A Bitter Pill to Swallow in J.C. Penney's Poison Pill Defense

When a company adopts a shareholders rights plan, it's often done with the purpose of entrenching management by making it impossible for activist investors to ride in and acquire a stake that would give them the ability to make changes. There's a reason they're called "poison pills": Because it kills off any attempt at wresting away control of a company.

Troubled retailer J.C. Penney (NYSE: JCP  ) has a rights plan that would be triggered if a shareholder acquired more than 10% of the company, but yesterday it announced it wanted to adopt a plan that would kick in if someone tried to buy more than 4.9% of its stock. Although that's usually a clear sign someone is angling to swoop in, in Penney's case no one appears to have any interest in it -- and the hedge funds that might have once agitated for change have wandered away.

Which is why Penney says its decision is not about entrenching management, but rather preserving an asset, namely its net operating losses. Following the debacle that was Ron Johnson's tenure as CEO, the retailer's operating losses exploded to nearly $1.9 billion, and following a bland "update" to the Christmas shopping season that was devoid of any detail whatsoever -- one that came after it released two more expansive roundups -- investors should brace themselves for even worse news.

Due to quirks in the tax code, Penney's near demise gave it a valuable asset, losses that it can carry forward for as long as 20 years and use to offset any profits it might generate in the future (as well as offsetting any profits made during the prior two years). But if there's a change in control of the company, the NOLs could actually be wiped out. And the way the tax code is written, what you think of as a "change in control" is not what the law says, so it lends credence to Penney's rationale.

According to the tax code, any investor with a 5% stake in the company that increases his holdings by 50% over three years' time -- going from just 5% to 7.5% -- would be considered a change in control that could kill off the NOLs. Although there are exceptions to the rule, there remains real risk to losing them, real enough that hundreds of companies have adopted such plans.

While it might seem curious that Penney would choose this moment to adopt the rights plan instead of when Pershing Square and others were actively agitating for change, the move is further suggestive of coming losses. Because "NOL poison pills" are far more restrictive than traditional ones, they're best enacted during a quiet period when no one is interested in acquiring your stock -- and when you expect to generate lots of losses -- so you'll be able to take full advantage of their value.

Doing so too long after the fact could induce a court to disallow them on the grounds the rights plan's purpose wasn't to protect the asset but rather a scheme to entrench management. Which means Penney is doing the right thing, but for investors it means it's for the wrong reasons. 

The Christmas season did not bring good cheer to many retailers, with the most troubled ones like Best Buy and American Eagle Outfitters finding large lumps of coal in their stockings. J.C. Penney is in no better shape, and arguably is in even worse straits than either. For those like me who had been counting on the troubled retailer to effect its turnaround, it appears this new poison pill will be a bitter pill to swallow.

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