Claims Trading Restrictions Dealt Setback

A debtor corporation that has NOLs can generally carry them forward and deduct them from income during future profitable years. However, when a debtor corporation undergoes an ownership change, ' 382 of the Internal Revenue Code can severely restrict its ability to use its NOLs. Section 382 imposes an annual cap on the amount of NOLs that a corporation may utilize ' essentially the applicable federal rate multiplied by the market value of the corporation's stock immediately before the ownership change. Because the stock value of an insolvent corporation is generally very low, this provision can reduce the amount of NOLs that may be used in any year to a minimal amount. In bankruptcy reorganizations, an ownership change can occur as a result of trading in the debtor's equity, but significantly can also occur as a result of the conversion of debt to new equity under a plan of reorganization, coupled with the cancellation of the old equity.

However, ' 382 provides two exceptions that can mitigate the impact on a debtor's ability to use its NOLs when a change in ownership is brought about by the conversion of debt to equity in a bankruptcy reorganization. Under ' 382(l)(5) (the 'L5 Exception'), the debtor can retain its ability to use the full amount of its NOLs in any year, but only if certain prerequisites are satisfied. At least 50% of the reorganized debtor's stock must be issued to former shareholders and qualified creditors (qualified creditors are persons who have not acquired their claims in the 18 months prior to the petition date, and do not receive 5% or more of the reorganized debtor's stock). Accordingly, if claims traders have recently acquired large amounts of claims against a debtor, such that over 50% of a reorganized debtor's stock will go to non-qualified creditors, the Debtor may lose its ability to use the L5 Exception. In addition, the reorganized debtor must similarly restrict trading in its new equity for two years to ensure that a post effective date change in ownership does not occur over such period.

Nonetheless, if a debtor cannot qualify for the L5 exception, it can still make use of ' 382(l)(6) (the 'L6 Exception'), which caps the amount of NOLs that the debtor can utilize in any year at the applicable federal rate multiplied by the market value of the stock after the ownership change brought about by the conversion of debt to equity (reflecting the increased value resulting from the discharge of creditors' claims). The L6 Exception does not require satisfaction of any of the L5 Exception prerequisites. Accordingly, a debtor, unable to take advantage of the L5 Exception, may still use up its NOLs after emergence from bankruptcy by using the L6 exception, just over a longer timeframe.

Claims Trading Restrictions Serve Ulterior Purpose

Although the stated purpose of such claims trading restrictions has been to preserve the debtor's unrestricted ability to utilize its NOLs under the L5 Exception, claims trading restrictions have also served, like the 'poison pill' anti-takeover device, to entrench existing management. Such restrictions inhibit large creditors from assuming a controlling position in the reorganization process because they are forced to 'trade at their own risk', and then, only with the consent of the debtor. Accordingly, claims trading restrictions have had the effect of severely chilling claims trading by substantial claimholders.

For example, in the Dana case, the claims trading order which the debtor sought as part of its first-day pleadings, purportedly to preserve its ability to take advantage of the L5 Exception, defined 'substantial claimholders' as any person holding at least $101,250,000 of claims against the debtor and required them to provide notice of their holdings to the debtor and, in redacted form, to the court. The proposed trading order then offered substantial claimholders a Hobson's Choice. Substan-tial claimholders could elect to trade freely in claims if they agreed to refrain from participating in the formulation of any plan of reorganization by or on behalf of the debtors and if they agreed to sell, prior to the effective date of the debtors' plan, claims in excess of the amount of claims that would be entitled to receive 4.5% of the equity in the reorganized debtors, but without compensation for any loss that such forced sale might cause. Otherwise, if substantial claimholders did not make the foregoing election, substantial claimholders would have to give the debtors 15 days notice prior to any claims acquisition and wait 30 days in case the debtors objected to the transaction, in which case, the transaction could only be effective upon final and non-appealable order of the court.

Because claims trades customarily close within a few days, the claims acquisition notice requirements for non-electing substantial claimholders would have made normal trading impossible for all practical purposes. Accordingly, substantial claimholders were given the false choice between continuing their trading on a severely restrained basis or consenting to their own exclusion from plan formulation and to a forced sell down of a portion of their claims without compensation for any losses.

