On August 9, 2006, Judge Burton R. Lifland of the United States Bankruptcy Court for the Southern District of New York entered a Final Order Establishing Procedures for Trading in Claims and Equity Securities of Dana Corporation (the “Dana NOL Trading Order”). The Dana NOL Trading Order is materially different from NOL trading orders that have been approved by other bankruptcy courts and, from the perspective of investors in claims and distressed securities, represents a material improvement.
Treatment of NOLs in Business Reorganizations
The Internal Revenue Code (“IRC”) allows net operating losses (“NOLs”) to be carried forward for up to 20 years. To prevent trading in losses, however, the IRC limits a corporate taxpayer’s ability to carry forward NOLs where a taxpayer undergoes an “Ownership Change.” In particular, IRC § 382(b) provides that, if a company undergoes an “Ownership Change” in any three year period, its ability to use NOLs to offset future taxable income will be limited, in any particular year, to a specified (and generally low) percentage of the value of its stock immediately prior to the “Ownership Change.”
Because chapter 11 plans of reorganization often provide for common stock to be distributed in respect of prepetition creditor claims, consummation of the plan will generally constitute an “Ownership Change” within the meaning of IRC § 382(b). To mitigate the effects of IRC § 382(b), Congress has provided a limited exception for business reorganizations. Specifically, IRC § 382(l)(5) and related regulations provide that a chapter 11 “Ownership Change” will not limit the debtor’s use of its NOLs if the chapter 11 plan distributes at least 50% of the stock of the reorganized debtors to what are colloquially known as “old and cold” creditors: (i) creditors who have held their claims at least 18 months before the commencement of the chapter 11 case; (ii) creditors who have held claims that arose after the 18 month cutoff if the creditors have always held such claims and the claims arose in the ordinary course of the debtor’s business; and (iii) generally, creditors who receive less than 5% of the stock issued under the plan on account of their claims.
If applicable, IRC § 382(l)(5) eliminates IRC § 382(b)’s restriction on the use of NOL carry forwards. However, even where IRC § 382(l)(5) is not available, a debtor may avail itself of IRC § 382(l)(6), which sets the market value of the common stock immediately after the Ownership Change (thus reflecting the increased value resulting from any discharge of creditors’ claims), thereby limiting the negative impact IRC § 382(b) has on a debtor’s ability to use its carry-forward NOLs.
NOL Trading Orders
Trading in claims and equity securities of a debtor has the potential to reduce the number of “old and cold” creditors, and debtors with large NOLs often use this as a justification to limit trading in claims and equity securities to preserve their ability to access IRC § 382(l)(5). In fact, it has become common for debtors to seek approval of an order limiting such trading as part of the “first-day” relief sought in a chapter 11 case. Notwithstanding that it is all but impossible to discern on the first day of a case whether the debtor will ultimately be able to confirm a plan that complies with IRC § 382(l)(5) or what economic benefits (if any) such a plan may provide, a number of Bankruptcy Courts have held that NOLs are property of the debtor’s estate and that claims trading that may limit the debtor’s ability to utilize NOLs is a violation of the automatic stay. These courts, often with only a minimal evidentiary showing, have granted sweeping injunctive relief at the very earliest stages of reorganizations to limit active trading in claims and equity securities.
While the precise form of prior NOL trading orders has varied, in addition to placing certain restrictions on trading of the debtor’s equity securities, they often: (a) restrict the ability of certain creditors or would be creditors to acquire claims against the debtor and/or (b) require investors that have acquired claims or securities during the case to sell down a portion of their holdings. While restrictions on trading and sell down directives are generally subject to review by the bankruptcy court, NOL trading orders often provide for them to be upheld without any showing that an IRC § 382(l)(5) plan will actually be confirmed or that any specific economic benefit will flow to the reorganized debtor as a result. Rather, trading restrictions have generally been upheld where the debtor can demonstrate that there exists a reasonable possibility that a IRC § 382(l)(5) plan may be confirmed and that the use of IRC § 382 (l)(5) may benefit the estate.
