The struggling retailer reduced the limit to 4.9 percent, from 10 percent, preventing any single shareholder from holding more than a 4.9 percent stake without board approval.
J.C. Penney is subject to the occasional takeover rumor, but more important, it has lately been a hedge fund hotel. William A. Ackman’s Pershing Square Capital Management came and noisily left. So did David Tepper’s Appaloosa Management, though less noisily. But others like George Soros’s fund and Richard Perry’s Perry Corporation have arrived and stayed. Still, Perry has reduced its stake, and hedge funds’ interest in the company has waned. The immediate conclusion of many in the media was that J.C. Penney’s move was intended to prevent any more activist investors from accumulating a large position.
But this may not be the case, and the reason lies in the tax reasons behind its action.
J.C. Penney can justify the low trigger because of tax rules that are even more complex than normal. When a company accumulates losses, called net operating losses or NOLs, these have value. If the company returns to profitability, it can use them for up to 20 years to offset future gains and avoid paying tax. In some cases, the NOLs can actually be transferred to other parties.
The tax code also sets forth a limit on the NOLs being transferred, a so-called ownership change.
Unfortunately, the way the tax code defines a change of control is quite broad. An ownership change occurs when the percentage of a company’s stock owned by shareholders with a stake of 5 percent or more increases by more than 50 percent over a three-year period. If, for example, a shareholder with a 5 percent stake acquired enough stock to go over the 7.5 percent level, this would constitute an ownership change. The company would be at risk of losing its NOLs unless an exception could be found.
The rules, of course, have lots of intricate exemptions that keep tax lawyers busy, but the 5 percent threshold is the sticking point.
The risk is that a shareholder goes over the 5 percent level and then again increases its shareholdings enough to kill the NOLs. The risk is real, and companies have used this risk to justify adopting poison pills that deter shareholders from acquiring as much as a 5 percent stake. According to FactSet SharkRepellent, 162 public companies have such poison pills, which are sometimes known as NOL poison pills, including Citigroup and Krispy Kreme.
But pills with these limits are controversial. They are a blunt hammer. A poison pill meant to preserve a company’s tax advantages could have exceptions and allowances for share increases less than 50 percent as well as initial positions above the 5 percent level. None do, though.
That is probably because a poison pill that limits a shareholder’s stake to less than 5 percent has a convenient side effect of deterring activist activity. A hedge fund may now be unwilling to undertake an activist campaign because it cannot buy enough stock to justify this activism.
And even though questions have been raised about the tactic, it has been blessed by the Delaware courts.
J.C. Penney stated on Tuesday that had $2 billion in NOLs. So it has some justification in adopting the new limit for its poison pill. The retailer is even taking steps to deal with any shareholder objections. It is putting the issue to a shareholder vote. If shareholders approve the pill, it will be in place until 2017, a relatively long period but not unusual.
In addition, J.C. Penney is going to ask shareholders to put similar provisions in its charter, making it more permanent. This seems a bit like overkill, though we haven’t seen the text.
If J.C. Penney’s shareholders approve the pill, it will make it make it difficult for anyone new to acquire a significant stake. Right now, according to Capital IQ, J.C. Penney has only two 5 percent shareholders — Soros Fund Management, with 6.6 percent, and the Vanguard Group, with 6.2 percent. They would be prevented from acquiring more shares. Other shareholders would be limited to a 4.9 percent stake.
But J.C. Penney could have adopted this poison pill at any time. Why is it doing so now, especially when it appears that the threat from hedge funds is receding?
I asked J.C. Penney for comment. Daphne Avila, an employee and representative of J.C. Penney responded that the “tax benefits represent a significant corporate asset that the company believes may deliver substantial benefits to stockholders.” She said that the J.C. Penney board had considered a number of factors, including “the potential for diminution upon an ownership change, and the risk of an ownership change occurring.”
It’s hard to even read tea leaves from this statement. But perhaps now that things have settled down — Mr. Ackman has left and J.C. Penney’s former chief executive has rejoined the company — the board felt that it was safe to just deal with this issue. Or maybe the board felt that it wanted to protect management for a while to make sure it had time to turn around the company’s fortunes.
Both seem to ring true, but it’s hard to know. And of course, there is the question of why it even bothered to lower the threshold for the poison pill at this time, since the company never acted while Mr. Ackman and others were acquiring shares.
We are left with a mystery, while shareholders may also be wondering what the true effect will be. The hedge funds, though, seem to have already come and gone.