Claims Trading Injunctions and Preservation of NOLs
First-day motions are an integral part of chapter 11 practice. Often, the orders entered on the first day of a case can have a substantial impact on the trajectory and outcome of the case. Some first-day motions are commonplace: applications to retain attorneys and other professionals, cash collateral or DIP financing motions, payroll motions and utilities motions. Many of the orders that result from these motions directly affect the interests of unsecured creditors in the case. Increasingly, however, bankruptcy courts are granting first-day motions that seek to enjoin creditors and shareholders from transferring their claims or their stock outside the bankruptcy case (anti-trading injunctions), often without prior notice to the affected parties. Chapter 11 debtors frequently have valuable net operating losses (NOLs), which management hopes can be carried forward to offset the taxable income that the reorganized company expects to produce. A debtor's desire to preserve, to the greatest extent possible, NOLs for use after confirmation of a plan is at the heart of the phenomenon of anti-trading injunctions. Creditors, particularly those holding large, unsecured claims against a debtor, should carefully scrutinize any motion seeking an anti-trading injunction to ensure that the interests of the debtor in preserving its NOLs are properly balanced against the creditors' interests in unrestricted alienation of their own property.
NOLs as Property of the Estate
The seminal case on NOLs as property of the estate is Official Comm. of Unsecured Creditors v. PSS Steamship Co. Inc. (In re Prudential Lines Inc.), 928 F.2d 565 (2nd Cir. 1991). In Prudential Lines, the creditors' committee and an unsecured creditor brought an adversary proceeding seeking to enjoin the debtor's parent from taking a worthless stock deduction after the commencement of the chapter 11 case. Under §382(g)(4)(D) of the Internal Revenue Code, the effect of that deduction by the parent would have been the complete elimination of a substantial NOL carry-forward. See Id. at 574. After conducting hearings in which the parent participated, the bankruptcy court entered preliminary and permanent injunctions prohibiting the parent from taking the deduction. See Id. at 568. The court found that the act of taking the deduction, although not aimed directly at the debtor, would have been an attempt to exercise control over property of the estate prohibited by 11 U.S.C. §362(a)(3). See Id.
On appeal, the Second Circuit held that a corporate debtor's right to use an NOL carryforward constituted property of the estate. See 928 F.2d at 573. The court also affirmed the bankruptcy court's holding regarding the stay violation, reasoning that "if [the parent] were allowed to take a worthless stock deduction...it would effectively eliminate the value of the NOL carryforward to [the debtor] and thus have an adverse impact on [the debtor's reorganization]." See Id. at 574. The Second Circuit also held that the bankruptcy court had the ability, under the equitable powers conferred by 11 U.S.C. §105(a), to enter the injunctions, given that the NOLs were property of the estate. It is now well-established that an NOL carryforward is property of a corporate debtor's estate. See, e.g., Gibson v. United States (In re Russell), 927 F.2d 414 (8th Cir. 1991); In re Phar-Mor Inc., 152 B.R. 924 (Bankr. N.D. Ohio 1993).
Section 382 of the Internal Revenue Code
In general, §382 severely limits a debtor's ability to use NOL carryforwards if the debtor undergoes an ownership change. See 26 U.S.C. §382(a), (b) and (k).1 An ownership change occurs if there is any change in the respective ownership of stock of a debtor and, after that change, the percentage of stock owned by any one 5-percent shareholder has increased more than 50 percentage points over the lowest percentage of stock owned by that shareholder during a three-year period. See 26 U.S.C. §382(g)(1) and (2). All shareholders owning less than 5 percent of the stock are aggregated and treated as a single "public group" shareholder.
If there is an ownership change, then the general rule of §382(b) limits the amount of NOLs that may be carried forward each year to the product of the value of the reorganized debtor multiplied by the long-term tax-exempt rate.2 This limitation typically causes a substantial reduction in the amount of NOL carryforwards that can be used in any year. For example, the debtors in the Conseco chapter 11 cases estimated that the general rule of §382(b) could have, depending on the market value of the equity in the reorganized company, limited them to approximately $7 million of NOL carry-forwards per year, destroying about $1.12 billion of NOLs having a potential tax savings of approximately $392 million. If possible, debtors are well-served by avoiding a plan of reorganization that results in an ownership change.
