As we reported in COVID-19: Revisiting Shareholder Rights Plans, the turmoil in U.S. equity markets created by the COVID-19 pandemic has resulted in many companies facing depressed stock prices, leaving them vulnerable to unsolicited acquisition proposals or activist activity, which has led to heightened interest in shareholder rights plans (also known as “poison pills”). Such depressed stock prices may also cause companies with significant net operating loss carryforwards (“NOLs”) to consider implementing an NOL rights plan, which is similar to a traditional shareholder rights plan but has distinct differences. WilmerHale’s Tax Group, along with the Mergers and Acquisitions practice, has prepared a high-level overview of the purpose and advantages of NOL rights plans.
Section 382 Background
The NOLs of a company1 generally can be used to offset its future taxable income, thereby making the company’s NOLs a potentially valuable asset. However, when a company undergoes an “ownership change,” as defined in Section 382 of the Internal Revenue Code and the Treasury Regulations promulgated thereunder (“Section 382”), Section 382 limits the company’s ability to use its pre-change NOLs to offset its future taxable income in each year following the ownership change. The annual limitation is generally equal to the value of the stock of the company immediately before the ownership change multiplied by a long-term tax-exempt interest rate published by the Internal Revenue Service. Today’s low stock prices, combined with historically low interest rates, would generally result in a very low Section 382 limitation, severely limiting (and potentially devaluing) a company’s NOLs following an ownership change. These factors, combined with the greater portion of public companies experiencing or expecting operating losses in the wake of the COVID-19 pandemic, have led to increased interest in NOL rights plans among our clients.
Definition of Ownership Change
The determination of whether an ownership change has occurred under Section 382 is complex, and non-tax professionals are often surprised at how an ownership change may be triggered under Section 382. An “ownership change” is generally defined as a greater than 50 percentage point change (by value) in a company’s equity ownership by one or more 5 percent shareholders over a rolling three-year period. An ownership change does not require that one person (or more than one person in coordinated acquisitions) acquire more than 50 percent of the company’s stock. An ownership change may occur as a result of unrelated 5 percent shareholders acquiring or disposing of a company’s stock in the public market with no involvement by the company. Issuances of stock by the company must also be taken into account in determining whether an ownership change has occurred.
Purpose of NOL Rights Plan
The objective of an NOL rights plan, also known as a net operating loss preservation plan, is to reduce the risk of triggering a Section 382 ownership change by 1) discouraging acquisitions of a company’s stock that cause the acquiror to become the beneficial owner of 5% of the company’s stock, and 2) discouraging any additional acquisitions (other than, in some cases, de minimis acquisitions of 0.5% to 1%) of the company’s stock by existing 5 percent shareholders. Like traditional shareholder rights plans, NOL rights plans generally discourage such acquisitions by providing for the distribution of certain stock purchase rights that entitle the company shareholders (other than the acquiring person) after such an acquisition to either purchase shares of the company’s stock at a significant discount (generally 50%) or, if elected by the company, receive additional shares of the company’s stock at no cost in exchange for the rights, in each case resulting in substantial dilution to the acquiring person. It is important to note that an NOL rights plan does not prevent an ownership change from occurring, as the plan does not prohibit acquisitions, but acts as a powerful deterrent.
Comparison to Traditional Shareholder Rights Plan
The mechanics of an NOL rights plan are similar to those of a traditional shareholder rights plan with several key differences. For more information regarding the mechanics of a traditional shareholder rights plan, see COVID-19: Revisiting Shareholder Rights Plans.
Threshold. First, in NOL rights plans, the applicable beneficial ownership threshold at which an acquisition will trigger the right of the company shareholders (other than the acquiring person) to purchase or receive additional shares is set just below 5% (typically 4.99% or 4.9%) as Section 382 aggregates changes in ownership by 5 percent shareholders to determine whether an ownership change has occurred. A traditional shareholder rights plan has a much higher threshold (typically 10-20%).
Definition of Beneficial Ownership. Second, “beneficial ownership” in NOL rights plans is typically defined, at least in part, by reference to Section 382, in addition to beneficial ownership as defined under securities laws and other indicia of ownership used in traditional shareholder rights plans. Stock ownership for purposes of Section 382 is determined based on a complex set of rules that take into account principles of constructive and beneficial ownership that differ from those rules under securities laws.
Exemption Provisions. Many NOL rights plans also contain exemption provisions that are not typically found in traditional shareholder rights plans. Since the purpose of an NOL rights plan is to deter acquisitions of a company’s stock that would cause a Section 382 ownership change and impair the company’s NOLs, these exemption provisions generally give the board of directors discretion to exempt a particular stock purchase from triggering the stock purchase rights if the board determines that the purchase would not endanger the company’s NOLs.
Duration. NOL rights plans also generally provide that the plan will terminate after three years or a shorter period if the NOLs being protected will expire before then. Termination of the plan also generally occurs upon a determination by the board of directors that the company has utilized all of its NOLs. Traditional shareholder rights plans are increasingly being limited to a shorter period, often one year or less.
Adoption of NOL Rights Plan
In contrast to traditional shareholder rights plans, which are often left on the shelf and only adopted if a threat emerges, NOL rights plans must be adopted preemptively to serve their purpose of deterring an ownership change. Subject to their fiduciary duties, boards of directors may adopt NOL rights plans without a vote of the shareholders. In practice, however, many plans have a sunset provision under which the plan will terminate if it is not approved by company shareholders within a year of its adoption. Companies adopting such plans also need to account for the policies of proxy advisory firms and institutional shareholders. Institutional Shareholder Services (or “ISS”) and Glass Lewis both impose certain minimum criteria on the terms of NOL rights plans, and will determine their recommendation on a case-by-case basis, considering factors such as the value of the NOLs and shareholder protection mechanisms, such as plan termination upon exhaustion or expiration of the NOLs.
NOL rights plans provide an attractive option for certain public companies, but the utility of such a plan depends upon many factors, including the amount (and potential value) of the company’s NOLs, the likelihood of a Section 382 ownership change occurring from public market trading or the company’s own actions (such as equity offerings), and costs of monitoring stock ownership and administering the plan. Companies interested in exploring the implementation of an NOL rights plan should contact the WilmerHale M&A and tax specialists listed below.