Claims Trading Restrictions Not Justified at Outset of Bankruptcy Cases

Debtors have relied on the automatic stay provisions of ' 362(a) of the Bankruptcy Code when seeking orders restricting claims trading at the outset of bankruptcy cases. Section 362 provides that the commencement of a bankruptcy case operates to stay any act to obtain possession or to exercise control over the property of the estate. However, claims trading restrictions at the outset of bankruptcy cases cannot be justified as a legal or a factual matter.

First, as a matter of law, even if NOLs are property of the bankruptcy estate, it does not follow that third party actions which incidentally affect that interest constitute an exercise of control over that property. Having an incidental effect on property is not the same as exercising control over that property. In In re UAL Corp., the Seventh Circuit reversed a lower court order that had enjoined the sale of United Airlines stock by an employee stock ownership plan. The order had been intended to protect the debtor's future use of its NOLs under the presumed authority of ' 362. See 412 F.3d 773, 777 (7th Cir. 2005). The Seventh Circuit ruled that, despite the effect such sales might have on United's ability to take future advantage of its NOLs, a third party's 'sale of stock does not obtain possession ' or exercise control over that interest.' Id. at 778.

Proponents of claims trading restrictions have relied on In re Prudential Lines, Inc., 928 F.2d 565 (2d Cir. 1991) to support their argument that claims trading can violate the automatic stay. In Prudential Lines, the court ruled that a parent corporation's attempt to take a worthless stock deduction, that would have eliminated its debtor subsidiary's ability to use its NOLs, constituted an act to exercise control over the debtor's property. See 928 F.2d at 575. The court concluded that NOLs were property of the estate and the automatic stay constituted authority to enjoin such action. Id.

However, Prudential Lines is easily distinguishable from the circumstances of third-party claims trading. In Prudential Lines, the creditors' committee had proposed a plan that would have cancelled the debtor subsidiary's stock, rendering it worthless to the parent corporation. In retaliation, the parent corporation attempted to eliminate the debtor's NOLs, by taking the worthless stock deduction, to put pressure on the creditors' committee plan. In stark contrast to the parent corporation in Prudential Lines, third parties trading in claims have no ability, much less any intent, to obtain possession or exercise control over the debtor's NOLs. The only, and much attenuated, connection between third party claims trading and a debtor's NOLs is that such activity might have an incidental effect on the debtor's ability to use the L5 Exception provided the debtor can satisfy the prerequisites to its use later in the case.

Second, as a factual matter, a debtor almost certainly cannot know at the outset of a bankruptcy case that it will be able to satisfy the prerequisites to the use of the L5 Exception or that the L5 Exception will be sufficiently more advantageous than the L6 Exception to merit imposition of claims trading restrictions so near to the petition date. The debtor cannot know at the outset of a bankruptcy case whether it will have useable NOLs at the time of plan confirmation because NOLs are reduced by cancellation of debt income arising from the conversion of debt to equity under a plan. Cancellation of debt income arises to the extent claims are discharged but not satisfied in full. In addition, NOLs are reduced by an amount equal to the interest accrued for the three years preceding the reorganization on the debt that is converted to equity.

Similarly, the debtor is unlikely to know to what extent it will have postpetition taxable income and over what time period. Accordingly, the debtor cannot know whether a L5 Exception plan will be materially more advantageous than a L6 Exception plan. The L5 Exception is only preferable if the debtor has large, short term, post emergence taxable income such that the annual cap on the use of NOLs imposed by the L6 Exception would be limiting.

The debtor also cannot know whe-ther present creditors, who will be the future holders of the reorganized debtor's equity, will vote to confirm a L5 Exception plan, particularly considering the sell down provision and the necessary restriction on new equity trading post emergence. Finally, the debtor likely will not know whether trading in the debtor's equity securities immediately prepetition has not already caused a change in ownership precluding any possibility of using the L5 Exception. Accordingly, claims trading restrictions are neither legally nor factually supportable at the outset of a bankruptcy case.

