Cravath, Swaine & Moore, (Feb. 11, 2000)

[LETTER OF INQUIRY]

November 9, 1999

Request for No Action Letter

Reorganization of Limited Liability Co.

Holding Period under Rule 144

Ladies and Gentlemen:

We respectfully request confirmation that, under the circumstances described below, a holder of securities received in the reorganization of a limited liability company as a corporation (in order to effect an initial public offering) may "tack" the holding period under Rule 144 of the limited liability company interests onto the holding period of the common stock received in the reorganization. In several recent no-action letters, the Staff of the Securities and Exchange Commission (the "Staff") has permitted tacking under Rule 144 in a reorganization of a limited partnership as a corporation, provided certain criteria are met to ensure compliance with the policy goals of the Rule. However, there is no publicly available no-action letter expressly permitting tacking of holding periods after a reorganization of a limited liability company as a corporation.

As stated in the preliminary note to Rule 144, the purpose of the required holding periods is to ensure that an investor has assumed the economic risk of his or her investment. The method for determining the holding periods for subsections (d) and (k) of Rule 144 are set forth in subsection (d). Rule 144(d) permits tacking of the holding periods for different securities where the underlying risks of an investment have not changed and no new investment decision is made, such as in a recapitalization. In particular, Rule 144(d)(3)(i) states that "securities acquired from the issuer ... pursuant to a ... recapitalization shall be deemed to have been acquired at the same time as ... the securities surrendered in connection with the recapitalization."

Analysis

In several recent no-action letters, the Staff has permitted partners of a limited partnership to tack the holding period of their interests in the limited partnership to the holding period of securities of a corporation which succeeded to the business of the limited partnership pursuant to Rule 144(d)(3)(i). In cases where tacking was permitted, the following criteria were present: (A) the partnership agreement or other organizational document expressly contemplated reorganization as a corporation and the holders seeking to tack did not have veto or other voting rights over the transaction; (B) there is no change in the business or operations of the company as a result of the reorganization; and (C) the equity interests of the stockholders of the successor corporation are based on their proportionate interests in the prior entity. ¹

Agreement Provisions Contemplating Reorganization

In the first no-action letter where the Staff expressly permitted tacking for a reorganization of a limited partnership into a corporation, Hygeia Sciences, Inc., the Staff noted that tacking was acceptable in that case particularly due to "the nature of the agreements entered into ... at the time of the formation of the Partnership ...." ² In Hygeia Sciences, Inc. and the line of no-action letters that followed, the Staff permitted tacking where the reorganization was expressly contemplated in formal written documents at the time of formation of the partnership. ³

In The Goldman Sachs Group, L.P. the Staff permitted tacking for those limited partners that did not have veto or other voting rights over the transaction, although they were able to choose the form of consideration they could receive in the transaction ⁴

In The Petersen Companies, Inc., ⁵ the Staff considered the reorganization of a limited liability company, but denied the requested interpretation, apparently on the basis that the relevant document did not contemplate the reorganization. In that letter, the Staff pointed out that in order to tack the holding period of the limited liability company interests to the holding period for the equity securities of the corporation, the operative agreement must have contemplated the reorganization in writing and the holders of units in the limited liability company could not retain veto power over the decision to reorganize. ⁶

Some limited liability companies are very similar to partnerships and utilize member votes to decide most significant matters. In other cases, limited liability companies utilize a board of directors as the principal governing body.

The present case involves a limited liability company with a controlling member that held in excess of 82% of the equity and voting interests and several minority members, including a 6% minority member. The limited liability company agreement expressly authorized its board of directors to "effect a conversion of the Company into a corporation organized under the laws of the State of Delaware by whatever means the Board deems desirable ... to effect the initial public offering of such corporations stock; provided that the expected gross proceeds of such transaction exceed $25 million." The original limited liability company agreement further specified the percentage of the common stock of the corporation that each member of the limited liability company would receive in the transaction and provided that "the Board shall have full discretion to effect [the] Conversion in the manner it shall choose as most appropriate to effect the Conversion". It also required all members to "provide all necessary cooperation, including, without limitation, the execution of any documents or filings that may be required." The original limited liability company agreement also specified that certain provisions, primarily relating to registration rights and restrictions on resale, would be carried forward and included in a stockholders agreement. The members had no veto or other voting rights on the decision to reorganize as a corporation to effect an initial public offering so long as the expected proceeds exceed $25 million.

The purpose and effect of these provisions was to allow the controlling member to decide whether to conduct an initial public offering and, in connection therewith, whether to convert the limited liability company to a corporation. The Board of the limited liability company was controlled by the 82% member. The 6% minority owner had one representative on the five person Board. The minority owners representative had no power to veto the decision to proceed with the conversion to a corporation in connection with the initial public offering.

