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Recent developments in high-profile Chapter 11 cases involving foundering corporate giants like United Airlines and Conseco have brought renewed attention to the role played by bankruptcy courts in regulating the trading of creditor claims and stock issued by debtor companies. Despite lawmakers’ efforts in 1991 to relieve the bankruptcy courts from the administrative burden associated with policing post-bankruptcy trading, courts are increasingly being asked to do so by debtors intent upon preserving valuable tax attributes that could be forfeited upon a significant change in stock ownership or in the makeup of their creditors. These developments are significant given the relative absence of regulation in the multibillion-dollar distressed securities industry that first developed in the 1980s and has continued to expand in a troubled economy. TRADING CLAIMS IN BANKRUPTCY While the outcome of a Chapter 11 restructuring can seldom be predicted with any degree of certainty in the current economic climate, one thing is assured: The company will not have the same creditors and shareholders at the end of the case that it had at the outset. The proliferation of vulture funds and other traders in distressed “securities” provides a ready market for creditors and shareholders who want to cut their losses without waiting until confirmation of a plan of reorganization that may not take place until several years later. Although trading in public securities issued by a debtor is regulated by disclosure and other requirements contained in federal securities laws, transfers of creditor claims are not subject to such regulation. As such, astute claims traders can profit considerably if claims acquired at a steep discount later reap significant recoveries. Whether such speculation turns a profit depends on the quality of an acquirer’s investigation of the debtor company’s affairs and an educated bet on the likely outcome of the case — information and expertise that few creditors have or are willing to develop. The disparity in resources and expertise between creditors and sophisticated claims speculators has been perceived as creating a potential for abuse in an unregulated market. For this reason, bankruptcy courts have played a role in monitoring and sometimes preventing claims trading. Court scrutiny has also been brought to bear because buying claims against a company can be a way to acquire a controlling stake in the company if it later decides to convert its debt to equity as part of a Chapter 11 plan of reorganization. Creditors selling their claims against a bankrupt company do not have the benefit of the same disclosure to which they would be entitled in connection with the Chapter 11 plan confirmation process. Neither the Bankruptcy Code nor its accompanying procedural rules expressly gives the bankruptcy courts the power to regulate trading once a company files for bankruptcy protection. Rule 3001(e) of the Federal Rules of Bankruptcy Procedure merely contains certain notification requirements that vary depending upon when a claim is transferred to ensure that the court has an accurate record of the identity of the holder of the claim and, in a Chapter 11 case, to ensure that the actual holder of the claim has an opportunity to vote to accept or reject a plan. It does not provide for any court involvement in the process. This was not always the case. Prior to 1991, Rule 3001(e) invited relatively open-ended bankruptcy court scrutiny of the fairness of a pending trade. At that time, the rule provided that substitution of the transferee as the holder of a claim after the filing of a proof of claim required court approval after notice and a hearing. Potential transferees typically provided notice not only to the transferor and the court, but to all other creditors and interested parties in the bankruptcy case. Third parties then had an opportunity to object to the transfer, the terms of which were disclosed to the court. Whether or not anyone objected, the bankruptcy court was in a position to determine whether the seller was sufficiently informed of the value of its claim or was susceptible to being misled. [FOOTNOTE 1] Rule 3001(e) was amended in 1991 with the express intention of curtailing judicial oversight of claims trading by limiting the requirement of court approval, minimizing what had to be disclosed to the court and eliminating third-party involvement altogether. [FOOTNOTE 2]Under the present version of the rule, no notice of a transfer need be given to anyone other than the court and the transferor. Moreover, the parties to the trade are not required to disclose the terms of transfer. If the transferor makes a timely objection to the transfer, the “court’s role is to determine whether a transfer has been made that is enforceable under nonbankruptcy law.” [FOOTNOTE 3] TAX ATTRIBUTES AND CHANGES IN CONTROL