Item 1A. Risk Factors
Item 1A. Risk Factors
You should carefully consider the risk factors set forth below, as well as the other information contained in this Form 10-K, including our consolidated financial statements and related notes. This Form 10-K contains forward-looking statements that involve risks and uncertainties. Any of the following risks could materially and adversely affect our business, financial condition or results of operations. Additional risks and uncertainties not currently known to us or those we currently view to be immaterial may also materially and adversely affect our business, financial condition or results of operations. The following risk factors are not necessarily presented in order of relative importance and should not be considered to represent a complete set of all potential risks that could affect our business, financial condition or results of operation.
Risks Relating to Our Business and Operations
MDC competes for clients in highly competitive industries.
The Company operates in a highly competitive environment in an industry characterized by numerous advertising and marketing agencies of varying sizes, with no single advertising and marketing agency or group of agencies having a dominant position in the marketplace. MDC is, however, smaller than several of its larger industry competitors. Competitive factors include creative reputation, management, personal relationships, quality and reliability of service and expertise in particular niche areas of the marketplace. In addition, because an agency’s principal asset is its people, barriers to entry are minimal, and relatively small agencies are, on occasion, able to take all or some portion of a client’s business from a larger competitor.
While many of MDC’s client relationships are long-standing, companies put their advertising and marketing services businesses up for competitive review from time to time, including at times when clients enter into strategic transactions or experience senior management changes. To the extent that the Company fails to maintain existing clients or attract new clients, MDC’s business, financial condition, operating results, and cash flows may be affected in a materially adverse manner.
MDC’s business could be adversely affected if it loses key clients.
MDC’s strategy has been to acquire ownership stakes in diverse marketing communications businesses to minimize the effects that might arise from the loss of any one client. The loss of one or more clients could materially affect the results of the individual agencies and MDC as a whole.
Our ten largest clients (measured by revenue generated) accounted for approximately 21% of our revenue for the three-year period ended December 31, 2020. A significant reduction in spending on our services by our largest clients, or the loss of several of our largest clients, could have a material adverse effect on our business, results of operations and financial position.
MDC’s ability to generate new business from new and existing clients may be limited.
To increase its revenues, MDC needs to obtain additional clients or generate demand for additional services from existing clients. MDC’s ability to generate initial demand for its services from new clients and additional demand from existing clients is subject to such clients’ and potential clients’ requirements, pre-existing vendor relationships, financial conditions, strategic plans and internal resources, as well as the quality of MDC’s employees, services and reputation and the breadth of its services. To the extent MDC cannot generate new business from new and existing clients due to these limitations, MDC’s ability to grow its business and to increase its revenues will be limited.
MDC’s business and results of operations have been adversely affected and could in the future be materially adversely affected by the COVID-19 pandemic.
The COVID-19 pandemic is adversely impacting, and is expected to continue to adversely impact, our business and results of operations.
As part of efforts to contain the spread of COVID-19, governmental authorities have imposed various restrictions, such as travel bans, stay-at-home orders and quarantines, social distancing measures and temporary business closures. COVID-19 and the actions taken by governments, businesses and individuals in response to the pandemic have resulted in, and are expected to continue to result in, a substantial curtailment of business activities, weakened economic conditions, and significant economic uncertainty.
Many clients have responded to weak economic and financial conditions by reducing their marketing budgets, thereby decreasing the market and demand for our services. This is adversely impacting and is expected to continue to adversely impact our business and results of operations.
We are also facing increased operational challenges as we take measures to support and protect employee health and safety, including limiting employee travel, closing offices, and implementing work-from-home policies for employees. In particular, our remote work arrangements, coupled with stay-at-home orders and quarantines, pose new challenges for our employees and our IT systems and extended periods of remote work arrangements could strain our business continuity plans and introduce operational risk, including but not limited to cybersecurity and IT systems management risks.
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The effects of the COVID-19 pandemic may also limit the resources afforded to or delay the implementation of our strategic initiatives and make it more difficult to develop and market innovative services. If our strategic initiatives are delayed or otherwise modified, such initiatives may not achieve some or all of the expected benefits, which could adversely impact our competitive position, business, results of operations and financial condition.
MDC’s business could be adversely affected if it loses or fails to attract or retain key executives or employees.
Employees, including creative, research, analytics, media, technology development, account and practice group specialists, and their skills and relationships with clients, are among MDC’s most important assets. An important aspect of MDC’s competitiveness is its ability to retain key employee and management personnel. Compensation for these key employees is an essential factor in attracting and retaining them, and MDC may not offer a level of compensation sufficient to attract and retain these key employees. If MDC fails to hire and retain a sufficient number of these key employees, it may not be able to compete effectively. Management succession at our operating units is very important to the ongoing results of MDC because, as in any service business, the success of a particular agency is dependent upon the leadership of key executives and management. If key executives were to leave our operating units, the relationships that MDC has with its clients could be adversely affected.
MDC is exposed to the risk of client defaults.
MDC’s agencies often incur expenses on behalf of their clients for productions and in order to secure a variety of media time and space, in exchange for which they receive a fee. The difference between the gross production costs and media purchases and the revenue earned by us can be significant. While MDC takes precautions against default on payment for these services (such as credit analysis, advance billing of clients, and in some cases acting as an agent for a disclosed principal) and has historically had a very low incidence of default, MDC is still exposed to the risk of significant uncollectible receivables from our clients. The risk of a material loss could significantly increase in periods of severe economic downturn. Such a loss could have a material adverse effect on our results of operations, cash flows and financial position.
MDC is subject to regulations and litigation risk that could restrict our activities or negatively impact our revenues.
Advertising and marketing communications businesses are subject to government regulation, both domestic and foreign. There has been an increasing trend in the United States for advertisers to resort to litigation and self-regulatory bodies to challenge comparative advertising on the grounds that the advertising is false and deceptive. Moreover, there has recently been an expansion of specific rules, prohibitions, media restrictions, labeling disclosures, and warning requirements with respect to advertising for certain products. Proposals have been made to ban the advertising of specific products and to impose taxes on or deny deductions for advertising which, if successful, may have an adverse effect on advertising expenditures and consequently, on MDC’s revenues.