The Dana NOL Trading Order
On March 3, 2006, Dana Corporation and certain of its subsidiaries (collectively, “Dana”) filed voluntary petitions for relief under chapter 11 of the Bankruptcy Code. On the same day, Dana sought approval of an interim NOL trading order, alleging that Dana had approximately $917 million of carry-forward NOLs, which Dana alleged could translate into future reductions of Dana’s tax liabilities by as much as $321 million based on a federal income tax rate of 35 percent (the “Dana NOL Motion”). Consistent with common practice, Dana provided no concrete evidence concerning the true value of the NOLs, Dana’s ability to use them to offset post-reorganization income, or the incremental benefit to Dana’s estate that would result from a plan satisfying IRC § 382(l)(5).
Dana’s Official Committee of Unsecured Creditors (the “Creditors’ Committee”), represented by Kramer Levin, argued that the evidence offered in support of the Dana NOL Motion was inadequate and urged the Court to adjourn the motion and require Dana to provide sufficient information to establish that a trading order would benefit the estate. After hearing testimony from Dana’s financial and tax professionals suggesting only that a trading order could potentially benefit the estate, the Court adjourned the motion for 90 days and instructed the Debtors to provide the Creditors’ Committee with a written report regarding the likelihood of an IRC § 382(l)(5) plan. When delivered, this report provided the Creditors’ Committee with vastly more information than had been offered at the outset of the case, but also raised additional concerns about whether, among other things, creditor recoveries would be positively affected by the confirmation of an IRC § 382(l)(5) plan.
On August 9, 2006, after months of negotiations between Dana, the Creditors’ Committee and other parties in interest, the Bankruptcy Court entered the Dana NOL Trading Order. Unlike earlier forms of NOL trading orders, the Dana NOL Trading Order does not restrict trading in claims during the course of the case or even require investors to notify the Debtors of trading activity. While the Dana NOL Trading Order does provide for a potential sell down by claim holders, the circumstances under which the selldown could be triggered were narrowly defined to offer significant protections to investors.
First, unlike prior NOL trading orders, the debtor cannot compel a sell down by establishing a mere possibility that an IRC § 382(l)(5) plan may be proposed in the future. Rather, the sell down obligation arises only after an IRC § 382(l)(5) plan has actually been confirmed by the Bankruptcy Court.
Second, the Dana NOL Trading Order gives those creditors whose claims could potentially be affected by the order a measure of control over whether they will be subject to a sell-down. In particular, under the Dana NOL Trading Order, no sell down obligation arises unless the largest class of unsecured claims that will receive Affected Securities (as defined below) under the IRC § 382(l)(5) plan has voted to accept the plan.
Third, the Dana NOL Trading Order requires that creditors receive detailed information concerning the financial impact of the IRC § 382(l)(5) plan prior to voting on the plan to ensure that they can properly judge the benefits such a plan provides against the negative impacts of the potential sell down obligation. Specifically, the Dana NOL Trading Order requires that the proponent of an IRC § 382(l)(5) plan file a disclosure statement setting forth, among other things: (i) the net present value of the projected tax savings of the IRC § 382(l)(5) plan as compared to an IRC § 382(l)(6) Plan based on the financial projections in the Disclosure Statement; (ii) a description of the restrictions on trading in the common stock and any other securities of the reorganized debtors (the “Affected Securities”) that will be required or imposed under the IRC § 382(l)(5) plan after the Effective Date; (iii) the projected value of the Affected Securities in the aggregate; and (iv) the projected tax savings of the IRC § 382(l)(5) plan as a percentage of the aggregate value of the Affected Securities.
In short, the experience in Dana provides a useful precedent for creditors seeking to resist the summary imposition of sweeping restrictions on trading in claims and debtor securities as part of the first day orders in Chapter 11 cases. Not only was the Creditors’ Committee able to extract a detailed analysis of the potential value of the debtors’ NOL carry forwards before any order was be imposed, but it negotiated significant protections to assure that creditors would not be subject to any sell down unless they had been properly informed of the benefits of any IRC § 382(l)(5) and such a plan had been confirmed with substantial creditor support.