Revenue Service be concerned about a change of control of the spun-off business?

Case Study Objectives: To Illustrate

The advantages and disadvantages of alternative restructuring strategies How spin-offs may be structured.

In an effort to focus on more attractive growth markets, Northrop Grumman Corporation (NGC), a global leader in aerospace, communications, defense, and security systems, announced that it would exit its mature shipbuilding business on October 15, 2010. Huntington Ingalls Industries (HII), the largest military US shipbuilder and a wholly owned subsidiary of NGC, had been under pressure to cut costs amidst increased competition from competitors such as General Dynamics and a slowdown in orders from the U.S. Navy. Nor did the outlook for the shipbuilding industry look like it would improve any time soon.

Given the limited synergy between shipbuilding and NGC's other businesses, HII's operations were largely independent of NGC's other units. NGC's management and board argued that their decision to separate from the shipbuilding business would enable both NGC and HII to focus on those areas they knew best. Moreover, given the shipbuilding business's greater ongoing capital requirements, HII would find it easier to tap capital markets directly rather than to compete with other NGC operations for financing. Finally, investors would be better able to value businesses (NGC and HII) whose operations were more focused.

After reviewing a range of options from outright sale to spin-off, NGC pursued a spin-off as the most efficient way to separate itself from its shipbuilding operations. If properly structured, spinoffs are tax free to shareholders. Furthermore, management argued that they could be completed in a timelier manner and were less disruptive to current operations than an outright sale of the business. The sale of the HII could have required a lengthy marketing period to potential buyers as well as a highly intrusive due diligence process by interested parties to any bidding process.

The spin-off represented about one-sixth of NGC's $36 billion in 2010 revenue. Effective March 31, 2011, all of the outstanding stock of HII was spun off to NGC shareholders through a pro rata distribution to shareholders of record on March 30, 2011. Each NGC shareholder received one HII common share for every six shares of NGC common stock held.1

The spin-off process involved an internal reorganization of NGC businesses, a Separation

and Distribution Agreement, and finally the actual distribution of HII shares to NGC shareholders. The internal reorganization and subsequent spin-off are illustrated in Figure 1. NGC (referred to as Current Northrop Grumman Corporation) first reorganized its businesses such that the firm would become a holding company whose primary investments would include HII and Northrop Grumman Systems Corporation (i.e., all other non-shipbuilding operations).

HII was formed in anticipation of the spin-off as a holding company for NGC's shipbuilding business, which had been previously known as Northrop Grumman Shipbuilding (NGSB). NGSB's name was changed to Huntington Ingalls Industries Company following the spin-off.

Reflecting the new organizational structure, Current Northrop Grumman common stock was exchanged for stock in New Northrop Grumman Corporation. This internal reorganization was followed by the distribution of HII stock to NGC's common shareholders.

Following the spin-off, HII became a separate company from NGC, with NGC having no ownership interest in HII. Renamed Titan II, Current NGC became a direct, wholly owned subsidiary of HII and held no material assets or liabilities other than Current NGC's guarantees of HII performance under certain HII shipbuilding contracts (under way prior to the spin-off and guaranteed by NGC) and HII's obligations to repay intercompany loans owed to NGC. New NGC changed its name to Northrop Grumman Corporation. The board of directors remained the same following the reorganization.

No gain or loss was incurred by common shareholders because the exchange of stock between the Current and New Northrop Grumman corporations did not change the shareholders' tax basis in the stock. Similarly, no gain or loss was incurred by shareholders with the distribution of HII's stock, since there was no change in the total value of their investment. That is, the value of the HII shares was offset by a corresponding reduction in the value of NGC shares, reflecting the loss of HII's cash flows.

Before the spin-off, HII entered into a Separation and Distribution Agreement with NGC. The Agreement governed the relationship between HII and NGC after completion of the spin-off. It also provided for the allocation between the two firms of assets, liabilities, and obligations (e.g., employee benefits, intellectual property, information technology, insurance, and tax- related assets and liabilities). The Agreement also provided that NGC and HII each would indemnify (compensate) the other against any liabilities arising out of their respective businesses. As part of the agreement, HII agreed not to engage in any transactions, such as mergers or acquisitions, involving share-for-share exchanges that would change the ownership of the firm by more than 50% for at least 2 years following the transaction. A change in control could violate the IRS's "continuity of interest" requirement and jeopardize the tax-free status of the spin-off.

Consequently, HII put in place certain takeover defenses to make takeovers difficult.

1The share exchange ratio of one share of HII common for each six shares of NGC common was calculated by dividing HII's 48.8 million common shares (having a par value of $0.01) by the 298 million NGC shares outstanding

Since fractional shares were created, shareholders owning 100 shares would be entitled to 16.6667 shares100/6. In this instance, the shareholder would receive 16 HII shares and the cash equivalent of 0.6667 shares. The cash to pay for fractional shares came from the aggregation of all fractional shares, which were subsequently sold in the public market. The cash proceeds were then distributed to NGC shareholders on a pro rata basis and were taxable to the extent a taxable gain is incurred by the shareholder.

Citation:

Foley, C. Fritz, and Kevin Sharer. "Project Titan at Northrop Grumman." Harvard Business School Case 215- 001, January 2015. (Revised September 2017.) adapted from the textbook.

Figure 1: