An empirical examination of prepackaged bankruptcy

Financial Management (Financial Management Association), Spring, 1995 by Brian L. Betker

A firm deciding between a prepack and a workout must consider the COD income generated by either alternative. The effects of a restructuring on COD income depend on whether the exchange involves swapping old debt for new equity.(12) To see this in an example, consider a firm with debt of 100 and assets with a fair market value of 90, so that insolvency is 10. The firm exchanges its debt for new debt with a market value of 75, generating 25 of COD income. If the exchange occurs in a workout, the firm would have to reduce its NOLs by 10 (the COD income avoided by the firm's insolvency) and pay taxes on 15 of COD income. These current taxes could be avoided, however, by using up NOLs of 15. The net effect is a reduction in NOLs of 25.

In a prepack, all current taxes would be avoided but the firm would have to reduce NOLs by 25, the amount of COD income avoided. Thus, as long as the firm has sufficient NOLs, the effect of a debt-for-debt exchange is the same in either a workout or a prepack.(13)

In a stock-for-debt restructuring, a prepack may have advantages over a workout. Suppose in the example, that the firm exchanges old debt for new stock with a market value of 75. In a workout, the firm can exclude 10 of the COD income (the amount of its insolvency) and avoid NOL reduction by claiming the stock-for-debt exception. In this case, the firm must either pay current taxes or use NOLs to avoid taxation on the other 15 of COD income. In a prepack, the firm can apply the stock-for-debt exception to all 25 of COD income and avoid both current taxes and NOL reduction entirely. If the firm's insolvency exceeds the COD income generated by the stock-for-debt exchange, there would be no taxes or NOL reduction in either a workout or a prepack. (Note that a firm may still prefer a prepack to avoid having to prove insolvency to the Internal Revenue Service.)

B. Preservation of Net Operating Loss Carryforwards

Section 382 of the Internal Revenue Code generally limits a corporation's use of its NOLs if it undergoes an "ownership change." An ownership change occurs if the percentage of the corporation's stock held by 5% shareholders increases by more than 50% over a three-year testing period.(14) A workout or bankruptcy usually involves swapping a majority of the firm's equity for old debt claims, i.e., a group of shareholders goes from owning 0% to more than half of the firm's stock. Thus, an ownership change is to be expected as a result of distressed restructuring.

When an ownership change occurs, a firm's annual use of its NOLs is limited to the value of the firm's equity immediately before the ownership change times the long-term tax-exempt rate (which was between 6% and 7% for most of the sample period). Since NOLs expire in 15 years if not used, this annual limit on their use severely reduces their value to the firm. Furthermore, if the firm does not continue its historic business for the two-year period following the ownership change, NOLs are reduced to zero.

Bankrupt firms are allowed to make a special election regarding postbankruptcy treatment of their NOLs. The bankruptcy exception of [section]382(1)(5) may be used, if old shareholders and historic creditors of the firm before the ownership change own at least 50% of the firm's stock after the ownership change.(15) When the bankruptcy exception applies, annual future use of NOLs is unlimited, although NOLs must be reduced according to a statutory formula.(16)