Certain of MDC’s agencies produce software and e-commerce tools for their clients, and these product offerings have become increasingly subject to litigation based on allegations of patent infringement or other violations of intellectual property rights. As we expand these product offerings, the possibility of an intellectual property claim against MDC grows. Any such claim, with or without merit, could result in costly litigation and distract management from day-to-day operations. If we are not successful in defending such claims, we could be required to stop offering these services, pay monetary damages, enter into royalty or licensing arrangements, or satisfy indemnification obligations that we have with some of our clients. Such arrangements may cause our operating margins to decline.
In addition, laws and regulations related to consumer privacy, use of personal information and digital tracking technologies have been proposed or enacted in the United States and certain international markets (including the European Union’s General Data Protection Regulation, or “GDPR,” the proposed European Union “ePrivacy Regulation” and the recently enacted California Consumer Privacy Act, or “CCPA”). We face increasing costs of compliance in an uncertain regulatory environment and any failure to comply with these legal requirements could result in regulatory penalties or other legal ability. Furthermore, these laws and regulations may impact the efficacy and profitability of certain digital marketing and analytics services we provide to clients, making it difficult to achieve our clients’ goals. These and other related factors could affect our business and reduce demand for certain of our services, which could have a material adverse effect on our results of operations and financial position.
Compliance with data privacy laws requires ongoing investment in systems, policies and personnel and will continue to impact our business in the future by increasing legal , operational and compliance costs. While we have taken steps to comply with data privacy laws, we cannot guarantee that our efforts will meet the evolving standards imposed by data protection authorities. In the event that we are found to have violated data privacy laws, we may be subject to additional potential private consumer, business partner or securities litigation, regulatory inquiries, governmental investigations and proceedings and we may incur damage to our reputation. Any such developments may subject us to material fines and other monetary penalties and damages, divert management’s time and attention, and lead to enhanced regulatory oversight all of which could have a material adverse effect on our business and results of operations.
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Some of MDC’s Partner Firms rely upon signatory service companies to employ union performers in commercials.
Some of MDC’s creative agencies that have not entered into the SAG-AFTRA Commercials Contract have traditionally used signatory service companies, which are parties to the SAG-AFTRA Commercials Contract, to employ SAG-AFTRA union performers appearing in television, new media, and other commercials produced by those agencies. SAG-AFTRA has recently persuaded the principal signatory service companies to change the way such signatory service companies do business. These changes will make it more cumbersome and expensive for advertising agencies which have not entered into the SAG-AFTRA Commercials Contract to produce advertisements using SAG-AFTRA members, and in some cases may preclude the use of SAG-AFTRA members in a production. If a Partner Firm is unable to produce a commercial using a union performer, it may reduce the amount of business conducted by such Partner Firm. Accordingly, if SAG-AFTRA’s recent restrictions on signatory service companies are not modified, it could have a material adverse effect on our business, results of operations and financial position.
We rely extensively on information technology systems and cybersecurity incidents could adversely affect us.
We rely on information technologies and infrastructure to manage our business, including digital storage of client marketing and advertising information and developing new business opportunities. Increased cybersecurity threats and attacks, which are becoming more sophisticated, pose a risk to our systems and networks. Security breaches, improper use of our systems and unauthorized access to our data and information by employees and others may pose a risk that sensitive data may be exposed to unauthorized persons or to the public. We also have access to sensitive or personal data or information that is subject to privacy laws and regulations. Our systems and processes to protect against, detect, prevent, respond to and mitigate cybersecurity incidents and our organizational training for employees to develop an understanding of cybersecurity risks and threats may be unable to prevent material security breaches, theft, modification or loss of data, employee malfeasance and additional known and unknown threats. In addition, we use third-party service providers, including cloud providers, to store, transmit and process data. Any breakdown or breach in our systems or data-protection policies, or those of our third-party service providers, could adversely affect our reputation or business.
MDC is consolidating its real estate footprint and may incur significant costs in doing so.
In 2020, MDC consolidated the real estate occupancy of its advertising and marketing agencies in New York City, in order to lower our leasing costs and improve collaboration among our agencies. In consolidation, many of MDC’s legacy properties will be or have been subleased or abandoned. In 2020, MDC incurred a charge of $22.7 million associated with the impairment of right-of-use lease assets and related leasehold improvements and the acceleration of variable lease expenses relating to these and similar actions. In addition, MDC is exploring opportunities for real estate consolidation in other markets. MDC may not be able to sublease its vacated office spaces on expected terms or at all. If we fail to sublet on expected terms the vacated leased offices, there could be a material adverse effect on our cash flows, financial condition and results of operations.
Risks Relating to Our Financial Condition and Results
Future economic and financial conditions could adversely impact our financial condition and results.
Advertising, marketing and communications expenditures are sensitive to global, national and regional macroeconomic conditions, as well as specific budgeting levels and buying patterns. Adverse developments including heightened economic uncertainty could reduce the demand for our services, which could have a material adverse effect on our revenue, results of operations, cash flows and financial position.
a. As a marketing services company, our revenues are highly susceptible to declines as a result of unfavorable economic conditions.
Global economic conditions affect the advertising and marketing services industry more severely than other industries. In the past, some clients have responded to weakening economic conditions with reductions to their marketing budgets, which include discretionary components that are easier to reduce in the short term than other operating expenses. This pattern may recur in the future. Decreases in our revenue would negatively affect our financial results, including a reduction of our estimates of free cash flow from operations.
b. If our clients experience financial distress, their weakened financial position could negatively affect our own financial position and results.
We have a diverse client base, and at any given time, one or more of our clients may experience financial difficulty, file for bankruptcy protection or go out of business. Unfavorable economic and financial conditions in the global economy could increase client financial difficulties resulting in reduced demand for our services, reduced revenues, delayed payments by clients, and increased write offs of accounts receivable.
c. Conditions in the credit markets could adversely impact our results of operations and financial position.
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Turmoil in the credit markets or a contraction in the availability of credit would make it more difficult for businesses to meet their capital requirements and could lead clients to change their financial relationship with their vendors, including us. If that were to occur, it could materially adversely impact our results of operations and financial position.