Dana Case Sets New Benchmark

In the Dana case, creditors vigorously opposed the proposed claims trading order which would have essentially frozen large players out of the case, arguing that the automatic stay does not provide an appropriate legal basis to restrict claims trading at the outset of a bankruptcy case and that, as a factual matter, the Debtors could not justify claims trading restrictions. In the end, on the strength of these arguments, a consensual order was entered in the Dana case, which essentially 'de-clawed' the proposed claims trading order effectively putting the burden on the Debtors, or plan proponent, to confirm an L5 Exception plan with the approval of creditors at large before any restrictions can be imposed.

The Dana claims trading order eliminates the Debtors' interference in claims trading during the Chapter 11 case. Only if a L5 Exception plan is filed must substantial claimholders disclose their holdings. During the Chapter 11 case, substantial claimholders may trade freely and will not have to submit their proposed claims acquisitions to the Debtors for approval. A forced sell down, although still a concern, cannot occur unless the proposed L5 Exception plan satisfies the protections provided by ' 1129 of the Bankruptcy Code, has been accepted by creditors at large and has been confirmed by the court. Thus, a forced sell down cannot be crammed down on the most affected creditors absent approval by creditors at large.

Also, to obtain confirmation of a L5 Exception plan, the disclosure statement must quantify the net present value of the tax savings of the L5 Exception plan as compared to a L6 Exception plan. The disclosure statement must also disclose the trading restrictions that must be placed on the reorganized Debtors' common stock and other securities post emergence under a L5 Exception plan. Accordingly, the proponent of a L5 Exception plan will be forced to justify the interference with creditors' vital interests necessitated by the decision to pursue a L5 Exception plan.

Importantly, a forced sell down of claims will first affect claims acquired after the disclosure statement hearing and will only secondarily affect claims acquired between the petition date and the disclosure statement hearing. In addition, the plan proponent is not allowed under any circumstances to force a substantial claimholder to reduce its amount of claims to an amount below the amount held as of the petition date. Accordingly, in the future, investors considering becoming substantial claimholders in other Chapter 11 cases could mitigate sell down risk by acquiring claims as early as possible.

Of course, substantial claimholders could also mitigate risk by using the influence arising from their large position in the capital structure to avoid a L5 Exception plan through plan negotiations and, if necessary, block confirmation of such a plan through their voting power. The claims trading order entered in the Dana case makes clear that substantial claimholders can participate in plan development provided they avoid disclosing that they are not qualified creditors. (The Internal Revenue Code allows debtors or plan proponents to assume that creditors are qualified creditors so long as they do not have actual knowledge to the contrary.) The Dana claims trading order specifically provides that negotiating the terms of a plan of reorganization will not constitute such a disclosure.

Conclusion

Unfortunately, the disputes over debtors' attempts to impose claims trading restrictions at the outset of bankruptcy cases have not led to any reported decisions. Nonetheless, despite the lack of applicable precedent, substantial claimholders should rely on the example set in the Dana case to resist future attempts to impose claims trading restrictions at the outset of future Chapter 11 cases.

Todd A. Feinsmith is a member of the law firm of Brown Rudnick Berlack Israels LLP. He specializes in the areas of bankruptcy and reorganization and may be reached at 617-856-8585 or [email protected]. John C. Elstad is an associate specializing in the areas of bankruptcy and reorganization, and may be reached at 617-856-8486 or [email protected].

In recent years, debtors in large corporate bankruptcies have sometimes sought and obtained, in varying degrees, authority at the outset of bankruptcy cases for severe restrictions on trading in claims against the debtors by substantial claimholders. These restrictions have included prohibitions against trading absent consent of the debtor, forced consent to a debtor-ordered 'sell down' of debt securities later in the case and deprivation of the right to participate meaningfully in plan formulation and negotiation (no matter how large one's holdings might be). The purported purpose of these restrictions has been to preserve the debtor's ability to deduct its past net operating losses (NOLs) from future revenues. In practice, however, these debt-trading orders have chilled the market for trading in debt securities and served to entrench existing management by effectively precluding substantial investors from acquiring meaningful positions in the debtor's debt securities.

