In Search of the Holy Grail

On Nov. 22, 2004, The Bond Market Association and The Loan Syndications and Trading Association announced that in a joint effort they had developed a model NOL order to address these disruptions. In its news release, The Loan Syndications and Trading Association stated that the model order would reduce the burdens of companies, investors and broker dealers (and their attorneys) “by creating a standard and less restrictive mechanism for dealing with the tax issues raised by debt trading during bankruptcy.” In striking a balance between the need to protect a bankrupt company's net operating losses and unrestricted trading, the model order establishes somewhat circumscribed stock and debt trading restrictions and procedures for implementing the proffered restrictions.

Although a detailed analysis of the model order is beyond the scope of this article, the model order takes a very creative approach to the trading problem. First, the model order requires “substantial” shareholders and claimholders (persons who hold stock or claims that equals or exceeds of a threshold percentage of stock (usually set at slightly less than 5%) or claims measured by principal and accrued interest which would be exchanged for slightly less than 5% of the stock of the company under the plan) to file notices with the bankrupt company which summarize their aggregate stock or debt holdings, calculated by using the detailed constructive ownership, aggregation and segregation rules of Section 382. The order proceeds to restrict acquisitions (and dispositions) of stock and most acquisitions of claims by “substantial” shareholders or claimholders or persons who would become “substantial” shareholders or claimholders.

In the case of the restrictions on trading in claims, the order carves out claims (such as debt issued within 18 months of the bankruptcy petition which would not qualify as “ordinary course” debt) that can be traded without limitation (the so-called “protected amount”). The order goes on to establish a “sell down” mechanism to preserve the bankrupt company's ability to avail itself of Section 382(l)(5) by requiring “substantial” claimholders to sell “qualified indebtedness” and reduce their positions below the threshold percentage of claims established by the order and prohibits any such claimholder from participating in the formulation of a plan of reorganization which is designed so as to comply with Section 382(l)(5) (a so-called “382(l)(5) Plan”) if it appears that the claimholder acquired the claim in order to influence the resolution of the bankruptcy. The footnotes to the model order indicate that this latter prohibition is designed to assure that claims subject to a “sell down” will continue to be treated as “qualifying indebtedness” in the hands of any subsequent claimholder.

Finally, the model order provides a mechanism for a “substantial” claimholder to object to the issuance of a “sell down” order that would prevent the issuance of such an order unless the bankrupt company can establish that there is a reasonable possibility that a 382(l)(5) Plan will be confirmed and, based on projections of a nationally recognized law firm or accounting firm, that substantial tax attributes will be available under the proposed 382(1)(5) Plan, that the “sell down” order is reasonably necessary and appropriate to assure compliance with the ownership requirements of the Section 382(l)(5) and that the use of Section 382(l)(5) will be more beneficial than the use of Section 382(1)(6).

Conclusion

It certainly remains to be seen whether this complex model order and the rigorous reporting required of claimholders and the bankrupt company will be embraced by the bankruptcy bar, but the model order is an admirable attempt to balance the competing interests of the parties to a bankruptcy.

Part Two of a Two-Part Article

In our article that appeared in last month's Bankruptcy Strategist, we discussed the special rule contained in Section 382(l)(5) with respect to the use of net operating losses by a company that has restructured under the protection of the bankruptcy court. See “In Search of the Holy Grail, Musings on Section 382(l)(5)“, 22 The Bankruptcy Strategist Number 2, 1. As discussed in that article, Section 382(l)(5) requires a bankrupt corporation to meet special stock ownership rules which forces the bankrupt company to track the ownership of its stock and its “qualified indebtedness” (“old and cold” and “ordinary course” debt) in the hopes of preventing dispositions which might render Section 382(l)(5) inapplicable. Internal Revenue Service regulations ameliorate the harsh holding period rules with respect to “qualified indebtedness” by permitting some trading of such indebtedness, so long as a person who acquires debt that would otherwise qualify as “qualified indebtedness” does not wind up being a 5% shareholder under the plan of reorganization. Where the stock, debt and claims against a bankrupt company are traded, companies execute lock up agreements with their stockholders or request orders from the bankruptcy court to restrict trading in the stock, debt or claims so as to protect its net operating loss carry forwards. Often, out of an excess of caution, the orders requested have been overly broad and have disrupted trading in such debt and claims.

A Model NOL Order

On Nov. 22, 2004, The Bond Market Association and The Loan Syndications and Trading Association announced that in a joint effort they had developed a model NOL order to address these disruptions. In its news release, The Loan Syndications and Trading Association stated that the model order would reduce the burdens of companies, investors and broker dealers (and their attorneys) “by creating a standard and less restrictive mechanism for dealing with the tax issues raised by debt trading during bankruptcy.” In striking a balance between the need to protect a bankrupt company's net operating losses and unrestricted trading, the model order establishes somewhat circumscribed stock and debt trading restrictions and procedures for implementing the proffered restrictions.

Although a detailed analysis of the model order is beyond the scope of this article, the model order takes a very creative approach to the trading problem. First, the model order requires “substantial” shareholders and claimholders (persons who hold stock or claims that equals or exceeds of a threshold percentage of stock (usually set at slightly less than 5%) or claims measured by principal and accrued interest which would be exchanged for slightly less than 5% of the stock of the company under the plan) to file notices with the bankrupt company which summarize their aggregate stock or debt holdings, calculated by using the detailed constructive ownership, aggregation and segregation rules of Section 382. The order proceeds to restrict acquisitions (and dispositions) of stock and most acquisitions of claims by “substantial” shareholders or claimholders or persons who would become “substantial” shareholders or claimholders.

In the case of the restrictions on trading in claims, the order carves out claims (such as debt issued within 18 months of the bankruptcy petition which would not qualify as “ordinary course” debt) that can be traded without limitation (the so-called “protected amount”). The order goes on to establish a “sell down” mechanism to preserve the bankrupt company's ability to avail itself of Section 382(l)(5) by requiring “substantial” claimholders to sell “qualified indebtedness” and reduce their positions below the threshold percentage of claims established by the order and prohibits any such claimholder from participating in the formulation of a plan of reorganization which is designed so as to comply with Section 382(l)(5) (a so-called “382(l)(5) Plan”) if it appears that the claimholder acquired the claim in order to influence the resolution of the bankruptcy. The footnotes to the model order indicate that this latter prohibition is designed to assure that claims subject to a “sell down” will continue to be treated as “qualifying indebtedness” in the hands of any subsequent claimholder.

Finally, the model order provides a mechanism for a “substantial” claimholder to object to the issuance of a “sell down” order that would prevent the issuance of such an order unless the bankrupt company can establish that there is a reasonable possibility that a 382(l)(5) Plan will be confirmed and, based on projections of a nationally recognized law firm or accounting firm, that substantial tax attributes will be available under the proposed 382(1)(5) Plan, that the “sell down” order is reasonably necessary and appropriate to assure compliance with the ownership requirements of the Section 382(l)(5) and that the use of Section 382(l)(5) will be more beneficial than the use of Section 382(1)(6).

Conclusion

It certainly remains to be seen whether this complex model order and the rigorous reporting required of claimholders and the bankrupt company will be embraced by the bankruptcy bar, but the model order is an admirable attempt to balance the competing interests of the parties to a bankruptcy.