If our available liquidity is insufficient, our financial condition could be adversely affected and we may be unable to fund contingent deferred acquisition liabilities, and any put options if exercised.
MDC maintains a committed $211.5 million senior secured revolving credit agreement due February 3, 2022 (the “Credit Agreement”), together with cash flow from operations, to fund its working capital needs and to fund the exercise of put option obligations and contingent deferred acquisition payments. If MDC is not able to renew or replace its Credit Agreement on favorable terms or at all, or if credit were otherwise unavailable or insufficient under the Credit Agreement, MDC’s liquidity could be adversely affected and MDC’s ability to fund its working capital needs and any contingent obligations with respect to put options or contingent deferred acquisition payments could be adversely affected. MDC has made acquisitions for which it has deferred payment of a portion of the purchase price, with the deferred acquisition consideration generally payable based on achievement of certain thresholds of future earnings of the acquired company. In addition, a noncontrolling shareholder in an acquired business often has the right to require MDC to purchase all or part of its interest, either at specified dates or upon the termination of such shareholder’s employment with the subsidiary or death (put rights). Payments to be made by the Company in respect of deferred acquisition consideration and noncontrolling shareholder put rights may be significantly higher than the amounts estimated by MDC because the actual obligation adjusts based on the performance of the acquired businesses over time.
MDC’s business strategy includes ongoing efforts to engage in acquisitions of ownership interests in entities in the marketing communications services industry and other strategic transactions.
The success of acquisitions or strategic investments depends on the effective integration of newly acquired businesses into MDC’s current operations. Such integration is subject to risks and uncertainties, including realization of anticipated synergies and cost savings, the ability to retain and attract executives and clients, the diversion of management’s attention from other business concerns, and undisclosed or potential legal liabilities of the acquired company. MDC’s failure to address these risks or other problems encountered in connection with our past or future acquisitions and other strategic transactions could cause MDC to fail to realize their anticipated benefits, incur unanticipated liabilities and harm MDC’s business generally. MDC’s acquisitions and other strategic transactions could also result in dilutive issuances of the Company’s equity securities, the incurrence of debt, contingent liabilities, amortization expenses, or impairment of goodwill and/or purchased long-lived assets, and restructuring charges, any of which could harm its financial condition or operating results. Furthermore, the anticipated benefits or value of MDC’s acquisitions and other strategic transactions may not materialize.
MDC’s results of operations are subject to currency fluctuation risks.
Although MDC’s financial results are reported in U.S. dollars, a portion of its revenues and operating costs are denominated in currencies other than the U.S. dollar. As a result, fluctuations in the exchange rate between the U.S. dollar and other currencies, particularly the Canadian dollar, may affect MDC’s financial results and competitive position.
Goodwill, intangible assets and right-of-use assets may become impaired.
We have recorded a significant amount of goodwill and intangible assets in our consolidated financial statements in accordance with GAAP resulting from our acquisition activities, which principally represent the specialized know-how of the workforce at the agencies we have acquired. We test, at least annually, the carrying value of goodwill for impairment, as discussed in Note 2 of the Notes to the Consolidated Financial Statements included herein. The estimates and assumptions about future results of operations and cash flows made in connection with the impairment testing could differ from future actual results of operations and cash flows. If MDC concludes that any intangible asset and goodwill values are impaired, any resulting non-cash impairment charge could have a material adverse effect on our results of operations and financial position. See Note 8 of the Notes to the Consolidated Financial Statements for details on goodwill and intangible asset impairment recorded in the twelve months ended December 31, 2020.
In addition, we have recorded a significant amount of right-of-use assets in our consolidated financial statements in accordance with GAAP as a result of the adoption of Accounting Standards Codification, Leases (“ASC 842”). Upon a triggering event, we test the right-of-use assets for impairment, as discussed in Note 2 of the Notes to the Consolidated Financial Statements included herein. If a right-of-use asset is impaired, the charge could have a material adverse effect on our results of operations and financial position. See Note 10 of the Notes to the Consolidated Financial Statements for details on lease impairments recorded related to right-of-use assets.
We may be subject to adverse tax consequences such as those related to changes in tax laws or tax rates or their interpretations, and the related application of judgment in determining our global provision for income taxes, deferred tax assets or liabilities or other tax liabilities given the ultimate tax determination is uncertain.
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We are a Canada-domiciled multinational company subject to tax in multiple U.S. and foreign tax jurisdictions. Significant judgment is required in determining our global provision for income taxes, deferred tax assets or liabilities and in evaluating our tax positions on a worldwide basis. While we believe our tax positions are consistent with the tax laws in the jurisdictions in which we conduct our business, it is possible that jurisdictional tax authorities may take a contrary view, which may have a significant impact on our global provision for income taxes.
Tax laws are dynamic and subject to change as new laws are passed and new interpretations of the law are issued or applied. The U.S. recently enacted significant tax reform, and certain provisions of the new law may adversely affect us. In addition, governmental tax authorities are increasingly scrutinizing the tax positions of companies. Many countries in the European Union, as well as a number of other countries and organizations such as the Organization for Economic Cooperation and Development, are actively considering changes to existing tax laws that, if enacted, could increase our tax obligations in countries where we do business. If U.S. or other foreign tax authorities change applicable tax laws, our overall taxes could increase, and our business, financial condition or results of operations may be adversely impacted.
Risks Relating to Our Class A Shares
Future issuances of equity securities, which may include securities that would rank senior to our Class A shares, may cause dilution to our existing shareholders and adversely affect the market price of our Class A shares.
