Anatomy of a Spin-Off

question 17

Essay

Anatomy of a Spin-Off

On October 18, 2006, Verizon Communication's board of directors declared a dividend to the firm's shareholders consisting of shares in a company comprising the firm's domestic print and Internet yellow pages directories publishing operations (Idearc Inc.). The dividend consisted of 1 share of Idearc stock for every 20 shares of Verizon common stock. Idearc shares were valued at $34.47 per share. On the dividend payment date, Verizon shares were valued at $36.42 per share. The 1-to-20 ratio constituted a 4.73% yield—that is, $34.47/ ($36.42 × 20)—approximately equal to Verizon's then current cash dividend yield.

Because of the spin-off, Verizon would contribute to Idearc all its ownership interest in Idearc Information Services and other assets, liabilities, businesses, and employees currently employed in these operations. In exchange for the contribution, Idearc would issue to Verizon shares of Idearc common stock to be distributed to Verizon shareholders. In addition, Idearc would issue senior unsecured notes to Verizon in an amount approximately equal to the $9 billion in debt that Verizon incurred in financing Idearc's operations historically. Idearc would also transfer $2.5 billion in excess cash to Verizon. Verizon believed it owned such cash balances, since they were generated while Idearc was part of the parent.

Verizon announced that the spin-off would enable the parent and Idearc to focus on their core businesses, which may facilitate expansion and growth of each firm. The spin-off would also allow each company to determine its own capital structure, enable Idearc to pursue an acquisition strategy using its own stock, and permit Idearc to enhance its equity-based compensation programs offered to its employees. Because of the spin-off, Idearc would become an independent public company. Moreover, no vote of Verizon shareholders was required to approve the spin-off, since it constitutes the payment of a dividend permissible by the board of directors according to the bylaws of the firm. Finally, Verizon shareholders have no appraisal rights in connection with the spin-off.

In late 2009, Idearc entered Chapter 11 bankruptcy because it was unable to meet its outstanding debt obligations. In September 2010, a trustee for Idearc’s creditors filed a lawsuit against Verizon, alleging that the firm breached its fiduciary responsibility by knowingly spinning off a business that was not financially viable. The lawsuit further contends that Verizon benefitted from the spin-off at the expense of the creditors by transferring $9 billion in debt from its books to Idearc and receiving $2.5 billion in cash from Idearc.

-Do you believe that it is fair for Idearc to repay a portion of the debt incurred by Verizon relating to Idearc's operations even though Verizon included Idearc's earnings in its consolidated income statement? Is the transfer of excess cash to the parent fair? Explain your answer.

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