A January 16th report from FactSet Insight discusses the growing trend of companies using their net operating losses (NOLs) as a poison pill defense. NOLs can be “carried” forward to offset future taxes, and are valuable assets for a firm. The use of NOL carries is, however, subject to relatively strict IRS limitations, including change in ownership events.
FactSet account executive Anthony Garcia notes that an increased position by a 5% shareholder can be sufficient to trigger an IRS-defined change in ownership without the shareholder actually taking over the company. Garcia notes: “Depending on the timing of share accumulation, an activist looking to attain the common 9.9% ownership in advance of an activist campaign could trigger a change in ownership and impair the value of the NOL-assets.”
Net operating losses as de facto poison pills
Yarra Square Partners returned 19.5% net in 2020, outperforming its benchmark, the S&P 500, which returned 18.4% throughout the year. According to a copy of the firm's fourth-quarter and full-year letter to investors, which ValueWalk has been able to review, 2020 was a year of two halves for the investment manager. Q1 2021 hedge fund Read More
The management of firms may in good faith adopt limits on the accumulation of the company’s shares using its charter and bylaws to minimize the possibility of a change in ownership. The methods for limiting changes in ownership can be designed specifically for NOL situations or serve as a more general limitation on ownership.
Garcia highlights that one consequence of limiting a change in ownership in the charter/bylaws is the limit can serve as a “de facto poison pill.” Firms can, of course avoid a change in ownership through an shareholder rights plan/poison pill that kicks in at various levels of share accumulation. In most cases, these poison pills have relatively low trigger limits, usually around 4.75% and 5%.
141 companies have included NOL-specific provisions as part of a poison pill since 2009, and 89 of those NOL poison pills are presently in-force. Some activists and others have criticized poison pills because they can allow management to become entrenched. Not being able to replace management is especially problematic given that NOL-assets are basically operating losses, which could mean that current management is not maximizing company profits.
Activists campaigns against companies with NOL poison pills
The FactSet report notes that companies with NOL ownership limits in the original charter and bylaws were targets in 13 activist campaigns. Activists were looking for board seats in three of the campaigns and won the proxy votes in two cases. For the firms with NOL protection in the charter and/or bylaws at the time of activism, five activist campaigns trying to change the BoD have seen four successful campaigns. Garcia highlights that in terms of overall activism (0.40 campaigns per company) and attempts to change board representation (0.07 per company), limits to the changes in ownership for the purpose of NOL protection does seem to effectively deter activism.
Among the 171 companies that adopted NOL-specific poison pills, these these firms have been involved in 25 activist campaigns with the purpose of changing board representation and 63 campaigns in total. In the 25 campaigns to change the board, 20 of the campaigns ended up with at least one board seat for the activist. Even taking out companies that adopted NOL provisions in the last year, the activism rate is 0.42 campaigns per firm and 0.17 campaigns per firm to change board representation. Of note, the activism rate against companies with NOL-focused poison pills is very close to that of companies with ownership limits, but the rate of campaigns that want changes in board representation is much higher and similar to the rate for overall activism.