However, the absolute priority rule, 11 U.S.C. §1129(b)(2)(B)(ii), often mandates the issuance of stock in satisfaction of creditors' claims. In these circumstances, the reorganization plan will almost always create an ownership change. The Internal Revenue Code provides two types of relief to the debtor that undergoes an ownership change in a bankruptcy case: the "bankruptcy exception" set forth in §382(l)(5) and the "special valuation" rule set forth in §382(l)(6).
The "bankruptcy exception" provides that the general rule of §382 does not apply if, in a bankruptcy case, the shareholders and certain qualified creditors own at least 50 percent of the stock of the reorganized debtor.3 A qualified creditor is a creditor who receives stock in the reorganized debtor in satisfaction of debt (a) held at least 18 months prior to commencement of the bankruptcy case or (b) that arose in the ordinary course of the debtor's business and that has been held by the same creditor at all times. See 26 U.S.C. §382(l)(5)(E). Additionally, a creditor may be presumed to be a qualified creditor—even if the creditor's claim was purchased after the commencement of the case—if that creditor does not become, as a result of the ownership change, a 5 percent shareholder. See 26 C.F.R. §1.382-9(d)(3).
Unrestricted claims trading can limit the debtor's ability to confirm a plan that distributes at least 50 percent of the stock to qualified creditors, particularly if large claims are traded. To preserve the ability to fit within the §382(l)(5) bankruptcy exception, debtors typically structure anti-trading injunctions to apply to claims that could be expected to entitle the holder, under a plan, to receive approximately 5 percent of the stock in the reorganized debtor. See, e.g., Williams Communications Group Inc., Case No. 02-11957 (BRL) (Bankr. S.D.N.Y. July 24, 2002) (subjecting transfers of claims equal to or greater than $200 million to the transfer-approval procedures; $200 million was the smallest claim that could be reasonably anticipated to lead to a distribution of 5 percent of the stock in a reorganized entity); In re Service Merchandise Co. Inc., Case No. 02-11957 (GCP) (Bankr. M.D. Tenn. April 6, 2000) (subjecting holders of unsecured claims equal to or greater than 4 percent of the total estimated unsecured claims to the notification and waiting periods). If creditors who each receive less than 5 percent of the stock in the reorganized debtor own, in the aggregate, less than 50 percent of that stock, then the debtor can use the presumption created by Treasury Regulation §1.382-9(d)(3) to fit within the "bankruptcy exception," thereby sheltering NOLs from the general limitation imposed by §382.
Debtors who anticipate utilizing the "bankruptcy exception" to §382 also seek to restrict trading in equity securities prior to confirmation of a plan. Anti-trading injunctions are usually structured to prevent any 5 percent shareholder from increasing its ownership or to prevent any person from becoming a 5 percent shareholder prior to confirmation of a plan. See, e.g., In re Conseco Inc., Case No. 02-49671 (Bankr. N.D. Ill. Dec. 18, 2002); Metrocall Inc., Case No. 02-11579 (RB) (Bankr. D. Del. July 8, 2002).
If the "bankruptcy exception" does not apply (either because the requisite amount of stock was not distributed to qualified creditors or because the debtor made an election to opt-out of the bankruptcy exception, which is permitted by §382(l) (5)(H)), then §382(l)(6) provides a special valuation rule. Specifically, the value of the reorganized debtor is the lesser of (a) the value of the stock in the reorganized debtor immediately after the ownership change or (b) the value of the debtor's pre-confirmation assets. See 26 C.F.R. 1.382-9(j). As noted above, the §382(b) annual limitation is determined by applying a long-term tax-exempt rate to the value of the pre-confirmation debtor, a valuation that is typically tested immediately before the ownership change. See 382(b), (e)(1). Thus, the special valuation rule gives effect to the increase in value resulting from any surrender or cancellation of creditors' claims under a plan. This increase can alleviate the burden of an ownership change on a debtor. Creditors opposing the entry of an anti-trading injunction can argue that the special valuation rule is available to the debtor even if the safe harbor of the bankruptcy exception is not. Therefore, the argument goes, the debtor's NOLs would not be destroyed by unrestricted claims trading (as they would have been in Prudential Lines by the worthless stock deduction), but only reduced.
