I know most bloggers today are consumed with the June avalanche of Supreme Court opinions and cert grants, but something interesting is afoot in the corporate law world (and more importantly the actual world). At the end of last week, Qatar Airways announced plans to purchase 10% of American Airlines. That move is definitely a little more interesting than Berkshire Hathaway reentering the airline sector and poses a lot of political concerns. What triggered my interest, I’m a little embarassed to say was the note in all the coverage that Qatar was going to purchase 4.75% now because it would need board approval to purchase any more. That sounds like an NOL poison pill! (Shamless plug to NOL poison pill paper, The Hostile Poison Pill.)
According to American Airlines Group’s latest 10K:
In addition, to reduce the risk of a potential adverse effect on our ability to use our NOL Carryforwards and certain other tax attributes for federal
income tax purposes, our Certificate of Incorporation contains certain restrictions on the acquisition and disposition of our common stock by
substantial stockholders (generally holders of more than 4.75%).
The Delaware courts have upheld the use of a 4.99 poison pill to protect a corporate asset (net operating loss carryovers are a deferred tax asset) because under the tax code, if a 5% shareholder (or group of them) increase ownership substantially, it can result in a severe impairment of the ability to use existing NOLs. Unlike many corporations that adopted NOL poison pills, American Airlines not only has a substantial amount of net operating loss carryforwards, but it has been using them the past few years to reduce pre-tax income.:
In 2016, we recorded a $1.6 billion provision for income taxes at an effective rate of approximately 38%, which was substantially non-cash as
we utilized our NOLs. Substantially all of our income before income taxes is attributable to the United States. At December 31, 2016, we had
approximately $10.5 billion of gross NOLs to reduce future federal taxable income, substantially all of which are expected to be available for use in
Interestingly, the merger with US Airways gave AA most of their NOLs, but the merger was also a Section 382 “ownership change,” so those NOLs are subject to a limitation that restricts their use somewhat. In addition, AA’s historical NOLs could have been limited following the company’s emergence from bankruptcy under an “ownership change,” but 382 is much more generous to bankruptcy debtors:
At December 31, 2016, we had approximately $10.5 billion of gross NOL Carryforwards to reduce future federal taxable income, substantially all of which are expected to be available for use in 2017. The federal NOL Carryforwards will expire beginning in 2022 if unused. We also had approximately $3.7 billion of NOL Carryforwards to reduce future state taxable income at December 31, 2016, which will expire in years 2017 through 2036 if unused. Our ability to deduct our NOL Carryforwards and to utilize certain other available tax attributes can be substantially constrained under the general annual limitation rules of Section 382 where an “ownership change” has occurred. Substantially all of our remaining federal NOL Carryforwards (attributable to US Airways Group) are subject to limitation under Section 382; however, our ability to utilize such NOL Carryforwards is not anticipated to be effectively constrained as a result of such limitation. We elected to be covered by certain special rules for federal income tax purposes that permitted approximately $9.0 billion (with $8.9 billion of unlimited NOL still remaining at December 31, 2016) of our federal NOL Carryforwards to be utilized without regard to the annual limitation generally imposed by Section 382. Similar limitations may apply for state income tax purposes. Our ability to utilize any new NOL Carryforwards arising after the ownership changes is not affected by the annual limitation rules imposed by Section 382 unless another future ownership change occurs. Under the Section 382 limitation, cumulative stock ownership changes among material stockholders exceeding 50% during a rolling three-year period can potentially limit a company’s future use of NOLs and tax credits.
Of course, the important question is how this relates to Qatar. Perhaps because AA’s NOLs are so valuable to them (unlike NOLs to a company that has a low probability of generating sufficient income to ever use them), AA has put transfer restrictions on its publicly-traded shares. One of these restrictions (Section 6 of its Articles of Incorporation) prohibits shareholders who own over 4.75% of AA stock from engaging in a transfer (sale or purchase) without consent of the Board (given in its sole discretion within 20 business days). The Board is required to determine whether the transfer will materially threaten the NOLs. (Note that 4.75% of AA stock is worth about $800 million, so most investors will never run up against this provision.) The provision is very narrowly-tailored — the provision expires in either 2021 or when the NOLs are gone. For comparison, a NOL poison pill is not narrowly tailored and may not protect from NOL impairment.
Whether a company adopts an NOL poison pill (poor fit to protect NOLs) or a charter amendment (well designed to protect NOLs), an intended or unintended consequence is that it basically allows a corporate board to pick its shareholders. Going public usually is a trade-off between liquidity and being able to know that your shareholders are not going to gain a majority without your knowing about it. With a 4.75% limit, no shareholder, whether Warren Buffett or a pesky hedge fund, can gain access without permission. This is a great tool against would-be activist shareholders wanting to shake up management (or worse). And, surprisingly, it can also be a tool against a foreign competitor making one of the stranger power plays against a backdrop of strange political events. So, AA has to live with Qatar Airways being a 4.75% shareholder, but not any larger. And, note that federal law prohibits foreign investors from owning more than 24.9% of voting equity securities and 49% of all equity securities of an airline.
Is there any way that Qatar Airways could gain some of that real estate between 4.75% and 24.9% without board approval? Qatar (as a shareholder) could litigate over the operation of the provision. It could argue that its purchasing 10% would not pose a threat to the NOLs and that the board refused to grant an exception in bad faith. The charter states that the board has “sole discretion” to make the determination of whether to grant an exception, but then states that the “good faith determination of the Board” will be conclusive and binding. Stay tuned!
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