The market price of our Class A shares could decline as a result of sales of a large number of our Class A shares in the market, or the sale of securities convertible into a large number of our Class A shares. The perception that these sales could occur may also depress the market price of our Class A shares. On March 7, 2017, we issued 95,000 Series 4 convertible preference shares (the “Series 4 Preference Shares”) with an initial aggregate liquidation preference of $95.0 million, which will be convertible into Class A shares or our Series 5 convertible preference shares at a current conversion price of $7.42 per share. Pursuant to the Goldman Letter Agreement, the conversion price would (subject to the closing of the Transactions) be reduced to $5.00 per share, subject to entry into definitive documentation between MDC and the holder. On March 14, 2019, we issued 50,000 Series 6 convertible preference shares (the “Series 6 Preference Shares” and, together with the Series 4 Preference Shares, the “Preference Shares”) with an initial aggregate liquidation preference of $50.0 million, which will be convertible into Class A shares or our Series 7 convertible preference shares at an initial conversion price of $5.00 per share. The terms of the Preference Shares provide that the conversion price may be reduced, which would result in the Preference Shares being convertible into additional Class A shares upon certain events, including distributions on our Class A shares or issuances of additional Class A shares or equity-linked securities, at a price less than the then-applicable conversion price. The issuance of Class A Shares upon conversion of the Preference Shares would result in immediate and substantial dilution to the interests of our Class A shareholders. In addition, the holders of the Preference Shares may ultimately receive and sell all of the shares issuable in connection with the conversion of such Preference Shares, which could result in a decline in the market price of our Class A shares. The market price of our Class A shares may also be affected by factors, such as whether the market price is near or above the conversion price, that could make conversion of the Preference Shares more likely.
Further, the Preference Shares rank senior to the Class A shares, which could affect the value of the Class A shares on liquidation or, as a result of contractual provisions, on a change in control transaction. For example, pursuant to the related purchase agreements, the Company has agreed, with certain exceptions, not to become party to certain change in control transactions that are approved by the Board other than a qualifying transaction in which holders of Preference Shares are entitled to receive cash or qualifying listed securities with a value equal to the then-applicable liquidation preference plus accrued and unpaid dividends. See Note 15 of the Notes to the Consolidated Financial Statements for more information regarding the Series 4 Preference Shares and the Series 6 Preference Shares.
Additionally, any convertible or exchangeable securities that we issue may have rights, preferences and privileges more favorable than those of our Class A shares, and may result in dilution to owners of our Class A shares. Because our decision to issue additional debt or equity securities in any future offering will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future issuances. Also, we cannot predict the effect, if any, of future issuances of our Class A shares on the market price of our Class A shares.
Our shares of common stock are thinly traded and our stock price may be volatile.
The market price of our Class A Shares has been subject to wide fluctuations, and this volatility may continue. Among the factors that could affect the price of our Class A Shares are the risks described in this “Risk Factors” section and other factors, including:
• developments or announcements related to the Proposed Transactions;
• quarterly variations in our operating results compared to market expectations;
• changes in expectations as to our future financial performance;
• a lack of liquidity in the market for our Class A Shares;
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• actual or expected sales of our Class A Shares by our shareholders;
• general market conditions; and
• domestic and international economic, legal and regulatory factors, including the effect of COVID-19 on these factors.
Risks Relating to Our Indebtedness
The indenture governing the Senior Notes and the Credit Agreement governing our secured line of credit contain various covenants that limit our discretion in the operation of our business.
MDC has Senior Notes due 2024 outstanding in the aggregate principal amount of $870.3 million. The indenture governing the Senior Notes and the Credit Agreement governing our lines of credit contain various provisions that limit our discretion in the operation of our business by restricting our ability to:
• sell assets;
• pay dividends and make other distributions;
• redeem or repurchase our capital stock;
• incur additional debt and issue capital stock;
• create liens;
• consolidate, merge or sell substantially all of our assets;
• enter into certain transactions with our affiliates;
• make loans, investments or advances;
• repay subordinated indebtedness;
• undergo a change in control;
• enter into certain transactions with our affiliates;
• engage in new lines of business; and
• enter into sale and leaseback transactions.
These restrictions on our ability to operate our business in our discretion could seriously harm our business by, among other things, limiting our ability to take advantage of financing, mergers and acquisitions and other corporate opportunities. The Credit Agreement is subject to various additional covenants, including a senior leverage ratio, a total leverage ratio, a fixed charge coverage ratio, and a minimum EBITDA level (as defined per the Credit Agreement). Events beyond our control could affect our ability to meet these financial tests, and we cannot assure you that they will be met.
Our substantial indebtedness could adversely affect our cash flow and prevent us from fulfilling our obligations, including the Senior Notes.
The net carrying value of MDC’s indebtedness was $843.2 million, net of debt issuance costs, as of December 31, 2020. In addition, we expect to make additional drawings under the Credit Agreement from time to time. As a holding company, our ability to pay principal and interest on our indebtedness is dependent on the generation of cash flow by and distributions from our subsidiaries. Our subsidiaries’ business may not generate sufficient cash flow from operations to meet MDC’s debt service and other obligations. If we are unable to meet our expenses and debt service obligations, we may need to obtain additional debt, refinance all or a portion of our indebtedness on or before maturity, sell assets or raise equity. We may not be able to obtain additional debt, refinance any of our indebtedness, sell assets or raise equity on commercially reasonable terms or at all, which could cause us to default on our obligations and impair our liquidity. Our inability to generate sufficient cash flow to satisfy our debt obligations, to obtain additional debt or to refinance our obligations on commercially reasonable terms would have a material adverse effect on our business, financial condition and results of operations.
Further, we currently receive senior unsecured and long-term debt and corporate quality ratings from Standard & Poor’s Rating Services and Moody’s Investor Service Inc. Our ratings are subject to periodic review, and we cannot assure you that we will be able to retain our current or any future ratings. If our ratings are reduced from their current levels, this could further adversely affect our liquidity and our business, financial condition and results of operation.
If we cannot make scheduled payments on our debt, we will be in default and, as a result, our debt holders could declare all outstanding principal and interest to be due and payable; the lenders under the Credit Agreement could terminate their commitments to loan us money and foreclose against the assets securing our borrowings; and we could be forced into bankruptcy or liquidation. Our level of indebtedness could have important consequences. For example, it could:
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• make it more difficult for us to satisfy our obligations with respect to the Senior Notes;
• make it difficult for us to meet our obligations with respect to our contingent deferred acquisition payments;
• limit our ability to increase our ownership stake in our Partner Firms;
• increase our vulnerability to general adverse economic and industry conditions;
• require us to dedicate a substantial portion of our cash flow from operations to payments on our indebtedness, thereby reducing the availability of our cash flow to fund working capital and other activities;
• limit our flexibility in planning for, or reacting to, changes in our business and the advertising industry, which may place us at a competitive disadvantage compared to our competitors that have less debt; and
• limit, particularly in concert with the financial and other restrictive covenants in our indebtedness, our ability to borrow additional funds or take other actions.
