Solyndra: Now It’s IRS’s Turn

Solyndra Inc. (Solyndra), the solar panel maker currently in Chapter 11 bankruptcy proceedings, has been making headlines for several years; the bankruptcy court’s recent decision to confirm Solyndra’s plan of reorganization, rather than ending the saga, appears to be the harbinger of a new round of controversy, this time between the IRS and Solyndra’s two largest shareholders.

The controversy stems from nearly $1 billion of net operating loss (NOL) carryforwards accrued before Solyndra entered bankruptcy protection.

This article describes how NOLs can survive a bankruptcy proceeding and speculates on the arguments Solyndra’s two largest shareholders may be relying on to preserve Solyndra’s NOLs following its emergence from bankruptcy.

A Brief History of Solyndra

By now, the reasons for Solyndra’s 15 minutes of fame are generally known. Solyndra was a start-up company that had developed a new type of solar photovoltaic panel. Commercialization of its panels required capital, which it was able to obtain in part from a U.S. Department of Energy (DOE) loan guarantee.

However, after it obtained the loan guarantee, demand for its panels started to fall precipitously due to the 2008 global economic downtown and fierce competition from cheaper Chinese-made panels. Although Solyndra struggled for two years to overcome these setbacks, it was ultimately forced to cease operations on Aug. 31, 2011. A week later, on Sept. 6, 2011, it filed for Chapter 11 bankruptcy protection. ¹Chapter 11 of the Bankruptcy Code permits a reorganization of a bankrupt corporation. The purpose is to give the corporation some protection from its creditors while it restructures and negotiates its debts and ownership interests with its creditors and owners in order to maximize its value as a going concern. In most instances, the bankrupt corporation remains in control of its business operations as a debtor in possession, and is subject to the oversight and jurisdiction of the bankruptcy court. In contrast, Chapter 7 of the Bankruptcy Code governs the process of a liquidation bankruptcy. Under Chapter 7, the business ceases operations, a trustee sells its assets and distributes the proceeds to its creditors, and any residual amount is returned to its owners.

Central to the NOL story is an event that occurred seven months prior to Solyndra’s bankruptcy. In February 2011, as part of a global restructuring of Solyndra’s operations and debt, DOE and Solyndra’s other creditors agreed to subordinate their recovery rights on Solyndra’s existing indebtedness to a new $75 million loan. The proceeds of this loan were intended to provide an infusion of cash that would be used to fund operations while Solyndra continued to look for other sources of capital.

The loan was underwritten by Solyndra’s two largest shareholders, Argonaut Ventures I LLC and Madrone Partners LP (the “Lead Investors”), which as of Jan. 2, 2010, owned, respectively, 35.73% and 11% of Solyndra. ²These figures are derived from Solyndra’s amended Securities and Exchange Commission Form S-1, which it filed on Mar. 16, 2010, in anticipation of an initial public offering (which was later canceled). It was funded by a group of investors consisting of the Lead Investors and existing holders of Solyndra’s preferred stock and outstanding secured convertible promissory notes (the “Participating Investors”).

An important aspect of this restructuring was the issuance of warrants representing, in the aggregate, 99.99% of Solyndra’s fully diluted equity ownership to the Lead Investors and the Participating Investors in return for their participation in the new $75 million loan. At the time the warrants were issued, however, most of the Participating Investors agreed to transfer them to the Lead Investors in the event that Solyndra voluntarily filed for bankruptcy. ³The Lead Investors explained to the Participating Investors that the latter’s agreement to transfer their warrants to the Lead Investors was consideration for the Lead Investors’ role in underwriting the new $75 million loan and having placed a significant amount of funds in escrow a month earlier at the request of DOE.

The purpose of these transfers was to allow the Lead Investors the ability to preserve and eventually use any NOLs that had accrued at the time of a bankruptcy filing.