In addition, the special valuation rule of §382(l)(6) does not require the payment of a "toll charge," which the debtor must pay if it uses the "bankruptcy exception." Therefore, the effect of unrestricted claims trading may not be as deleterious as the debtor contends.
Enforcement of the Automatic Stay
Acutely aware of §382 and its limitations, debtors are seeking orders restricting post-petition claims trading and equity transfers. Using Prudential Lines as their primary authority, debtors have been successful in convincing bankruptcy courts that certain claims and/or equity trading constitute an act to exercise control over the debtors' NOLs in violation of the automatic stay. Typically, debtors seek to impose transfer restrictions, notification procedures and waiting periods that must be complied with before the transfer of any restricted claim or interest can be deemed effective. The waiting periods typically range from 10-30 days from the date that notice of the intended transfer is given to the debtor. In the absence of an objection from the debtor, then the transaction can proceed (subject, of course, to applicable non-bankruptcy laws). If the debtor files an objection, then the transaction cannot be deemed effective until the entry of an order by the bankruptcy court permitting the transaction. These procedures are designed to give the debtor an opportunity to obtain injunctive relief to prevent the elimination or even reduction in the value of the debtors' NOLs. They also, however, cause a loss of liquidity for creditors' claims and can impose substantial burdens on creditors, indenture trustees, broker/dealers, and other parties involved in the purchase or sale of publicly-traded securities.
Many of the anti-trading injunctions are being entered without prior notice to the holders of the restricted equities or claims and without the initiation of an adversary proceeding. Even though orders limiting trading of claims or stock involve the grant of injunctive relief, courts have determined that, notwithstanding Fed. R. Bankr. P. 7001, an adversary proceeding is not required to obtain such orders. See In re First Merchants Acceptance Corp., 1998 U.S. Dist. LEXIS 21390 (Bankr. D. Del. 1998); In re Phar-Mor Inc., 152 B.R. 924 (Bankr. N.D. Ohio 1993). In Phar-Mor, the court determined that the motion was, in essence, an attempt to enforce the automatic stay. Thus, the debtors only needed to establish the existence of property of the estate (i.e., the NOLs) and an attempt to exercise control over that property (i.e., the trading of certain shares) in order to be entitled to the relief they sought.
The lesson from anti-injunction orders is clear: Any creditor holding large unsecured claims that may seek to sell those claims or to acquire additional claims should consider filing a motion for relief from the automatic stay. The motion should be filed as soon as possible after the commencement of the case and, if possible, before the debtor has an opportunity to obtain an anti-trading injunction containing a burdensome waiting period.
Alternatively, the creditor should attempt to limit the breadth of the anti-trading injunction by filing and prosecuting an objection to the debtor's motion. For example, a creditor may be able to limit the debtor's ability to object to a proposed transfer until such time as the aggregate amount of the previously-transferred claims approaches the 50 percent requirement of the "bankruptcy exception." The objecting creditor may also be able to shorten the notification and/or waiting periods, or the time within which the court must conduct a hearing to consider any objection filed by a debtor. See 11 U.S.C. §362(e). Absent the grant of a motion for relief from the automatic stay or a carve-out in the anti-trading injunction that permits claims-trading that will not adversely affect the debtor's NOLs, the creditor may find itself stuck in line, possibly waiting for a reorganization plan to be proposed and confirmed before it receives any payment on account of its claim.
2 "New loss corporation" and "old loss corporation" are terms used extensively throughout §382. This article uses "reorganized debtor" to refer to a new loss corporation and "debtor" to refer to an old loss corporation. If a debtor's plan does not result in an ownership change, however, the reorganized debtor never becomes a new loss corporation and, accordingly, is not subject to §382. Return to article
3 There is a toll charge for use of the "bankruptcy exception": the reorganized debtor's NOLs are reduced by the amount of interest paid or accrued on the debt converted into equity under a plan during the tax year in which the ownership change occurs and during the three prior tax years. See 26 U.S.C. §382(l)(5)(B). Return to article