Despite our current debt levels, we may be able to incur substantially more indebtedness, which could further increase the risks associated with our leverage.
We may incur substantial additional indebtedness in the future. The terms of our Credit Agreement and the indenture governing the 7.50% Notes permit us and our subsidiaries to incur additional indebtedness subject to certain limitations. If we or our subsidiaries incur additional indebtedness, the related risks that we face could increase.
We are a holding company dependent on our subsidiaries for our ability to service our debt.
MDC is a holding company with no operations of our own. Consequently, our ability to service our debt is dependent upon the earnings from the businesses conducted by our subsidiaries. Our subsidiaries are separate and distinct legal entities. Although our operating subsidiaries have generally agreed to allow us to consolidate and “sweep” cash, subject to the timing of payments due to noncontrolling interest holders, any distribution of earnings to us from our subsidiaries is contingent upon the subsidiaries’ earnings and various other business considerations. Also, our right to receive any assets of any of our subsidiaries upon their liquidation or reorganization, and therefore the right of the holders of common stock to participate in those assets, will be structurally subordinated to the claims of that subsidiary’s creditors. In addition, even if we were a creditor of any of our subsidiaries, our rights as a creditor would be subordinate to any security interest in the assets of our subsidiaries and any indebtedness of our subsidiaries senior to that held by us.
Risks Relating to the Proposed Transactions
The Proposed Transactions may give rise to taxable income in the United States for the Company and its subsidiaries, and there can be no assurances that material adverse tax consequences will not result from the Proposed Transactions or related transactions in Canada, the U.S., or other jurisdictions. Any such adverse tax consequences could adversely affect the Combined Company or its share price, following completion of the Proposed Transactions.
The Redomiciliation should qualify as a “reorganization” under section 368(a) of the Internal Revenue Code. Specifically, the Redomiciliation should be treated, for U.S. federal income tax purposes, as if the Company (i) transferred all of its assets and liabilities to a new U.S. corporation (MDC Delaware) in exchange for all of the outstanding stock of MDC Delaware and (ii) then distributed the stock of MDC Delaware that the Company received in the transaction to the Company’s shareholders in liquidation of the Company. Additionally, the Company expects the Business Combination to be treated as a deemed transfer by New MDC of its assets to OpCo and an assumption of New MDC’s liabilities by OpCo in a transaction intended to qualify as a contribution to OpCo in exchange for OpCo Common Units or OpCo Preferred Units under section 721 of the Internal Revenue Code of 1986, as amended, and any successor provision of U.S. federal law (the “Code”), and that Stagwell’s contributions of its businesses to OpCo is similarly intended to be subject to section 721 of the Code. Certain elements of the structure can be expected to give rise to corporate taxable income for the Combined Company. Additionally, because setting up the Up-C structure in the Business Combination involves a contribution by New MDC of its assets to OpCo, and an assumption by OpCo of New MDC’s liabilities, the flexibility of the Company, MDC Delaware, New MDC and OpCo to incur certain liabilities or fund certain expenses outside of the ordinary course of their businesses prior to effecting the Proposed Transactions will be significantly limited, including certain liabilities incurred in connection with implementing the Proposed Transactions, as such liabilities could trigger unanticipated tax costs for New MDC in connection with the implementation of the Proposed Transactions. To the extent that liabilities assumed by OpCo as part of the Proposed Transactions are viewed as non-ordinary course liabilities, such assumption may give rise to U.S. corporate taxable income for New MDC resulting from the assumption. Additionally, to the extent OpCo is treated as assuming such a liability, under relevant U.S. tax rules a portion of OpCo’s other liabilities may also be recharacterized and give rise to additional corporate taxable income for New MDC.
There can be no assurances that material additional adverse U.S. tax consequences will not result from the Proposed Transactions, and there can be no assurance that the Internal Revenue Service will agree with or not otherwise challenge the Company’s position on the tax treatment of the Proposed Transactions or of internal restructuring transactions undertaken prior
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to, after, or in connection with the Proposed Transactions, which could result in higher U.S. federal tax costs for the Combined Company than currently anticipated, including a reduction in the net operating loss carryforwards of Maxxcom Inc. (which will become tax attributes of the Combined Company as a result of the Proposed Transactions).
The Company has not applied for a ruling related to the Proposed Transactions and does not intend to do so. Any adverse tax consequences resulting from the Proposed Transactions or the operations of the Combined Company after the Proposed Transactions could adversely affect the Combined Company or its share price following the completion of the Proposed Transactions. Moreover, U.S. tax laws significantly limit the Combined Company’s ability to redomicile outside of the U.S. once the Proposed Transactions are complete.
The Redomiciliation may give rise to significant Canadian corporate tax.
As a result of the Redomiciliation, the Company expects to incur Canadian corporate tax liability in the amount of approximately $21 million. However, such amount is only an estimate and the actual amount of Canadian corporate tax liability may be significantly higher than the Company’s estimate.
For purposes of the Canadian Tax Act, the Company’s taxation year will be deemed to have ended immediately prior to it ceasing to be a resident of Canada as a result of the Redomiciliation. Immediately prior to the time of this deemed year end, the Company will be deemed to have disposed of each of its properties for proceeds of disposition equal to the fair market value of such properties at that time and will be deemed to have reacquired such properties for a cost amount equal to that fair market value. The Company will be subject to income tax under Part I of the Canadian Tax Act on any income and net taxable capital gains which arise as a result of this deemed disposition (after the utilization of any available capital losses or non-capital losses). The Company will also be subject to “emigration tax” under Part XIV of the Canadian Tax Act on the amount by which the fair market value, immediately before the Company’s deemed year end, of all of its properties exceeds the total of certain of its liabilities and the paid-up capital, determined for purposes of that emigration tax, of all the issued and outstanding shares of the Company immediately before such deemed year end.
