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Companies Should Consider Adopting Net Operating Loss Rights Plans in the Wake of the Coronavirus (COVID-19) to Protect Net Operating LossesMarch 20, 2020
As boards of directors consider measures to limit the fallout from the coronavirus (COVID-19) pandemic, they should examine their companies’ ability to use net operating losses (NOLs) against future income, including NOL carryforwards and current NOLs resulting from the pandemic. Stock market volatility, share price drops, significant cuts to interest rates, and the recently proposed Section 382 regulations1 may all contribute to a significant diminution in the value of a company’s NOLs should an ownership change occur. In light of this risk, companies and their boards may want to consider adopting an NOL rights plan (or “tax benefit preservation plan”), as this may be an effective measure to prevent certain ownership changes, thereby preserving potentially valuable corporate tax assets.
At the time of writing, Senate Republicans have introduced legislation that, among other things, would enhance the value of NOLs where no “ownership change” (discussed below) has taken place. In its current form, this legislation would provide no relief to companies that undergo an ownership change, making measures to prevent such an ownership change even more critical to companies with NOLs.
Very generally, when a company with NOLs (a “Loss Company”) undergoes an “ownership change,”2 Section 382 of the Internal Revenue Code of 1986 as amended (the “Code”) limits the annual use of the Loss Company’s NOLs and certain other tax attributes for taxable periods following an ownership change. The Section 382 “base” limitation is measured by the value of the Loss Company on the change-of-control date3 multiplied by the then-prevailing federal long-term tax-exempt rate (1.63% for March 2020).4 This Section 382 base limitation is increased by the amount of any recognized built-in gain (RBIG) or reduced by the amount of any recognized built-in loss (RBIL) during the five-year period following the ownership change date (the “Recognition Period”). The purpose of this adjustment to the base limitation is to provide neutrality between the tax result that would have been obtained for a Loss Company if the assets giving rise to a net unrealized built-in gain (i.e., the amount by which the fair market value of those assets exceeds the Loss Company’s adjusted basis in such assets) (NUBIG) or a net unrealized built-in loss (i.e., the amount by which the Loss Company’s adjusted tax basis in its assets exceeds their fair market value) (NUBIL) had been sold shortly prior to the ownership change and the result that would obtain if the assets in question were sold during the Recognition Period. Complicated rules govern the measurement of RBIGs, RBILs, NUBIGs, and NUBILs under current law, and, proposed regulations issued on September 9, 2019 and January 10, 2020 would, once finalized, significantly reduce the measurement of RBIG and NUBIG for purposes of the relevant calculation. These proposed regulations, if finalized in their current form, are expected to have an adverse effect on Loss Companies.
Importantly, once a Section 382 limitation is in place for any NOLs, the limitation will remain in place as a ceiling on a Loss Company’s ability to use such NOLs. It is, therefore, critical, in situations where it is not possible to obtain a high Section 382 limitation, to try and avoid the occurrence of a change in control to the extent possible.
Because a Loss Company’s annual Section 382 NOL limitation is largely a function of the Loss Company’s value multiplied by the prevailing long-term tax-exempt rate, the consequences of the coronavirus (COVID-19) pandemic, falling share prices, and interest rates have created a perfect storm of factors to severely limit the use of NOLs following an ownership change. Accordingly, Loss Companies may want to consider whether an NOL rights plan (described below) may help avoid an ownership change during this period to preserve the value of their NOLs in the future.
One other mechanism Loss Companies have used to protect their NOLs is a charter provision that prohibits shareholders from acquiring 5% positions in their stock and subjects shareholders to potential forfeiture of shares if this 5% threshold is exceeded. This restriction would reduce the chances that a Loss Company would undergo an ownership change by limiting the number of 5% shareholders that would be included in the relevant calculation. Adopting such a charter provision, however, generally requires shareholder approval, which may be difficult to secure during a liquidity crisis before the actual occurrence of an ownership change.
An alternative to a charter amendment is a board-adopted “NOL rights plan.” Intended to limit shareholders’ ability to cross the 5% ownership threshold, this type of rights plan can have a secondary effect of preventing existing 5% shareholders from accumulating additional shares, although a board’s deliberations should clearly reflect the board’s rationale and judgment to adopt the rights plan for the purpose of protecting the company’s NOLs. Mechanically, an NOL rights plan permits shareholders to acquire (through a buy-in or exchange feature) additional shares at a discount if a shareholder would otherwise cross the 5% threshold or, in the case of an existing 5% shareholder, increase its ownership percentage. The NOL rights plan is similar, but is triggered at a lower (5%) beneficial ownership threshold than other more traditional forms of so-called “poison pills.”
