S G Warburg Group plc (Warburgs) plans an innovative groupreorganisation following the sale of its investment bankingbusiness to Swiss Bank Corporation (SBC) which is expected tocomplete at the end of June.

It proposes a scheme of arrangement pursuant to which itssubsidiary, Mercury Asset Management (MAM), will buy Warburgs.Warburgs shareholders will receive shares in MAM and cash (or loannotes) representing their share of the proceeds of sale of theinvestment banking business.

Following the sale, the ownership structure of MAM will becumbersome. Warburgs owns 75 per cent. of MAM and a variety ofminority shareholders own the remaining 25 per cent. Warburgs' onlyother significant asset will be the proceeds from the sale of theinvestment banking business - some £860 million.

It is therefore commercially desirable to collapse the groupstructure and give shareholders a direct stake in MAM (and theirshare of the sale proceeds). There are a number of possible ways toachieve this goal, the paramount consideration being to minimisethe risk of the MAM shares and/or cash proceeds being treated as adistribution to Warburgs shareholders. The consequences of thiswould be that Warburgs would be liable to pay ACT on thedistribution and its shareholders would be treated as receivingincome.

The main other options that could have been considered were ademerger of the investment banking business and MAM either usingthe dividend method or a scheme under section 110 of the InsolvencyAct 1986.

Dividend method. Using this structure, Warburgs couldhave paid a dividend in specie to its shareholderscomprising shares in MAM (or in a newly formed company to which MAMwould have been transferred - a so-called three cornered demerger).SBC could then have bid for the remainder of Warburgs'business.

Distributions to effect a demerger are treated as exemptdistributions (section 213(3), Income and Corporation Taxes Act1988) and thus avoid the tax consequences outlined above. But anumber of criteria need to be satisfied, one of which is that thedemerger must not be part of a scheme the main purpose, or one ofthe main purposes, of which is the sale of a business carried on bythe distributing company to a third party. As this is a key elementof the transaction it is unlikely that Warburgs could have obtainedthe necessary tax treatment to make the dividend methodattractive.

Section 110 scheme. Broadly, a section 110 schemeinvolves the liquidation of a parent company (Warburgs) and thetransfer of its assets (including MAM and its investment bankingbusiness) to two or more newly formed companies. The considerationeach new company gives in exchange for the transfer of the assetsis the issue of shares in the new companies which the liquidatordistributes, under section 110 of the Insolvency Act 1986, toshareholders of the liquidated company in satisfaction of theirrights on the winding up of the parent company. The parent companyis then dissolved leaving two separate companies each holding part of the assets of the old company.

The main advantages of a section 110 scheme are that there arereliefs from corporation tax on any gain on the disposal of theparent company's assets to the new companies and the distributionby the liquidator of shares in the two new companies to the parentcompany shareholders is not treated as income in the hands ofshareholders because a distribution in a liquidation is not adistribution for tax purposes.

But there are also a number of factors which make a section 110demerger unattractive, some or all of which are likely to have beenrelevant in Warburgs' case. It is a complex and lengthy process;the voluntary liquidation of the parent company may trigger defaultclauses in financing and other documents; and significantly in thecase of a listed company, the liquidator is required to buy out anydissenting shareholders.

The main features of the Warburgs scheme are:

* The issue of new MAM shares to Warburgs shareholders.

* A cash payment (or loan notes) representing part of the saleproceeds of the investment banking business to Warburgsshareholders. The obligation to make this payment will be satisfiedby MAM exercising a put option on SBC to purchase Warburgs oncompletion of the scheme. The proceeds of sale of the investmentbanking business will then effectively be held directly by MAM.

* Cancellation of the existing Warburgs ordinary and convertibledeferred shares and the issue of new Warburgs ordinary shares toMAM. Cancellation of the shares is preferable to transfer mainly toavoid a stamp duty charge.

* Conversion of the MAM shares held by Warburgs into deferredshares which will then be bought back by MAM and cancelled.

The scheme must be approved by Warburgs' ordinary andconvertible deferred shareholders at meetings convened at thedirection of the court (section 425, Companies Act 1985). Atthese meetings, the scheme must be approved by a majority innumber representing three quarters in value of themembers voting.

A section 425 scheme does not do away with other regulatoryrequirements. Shareholder approval at extraordinary generalmeetings of Warburgs and MAM will therefore be required for anumber of matters including, for example, authority to allot newshares, disapplication of pre-emption rights, reduction of capitaland approval of a Super Class 1 transaction.

As part of the agreement between MAM and Warburgs relating tothe scheme, minority shareholders in MAM will receive a specialdividend of approximately £18 million. The reason given forthe payment is to reflect the change in the nature of theirrelationship with the controlling shareholder, but presumably itwill also encourage them to vote in favour of the transaction!

After the scheme has been approved by members it must besanctioned by the court, following which a copy of the court ordermust be filed with the Registrar of Companies. The scheme will thenbecome effective and binding on all members.

A company cannot be a member of a company which is its holdingcompany (section 23, Companies Act 1985). No Warburgs sharescan therefore be issued to MAM whilst Warburgs holds a 75 per cent.interest in MAM. The scheme therefore provides for MAM to issue newshares to Warburgs shareholders, diluting Warburgs holding in MAMfrom 75 per cent. to around 40 per cent. before shares in Warburgsare issued to MAM.

At first glance it may appear that the payment of the proceedsof the sale of the investment banking business to Warburgsshareholders could constitute financial assistance for theacquisition of its own shares contrary to section 151 of theCompanies Act 1985. But section 151 does not prohibit anything donein pursuance of an order of the court under a section 425 scheme ofarrangement (section 153(3)(e)). It could also be arguedthat the payment does not constitute a gift but compensation to theshareholders for giving up legal rights.

Because the scheme is structured as a takeover, Warburgsshareholders will be treated as receiving capital rather thanincome.

Subject to an appropriate Inland Revenue clearance beinggranted, shareholders will not be treated as having made a disposalfor capital gains tax purposes to the extent that they receiveeither new MAM shares and/or loan notes (roll-overrelief).CJM.

* The principal legal advisers on the transaction wereSlaughter and May (S.G. Warburg Group PLC), Clifford Chance (SwissBank Corporation), Herbert Smith (Lazard Brothers, financialadvisers to MAM) and Allen & Overy (Mercury AssetManagement).