|What Happened with
the AOL/CompuServe Talks?
by Jim Surowiecki
NEW YORK, NY. (Apr. 24, 1997) -- As recently as a week ago, the proposed
acquisition of COMPUSERVE (Nasdaq: CSRV) by AMERICA ONLINE
(NYSE: AOL) looked to be an almost sure thing. For shareholders of both
CompuServe and H&R BLOCK, the rather unlikely parent company which owns
80% of CompuServe, that was very good news. But it now seems almost certain
that the deal has hit a permanent snag on some proposed federal legislation
to seal up a tax loophole that for three decades has allowed acquisitions
to go through on a tax-free basis. This has changed the financial fundamentals
of the deal to the point that it no longer makes sense, and both companies
appear to be walking away from the table.
For nearly a year now, H&R Block has been trying to divest itself of
its entire CompuServe stake. Last year, it had planned to offer the stake
in an IPO, but a sharp tumble in CompuServe's share price, coupled with a
more general Wall Street malaise about new offerings, put an end to that
idea. Investors' flight from CompuServe stock reflected both the flip side
of their previous infatuation with anything Internet-related and, more
substantively, serious doubts about CompuServe's ability to compete against
companies like MICROSOFT (Nasdaq: MSFT) and AOL.
CompuServe's woes have only continued over the last six months. The company
announced that it was discontinuing WOW!, the family-friendly version of
Internet access that was designed only for Windows 95 users. It suggested
that it was re-centering its business around business users, and it brought
in new management, although it has not had a CEO for several months now.
Although the company has fallen to less than a third of its initial public
offering (IPO) price, CompuServe still does have some assets of value. The
online subscription part still has more than a two and a half million subscribers
in the United States and remains the biggest American player in the European
market. The crown jewel of the company remains its network services business.
Compuserve's elaborate infrastructure of modems and high-speed lines would
be an important addition to any Internet service. Its network services to
business are growing revenues at a 25% annualized rate, despite the
well-publicized woes of the rest of the company. At a time when AOL has been
struggling to add modems fast enough to meet consumer demand, the technical
benefits of an acquisition of CompuServe would not have been negligible.
With America Online actively considering a public offering of subsidiary
ANS at some point in the future, CompuServe's network services business would
not have been without value. In fact, AT&T (NYSE: T) offered to
buy CompuServe's modems and lines when it became clear that the company was,
so to speak, on the block. But H&R Block held off, in no small part because
the very provision that the proposed federal law would repeal made it enormously
advantageous to sell the company as a whole, rather than auctioning off its
What is this tax loophole that makes H&R Block want to sell off all of
CompuServe, rather than dice it up piecemeal? The tax loophole that Congress
is now attempting to close has to do with so-called "Morris Trust transactions."
These transactions involve the restructuring of one company so that it is
able to sell part of itself to another firm without paying any taxes on the
deal. In this case, it would be H&R Block that would benefit from the
Morris Trust provision as it would be selling its majority stake in former
subsidiary CompuServe without any tax penalties. Morris Trust transactions
are often termed "nonsale sales" because of the lack of tax consequences
and are specifically designed to take advantage of a three-decade-old Supreme
Court ruling that exempted these deals from taxation.
When two companies merge in a stock-for-stock swap, as U.S. ROBOTICS
(Nasdaq: USRX) and 3COM (Nasdaq: COMS) will later this year, the new company
generally does not have to pay taxes. When one company acquires a division
of another company with cash, though, the transaction is taxable. What the
Morris Trust structure does is allow the selling company to spin off the
part of the company that isn't being sold. The buyer then acquires the remainder
of the company -- which is to say, the division it really wanted in the first
place -- by paying in stock and acquiring an agreed-upon level of debt that
remains with the "old" company. H&R Block would get rid of CompuServe
and some of its debt, AOL would get CompuServe, and neither would pay any
Although these deals have been legal since the 1960s, it was not until this
decade, when restructuring and spinning off became corporate dogma, that
Morris Trust transactions took place with regularity. This year alone,
RAYTHEON (NYSE: RTN) spent $9.5 billion to acquire Hughes Electronics'
defense business; AEGON NV (NYSE: AEG) spent $3.5 billion to buy
PROVIDIAN's (NYSE: PVN) insurance business; KNIGHT-RIDDER (NYSE: KRI) bought four newspapers from WALT DISNEY (NYSE:DIS) for $1.65
billion; and, most recently, AIRTOUCH (NYSE: ATI) agreed to buy US
WEST's (NYSE: USW) cellular business. Although none of these deals have
been completed, both the Senate and House versions of the repeal bill contain
a grandfather clause that would allow them to go through unscathed. All Morris
Trust transactions announced by April 16 will be permitted to go ahead. That,
of course, leaves out any AOL-CompuServe transaction. According to Dow Jones,
both AOL and H&R Block are lobbying Congress for an exemption to the
law, but the possibility of success is uncertain.
What makes the Morris Trust repeal particularly interesting is that in it
one can see the campaign against so-called "corporate welfare" bearing its
first fruits. The federal tax code is littered with exceptions and exemptions
that allow corporations to get unintended tax breaks, and the recent
budget-balancing fervor has led congressmen on both sides of the aisle to
look at these provisions more closely. This legislation, in fact, was sponsored
in the House by conservative Rep. Bill Archer, head of the Ways and Means
Committee, and in the Senate by William Roth of Delaware, the Republican
head of the Finance Committee, and by Democrat Daniel Moynihan of New York.
As a bipartisan endeavor, it is essentially certain to pass. Roth and Moynihan
were clear in their statement on the bill, arguing that Congress had designed
the original statute to allow corporations some flexibility in restructuring
their businesses internally, and that it had never been meant to "insulate"
sales from taxation.
"The recent transactions that raise concerns have very little to do with
individual shareholder tax planning," Roth and Moynihan said, implying that
these deals were being structured as they were to bypass tax consequences.
Archer added, "The misuse of this provision in the tax code to avoid payment
of taxes should be terminated." Although Archer has previously expressed
some skepticism about the idea that tax loopholes could be considered corporate
welfare, he has stated he wants the loophole closed in order to "protect
taxpayers." This leaves investment bankers for AOL and H&R Block struggling
to find a new way of structuring the deal, with AOL now considering just
purchasing parts of CompuServe's business instead of the whole enchilada.
CompuServe fell more than ten percent after the Morris Trust news was announced.
Perhaps the AT&T offer may start looking a little better.