Recently, in the Dana Corp. et al. case (Case No. 06-10354 Bankr. S.D.N.Y.), creditors fought back and won a substantial victory. The claims trading order entered in the Dana case dramatically limited the debtors' interference in claims trading. In the future, creditors should rely on the example set in the Dana case to resist any attempt to impose claims trading restrictions at the outset of bankruptcy cases.

Preserving NOLS in Bankruptcy

A debtor corporation that has NOLs can generally carry them forward and deduct them from income during future profitable years. However, when a debtor corporation undergoes an ownership change, ' 382 of the Internal Revenue Code can severely restrict its ability to use its NOLs. Section 382 imposes an annual cap on the amount of NOLs that a corporation may utilize ' essentially the applicable federal rate multiplied by the market value of the corporation's stock immediately before the ownership change. Because the stock value of an insolvent corporation is generally very low, this provision can reduce the amount of NOLs that may be used in any year to a minimal amount. In bankruptcy reorganizations, an ownership change can occur as a result of trading in the debtor's equity, but significantly can also occur as a result of the conversion of debt to new equity under a plan of reorganization, coupled with the cancellation of the old equity.

However, ' 382 provides two exceptions that can mitigate the impact on a debtor's ability to use its NOLs when a change in ownership is brought about by the conversion of debt to equity in a bankruptcy reorganization. Under ' 382(l)(5) (the 'L5 Exception'), the debtor can retain its ability to use the full amount of its NOLs in any year, but only if certain prerequisites are satisfied. At least 50% of the reorganized debtor's stock must be issued to former shareholders and qualified creditors (qualified creditors are persons who have not acquired their claims in the 18 months prior to the petition date, and do not receive 5% or more of the reorganized debtor's stock). Accordingly, if claims traders have recently acquired large amounts of claims against a debtor, such that over 50% of a reorganized debtor's stock will go to non-qualified creditors, the Debtor may lose its ability to use the L5 Exception. In addition, the reorganized debtor must similarly restrict trading in its new equity for two years to ensure that a post effective date change in ownership does not occur over such period.

Nonetheless, if a debtor cannot qualify for the L5 exception, it can still make use of ' 382(l)(6) (the 'L6 Exception'), which caps the amount of NOLs that the debtor can utilize in any year at the applicable federal rate multiplied by the market value of the stock after the ownership change brought about by the conversion of debt to equity (reflecting the increased value resulting from the discharge of creditors' claims). The L6 Exception does not require satisfaction of any of the L5 Exception prerequisites. Accordingly, a debtor, unable to take advantage of the L5 Exception, may still use up its NOLs after emergence from bankruptcy by using the L6 exception, just over a longer timeframe.

Claims Trading Restrictions Serve Ulterior Purpose

Although the stated purpose of such claims trading restrictions has been to preserve the debtor's unrestricted ability to utilize its NOLs under the L5 Exception, claims trading restrictions have also served, like the 'poison pill' anti-takeover device, to entrench existing management. Such restrictions inhibit large creditors from assuming a controlling position in the reorganization process because they are forced to 'trade at their own risk', and then, only with the consent of the debtor. Accordingly, claims trading restrictions have had the effect of severely chilling claims trading by substantial claimholders.

For example, in the Dana case, the claims trading order which the debtor sought as part of its first-day pleadings, purportedly to preserve its ability to take advantage of the L5 Exception, defined 'substantial claimholders' as any person holding at least $101,250,000 of claims against the debtor and required them to provide notice of their holdings to the debtor and, in redacted form, to the court. The proposed trading order then offered substantial claimholders a Hobson's Choice. Substan-tial claimholders could elect to trade freely in claims if they agreed to refrain from participating in the formulation of any plan of reorganization by or on behalf of the debtors and if they agreed to sell, prior to the effective date of the debtors' plan, claims in excess of the amount of claims that would be entitled to receive 4.5% of the equity in the reorganized debtors, but without compensation for any loss that such forced sale might cause. Otherwise, if substantial claimholders did not make the foregoing election, substantial claimholders would have to give the debtors 15 days notice prior to any claims acquisition and wait 30 days in case the debtors objected to the transaction, in which case, the transaction could only be effective upon final and non-appealable order of the court.