The quantum of Canadian federal income tax payable by the Company as a result of the Redomiciliation will depend upon a number of considerations including the fair market value of its properties, the amount of its liabilities, the Canada-U.S. dollar exchange rate, its shareholder composition, as well as certain Canadian tax attributes, accounts and balances of the Company, each as of the time the Redomiciliation becomes effective on the Redomiciliation Effective Date (the “Redomiciliation Effective Time”). Prior to the Redomiciliation Effective Time, there is no certainty that the fair market value of the properties of the Company will not increase, and there is no certainty that the estimated fair market value of the properties of the Company or the amounts of its relevant tax attributes will be accepted by Canadian federal tax authorities, which may result in additional taxes payable as a result of the Redomiciliation. The Company has not applied to the Canadian federal tax authorities for an advance tax ruling relating to the Redomiciliation and does not intend to do so. Additionally, it is possible that valuations and implied valuations of the Company’s property are made available which may be relevant in assessing the potential Canadian tax costs of the Redomiciliation. As a result, the quantum of Canadian tax payable by the Company may significantly exceed the Company’s estimates that are reflected in the Form S-4. Any such adverse tax consequences could adversely affect the Combined Company and its share price.
If the IRS does not agree with the Company’s determination of the “all earnings and profits amount” attributable to the Company’s shares, certain U.S. Holders may owe a higher than anticipated amount of U.S. federal income taxes as a result of the Proposed Transactions (and specifically, the Redomiciliation).
Subject to the potential application of the passive foreign investment company (as defined under Section 1297 of the Code) rules, certain beneficial owners of the Company’s Class A Shares or Class B Shares that are, for U.S. federal income tax purposes, (i) individual citizens or residents of the United States; (ii) corporations created or organized in the United States or in any state thereof; (iii) estates the income of which is subject to United States federal income tax regardless of its source; or (iv) trusts if (a) a court within the United States can exercise primary supervision over the administration of the trust or (b) they have a valid election in place to be treated as a United States person and one or more United States persons has authority to control all substantial decisions of the trust (each such person, a “U.S. Holder”) that, at the time of the Redomiciliation, (i) own shares of the Company with a fair market value of $50,000 or more and (ii) would otherwise recognize taxable gain for U.S. federal income tax purposes with respect to their shares of the Company in connection with the Proposed Transactions (and specifically, the Redomiciliation), may make the “all earnings and profits” election with respect to their shares of the Company in lieu of recognizing such taxable gain. A U.S. Holder that validly makes such “all earnings and profits” election will be required to include in income, as a deemed dividend, the “all earnings and profits amount” (as defined under applicable Treasury Regulations) that is attributable, under U.S. tax principles, to such U.S. Holder’s shares of the Company. Additionally, U.S. persons that own directly, indirectly or constructively (under specified attribution rules), 10% or more of the total combined voting power or of the total value of all classes of the Company’s equity (each such person, a “10% U.S. Shareholder”) may be subject to special rules which depend on the Company’s calculation of its earnings and profits.
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The Company is currently in the process of determining its historical earnings and profits and also expects to determine its earnings and profits for the taxable year of the Redomiciliation ending with the date of the closing of the Redomiciliation (the “Redomiciliation Effective Date”). Although the Company will not complete this determination until after completion of the Proposed Transactions, the Company currently expects to have a significant amount of earnings and profits for the taxable year of the Redomiciliation. The calculation of “all earnings and profits” depends on the applicable shareholder’s period of ownership and the outcome may differ based on the particular shareholder. At this stage, there can be no assurances regarding the “all earnings and profits amount.” In general, the “all earnings and profits amount” attributable to the shares of the Company held by a particular U.S. Holder should depend on the Company’s accumulated earnings and profits from the date that the shares of the Company were acquired by such U.S. Holder through the Redomiciliation Effective Date. The determination of the Company’s earnings and profits is a complex determination and may be impacted by numerous factors. Accordingly, there can be no assurance that the IRS will agree with the Company’s determination of such earnings and profits.
If the IRS does not agree with the Company’s determination of the amount, timing or source of its earnings and profits, the earnings and profits of the Company may be greater than anticipated, and the effect of such earnings and profits on shareholder taxation may be greater than anticipated. In such case, a U.S. Holder that makes an “all earnings and profits” election or a 10% U.S. Shareholder could have a greater than anticipated “all earnings and profits amount” in respect of such U.S. Holder’s MDC shares and thereby recognize greater taxable income. In addition, MDC shareholders who receive “all earnings and profits” data from the Company may bring suit against the Company if such data is successfully disputed by the IRS.
U.S. Holders are strongly urged to consult their own tax advisors regarding the U.S. federal income tax consequences of the Proposed Transactions to them in their particular circumstances, including whether they would be considered 10% U.S. Shareholders, whether to make the “all earnings and profits” election where applicable, and the appropriate filing requirements with respect to this election
Additionally, special rules apply to 10% U.S. Shareholders. 10% U.S. Shareholders should consult their own tax advisors regarding the U.S. federal and other applicable tax consequences of the Proposed Transactions to them in light of their particular circumstances.
Completion of the Proposed Transactions may affect the timing of audit or reassessments by tax authorities.
The determination of income and other tax liabilities of the Company and its subsidiaries requires interpretation of complex domestic and foreign laws and regulations that are subject to change. The Company’s interpretation of taxation law may differ from the interpretation of the tax authorities. There are tax matters under review for which the timing of resolution is uncertain. While the Company believes that the provision for income taxes is adequate, completion of the Proposed Transactions may affect the timing of audit and reassessment of taxes by certain tax authorities, which reassessments may be without technical merit and possibly material.
The Company will allocate time and resources to effecting the Proposed Transactions and incur non-recurring costs related to the Proposed Transactions.
The Company and its management have allocated and will continue to be required to allocate time and resources to effecting the completion of the Proposed Transactions and related and incidental activities, including preparing the “all earnings and profits amount” attributable to the shares of the Company, which data certain U.S. Holders may request. There is a risk that the challenges associated with managing these various initiatives may have a business impact and that consequently the underlying businesses will not perform in line with expectations. This could have an adverse effect on the reputation, business, financial condition or results of operations of the Combined Company.
