Net operating losses (NOLs) represent a valuable asset for corporations realizing a net loss in a given year. The Internal Revenue Code permits taxpayers, including corporations, to carry forward NOLs to offset against taxable income and reduce tax liabilities for future years. However, as they are generally not transferable, the IRS Code limits corporations from utilizing NOLs following a change in ownership.
Pursuant to Section 382 of the IRS Code, an ownership change occurs when the percentage of a corporation’s equity held or beneficially owned by persons holding 5 percent or more of the corporation’s stock increases by more than 50 percentage points over the lowest percentage of equity owned by such shareholders at any time during the preceding three-year period or since the last ownership change. An ownership change can also result from a worthless stock deduction claimed by any person or entity owning 50 percent or more of the corporation’s stock. Sections 382 and 383 of the IRS Code limit the amount of future taxable income if an ownership change occurs, that may be offset by a corporation’s pre-change losses and excess credits, which include the corporation’s NOLs.
When a corporation files for protection under Chapter 11 of the U.S. Bankruptcy Code, it can set off a flurry of activity by shareholders, including both trading — as shareholders seek to dump their stock before losing any more value and distressed debt investors seek to acquire such stock at a discount — as well as claiming deductions for worthless stock. Once NOLs or other similar tax credits are limited under Sections 382 and 383 of the IRS Code, their use is limited forever. When a corporation files for Chapter 11 protection and the resulting transfers of stock result in an ownership change before the corporation’s exit from Chapter 11, such transfer may negatively impact the corporation’s ability to utilize its NOLs to offset tax liabilities following successful restructuring.
A successful Chapter 11 restructuring almost always results in a change of ownership because equity cannot retain its ownership unless all unsecured creditors first get paid. However, under specified circumstances, the IRS Code permits a debtor to retain its NOL credits during a Chapter 11 restructuring, notwithstanding substantial change of equity holders under a confirmed Chapter 11 plan. Therefore, where valuable NOL credits are in play, a debtor may need to limit any potential for ownership change during a Chapter 11 case that could negatively affect its ability to utilize NOL carryovers after emerging from bankruptcy.
Accordingly, debtors are interested in closely monitoring their shareholders’ identities during a Chapter 11 case and potentially limiting trading. It has become increasingly common for corporate Chapter 11 debtors to seek the intervention of the bankruptcy courts at the outset of the case to place limits on stock trading and prevent any change in ownership that could impact the availability of NOL credits and, in turn, the value of the corporation’s bankruptcy estate. Such relief is often sought via a first-day motion — i.e., a motion filed on the first day of the bankruptcy case — requesting entry of both preliminary and final orders enjoining shareholders from transferring stock, requiring shareholders to provide notice of any material transfer, voiding any transfers that are made without such notice and/or limiting the shareholders’ ability to take a worthless stock deduction. Although the Bankruptcy Code does not expressly authorize bankruptcy courts to impose such injunctive relief, courts reason that NOL credits represent a valuable asset of the bankruptcy estate that must be protected via trading injunctions, finding justification for such relief in Section 362(a)(3) of the Bankruptcy Code, which acts as a stay of “any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate.” (See In re Prudential Lines, 928 F.2d 565 (2d Cir. 1991).)
Because trading injunctions typically are sought early in Chapter 11 cases, and the bankruptcy courts usually adjudicate first-day motions on an expedited basis, stock trading injunctions may be entered before many creditors or shareholders are even aware of the bankruptcy filing or have time to get their arms around such requests and appropriately respond. It is important for institutional investors, upon learning of a corporation’s bankruptcy filing, to promptly consult with bankruptcy counsel to determine whether the debtor is seeking a trading injunction and the impact that any such injunction will have on the investors’ ability to trade their shares or claim a deduction for stock that has become worthless.
Among other things, a holder of a debtor’s equity must quickly address the following questions:
- Has the debtor requested a trading injunction?
- What is the scope of any such request?
- What equity threshold would trigger trading restrictions or notice requirements (typically around 5 percent)?
- What form of notice is required to be provided to the debtor before a transfer of stock?
- Are there any substantive objections that should be raised to the request for a trading injunction?
Because the specifics of each request for a trading injunction will depend on the circumstances, the exact terms of a trading injunction will vary from case to case. Trading injunctions might include provisions that enjoin the transfer of equity interests outright. Such injunctions should be tailored and limited to investors holding 5 percent or more of the debtor’s stock. In addition, trading injunctions may provide for a prohibition on trading that is only triggered upon a certain dollar amount of claim trades. These injunctions may limit claims trading to protect a debtor’s ability to preserve NOLs through a confirmed plan. When an investor has owned 50 percent or more of a debtor’s stock during the prior three-year period, debtors may seek to limit investors’ ability to take a worthless stock deduction, which could also result in a loss of NOL tax deductions.
Although corporate Chapter 11 debtors may have a strong interest in protecting their NOL carryovers and trading injunctions may well preserve value for a debtor’s bankruptcy estate, the imposition of trading injunctions is strong medicine, and the practice is not without its critics. Critics assert that Congress never intended the automatic stay imposed by Section 362 of the Bankruptcy Code to extend to NOLs. They claim the automatic stay is intended to limit actions to exercise possession or control over estate property and should not be extended to limit investors’ ability to exercise their rights for their property — i.e., their stock holdings — simply because such exercise may have an incidental effect on a debtor’s NOLs. Critics have also argued that the imposition of trading injunctions goes far beyond the bankruptcy court’s equitable powers and that trading injunctions violate the Fifth Amendment by interfering with shareholders’ property rights.
In consultation with bankruptcy counsel, shareholders should consider whether any requested trading injunction is overly broad and has a greater limiting effect than is necessary to protect the debtor’s NOL carryovers. Where trading injunctions are sought on the first day of a Chapter 11 filing, shareholders may argue that such injunctions are premature, particularly where the value or utility of the debtor’s NOLs has yet to be determined, and no plan of reorganization has been formulated. At the outset of a case, a debtor likely cannot show that it will generate future taxable income before the NOLs expire or that its NOLs have not already been limited by pre-bankruptcy trading.
To obtain a preliminary trading injunction in connection with a first-day motion, a debtor must show:
- The debtor is likely to succeed on the merits.
- The debtor will suffer irreparable harm without the injunction.
- Whether the injunction will harm others or serve the public interest.
As some critics have noted, these standards are challenging to establish on the first day of a Chapter 11 case because a debtor will have difficulty showing that successful reorganization and future profits are likely or that NOL credits will be limited without such an injunction. (See “Winning Losses: Trading Injunctions and the Treatment of Net Operating Loss Carryovers in Chapter 11,” Yale Journal on Regulation, Vol. 32 (2015).)
Trading injunctions frequently include provisions rendering stock trades void ab initio where an affected investor fails to provide the debtor with the requisite notice required by the court’s order. Accordingly, consultation with bankruptcy counsel is necessary regardless of whether a shareholder intends to challenge the imposition because noticing provisions might impose affirmative reporting obligations upon the shareholder.
Meet the Authors
Matts Batryn is a member of the firm’s business department, representing commercial banks, investment funds, private equity sponsors, non-bank lenders and public and private corporations in structuring secured and unsecured credit facilities, including acquisition financings, syndicated loans, asset-based loans, real estate secured transactions and debtor-in-possession facilities.
Daniel Pereira concentrates his practice on bankruptcy, insolvency and related matters. Daniel advises clients on a wide array of issues, including both transactional and litigation matters. Although Daniel primarily focuses his practice on representing creditors, he also has experience representing debtors and other interested parties, particularly foreign debtors, in cross-border insolvency and restructuring proceedings.