Because claims trades customarily close within a few days, the claims acquisition notice requirements for non-electing substantial claimholders would have made normal trading impossible for all practical purposes. Accordingly, substantial claimholders were given the false choice between continuing their trading on a severely restrained basis or consenting to their own exclusion from plan formulation and to a forced sell down of a portion of their claims without compensation for any losses.

Claims Trading Restrictions Not Justified at Outset of Bankruptcy Cases

Debtors have relied on the automatic stay provisions of ' 362(a) of the Bankruptcy Code when seeking orders restricting claims trading at the outset of bankruptcy cases. Section 362 provides that the commencement of a bankruptcy case operates to stay any act to obtain possession or to exercise control over the property of the estate. However, claims trading restrictions at the outset of bankruptcy cases cannot be justified as a legal or a factual matter.

First, as a matter of law, even if NOLs are property of the bankruptcy estate, it does not follow that third party actions which incidentally affect that interest constitute an exercise of control over that property. Having an incidental effect on property is not the same as exercising control over that property. In In re UAL Corp., the Seventh Circuit reversed a lower court order that had enjoined the sale of United Airlines stock by an employee stock ownership plan. The order had been intended to protect the debtor's future use of its NOLs under the presumed authority of ' 362. See 412 F.3d 773, 777 (7th Cir. 2005). The Seventh Circuit ruled that, despite the effect such sales might have on United's ability to take future advantage of its NOLs, a third party's 'sale of stock does not obtain possession ' or exercise control over that interest.' Id. at 778.

Proponents of claims trading restrictions have relied on In re Prudential Lines, Inc., 928 F.2d 565 (2d Cir. 1991) to support their argument that claims trading can violate the automatic stay. In Prudential Lines, the court ruled that a parent corporation's attempt to take a worthless stock deduction, that would have eliminated its debtor subsidiary's ability to use its NOLs, constituted an act to exercise control over the debtor's property. See 928 F.2d at 575. The court concluded that NOLs were property of the estate and the automatic stay constituted authority to enjoin such action. Id.

However, Prudential Lines is easily distinguishable from the circumstances of third-party claims trading. In Prudential Lines, the creditors' committee had proposed a plan that would have cancelled the debtor subsidiary's stock, rendering it worthless to the parent corporation. In retaliation, the parent corporation attempted to eliminate the debtor's NOLs, by taking the worthless stock deduction, to put pressure on the creditors' committee plan. In stark contrast to the parent corporation in Prudential Lines, third parties trading in claims have no ability, much less any intent, to obtain possession or exercise control over the debtor's NOLs. The only, and much attenuated, connection between third party claims trading and a debtor's NOLs is that such activity might have an incidental effect on the debtor's ability to use the L5 Exception provided the debtor can satisfy the prerequisites to its use later in the case.

Second, as a factual matter, a debtor almost certainly cannot know at the outset of a bankruptcy case that it will be able to satisfy the prerequisites to the use of the L5 Exception or that the L5 Exception will be sufficiently more advantageous than the L6 Exception to merit imposition of claims trading restrictions so near to the petition date. The debtor cannot know at the outset of a bankruptcy case whether it will have useable NOLs at the time of plan confirmation because NOLs are reduced by cancellation of debt income arising from the conversion of debt to equity under a plan. Cancellation of debt income arises to the extent claims are discharged but not satisfied in full. In addition, NOLs are reduced by an amount equal to the interest accrued for the three years preceding the reorganization on the debt that is converted to equity.

Similarly, the debtor is unlikely to know to what extent it will have postpetition taxable income and over what time period. Accordingly, the debtor cannot know whether a L5 Exception plan will be materially more advantageous than a L6 Exception plan. The L5 Exception is only preferable if the debtor has large, short term, post emergence taxable income such that the annual cap on the use of NOLs imposed by the L6 Exception would be limiting.

