We appreciate your comments on last week's profile of the acquisition of Commerce Bancorp (NYSE:CBH) by Toronto-Dominion Bank (NYSE:TD). Of special note was an email from a reader which enclosed a fascinating missive by tax analyst Robert Willens of Lehman Brothers (NYSE:LEH).
In his October 3, 2007 research note, Willens describes TD's peculiar choice of accounting for the acquisition "whereby CBH’s shareholders will receive, in exchange for each of their shares, 0.4142 shares of a TD common share together with $10.50 in cash." The TD press release on the deal makes clear that the structure of the acquisition will make both the cash and stock paid in consideration to CBH shareholder fully taxable.
"Accordingly," writes Willens, "the transaction, even though it involves a 'merger' in which the majority of the consideration to be conveyed to the target shareholders is stock in the acquiring corporation, will not be structured in a manner that would permit it to constitute a reorganization. Thus, even the stock issued by the acquiring corporation will be taxed to the recipient shareholders..."
Now why, we wonder, would the nice folks at TD deliberately stick it to CBH shareholders, who already are getting less than a spectacular deal by taking TD stock as 75% of the consideration? The answer may lie in the final paragraph of Willen's remarkably clear explanation of the US tax code.
By structuring the transaction as a taxable purchase of stock, as opposed to a reorganization, TD will secure a 'cost basis' in the acquired stock; a basis measured by the amount of cash and the fair market value of the TD stock it issues in the transaction. If the transaction had constituted a tax-free reorganization, TD’s basis in the CBH stock would be, generally, an amount equal CBH’s net 'inside' asset basis. See Reg. Sec. 1.358-6(c)(2). Thus, it may be that the desire to obtain a (much higher) cost basis in the CBH stock was one of the factors that is motivating TD to structure the acquisition of CBH as what amounts to a 'taxable merger'.
The logic behind the taxable election at first eluded us. TD officials tell The IRA that the tax election has do with cross-border dividends between the US and Canada.
But then we saw that Sullivan & Cromwell is advising CBH on the transaction. We recalled an episode in 2005 when we were contacted by a fellow named Marty Madden, EVP and Chief Financial Officer of First National Bank of La Grange. Mr. Madden was interested in our views on a proposal he had authored along with S&C partner Rodgin Cohen, concerning the use of derivatives to allow the inclusion of "identifiable intangibles" in tier one bank equity
Of course, being safety and soundness hawks, we turned away Madden's suggestion to help champion the cause of core deposit intangibles and wrote in December 2005: "To say we were flabbergasted by S&C's suggestion to use a derivative transaction to window-dress the true value of bank equity is an understatement, but we're not surprised. As valuations for banks have extended higher and higher above book value -- sometimes as much as 5x book -- the accounting profession, assisted by investment bankers, consultants and lawyers, has diligently come up with a number of creative ways to explain the lofty premiums being paid, using concepts such as core deposit intangibles." We continued: "The degree of financial excess in the financial markets today is such that a reputable legal firm like Sullivan & Cromwell and a solid $384 million asset bank holding company such as F.N.B.C of La Grange are willing to peddle what we view as nonsense, apparently in the name of enabling ever more M&A transactions. Just another point of validation that anything is possible in the derivative economy."
But looking at the TD/CBH transaction and the seemingly irrational deal terms imposed by TD, terms which leave the sellers with a sizable tax bill, made us speculate: Could TD be preparing to argue to the Fed, OCC, FDIC and Canadian authorities that the new, higher cost basis in CBH should allow all of the bank's capital, including purchased intangibles, to be counted as Tier One capital? Does the tax law legerdemain enable TD to count the avoided goodwill as tangible capital? As we noted last week, the TD portfolio in the US is already just 87% tangible assets, the rest purchased goodwill. CBH itself has 4% intangibles, which when added to the goodwill generated by the 2.6x book TB was paying for the US bank would have pushed TB's US bank portfolio down pretty close to 20% intangibles. The other issue we see is that CBH is not particularly well-capitalized. With a Tier One leverage ratio of less than 6% and an MBS portfolio that is 3x peer, CBH may by just a misstep away from a regulatory MOU regarding the capital adequacy of its US units. Indeed, given that CBH is in the bottom quintile of its peer group in terms of capital, we could see regulators requiring TD to raise bank-level capital significantly as a condition of approval.
Thus comes the question we asked TD (and are awaiting an answer): If the regulators on either side of the 54th parallel shoot down TD's imaginative 'cost basis' election for accounting treatment of the CBH purchase, will that kill the deal? Beyond the explanation provided by TD, is there a connection between the adverse tax treatment of CBH shareholders and the regulatory approval of TD's higher cost basis? Remember, TD's BankNorth unit has 82% tangible assets, just 6% Tier One leverage ratio as of June 2007 and a dismal record of financial performance. Add an undercapitalized CBH to that mix in a deteriorating credit environment and TD could end up scrambling to raise additional capital in an unfriendly market for bank paper.
As and when we hear back from TD, we'll update this analysis.