Solyndra’s Reorganization Plan
And the Federal Government’s Opposition

Solyndra Sept. 7 filed a plan of reorganization with the bankruptcy court. The plan covers two different entities: 360 Degree Solar Holdings Inc. (Holdings, which formerly was Solyndra) and Solyndra LLC (LLC). LLC was the operating business, and Holdings is the holding company that owns LLC.

In the plan, the Lead Investors (who are the plan sponsors) agree to contribute cash in an amount equal to $7.5 million more than the amount they will receive as creditors of Solyndra. This cash, along with the proceeds from the sale of LLC’s assets, will be used to pay a portion of the claims against Holdings and LLC as follows:

• The debt claims of at least some of the secured creditors, including the Lead Investors and the Participating Investors, will be paid in full.
• The claims of the unsecured creditors, including DOE, will be paid about three cents on the dollar.

Following the payment of these claims, LLC will liquidate, while Holdings will be left as a shell company with no employees, no business activity, and no assets with one significant exception. Holdings will exit bankruptcy protection with NOL carryforwards of as much as $975 million and $12 million in tax credits. ⁴These NOL carryforwards resulted from the substantial losses incurred by LLC (which losses were likely treated as accrued by Holdings under the U.S. tax rules) while LLC was an operating business. The plan of reorganization notes that the losses were “largely funded by Solyndra’s investors, in addition to the Department of Energy.” The tax credits are general business credits for research and development conducted by Solyndra. Documents filed with the bankruptcy court indicate that these tax attributes could have a value of as much as $350 million.

These documents also indicate that, after Holdings exits bankruptcy protection, its historic shareholders will retain their interests in Holdings, the Lead Investors will hold warrants giving them the rights to acquire control of nearly 100% of Holdings, and at least one of the Lead Investors plans to exercise those rights.

Nearly all of Solyndra’s creditors and parties in interest entitled to vote on the plan voted in favor of it. Solyndra’s largest creditor, the federal government, objected. In a brief filed on behalf of the IRS, a party in interest, the U.S. Department of Justice (DOJ) argued, “The only reason for the shell corporation to exist post-confirmation is to enable its owners to exploit those tax attributes, which would be lost in liquidation.”

DOJ cited numerous instances in which communications between the various parties to the 2011 restructuring referred to the Lead Investors’ goal of preserving the NOLs. Based on these statements, DOJ urged the bankruptcy court to reject the plan of reorganization because “its principal purpose is the avoidance of future income tax liabilities of the Plan Sponsors.” ⁵Under §1129(d) of the Bankruptcy Code, a bankruptcy court may not confirm a plan of reorganization if the principal purpose of the plan is the avoidance of taxes.

The bankruptcy court Oct. 22 rejected the federal government’s objection and confirmed Solyndra’s plan of organization, although it did agree temporarily to stay the confirmation order until Nov. 1 (later extended to Nov. 5 due to Hurricane Sandy) pending a further entry of stay by the U.S. District Court for the District of Delaware.

DOJ Nov. 1 gave notice that it was appealing the bankruptcy court’s confirmation order, and it also requested a further stay of the confirmation order from the district court. The Delaware court Nov. 6 denied the federal government’s request for a further stay.

Have Solyndra’s NOLs Been Preserved?

One question that has not been answered by the bankruptcy court’s decision is whether the Lead Investors succeeded in their goal of preserving Holdings’ NOLs. This will depend on whether they are able to successfully navigate the “anti-loss trafficking” rules of §382 of the Internal Revenue Code.

Section 382’s NOL Limitation Rules

Under §382(a), if a company with an NOL carryover (generally referred to as a loss corporation) undergoes a change of ownership (see discussion of this term below), the amount of its NOL that can be used to reduce its future taxable income is subject to an annual limitation equal to the value of the loss corporation (i.e., the value of its stock) multiplied by the long-term tax-exempt rate for the month in which the ownership change occurs. ⁶For example, if a loss corporation that experiences a change in ownership has a $25 NOL, a value of $100, and the tax-exempt rate for the month in which the ownership change occurs is 5%, then the amount of its §382 limitation is $5 (5% x $100), and it will take five years ($25 ÷ $5) for the loss corporation to fully utilize its $25 NOL.

