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Thomas Wechter
Colleen
Feeney Romero

The Bear Stearns Acquisition

Just when you thought tax planning was dead.

November 13, 2008
by Tom Wechter, JD/LLM and Colleen Feeney Romero, JD

The recent acquisition of Bear Stearns Companies, Inc. by JPMorgan Chase & Co. demonstrates how an acquisition of a troubled company can be structured to allow the shareholders of the troubled company to recognize the losses inherent in their stock interests, while retaining an economic interest in the acquirer in the form of stock. The Bear Stearns shareholders were sitting on substantial unrealized losses, as a result of the drastic decline in the price of Bear Stearns stock. At the same time, JPMorgan Chase wanted to acquire Bear Stearns stock for its own stock, in a transaction that was an acquisitive reorganization. However, if the Bear Stearns stock was acquired by JPMorgan Chase, in an exchange otherwise qualifying as reorganization, the Bear Stearns shareholders would not have been able to recognize for tax purposes the loss inherent in their stock.

Bear Stearns Structure

At the time, Bear Stearns had outstanding voting common stock and nonvoting preferred stock. Under the merger agreement, JPMorgan Chase formed a new subsidiary funded with the appropriate amount of JPMorgan Chase voting common stock. The new merger subsidiary merged with and into Bearn Stearns. By operation of law, the stock of the new subsidiary, owned by JPMorgan Chase, was converted to Bear Stearns stock. The Bear Stearns voting common stock was exchanged for the JPMorgan Chase voting common stock, which the new subsidiary delivered to Bear Sterns in the merger. The Bear Stearns nonvoting preferred stock was not to be acquired by JPMorgan Chase, and remained outstanding in the hands of the current owners.

Intentional Failure to Qualify As a Reorganization Under
Code §§386(a)(1)(A) or (a)(1)(B)

The transaction only constitutes as reorganization if the requirements of an “A” or a “B” reorganization are met. An “A” reorganization structured as a reverse triangular merger occurs if stock of the parent corporation in control of the subsidiary is used in a transaction in which the subsidiary is merged into the acquired corporation. Bear Stearns survived the merger, as a wholly-owned subsidiary of JPMorgan Chase. The reverse triangular merger would have qualified as an “A” reorganization, if after the transaction, Bear Stearns, as a wholly-owned subsidiary of JPMorgan Chase, owned substantially all of its properties, and if the shareholders of Bear Stearns exchanged stock constituting control in exchange for voting stock of JPMorgan Chase. Code Section 368(a)(2)(E).

A “B” reorganization is an acquisition of the stock of one corporation by another in exchange solely for voting stock of the acquirer or in exchange for voting stock of the parent corporation of the acquirer, if immediately after the acquisition the acquirer has control of the other corporation. Code Section 368(a)(1)(B). The acquisition would have qualified as a “B” reorganization if JPMorgan Chase had control of Bear Stearns.

For these purposes “control” means the direct ownership of stock having at least 80 percent of the total voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock. Code Section 368(c). JPMorgan Chase did not acquire 80 percent of the total number of shares of all other classes of stock of Bear Stearns, since it did not acquire the Bear Stearns nonvoting preferred shares.

The acquisition did not qualify as an “A” reorganization because the shareholders of Bear Stearns did not exchange stock constituting control of Bear Stearns for voting stock of JPMorgan Chase. In addition, the acquisition did not qualify as a “B” reorganization, even though JPMorgan Chase acquired 100 percent of the Bear Stearns voting common stock, since JPMorgan Chase after the transaction was not in control of Bear Stearns. Thus by intentionally failing to qualify as a reorganization, the nonrecognition provisions were inapplicable — the Bear Stearns shareholders were able to recognize the loss in their stock.

Revenue Ruling 76-223, 1976-1 C.B. 103 provides an example of how the Bearn Stearns acquisition could have been structured to qualify as a reorganization. Under Revenue Ruling 76-223, the acquired corporation had outstanding voting common stock and nonvoting preferred stock. The acquirer did not wish to purchase the nonvoting preferred stock. As part of the plan, the charter of the acquired corporation was amended to grant voting rights to the preferred stock. Then, the acquirer obtained all of the voting common stock in exchange for voting common stock of the acquirer. The voting common stock obtained was more than 80 percent of the voting stock. The voting preferred stock of the acquired corporation remained outstanding. The ruling concluded that the acquisition of the voting common stock of the acquired corporation was a “B” reorganization, since immediately after the acquisition the acquirer owned stock possessing more than 80 percent of the total combined voting power of all classes of stock entitled to vote and there was no nonvoting class of stock outstanding. As a result of the conversion of the nonvoting preferred into voting preferred of the acquired corporation, there was no other class of stock outstanding at the time of the acquisition of the voting common stock.

Bear Stearns Structure Contrasted to Acquisition of
Merrill Lynch Structure

The Bear Stearns acquisition structure can be contrasted with the acquisition of Merrill Lynch by Bank of America, which was intended to be a reorganization. As in the Bear Stearns acquisition, the Merrill Lynch acquisition was structured as a reverse triangular merger, where the common stock of Merrill Lynch was converted into common stock of Bank of America and the Merrill Lynch preferred shares were converted into Bank of America preferred shares with substantially identical rights, privileges and preferences as the Merrill Lynch preferred. Since Bank of America exchanged its preferred stock with the same rights, privileges and preferences for the Merrill Lynch preferred, the Merrill Lynch preferred stock must have been voting, for the transaction to satisfy the control requirements of the reorganization provisions. If the Merrill Lynch preferred stock was nonvoting, then the exchange would have resulted in the shareholders of Merrill Lynch having received nonvoting preferred. As a result, the transaction would not have satisfied the requirement that the shareholders holding stock representing “control” of the acquired corporation receive voting shares. And, the Merrill Lynch shareholders would not recognize any gain or loss on the exchange of their shares for Bank of America shares.

In the acquisition of Bear Stearns, JPMorgan Chase structured the transaction to avoid reorganization treatment, so that the shareholders of Bear Stearns recognized their losses inherent in their stock. Since JPMorgan Chase did not acquire stock of Bear Stearns constituting control of Bear Stearns and the shareholders of Bear Stearns did not surrender stock in Bear Stearns constituting control of Bear Stearns, the acquisition did not qualify as either an “A” or a “B” reorganization. The Bear Stearns acquisition is not a one of a kind, especially in light of the current economic environment where shareholders have large unrealized losses. It is understood that the acquisition of Wachovia Corp. by Wells Fargo & Co. is structured similarly as the Bear Stearns — avoiding reorganization treatment and allowing the shareholders of Wachovia to recognize their losses.

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Thomas R. Wechter, JD/LLM, Partner, concentrates his practice in the area of tax planning for individuals, corporations, and partnerships and also handles matters involving tax controversies. Wechter has a LL.M. degree in Tax from New York University. Colleen M. Feeney Romero, JD, Associate, concentrates her practice in taxation, including tax planning and litigation matters involving individuals, corporations and partnerships. Both work at the law firm of
Schiff Hardin LLP.