What rulemakers apparently overlooked when attempting to remove the bankruptcy courts from the process was the resulting potential for mayhem in Chapter 11 reorganizations involving companies with valuable tax attributes. An indispensable feature of almost every Chapter 11 case involving a business that is attempting to reorganize by reworking its capital structure or spinning off divisions is the ability to preserve as much as possible existing net operating losses (NOLs) to offset against future tax liabilities of the reorganized or successor entity. NOLs are an excess of deductions over income in any given year. They can generally be carried back to use against taxable income in the two previous years (five previous years, for ordinary losses incurred in 2001 and 2002) and, to the extent not used, may be carried forward for 20 years. Losses remain with the debtor during a bankruptcy case because a bankruptcy filing for a corporation does not create a new taxable entity. The fly in the ointment is provisions in the Internal Revenue Code (IRC) that significantly limit the ability of a company to preserve its NOLs upon a “change in ownership.” [FOOTNOTE 4]The vast majority of all corporate reorganizations under Chapter 11 result in a change of ownership under � 382 of the IRC. An ownership change occurs if there is any change in the respective ownership of stock of a debtor and, after that change, the percentage of stock owned by any one 5-percent shareholder has increased more than 50 percentage points over the lowest percentage of stock owned by that shareholder during a three-year period. [FOOTNOTE 5]All shareholders owning less than 5 percent of the stock are aggregated and treated as a single “public group” shareholder. CHANGE OF OWNERSHIP When a change of ownership takes place pursuant to a plan of reorganization, the tax attributes that remain after giving effect to other attribute reduction rules in the IRC are generally — although not always — subject to an annual limitation on future use. That limitation is equal to the annual long-term tax-exempt bond rate (currently about 4.7 percent) times the value of the company’s equity immediately after the change of ownership (and after giving effect to the reduction in liabilities occurring pursuant to the plan of reorganization). Under certain limited circumstances, a debtor can undergo a change of ownership in bankruptcy and emerge without any � 382 limitation on its NOLs or built-in loss. In order to qualify for this election: (i) shareholders and creditors of the company must end up owning at least 50 percent of the reorganized debtor’s stock (by vote and value); (ii) shareholders and creditors must receive their 50 percent stock ownership in discharge of their interest in and claims against the debtor; and (iii) stock received by creditors can only be counted toward the 50 percent test if it is received in satisfaction of debt that (a) had been held by the creditor for at least 18 months on the date of the bankruptcy filing (i.e., was “old and cold”), or (b) arose in the ordinary course of the debtor’s business and is held by the person who at all times held the beneficial interest in that indebtedness. [FOOTNOTE 6] IRC � 382(l)(5) serves a valuable rehabilitative purpose by permitting bankrupt corporations that can qualify for it to restructure their finances and emerge from bankruptcy with a largely unfettered ability to use their NOLs to shelter income earned after an ownership change takes place as part of a Chapter 11 plan of reorganization. However, that ability can be compromised. Thus, if the company’s business enterprise is not continued at all times during the two-year period beginning upon confirmation of a plan or, if a second change in ownership takes place within two years, the company will forfeit the right to benefit from the liberal rules of � 382(l)(5). Also, a debtor company making use of � 382(l)(5) must undergo a statutory NOL “haircut” whereby it loses certain interest deductions taken within the previous three tax years. These rules place a heavy burden on the debtor to monitor the identity of its creditors and shareholders with fairly exacting precision. A significant volume of stock or claims transfers can jeopardize the debtor-company’s ability to get the full benefit of its NOLs. Bankruptcy courts recognized this relatively early on, finding that NOLs are property of a Chapter 11 debtor’s bankruptcy estate and scotching any action that had the potential to adversely affect them. The seminal case in this area is In re Prudential Lines Inc., [FOOTNOTE 7]where the bankruptcy court found that an NOL was property of the debtor’s bankruptcy estate and that the efforts of the debtor’s corporate parent to claim a worthless stock deduction, which, under the law, as it then stood would render the debtor’s NOL useless, violated the automatic stay. Other courts have since followed