In addition, the Company expects to incur a number of non-recurring costs associated with the Proposed Transactions, including taxes, legal fees, advisor fees, proxy solicitor fees, filing fees, mailing expenses, financial printing expenses and other fees. There can be no assurance that the actual costs will not exceed those estimated and the actual completion of the Proposed Transactions may result in additional and unforeseen expenses. Many of these costs will be payable whether or not the Proposed Transactions are completed. While it is expected that benefits of the Proposed Transactions achieved by the Combined Company will offset these transaction costs over time, this net benefit may not be achieved in the short-term or at all, particularly if the Proposed Transactions are delayed or do not happen at all. These combined factors could adversely affect the business, results of operations or financial condition of the Combined Company.
The calculation of the number of Stagwell OpCo Units and the Stagwell Class C Shares to be issued will not be adjusted if there is a change in the value of Stagwell or its assets or the value of MDC before the Proposed Transactions are completed.
The calculation of the number of the Stagwell OpCo Units and the Stagwell Class C Shares to be issued to Stagwell in the Proposed Transactions will not be adjusted (i) if the value of the business or assets of Stagwell increases prior to the consummation of the Proposed Transactions or the value of MDC decreases prior to the Proposed Transactions, or (ii) if the value of the business or assets of Stagwell declines prior to the consummation of the Proposed Transactions or the value of MDC
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increases prior to the Proposed Transactions. MDC may not be permitted to terminate the Transaction Agreement because of changes in the value of Stagwell’s assets.
The Proposed Transactions may not be completed on the terms or timeline currently contemplated, or at all, as MDC and Stagwell may be unable to satisfy the conditions or obtain the approvals required to complete the Proposed Transactions or such approvals may contain material restrictions or conditions.
Completion of the Proposed Transactions is subject to numerous conditions, including the occurrence of, among other things, receipt of approvals and the satisfaction of other conditions, including (i) the receipt of the required shareholder approvals, and (ii) with respect to the Redomiciliation, authorization of the director duly appointed (the “Director”) under Section 260 of the Canada Business Corporations Act (the “CBCA”). Although the Company is diligently applying its efforts to take, or cause to be taken, all actions to do, or cause to be done, all things necessary, proper or advisable to obtain the requisite approvals, there can be no assurance that these conditions will be fulfilled or that the Proposed Transactions will be completed on the terms or timeline currently contemplated, or at all. MDC has and will continue to expend time and resources and incur expenses related to the Proposed Transactions. Many of these expenses must be paid regardless of whether the Proposed Transactions are consummated. Governmental agencies may not approve the Proposed Transactions, may impose conditions to the approval of the Proposed Transactions or require changes to the terms of the Proposed Transactions. Any such conditions or changes could have the effect of delaying completion of the Proposed Transactions, imposing costs on or limiting the revenues of the Combined Company following the Proposed Transactions or otherwise reducing the anticipated benefits of the Proposed Transactions.
Completion of the Proposed Transactions may trigger certain provisions in agreements to which the Company or a Stagwell Entity is a party.
The completion of the Proposed Transactions may trigger certain change in control, right of first offer, notice, consent, assignment or other provisions in agreements to which the Company or its subsidiaries are a party. In addition, while the Proposed Transactions will not result in an effective change of control of any Stagwell Entity, the completion of the Proposed Transactions may trigger certain technical provisions in agreements to which a Stagwell Entity is a party. If such Stagwell Entity is unable to assert that such provisions should not apply, or the Company or such Stagwell Entity are unable to comply with or negotiate waivers of those provisions, the counterparties may exercise their rights and remedies under the agreements, including potentially terminating such agreements or seeking monetary damages. Even if the Company or the applicable Stagwell Entity is able to negotiate waivers, the counterparties may require a fee for such waivers or seek to renegotiate the agreements on terms less favorable to the Combined Company.
Failure to complete the Proposed Transactions could adversely affect the market price of the Company’s Class A Shares as well as its business, financial condition and results of operations.
If the Proposed Transactions are not completed for any reason, the price of the Class A Shares may decline, or MDC’s business, financial condition and results of operations may be impacted to the extent that the market price of MDC’s shares reflects positive market assumptions that the Proposed Transactions will be completed and the related expected benefits will be realized; based on significant expenses, such as legal, advisory and financial services which generally must be paid regardless of whether the Proposed Transactions are completed; based on potential disruption of the business of MDC and distraction of its workforce and management team; and the requirement in the Transaction Agreement that, under certain limited circumstances, MDC must pay Stagwell a termination fee of $5,855,000.
Investors holding the Company’s shares prior to the completion of the Proposed Transactions will, in the aggregate, have a significantly reduced ownership and voting interest in the Combined Company after the Proposed Transactions and will exercise less influence over management.
Investors holding the Company’s shares prior to the completion of the Proposed Transactions will, in the aggregate, own a significantly smaller percentage of the Combined Company after the completion of the Proposed Transactions. On a pro forma basis (and (i) without giving effect to the conversion of any Combined Company Preferred Shares and (ii) including unvested restricted stock and restricted stock units of MDC), following the completion of the Proposed Transactions, it is anticipated that the existing holders of Class A Shares (including Stagwell) and Class B Shares will receive Combined Company Class A Common Shares and Combined Company Class B Common Shares equal to approximately 26% of the common equity of the Combined Company and Stagwell would be issued an amount of Combined Company Class C Common Shares equivalent to approximately 74% of the voting rights of the Combined Company and exchangeable, together with Stagwell OpCo Units, for Combined Company Class A Common Shares on a one-for-one basis at Stagwell’s election following a six-month holding period. Consequently, the Company’s shareholders, collectively, will be able to exercise less influence over the management and policies of the Combined Company than they will be able to exercise over the Company’s management and policies prior to the completion of the Proposed Transactions. However, the number of Stagwell OpCo Units, the number of Stagwell Class C Shares and the percentage of the Combined Company that Stagwell will hold following the consummation of the Proposed Transactions
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will each be reduced, and the percentage of the Combined Company that existing Company shareholders will hold will be proportionally increased, if Stagwell is unable to effect the certain restructuring transactions prior to the closing of the Proposed Transactions.