However, if the loss corporation also fails to continue its historic business (or use a significant portion of its assets in another business) for at least two years following the ownership change (referred to as the “continuity of business enterprise” requirement), the NOL is eliminated in its entirety. ⁷§382(c)(1); Regs. §1.368-1(d).

An ownership change occurs with respect to a corporation if it is a loss corporation on a testing date and, immediately after the close of the testing date, the percentage of stock of the corporation owned by shareholders owning at least 5% of the stock of the loss corporation (each a 5% shareholder) increased by more than 50 percentage points over the lowest percentage of stock of such corporation owned by such shareholders at any time during the testing period. ⁸§382(g); Regs. §1.382-2T(a)(1).

A testing period is generally a three-year period ending on a testing date. ⁹Regs. §1.382-2T(d)(1). A testing date is any day on which either a change in the percentage of stock of the loss corporation owned by a 5% shareholder occurs or an option to acquire stock is issued or transferred and on such date the option is treated as exercised. ¹⁰Regs. §1.382-2(a)(4).

Note that in applying the definition of testing date, two rules under §382 are particularly relevant to Solyndra’s facts. First, options are defined as including warrants. ¹¹Regs. §1.382-4(d)(9)(i). Second, an option (or warrant) is treated as having been exercised on the date it is issued or transferred if:

• on that date the holder of the option (or warrant) and certain related persons have, in the aggregate, a more-than-50% ownership interest in the loss corporation (which ownership percent is determined as though the option/warrant were exercised on such issuance or transfer date); and
• a principal purpose of the option is to avoid an ownership change. ¹²See generally, Regs. §1.382-4(d)(4).

Persons may be related for purposes of this rule if they have a formal or informal understanding among themselves to make a coordinated acquisition of stock of the loss corporation. ¹³Regs. §1.382-4(d)(4)(ii)(A).

Section 382 and Bankrupt Loss Corporations

In the case of a change in ownership of a bankrupt loss corporation (which generally has no value), the general rule of §382(a) would produce a limitation of zero. To prevent this from happening, §382(l)(5) turns off §382(a)’s loss limitation rule if the following requirements are met:

• immediately before an ownership change, the loss corporation is under the jurisdiction of a bankruptcy court; and
• immediately after the ownership change, persons who were shareholders and/or certain creditors of the loss corporation immediately before such ownership change own (as a result of being such prior shareholders or creditors) at least 50% of the stock of loss corporation after the ownership change. ¹⁴Under §382(l)(5)(E), stock held by a former creditor is taken into account for purposes of this rule only if it was received in exchange for debt that was held by the creditor for at least 18 months before the bankruptcy case was filed or that arose in the ordinary course of the trade or business of the bankrupt loss corporation and is held by the person who at all times held the beneficial interest in such indebtedness. Under §382(l)(5)(B), the loss corporation’s NOL will be reduced by any interest paid or accrued by the loss corporation on the converted debt during a specified period.

In addition, §382(l)(5) stipulates that if a second ownership change in the reorganized loss corporation occurs within the two-year period following the ownership change that qualified for the §382(l)(5) exception, the §382 limitation going forward from that second ownership change is zero. ¹⁵§382(l)(5)(D).

The exception in §382(l)(5) is based on a recognition that, by the time a corporation is in bankruptcy, it is often the corporation’s creditors, and not its shareholders, who are effectively its economic owners. In such cases, a bankruptcy court may approve a plan in which the company’s creditors (and even some shareholders) are issued new shares of stock in return for agreeing to cancel some or all of their existing claims against the company.

