In previous Alerts, we have addressed the complexities of claims in bankruptcy. Likewise, trading in claims and securities can present challenges. Difficulties have arisen in large Chapter 11 reorganizations as constituencies engaged in the Chapter 11 process, who are major players in the case, seek to trade in securities relating to that case. This Alert explores the impact that some trading activities may have on potential recoveries in the bankruptcy and the help (and impact) of the Internal Revenue Code.
Section 382 of the Internal Revenue Code limits the amount of net operating losses (and certain other tax attributes) that can be utilized to offset future taxable income of a loss corporation, if a "section 382 ownership change" occurs. The IRS has ruled in Private Letter Ruling 200713015 (the "PLR") that certain shares of stock of a bankrupt corporation (we'll call it "LossCo") that were actually acquired by an entity (we'll call it "Acquiror") will be treated as if they were not acquired for purposes of determining whether LossCo underwent a section 382 ownership change. The rationale underlying the PLR could create meaningful opportunities for corporations in bankruptcy to preserve what could be a significant, but otherwise lost, tax attribute – its net operating losses. In addition, the facts of the PLR serve as a reminder of the importance in the bankruptcy context of being vigilant so as not to inadvertently sacrifice valuable tax attributes.
The rules for determining whether a section 382 ownership change has occurred are complex. However, a section 382 ownership change generally occurs if there is a greater than 50% change in stock ownership of the loss corporation (by value) at any time during a testing period. A testing period can be no more than three years, but can be less.
In the PLR, LossCo stock was publicly traded and widely held. LossCo had financial difficulty and was generating net operating losses. As a result of this financial difficulty, LossCo, and certain of its subsidiaries, filed voluntary bankruptcy petitions. Subsequent to these filings, LossCo filed a motion requesting that the bankruptcy court impose trading restrictions on LossCo's stock (the "Trading Order"). This motion was granted. However, between the time that the motion was filed and granted, sufficient LossCo stock was acquired by Acquiror (the "Total Shares") to cause LossCo to undergo a section 382 ownership change. Acquiror's acquisition of LossCo stock would have violated the terms of the Trading Order had it been in effect at the time of the stock acquisition.
Recognizing the potential dilemma, LossCo and Acquiror proceeded to calculate the number of shares of LossCo stock that could be purchased by Acquiror without causing LossCo to undergo a section 382 ownership change (the "Safe Shares"). Thereafter, both LossCo and Acquiror asked the bankruptcy court for help. The bankruptcy court obliged and ordered that Acquiror's purchase of the number of shares equal to the Total Shares less the Safe Shares, or the excess shares (the "Excess Shares"), be void ab initio, and that Acquiror was obligated to sell the Excess Shares back to the public (the "Stipulation and Order"). Acquiror was also obligated to donate any gain from the sale of the Excess Shares to a charity selected by LossCo. Acquiror sold the Excess Shares and donated the gain amount to a charity. The IRS ruled that Acquiror would not be treated as having acquired ownership of the Excess Shares for purposes of section 382, so long as the Trading Order and the Stipulation and Order remained in effect and were not set aside by a court of competent jurisdiction.
Corporations with net operating losses (or certain other tax attributes) that are either considering filing for, or have filed for, bankruptcy protection and their shareholders and creditors should be cognizant of the fact that section 382 ownership changes, either before or after filing a bankruptcy petition, could cause a forfeiture of a valuable tax attribute. Put another way, vigilance is critical in this regard. To the extent a potential section 382 ownership change in such a corporation has occurred, consideration should be given to whether the PLR can be applied affirmatively under the given facts. If so, the PLR provides a potential mechanism by which the value of the net operating losses of the bankrupt corporation can be maintained by avoiding a section 382 ownership change at an inopportune time in the corporation's history.
There is also an important tax-specific observation with respect to the PLR. Assuming that certain requirements are met, the IRS may permit the reversal of potentially disadvantageous tax consequences with respect to transactions that have been legally rescinded, at least to the extent the rescission happens in the same tax year. See, e.g., Revenue Ruling 80-58 and Private Letter Ruling 200716024. In the PLR, the IRS appears to extend the doctrine of rescission to an "in-part" rescission. In other words, one may have thought that in order for the doctrine of rescission to apply, the entire transaction had to be unwound. This would have required the disposition of the Total Shares under the facts of the PLR. However, under the PLR, only the Excess Shares were required to be sold, and the IRS, nevertheless, applied the doctrine of rescission.