The announcement and pendency of the Proposed Transactions could have an adverse effect on the stock price of the Class A Shares as well as the business, financial condition, results of operations or business prospects of MDC and Stagwell.
The announcement and pendency of the Proposed Transactions could disrupt MDC’s and Stagwell’s businesses in negative ways. For example, customers and other third-party business partners of MDC or Stagwell may seek to terminate and/or renegotiate their relationships with MDC or Stagwell as a result of the Proposed Transactions, whether pursuant to the terms of their existing agreements with MDC and/or Stagwell or otherwise. In addition, current and prospective employees of MDC and Stagwell may experience uncertainty regarding their future roles with the Combined Company, which might adversely affect MDC’s and Stagwell’s ability to retain, recruit and motivate key personnel. Should they occur, any of these events could adversely affect the stock price of the Class A Shares, or harm the financial condition, results of operations or business prospects of, MDC or Stagwell.
Some of MDC’s directors and executive officers have interests in seeing the Proposed Transactions completed that may be different from, or in addition to, those of other MDC Canada Shareholders.
Certain of MDC’s directors and executive officers have interests in the Proposed Transactions that may differ from, or be in addition to, those of the Company’s shareholders generally. These interests may present such executive officers and directors with actual or potential conflicts of interest. These interests include, but are not limited to, the continued service of certain directors of MDC as directors of the Combined Company following the Proposed Transactions, the continued employment of all of MDC’s current executive officers by the Combined Company following the Proposed Transactions, the treatment in the Proposed Transactions of equity awards, and with respect to Mark Penn, potential receipt of distributions as a result of the Proposed Transactions and the ownership of interests in Stagwell. The members of the MDC Special Committee and the MDC Board of Directors (with the interested directors abstaining) were aware of these interests and considered them, among others, in their approval and adoption of the Transaction Agreement and the Proposed Transactions and their recommendation that the Company’s shareholders adopt the Transaction Agreement and approve the Proposed Transactions.
MDC and Stagwell may have difficulty attracting, motivating and retaining executives and other employees in light of the Proposed Transactions.
MDC and Stagwell may have difficulty attracting, motivating and retaining executives and other employees in light of the Proposed Transactions. Uncertainty about the effect of the Proposed Transactions on the employees of MDC and Stagwell may have an adverse effect on MDC and Stagwell. This uncertainty may impair MDC’s and Stagwell’s ability to attract, retain and motivate personnel until the Proposed Transactions are completed. Employee retention may be particularly challenging during the pendency of the Proposed Transactions, as employees may feel uncertain about their future roles with MDC or Stagwell after their combination. If employees of MDC or Stagwell depart because of issues relating to the uncertainty or perceived difficulties of integration or a desire not to become employees of MDC after the Proposed Transactions are consummated, MDC’s ability to realize the anticipated benefits of the Proposed Transactions could be reduced.
Litigation relating to the Transactions could result in an injunction preventing the completion of the Transactions and/or substantial costs to MDC.
Securities class action lawsuits and derivative lawsuits are often brought against public companies that have entered into acquisition, merger or other business combination agreements like the Transaction Agreement. Following the filing of our registration statement on Form S-4, dated February 8, 2021, three securities lawsuits have been filed against us and our directors relating to alleged omissions of material information in the Form S-4 with respect to the Transaction. Defending against these and any additional claims can result in substantial costs and divert management time and resources. An adverse judgment in any current or future claim could result in monetary damages, which could have a negative impact on MDC's liquidity and financial condition. The lawsuits that have been filed to date seek, and any additional lawsuits could also seek, among other things, injunctive relief or other equitable relief, including a request enjoin the parties from consummating the Proposed Transactions. One of the conditions to the closing of the Proposed Transaction is that no injunction by any governmental entity having jurisdiction over MDC has been entered and continues to be in effect and no law has been adopted, in either case that prohibits the closing of the Proposed Transactions. Consequently, if a plaintiff is successful in obtaining an injunction prohibiting completion of the Proposed Transactions, that injunction may delay or prevent the mergers from being completed within the expected time frame or at all, which may adversely affect MDC's business, financial position and results of operations.
There can be no assurance that any of the defendants will be successful in the outcome of the existing or any potential future lawsuits. The defense or settlement of any lawsuit or claim that remains unresolved at the time the mergers are completed may adversely affect MDC's business, financial condition, results of operations and cash flows.
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The COVID-19 pandemic triggered an economic crisis which may delay or prevent the consummation of the Proposed Transactions.
In March 2020, the World Health Organization declared the COVID-19 coronavirus outbreak a pandemic. The coronavirus has spread throughout the world and has resulted in unprecedented restrictions and limitations on operations of many businesses, educational institutions and governmental entities, including in the United States and Canada. Given the ongoing and dynamic nature of the COVID-19 crisis, it is difficult to predict the impact on the business of MDC and Stagwell, and there is no guarantee that efforts by MDC and Stagwell to address any adverse impact of COVID-19 will be effective. If MDC or Stagwell is unable to recover from a business disruption on a timely basis, the Proposed Transactions and the Combined Company’s business and financial conditions and results of operations following the completion of the Proposed Transactions would be adversely affected. The Proposed Transactions may also be delayed and adversely affected by the coronavirus outbreak, and become more costly. Each of MDC and Stagwell may also incur additional costs to remedy damages caused by such disruptions, which could adversely affect its financial condition and results of operations.
If the Proposed Transactions are consummated, the Combined Company will be subject to certain risks, including tax-related risks.
As more fully discussed in the Company’s Registration Statement on Form S-4 filed with the SEC on February 8, 2021 (the “Form S-4”), the Combined Company will be subject to certain risks, including risks related to the proposed Up-C structure, tax-related risks, risks that the expected benefits of the Proposed Transactions may not be realized, and risks related to the business of the Combined Company.
Item 1B. Unresolved Staff Comments
None.
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