Bankruptcy courts often place transfer restrictions on the bankrupt corporation’s stock and debt to preserve valuable tax attributes, such as net operating losses (NOLs).1 The transfer restrictions generally fall within the court’s authority to “control” the bankrupt corporation’s property under Section 362(a)(3) of the Bankruptcy Code. The Second Circuit endorsed this idea in its Prudential Lines decision, which upheld a Bankruptcy Court injunction that prevented one group member from taking a worthless stock deduction on the bankrupt member that would have would have eliminated the bankrupt member’s NOL.2 The Second Circuit ruled NOL’s are property of the bankrupt corporation, and that transfer restrictions are appropriate controls to protect the NOLs.3
Transfer Restrictions in General
Transfer restrictions in bankruptcy can preserve NOLs from a variety of potential pitfalls. The most common reasons for transfer restrictions are: (1) preventing a majority shareholder from claiming a worthless stock deduction, which basically eliminates the bankrupt corporation’s NOLs, as in Prudential Lines; (2) preventing an ownership change while the corporation is in bankruptcy;4 (3) maintaining sufficient “old and cold” stockholders and debt holders so that the bankrupt corporation satisfies the requirements for the Section 382(l)(5)5 bankruptcy exception;6 and (4) preventing a second ownership change within two years after qualifying for the Section 382(l)(5) bankruptcy exception.7
Notwithstanding Prudential Lines and other subsequent decisions,8 the power of bankruptcy courts to restrict stock and debt transfers to preserve NOLs may have some constraints. In a 2005 decision, the Seventh Circuit vacated as moot a Bankruptcy Court injunction that prevented a bankrupt corporation’s ESOP from selling shares of the corporation.9 The injunction’s purpose was to prevent an ownership change, but the Seventh Circuit noted in dicta that the transfer restriction was an unfair penalty on the parties subject to the restriction and was not appropriate merely to prevent a possible ownership change.10 The Seventh Court commented that the transfer restrictions likely would be okay if the Bankruptcy Court had crafted a covenant to compensate parties harmed by the transfer restriction.11
Recent Holding Requiring Sell-Downs
In a recent bankruptcy decision, In re. Dana Corp., the Bankruptcy Court authorized certain “sell down” procedures to protect the loss corporation’s NOLs.12 The purpose of the sell-down mechanism was to preserve the bankrupt corporation’s ability to qualify for the Section 382(l)(5) bankruptcy exception and meet the requirement that “old and cold” stockholders and debt holders retain 50 percent or more of the bankrupt corporation’s equity.13 Debt is generally considered “old and cold” if the debt arose at least 18 months before the bankruptcy filing or in the ordinary course of business.14 The tax regulations generally permit an assumption that debt is old and cold as long as the debt holder is not a 5 percent shareholder when the loss corporation emerges from bankruptcy.15 As a result, debt that might otherwise have favorable old and cold status when the debt is exchanged in bankruptcy for equity could be disqualified if the holder increases the amount of debt it holds and consequently becomes a 5 percent shareholder when the debt is exchanged for equity. To prevent this problem in In re Dana Corp. and preserve old and cold status under the presumption of Treas. Reg. Section 1.382-9(d)(3), the sell down procedures required certain debt holders to reduce their positions to a threshold amount.16 The sell-down procedures did not otherwise restrict general trading in claims against the bankrupt company.17
Sell-down provisions essentially prevented the creation of new 5 percent shareholders by forcing debt holders that acquire additional claims during the course of the bankruptcy to sell down their claims to the extent the additional claims would cause the debt holder to become a 5 percent shareholder. This, in turn, preserved sufficient old and cold stockholders and debt holders to enable the bankrupt corporation to qualify for the Section 382(l)(5) bankruptcy exception.
Net operating losses can have significant value to bankrupt corporations when the corporation ultimately emerges from bankruptcy and attains profitability. Care should be taken to preserve the corporation’s NOLs throughout and after the bankruptcy process. Consequently, internal financial personnel and tax advisors should be involved in initial bankruptcy planning so that appropriate transfer restrictions or sell down procedures can be implemented in a timely manner, including first day motions or shortly after bankruptcy proceedings begin.
1 For a detailed discussion of transfer restrictions in bankruptcy see Henderson and Goldring, Tax Planning for Troubled Corporations, Section 508.2.4 (2007 ed.).
2 In re Prudential Lines, 928 F.2d 565 (2nd Cir. 1991).
4 The loss corporation’s value presumably is close to zero while in bankruptcy, and an ownership change as defined in Section 382(g) consequently would result in a limitation close to zero.
5 Unless otherwise noted, all references to “IRC,” the “Code,” or “Section,” are references to the Internal Revenue Code of 1986, as amended. All references to “Treasury regulations” or “Treas. Regs.” are to the Treasury regulations issued under the IRC.
6 Section 382(l)(5) provides that the annual Section 382 limitation on NOLs does not apply to an ownership change that occurs pursuant to a bankruptcy reorganization when specific requirements are met, including the retention of “old and cold” pre-bankruptcy shareholders or debt holders under Section 382(l)(5)(E) and Treas. Reg. Section 1.382-9(d).
7 A second ownership change within two years negates the benefits of the Section 382(l)(5) bankruptcy exception and triggers a limitation of zero for tax periods following the second change date.
8 See also, for example, In re Phar-Mor, Inc., 152 B.R. 924 (Bankr. N.D. Ohio 1993) (the court restricted transfers by two minority 5 percent shareholders when the combined transfers would have caused a Section 382 ownership change).
9 In re UAL Corp., 412 F.3d 775 (7th Cir. 2005) (the Seventh Circuit commented in dicta that transfer restrictions used to prevent a potential ownership change are not an exercise in control over the corporation’s losses in the same manner as the restriction used to prevent a worthless stock deduction in Prudential Lines).
10 In re UAL Corp., 412 F.3d 775 (7th Cir. 2005).
12 In re Dana Corp., Case No. 06-10354 (BRL) (Bankr. S.D.N.Y. Aug. 9, 2006).
14 Section 382(l)(5)(E).
15 Treas. Reg. Section 1.382-9(d)(3).
16 In re Dana Corp., Case No. 06-10354 (BRL) (Bankr. S.D.N.Y. Aug. 9, 2006).
Bryan D. Keith