suit, recognizing that preservation of a debtor’s NOL may be crucial to the success of the reorganization. [FOOTNOTE 8] COURT INTERVENTION Debtors have been swift to seek court intervention in cases with the potential for a significant volume of claim or stock trading. Companies like First Merchants Acceptance Corp., [FOOTNOTE 9]Service Merchandise Co., [FOOTNOTE 10]Phar-Mor Inc., [FOOTNOTE 11]South East Banking Corp. [FOOTNOTE 12]and, more recently, Williams Communications Group, [FOOTNOTE 13]Conseco, [FOOTNOTE 14]Metrocall, [FOOTNOTE 15]United Airlines, Provell Inc. and Worldtex Inc., have sought at the outset of a bankruptcy case court approval of procedures designed to monitor trading and afford the debtor an opportunity to prevent trading if it threatens important tax attributes. Conseco obtained a bankruptcy-court-order blocking major shareholders from selling or transferring common stock as part of its first day Chapter 11 filings. United Airlines successfully enjoined the trustee of its employee stock ownership plan from selling its majority stock holdings to preserve NOLs estimated to exceed $20 billion (although the bankruptcy court may permit the sale of approximately 3.9 million shares based upon a March 4, 2003 ruling by the IRS that the sale would not jeopardize tax benefits). Provell Inc. established procedures requiring 15 days advance notice of a proposed transfer of claims aggregating more than $1.5 million in face value in an effort to preserve over $70 million in NOL carryforwards. In fact, NOL preservation motions are becoming almost routine in large Chapter 11 cases. ANALYSIS High-profile bankruptcy cases such as the Chapter 11 cases filed by WorldCom, Enron, Global Crossing, Kmart and Conseco have focused attention on investing in the debt of troubled companies and highlighted the arguably dominant role played by vulture investors in large and medium-size Chapter 11 cases. These cases and many others also illustrate some of the challenges confronted by companies seeking to reorganize in bankruptcy. The practical challenge for debtors that possess sizeable NOLs is to safeguard these tax attributes by avoiding an ownership change (or excessive claims trading) until confirmation and consummation of a plan of reorganization. Notwithstanding rulemakers’ efforts in 1991 to remove the bankruptcy court from the claims trading market, recent developments indicate that the courts are still very much involved in regulating trading of claims and interests if the success of the debtor’s reorganization is at stake. These developments also suggest that as part of pre-bankruptcy strategic planning, potential debtors should determine whether they have any NOLs or other tax attributes that require protection. The unwary debtor may find that it has already undergone an ownership change (or has lost its ability to qualify for � 382(l)(5)) prior to filing, or that it is dangerously close to the threshold. Rapid action may be necessary given the robust market for trading in the claims and stock of financially troubled companies. Creditors should also be vigilant to ensure that when a debtor seeks court approval of procedures restricting claim and equity trading, it demonstrates that the benefit derived by the estate through preserving tax attributes outweighs prejudice to creditors and shareholders who are being precluded from liquidating their holdings. John J. Rapisardi is a partner in and co-head of the business restructuring and reorganization practice of Jones Day ( www1.jonesday.com). Mark G. Douglas, the practice development facilitator, assisted in the preparation of this article. If you are interested in submitting an article to law.com, please click herefor our submission guidelines. ::::FOOTNOTES:::: FN1 See, e.g., In re Allegheny Intern., Inc., 100 B.R. 241 (Bkrtcy. W.D. Pa. 1988). FN2 In re Olson, 120 F3d 98, 101-02 (8th Cir. 1997). FN3 See1991 Advisory Committee Note to Fed. R. Bankr. P. 3001. FN4 See26 USC �382(a), (b) and (k). FN5 See26 USC �382(g)(1) and (2). FN6 See26 USC �382(1)(5)(E). FN7 Prudential Lines, Inc., 107 B.R. 832 (Bankr. S.D.N.Y. 1989), aff’d, 928 F.2d 565 (2d Cir. 1991). FN8 See, e.g., Gibson v. United States (In re Russell), 927 F2d 413 (8th Cir. 1991); In re Phar-Mor Inc., 152 B.R. 924 (Bankr. N.D. Ohio 1993). FN9 First Merchants Acceptance Corp., 1998 Bankruptcy LEXIS 1816 (Bankr. D. Del. Jan. 20, 1998). FN10 In re Service Merchandise Co., Inc., 2000 Bankr. LEXIS 1523 (M.D. Tenn. Dec. 2000). FN11 Phar-Mor, Inc., 152 B.R. at 927. FN12 In re Southeast Banking Corp., Case No. 91-14561-BKC-PGH (Bankr. S.D. Fla. July 21, 1994). FN13 Williams Communications Group Inc., Case No. 02-11957 (BRL) (Bankr. S.D.N.Y. July 24, 2002). FN14 In re Conseco Inc., Case No. 02-49671 (Bankr. N.D. Ill. Dec. 18, 2002). FN15 In re Metrocall Inc., Case No. 02-11579 (RB) (Bankr. D. Del. July 8, 2002).

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