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Sacrificing Liquidity and Accountability on the Altar of NOL Preservation
May 9, 2007
Chapter 11 debtors frequently seek to limit trading to preserve potential value in tax net operating losses or "NOLs." In response to cries of "preserving estate value," many bankruptcy courts have approved these trading restrictions. More recently, however, courts have recognized that inherent policy conflicts exist and have started including some qualifications to NOL trading orders. In any event, the debtors' recent objection in In re Global Power Equipment Group Inc., et al., Case No. 06-11045 (Bankr. Del. April 19, 2007), to a fund's proposed $12 million trade serves an important reminder of how trading orders can raise thorny issues.
The alleged face value of unrestricted NOL use certainly enjoys "sound-bite" value, sometimes touted in billions of dollars. Admittedly, there is drama in obscure tax benefits. However, even in the face of temptation it remains important to thoroughly cross-examine the facts and underlying assumptions that drive the analysis. NOL trading orders carry very real costs, borne by the very holders to be restricted: e.g., lost liquidity impacts not only buyers but also sellers seeking to realize value; and the entrenching effect of the governance provisions that "come with" the order is a lasting burden borne by new owners.
NOLs AND OWNERSHIP CHANGES
NOLs are valuable because they can shield operating income and increase cash flow by reducing future corporate taxes. Section 382 of the U.S. Tax Code restricts "trafficking in NOLs" – that is, a buyer reducing overall tax liabilities by acquiring control of a loss-making entity to use the target's NOLs. Section 382 accomplishes this goal by limiting use of NOLs if, generally speaking, the company undergoes an "ownership change" shifting more than 50% of the stock to certain new holders. It is important to note that this ownership change does not result in the loss of NOLs; rather, the subject company's NOL usage is merely capped at a fixed amount each year. The core issue is timing of NOL use, not the absolute amount.
Of course, bankruptcy often shifts ownership from shareholders to creditors. Rather than simply restrict all NOL use following a bankruptcy, Section 382 provides for exceptions that may permit unrestricted use of NOLs. One exception generally treats as exempt "old and cold" shareholders those creditors receiving equity who were either (1) trade claimants or (2) other creditors receiving stock in respect of claims held by them for at least 18 months prior to the bankruptcy.
In order to ensure a large class of "exempted" continuing holders, a trading order may require that current 5% holders of a class of claims (or any person who will become a 5% holder following a trade) provide advance notice of any proposed trades. Debtors may either approve the trade or deny it if they believe it could trigger an ownership change. In most cases, the practical effect of an NOL trading order is simply to prevent any significant accumulations. Liquidity (and accountability) is impaired, with trading restricted and control over the reorganization process made more diffuse.
SOME OBSERVATIONS FROM GLOBAL POWER
In Global Power, the trading procedures required holders of claims in excess of $5.5 million to notify Global Power prior to effectuating trades. After receiving notice, Global had 10 business days in which to object to a proposed trade. On April 5, 2007, Global Power received notice of a potential trade involving $12 million of its convertible notes. On April 19, 2007, Global Power objected to the trade because "depending" on the ultimate valuation and subject to the outcome of pending negotiations, its plan of reorganization "may" involve issuing new common stock in the reorganized company in whole or partial satisfaction of claims, such as the convertible notes. Global Power argued that, under potential scenarios, the proposed trade could result in an ownership change. As of this writing, the bankruptcy court has not heard the objection.
SO MUCH SACRIFICE FOR "MAYBE" AND " DEPENDING"?
Certain things are clear from NOL trading orders: First, these orders are barriers to the market for freely trading in securities and prevent accumulating significant positions useful to drive the reorganization process. Furthermore, the restrictions do not end on emergence: indeed, Section 382 imposes a two-year look back that, if violated, destroys the entire NOL. Debtors must adopt post-emergence charters that restrict 5% equity owners, adding to the "injury" of lost liquidity the "insult" of management entrenchment. That last point bears repeating – if the debtor seeks unrestricted NOL use, the entire NOL will be forfeited (rather than merely restricted to yearly use caps) if ownership changes within two years of emergence. Under the auspices of NOL preservation, and ostensibly for "shareholder benefit," rights to sell or buy are restricted, shareholder influence is limited and post-emergence M&A options are reduced.
NOL value analysis is never perfectly certain: the total amount remaining is subject to question; the projected incremental value of full use versus capped use is hardly clear; and the potential for post-emergence M&A raises a very basic question. Global Power's objection itself reveals assumptions underlying the NOL order's assertions, assumptions that may or may not stand up to real scrutiny. For example, in Global Power, the court is specifically asked to make assumptions involving (1) the company's ultimate valuation, (2) the outcome of negotiations with the committees and (3) the possibility that its chapter 11 plan of reorganization would involve the issuance of a new common stock to certain parties. Furthermore, NOL orders provide only possible incremental value – that is, without the order, the NOL will continue subject to yearly use caps based on equity value at emergence. Add to this mix the very real fact that an ownership change post-emergence can forfeit the entire NOL, and it becomes clearer that NOL orders are not simply about preserving "all options."
Many important assumptions must be tested, especially when you consider that only incremental value is to be preserved. By way of example only: (i) has an "ownership change" already occurred under Section 382? (ii) what is the projected full amount of the NOL that remains after the debt cancellation in the reorganization? (iii) what are the tax attributes among corporate assets and corporate subsidiaries (and impact to such attributes of the reorganization)? (iv) what actually is the projected post-emergence net taxable income? (v) what is the impact of the capital expenditure budgets and related depreciation? (vi) is the real exit post-emergence to be a sale in the near future? Even within two years?
Only after fully analyzing the many core assumptions and underlying facts can one develop and test a credible model to compare and contrast the projected benefits of one type of NOL treatment (full usage, with severe liquidity restrictions) over another (capped usage, with no liquidity restrictions).
The "optionality" that debtors seek to preserve through trading orders comes at quite an expense. Not only do NOLs have inherently uncertain value, the actual incremental value of taking one approach rather than another may not be clear or withstand even light scrutiny. Finally, if the approach of preserving unrestricted NOL use is taken, that choice comes with consequences that restrict governance and hinder certain sales post-emergence.
At a minimum, interested parties should seek expert advice from those experienced with NOLs. Rather than merely sacrifice liquidity and accountability in the face of an alleged tax benefit, stakeholders should be proactive: First, urge debtors to explore other types of plan mechanics and distributions that obviate the need for trading restraints (e.g., directed cash, debt or stock distributions to certain creditor classes or types of creditors so as to avoid a "change of ownership" under the rules). Second, work with debtors to understand the real potential for incremental gain (current claim holders are the future owners after all!). Third, stand up and be heard: don't merely accept that NOL orders are standard devices from previous cases; instead, scrutinize the offered benefits and request that they be weighed against the detriments.
No party should simply acquiesce to reflexive trading limitations that so clearly impact current as well as future liquidity, governance and value. There is no equity in targeting the traders here. Value for all is reduced when trading orders limit the pool of distressed debt purchasers, not only by reducing available buyers but also by increasing the costs of managing the reorganization process. Modern corporate governance shows that entrenching devices that limit large accumulations have costs that befall big and small alike. In this light, it is not unrealistic to expect some cross-examination of hypothetical scenarios proffered to restrict trading and tie up the capital structure. Indeed, given the burdens that any party typically seeking a preliminary injunction must satisfy (e.g., likelihood of success on the merits, irreparable harm, equities, etc.), courts should not avoid demanding a record with more than merely conclusory and/or speculative benefits.