If such creditors owned none of the loss corporation’s stock prior to the bankruptcy, §382(a) would effectively eliminate its NOLs if, after the bankruptcy, the creditors owned 50% or more of its stock. Section 382(l)(5) is intended to prevent the elimination of a loss corporation’s NOLs if the change in ownership of the loss corporation’s stock results largely from the acquisition of the loss corporation’s stock by its creditors (as well as any historic shareholders that increase their equity interests in the loss corporation) as part of a bankruptcy proceeding.

Has There Been/Will There Be
A Change in Ownership of Holdings Stock?

The key factor in determining whether Holdings (nee Solyndra) has emerged from bankruptcy with its NOL fully intact is the occurrence of an ownership change in its stock. It is not clear whether such a change occurred in the past or will occur in the future.

As noted above, warrants representing almost 100% of Solyndra’s fully diluted equity ownership were issued to the Lead Investors and Participating Investors during the February 2011 restructuring, and then the Participating Investors transferred their warrants to the Lead Investors in September 2011 when Solyndra filed for bankruptcy. This presents two opportunities for IRS to argue that the warrants were deemed exercised and that a change in ownership occurred.

IRS could argue that the warrants were deemed exercised at the time they were issued. If so, it is possible that there would be no ownership change at that time because the warrants were held by the Participating Investors and the Lead Investors. This would mean that any stock received as a result of the deemed exercise of the warrants would also be held by both groups of investors and not just the Lead Investors.

IRS could also argue that the warrants were deemed exercised at the time they were transferred to the Lead Investors. At that point, any stock received as a result of the deemed exercise of the warrants would be held almost exclusively by the Lead Investors.

To prevent an ownership change in that instance, the Lead Investors must have owned at least 50% of the stock of Holdings at all times during the three-year period ending on the date of the transfer. As noted above, as of Jan. 2, 2010, the Lead Investors owned together 46.73% of Solyndra (later Holdings). This suggests that there was an ownership change on the date the Participating Investors transferred their warrants to the Lead Investors.

If it is determined that there was a change in ownership as a result of the Participating Investors’ transfer of their warrants to the Lead Investors, then Holdings may be seeking to qualify for §382(l)(5)’s exception from the general §382(a) NOL limitation rule for bankrupt loss corporations. To do so, Holdings would have to overcome several possible challenges.

It would have to ensure that the timing of the Lead Investors’ receipt of the warrants would be respected so that Holdings would be treated as being under the jurisdiction of a bankruptcy court immediately before the ownership change occurred. Otherwise, the ownership change would flunk the first part of §382(l)(5).

Holdings would also have to show that the Lead Investors owned their stock in Holdings after the ownership change “as a result of being shareholders or creditors immediately before such change.” ¹⁶See §382(l)(5)(A)(ii). As noted above, the purpose of this language generally is to prevent the creation of a §382 limitation of zero in cases where a change in ownership occurs as a result of a bankrupt loss corporation’s creditors agreeing to cancel their claims against the loss corporation in return for newly issued stock in the reorganized loss corporation. Since Holdings will emerge from bankruptcy protection with none of its creditors having received newly issued shares of Holdings and with its historic shareholders’ interests in Holdings largely, if not entirely, unchanged, it is not clear whether this requirement would be met.

Finally, if Holdings qualifies for the §382(l)(5) exception, then the Lead Investors will have to manage their subsequent exercise of the warrants so that they do not trigger an ownership change within the two-year period following the date they received the warrants from the Participating Investors. Otherwise, the §382 limitation on Holdings’ NOL will be zero going forward.

Postscript

As noted above, DOJ has appealed the bankruptcy court’s decision to confirm Holdings’s plan of reorganization. If IRS were to lose the appeal, the battle over Solyndra’s NOLs will shift to IRS’s examination and appeals function where IRS will have the opportunity to challenge Holdings’s use of the NOLs on a future tax return.

In short, the Solyndra saga is far from over. Stay tuned.