March 1997
James McAleese, Esq.
Principal, McAleese & Associates, P.C.

Originally attacked as "payoffs for layoffs" by its congressional opponents, the ability of defense contractors to recover post-merger restructuring costs was salvaged by a congressional compromise in 1996. That compromise now requires a verifiable savings ratio of at least $2 of savings per $1 of contractor restructuring cost to be reimbursed by DoD for all future mergers. As you know, last year we crafted many of the legal arguments which educated Congress to the multi-billion dollar liability that DoD would incur if it retroactively repealed contractor ability to recoup "sunk" restructuring costs. Specifically, contractor recoupment of such "external restructuring costs" from DoD is intended to accelerate contractor liquidation of underutilized facilities and redundant personnel. This will reduce DoD’s long-term costs by maximizing contractor efficiency and utilization rates. Likewise, recoupment of those costs is critical to contractors because post-merger restructuring costs often run as high as five-percent (5%), or more, of the companies’ combined post-merger gross revenues. The necessity of contractors to (1) accelerate restructuring to generate immediate positive cashflow, and (2) then recoup those "sunk" restructuring costs from DoD, is critical to protecting stock value via aggressive retirement of debt in highly-leveraged acquisitions and stock mergers. This is particularly true given the premium prices commanded by the recent sale of defense assets. That recoupment not only accelerates contractor return to pre-merger debt-to-equity levels, but substantially increases projected net earnings and shareholder return-on-equity, which is immediately reflected in the stock price.

Unfortunately, a public mandate to balance the federal budget is causing the emergence of a strong faction in Congress to quash all appearances of "corporate welfare." Reps. Bernard Sanders (I-VT) and Christopher Smith (R-NJ) resurrected the controversial issue of "payoffs for layoffs" on February 6, 1997, by introducing legislation (HR 648) to make all restructuring costs of the proposed Boeing-McDonnell Douglas merger unallowable. This widespread bipartisan grass-roots attack on perceived "corporate welfare" across both the House and Senate is consistent with Sen. Tom Harkins’ (D-IA) recent request that new Secretary of Defense, William Cohen, prohibit recoupment of costs incurred by Boeing in its proposed acquisition of McDonnell Douglas. Sister legislation is currently being introduced in Congress (HR 925 introduced on March 5, 1997) to prohibit restructuring cost recoupment by Raytheon-Hughes-Texas Instruments and all future merging contractors as well. The bottom line is that if Congress and the Administration are to have any credibility at all in containing entitlements to balance the budget, they must eliminate all appearances of corporate welfare. This will make it much tougher to fend off the renewed congressional attack this year.

Last year we were instrumental in persuading Congress that retroactive repeal of contractor reimbursement of restructuring costs, incurred back to inception in 1994, would likely trigger multi-billion dollar liability to DoD under the recent Supreme Court opinion in Winstar. As you know, under Winstar, the government is monetarily liable when it "induces" parties to enter into transactions, and then subsequently enacts legislation or promulgates regulations, which are either (1) "targeted" at, or (2) have the "effect" of, voiding or impairing those contracts or business agreements. In other words, it makes the government liable when it persuades private parties to rely to their material detriment upon a specific government position, and then later repudiates that position as inconvenient, politically incorrect, or just too expensive. This will be revisited for those recently announced defense mergers where the value of the transaction, or the terms of the financing, were "induced" at least in part by reliance on the current law to recoup those post-merger restructuring costs.

However, even if its authors are unsuccessful in achieving a total repeal, a second congressional compromise could expand the definition of "costs" to include government "opportunity costs," such as lost tax revenues for those sales of defense assets which are styled as tax exempt corporate re-organizations. The growing public perception that recent sales of defense assets at premium prices were manipulated to exploit current tax exempt corporate re-organization loopholes, has added even further fuel to this "windfall" fire. This creates the appearance of a double government subsidy, in the form of preferential tax exempt status and reimbursement of the post-merger restructuring costs, to generate even greater windfall profit. Such a second congressional compromise would so exponentially increase the magnitude of savings necessary to clear the $2:$1 savings/cost ratio, as to effectively ensure that no contractor could qualify for recoupment of post-merger restructuring costs from DoD.

This has obvious implications for both pending, and future, defense mergers "targeted" by this legislation. This also has implications to previously "grandfathered" defense contractors. Specifically, targeted contractors will likely raise strong equity arguments that such grandfathered contractors should also be stripped of their prior "entitlements" to provide a level playing field for future DoD competitive procurements. The anticipated rationale is that the grandfathered contractors will otherwise enjoy an inherent price advantage in all future DoD competitions, because DoD will have subsidized their restructuring to enhance their efficiency. Therefore, meticulous legal attention must be given, by both targeted and grandfathered contractors, to factually reconstruct (1) the specific transactional "inducements," and (2) the extent to which the asset valuation or financing terms relied upon contractor reimbursement of post-merger restructuring costs in the aggressive retirement of that debt.

Legally documenting such contractor inducements is critical, given that the congressional sponsors drafted the resurrected legislation with the express intention of narrowing the government’s vulnerability to the blanket liability arguments we so successfully asserted last year. While the refined Winstar liability arguments should be used as a last resort following negotiation impasse, contractor failure to methodically pre-position the specific sequence of inducements virtually assures that interminable litigation will be the most likely outcome. The resulting impacts to customer goodwill, net earnings, cashflow, and potential default on the financing terms are obvious. Having anticipated such renewed congressional targeting from our involvement in the original compromise, we have already refined the necessary protocols, negotiation, and last-resort litigation strategies to protect the legitimate right to continuing reimbursement. This will continue to benefit contractors, shareholders, investment banks, and our strong national defense. Please advise if your management has an interest in exploring these options further.