The Right Timing for NOL Rights Plan Adoption

William L. McRae, James E. Langston, and Corey M. Goodman are partners at Cleary Gottlieb Steen & Hamilton LLP. This post is based on a Cleary Gottlieb memorandum by Mr. McRae, Mr. Langston, Mr. Goodman, and Jason R. FactorRelated research from the Program on Corporate Governance includes Toward a Constitutional Review of the Poison Pill by Lucian Bebchuk and Robert J. Jackson, Jr. (discussed on the Forum here).

In the current climate of market volatility prompted by the COVID-19 pandemic, more and more public companies with valuable US tax assets (e.g., net operating loss carryforwards) may, or at least should, consider adopting a shareholder rights plan in order to preserve those tax assets. These plans are commonly referred to as “NOL rights plans” (or “NOL poison pills”).

I. Background

What is an NOL Rights Plan?

An NOL rights plan is a variation on the traditional takeover defense rights plan, but is designed to protect a corporation’s US NOL carryforwards and other US tax attributes, rather than simply deter takeovers and other hostile attacks not supported by the board of directors.

NOLs and other tax attributes can be irreversibly limited if the corporate stock undergoes an “ownership change” (as determined under US tax principles), which can be triggered by certain acquisitions of the corporation’s stock. An NOL rights plan is intended to discourage acquisitions of the stock that might trigger an ownership change.

Why use one?

The effects of an ownership change can be rather severe.

If an ownership change occurs, the company’s NOL carryforwards and other tax attributes become subject to an annual limitation. The limitation generally equals the company’s market cap at the time of the ownership change, multiplied by the long-term tax exempt interest rate (1.47% for ownership changes occurring in May 2020, and trending down).

Once an ownership change occurs, its effects cannot be reversed.

Differences between NOL rights plans and takeover defense rights plans.

The relevant tax “ownership change” rules (which can be found in section 382 of the Internal Revenue Code, and related Treasury regulations) track the ownership of “5 percent shareholders.” For this reason, NOL rights plans have lower ownership triggers than typical rights plans ― typically 4.9-4.99% for an NOL rights plan, versus 10-20% for a traditional rights plan. Thus, NOL rights plans are intended to discourage the creation of new “5 percent shareholders” or increases in ownership by existing ones.

II. Why Use One Now?

NOL rights plans may be more desirable in a market with stock price volatility, or the risk of significant price decreases, for the following reasons:

1. Higher Severity. A decreased stock price increases the severity of a company undergoing an “ownership change.”

  • A lower price at the time of an ownership change leads to a lower NOL limitation.

2. Higher Likelihood. A decreased stock price may increase the likelihood of an ownership change occurring, if investors use it as an opportunity to purchase large blocks of stock.

3. More Tax Assets Worth Protecting. In current market conditions, companies may be more likely to have (or to generate) significant NOL balances or other tax attributes that are worthy of protection.

  • Additionally, after 2017 tax reform, new tax assets were created. Items like the new “interest expense limitation” will also be limited if there’s an “ownership change.”
  • Recently proposed regulations, if finalized in their current form, will make an ownership change more adverse than was previously the case.

III. Potential Complexities

NOL rights plans can present additional complexities. Among them:

1. More difficult to administer.

To address complex tax ownership and attribution rules, NOL rights plans have more complicated rules on beneficial ownership than standard rights plans. As a result, greater precision can be required in administering an NOL rights plan, and tracking tax ownership.

For example, the tax rules look to economic ownership of the company’s stock – that is, percentage ownership by value. Schedule 13 filings are only a starting point for the tax beneficial ownership tests.

There are also complicated tax attribution rules that can treat one shareholder as constructively owning stock actually owned by others, as well as owning stock through certain options and other derivatives.

For these purposes, fund manager positions are typically broken down to the fund level, which will often own less than 5% individually. But the amounts can be aggregated in certain cases where there is coordination among different funds. This aspect of the tax ownership rules requires particular attention in light of the consolidation of ownership of most public companies among institutional investors.

Because they are focused on economic ownership, tax ownership rules can be particularly difficult to apply and monitor in the case of issuers with multiple classes of equity outstanding.

2. Limited Protection.

NOL rights plans do not provide complete protection. They cannot prevent a tax ownership change; they can only discourage one (albeit with strong incentives).

If an ownership change occurs, the NOL rights plan punishes the offending acquiror, but does not undo the NOL limitation.

For companies in need of protection, stock transfer restrictions in the company charter are more effective at protecting NOLs (because they can render trades null and void ab initio). But they require stockholder approval and therefore are often impractical to implement.

IV. What Companies Should Be Thinking About

NOL rights plans only make sense for companies with large balances of tax attributes to protect. Companies should consider whether they need the protection of an NOL rights plan, and how to tailor their NOL rights plan appropriately to achieve that protection. They should also consider how ISS, Glass Lewis and other proxy advisory services might react to a proposal to adopt one. The following information will be relevant in considering whether to adopt an NOL rights plan:

1. Likelihood of having an ownership change – How much cushion is there?

“Cushion” is a way to think about how much stock can change hands before there is an NOL problem.

Under section 382, an “ownership change” occurs if the “5% shareholders” of the corporation increased their ownership by more than 50 percentage points over their lowest percentage ownership in the corporation during a 3-year “testing period.”

The cushion is a function of how much of a “change” has occurred in the past 3 years, and how close it is to 50%. The closer it is, the more likely an NOL rights plan will be useful and justifiable.

The amount of cushion may influence the expiration date of an NOL rights plan. If significant ownership positions were acquired at the beginning of the 3-year period, the cushion will naturally improve with the passage of time. A rights plan of shorter duration may make sense in these circumstances. By contrast, if significant positions were acquired more recently, a longer duration would be necessary to protect the company from potential ownership changes.

Companies can monitor public filings to approximate their cushion, although additional diligence may be needed with the company’s shareholders, particularly if there is only a small cushion.

2. Value and usability of company’s NOLs and other tax attributes

It is relevant to look both at expected cash tax savings (depends on income projections) and accounting implications of a limitation (e.g., a valuation allowance against a deferred tax asset).

3. Severity of an NOL limitation

This is a function of a number of factors, including the company’s market value, the current long-term tax-exempt rate, the size of their NOLs, the likelihood that they will use the NOLs.

The company should form a view, based on income projections, of how low of a limitation on their tax attributes they could tolerate, which would still afford them the ability to extract value from their tax attributes.

V. Conclusion

An NOL rights plan can be a valuable tool to help a public company preserve its valuable tax attributes and its ability to save taxes on future profits. It doesn’t make sense for everyone, but companies with significant pools of tax attributes should consider whether this form of protection is right for them, particularly given the new risks presented by a highly volatile stock market.

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