The original limited liability agreement required "all Members to discuss in good faith the mechanics of creating a Corporation". In accordance with this provision, the members discussed a number of issues that arose in connection with the implementation of the initial public offering. In these discussions the members agreed upon certain matters, including, at the request of the controlling member, the terms on which a new investor would be admitted prior to the reorganization, the terms of settlement of certain outstanding third party litigation involving the majority member and the duration of the "lock up" requested by the underwriters and, at the request of the 6% minority member, an extension of the time during which certain put rights could be exercised. The members also agreed to adjust the terms of the stock that would be issued in the reorganization. The original limited liability company agreement specified that each of the existing classes of membership interests would receive a separate class of stock with ownership and voting rights proportionate to their former membership interests and that the public would receive a separate class of stock with unspecified voting rights. The original agreement also required the members stock to be convertible into the public stock. To simplify the capital structure and clarify the voting rights of the public stock, the members agreed to execute an amendment to the limited liability company agreement permitting the corporation to create high and low voting common stock and allow the 6% minority member to choose whether to receive the high or low voting common stock in the reorganization. This amendment did not change the equity interest that would be received by each member and allowed the 6% member the ability to retain the same voting rights that it would have had under the terms of original limited liability company agreement. Significantly, the controlling member could have required the public stock to be low voting, through its ownership of over 80% of the voting rights, or possibly through the Boards authority to control the mechanics of effecting the initial public offering, and the minority members would not have had the right to veto this determination if it had ever been put to a vote.

We believe that under the circumstances described above the 6% minority owner made its decision to permit a reorganization and an initial public offering at the time it agreed to the terms of the original limited liability company agreement and that the conversion to a corporation did not involve a new investment decision by the 6% minority member. The members of the limited liability company, as such, had neither veto nor voting rights with respect to the decision to reorganize and conduct an initial public offering (so long as the proceeds requirement was satisfied). Neither the requirement for Board approval nor the requirement to discuss the terms of the transaction with the minority members provided those members with a veto. ⁷ The fact that the members participated in certain decisions and agreed to certain clarifications and changes to the original limited liability company agreement terms did not change the basic understanding that the fundamental decision was to be made by the controlling member, and that the minority members did not have any right to veto that decision. Moreover, these technical changes were similar to those described in the Peapod, Inc. no-action letter. ⁸

No Change in Business or Operations

Hygeia Sciences, Inc. and the no-action letters that follow it require that the business and operations of the successor be the same as the business and operations of the predecessor. In the transaction described herein the corporation succeeded to all of the assets, liabilities and operations of the limited liability company. The only change was that the board of directors of the corporation no longer included a representative of the 6% minority holder and two new independent directors were added to comply with stock exchange requirements.

Proportionate Equity Interests

Hygeia Sciences, Inc. and the no action letters that follow it require that the interests in the corporate successor be based on the interests in the predecessor entity. In this case, as required by the original limited liability agreement, each member received an equity interest in the corporation that was the same as its equity interest in the predecessor limited liability company. Those interests were then proportionately diluted by the issuance of common stock to the public.

Conclusion

We believe that the Staffs position in The Petersen Companies indicated that the criteria for allowing tacking for the reorganization of a limited liability company are parallel to the criteria set forth above for reorganizations of limited partnerships. Although the Staff refused to allow tacking in The Petersen Companies ⁹, the Staffs reasoning would appear to support the conclusion that the criteria are the same.

Based on the foregoing, we respectfully request the Staff to concur with our opinion that, pursuant to Rule 144(d)(3)(i), the circumstances described above are sufficient to permit tacking of the Rule 144(d) and (k) holding periods for the former 6% minority member of the limited liability company in the reorganization of that limited liability company as a corporation.

If you have any questions concerning the foregoing or if you need any additional information, please do not hesitate to contact me at (212) 474-1270 or Tricia A. Hoefling at (212) 474-1360.

Sincerely,

William P. Rogers, Jr.

Office of the Chief Counsel

Division of Corporation Finance

Securities and Exchange Commission

450 Fifth Street, N.W.

Washington, D.C. 20549

[STAFF REPLY LETTER]

February 11, 2000

RESPONSE OF THE OFFICE OF CHIEF COUNSEL

DIVISION OF CORPORATION FINANCE

Re: Cravath, Swaine & Moore

Incoming letter dated November 9, 1999

Based on the facts presented, but without endorsing your argument under rule 144(d)(3)(i), the Division agrees that the described minority member of a limited liability company succeeded by a corporation should calculate the holding period for common shares in the successor corporation in reference to the date of purchase and full payment for interests in the predecessor limited liability company. We have noted that the minority member had ceded any authority to grant or to withhold approval of the reconstitution into corporate form by the terms of the limited liability agreement that created the predecessor.

This position is based on the representations made to the Division in your letter. Different facts or conditions might require another result.

Sincerely,

Michael Hyatte

Special Counsel

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