Any NOL rights plan would need to be tailored for the particular Loss Company adopting it, but any such plan would tend to have common features that include:
- Grandfathering of existing 5% or greater shareholders up to their current ownership percentage;
- A measurement of beneficial ownership that tracks Section 382 of the Code and the Treasury regulations promulgated thereunder.
- This measurement method may be particularly important where a Loss Company has significant institutional investors, as it generally would permit the Loss Company to track ownership on a fund-by-fund basis rather than by reference to an entire fund family.
- The measurement method would also track coordinated activity by otherwise unrelated parties and acquisitions by way of derivative instruments or similar arrangements.
- Board discretion to waive the application of the poison pill dilution in a situation that is not expected to result in an ownership change or is not expected to jeopardize NOLs.
A limitation on the effectiveness of an NOL rights plan worth noting is that it cannot prevent existing 5% shareholders from selling their positions, even though such sales may affect the ownership change determination. In addition, the anti-dilutive rights cannot be forcibly implemented, particularly where the exercise right depends on shareholders to exercise their right to purchase additional shares for cash.
In addition to tax considerations, Loss Companies should carefully consider and consult with counsel about governance issues and other related non-tax implications to the adoption of an NOL rights plan and the detailed structure of the associated dilutive rights. Adoption of the rights plan will need to comply with state corporate law, stock exchange listing, and applicable federal securities law requirements. Companies should also consider how a NOL rights plan will be received by shareholders and proxy advisors such as Institutional Shareholder Services (ISS) before adopting any plan. Generally, ISS will recommend against one or more of a company’s director nominees if a company adopts a rights plan, including an NOL rights plan, and does not seek stockholder ratification of the plan at the company’s next annual meeting of shareholders. However, ISS will be more accommodating if the NOL rights plan is presented for shareholder ratification after adoption, provided that it has a term of three years or less. Under its current voting policy, ISS will consider these proposals on a case-by-case basis after considering the following factors and assuming the plan has a term of the shorter of three years (or less) and exhaustion of the NOLs: (i) the ownership threshold that would trigger the rights plan (with ISS understanding that these plans generally have a trigger of slightly less than 5%); (ii) the value of the NOLs; (iii) shareholder protection mechanisms (sunset provision or commitment to cause expiration of the pill upon exhaustion or expiration of NOLs); (iv) the company’s existing governance structure, including board independence, existing takeover defenses, track record of responsiveness to shareholders, and any other problematic governance concerns; and (v) any other relevant factors.
Important structural considerations include whether the plan will require a buy-in or allow cashless exchange of rights for additional shares (or both, giving the board flexibility) and how the dilutive measures will be implemented in practice (e.g., by setting up a trust to facilitate the issuance of new shares to shareholders that elect to exercise the exchange right).
Given the inherent inability to (i) prevent sell-downs by greater than 5% shareholders and (ii) force other shareholders to purchase additional shares pursuant to the dilutive rights (at least if a cashless exchange feature is not utilized), an NOL rights plan admittedly cannot prevent every ownership change. However, as NOLs begin to accumulate, stock prices remain low, and interest rates approach zero, Loss Company’s boards of directors should, nevertheless, give careful consideration to whether an NOL rights plan may be useful for purposes of protecting a valuable corporate asset.
2 An ownership change refers to any acquisition of more than 50% of a corporation’s equity by certain “5% shareholders” during a three-year testing period. Such an ownership change may occur pursuant to a restructuring in bankruptcy, an M&A transaction, or the accumulation of shares by significant holders.
3 In the case of a publicly traded company, this is measured by the prevailing trading price of its shares.
4 The March long-term tax-exempt rate was set prior to the substantial interest rate cuts by the Federal Reserve to near zero. The long-term tax-exempt rate for April and succeeding months is likely to be significantly lower.
This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Alexander Anderson, an O’Melveny partner licensed to practice law in New York, Robert Blashek, an O’Melveny partner licensed to practice law in California and New York, Robert Fisher, an O'Melveny partner licensed to practice law in California, Robert Plesnarski, an O'Melveny partner licensed to practice law in the District of Columbia and Pennsylvania, Shelly Heyduk, an O’Melveny partner licensed to practice California, Luc Moritz, an O’Melveny partner licensed to practice law in California, and Billy Abbott, an O’Melveny counsel licensed to practice law in California and New York, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.
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