The debtor also cannot know whe-ther present creditors, who will be the future holders of the reorganized debtor's equity, will vote to confirm a L5 Exception plan, particularly considering the sell down provision and the necessary restriction on new equity trading post emergence. Finally, the debtor likely will not know whether trading in the debtor's equity securities immediately prepetition has not already caused a change in ownership precluding any possibility of using the L5 Exception. Accordingly, claims trading restrictions are neither legally nor factually supportable at the outset of a bankruptcy case.

Dana Case Sets New Benchmark

In the Dana case, creditors vigorously opposed the proposed claims trading order which would have essentially frozen large players out of the case, arguing that the automatic stay does not provide an appropriate legal basis to restrict claims trading at the outset of a bankruptcy case and that, as a factual matter, the Debtors could not justify claims trading restrictions. In the end, on the strength of these arguments, a consensual order was entered in the Dana case, which essentially 'de-clawed' the proposed claims trading order effectively putting the burden on the Debtors, or plan proponent, to confirm an L5 Exception plan with the approval of creditors at large before any restrictions can be imposed.

The Dana claims trading order eliminates the Debtors' interference in claims trading during the Chapter 11 case. Only if a L5 Exception plan is filed must substantial claimholders disclose their holdings. During the Chapter 11 case, substantial claimholders may trade freely and will not have to submit their proposed claims acquisitions to the Debtors for approval. A forced sell down, although still a concern, cannot occur unless the proposed L5 Exception plan satisfies the protections provided by ' 1129 of the Bankruptcy Code, has been accepted by creditors at large and has been confirmed by the court. Thus, a forced sell down cannot be crammed down on the most affected creditors absent approval by creditors at large.

Also, to obtain confirmation of a L5 Exception plan, the disclosure statement must quantify the net present value of the tax savings of the L5 Exception plan as compared to a L6 Exception plan. The disclosure statement must also disclose the trading restrictions that must be placed on the reorganized Debtors' common stock and other securities post emergence under a L5 Exception plan. Accordingly, the proponent of a L5 Exception plan will be forced to justify the interference with creditors' vital interests necessitated by the decision to pursue a L5 Exception plan.

Importantly, a forced sell down of claims will first affect claims acquired after the disclosure statement hearing and will only secondarily affect claims acquired between the petition date and the disclosure statement hearing. In addition, the plan proponent is not allowed under any circumstances to force a substantial claimholder to reduce its amount of claims to an amount below the amount held as of the petition date. Accordingly, in the future, investors considering becoming substantial claimholders in other Chapter 11 cases could mitigate sell down risk by acquiring claims as early as possible.

Of course, substantial claimholders could also mitigate risk by using the influence arising from their large position in the capital structure to avoid a L5 Exception plan through plan negotiations and, if necessary, block confirmation of such a plan through their voting power. The claims trading order entered in the Dana case makes clear that substantial claimholders can participate in plan development provided they avoid disclosing that they are not qualified creditors. (The Internal Revenue Code allows debtors or plan proponents to assume that creditors are qualified creditors so long as they do not have actual knowledge to the contrary.) The Dana claims trading order specifically provides that negotiating the terms of a plan of reorganization will not constitute such a disclosure.

Conclusion

Unfortunately, the disputes over debtors' attempts to impose claims trading restrictions at the outset of bankruptcy cases have not led to any reported decisions. Nonetheless, despite the lack of applicable precedent, substantial claimholders should rely on the example set in the Dana case to resist future attempts to impose claims trading restrictions at the outset of future Chapter 11 cases.

Todd A. Feinsmith is a member of the law firm of Brown Rudnick Berlack Israels LLP. He specializes in the areas of bankruptcy and reorganization and may be reached at 617-856-8585 or [email protected]. John C. Elstad is an associate specializing in the areas of bankruptcy and reorganization, and may be reached at 617-856-8486 or [email protected].