The ability to sell assets during the course of a chapter 11 case without incurring the transfer taxes customarily levied on such transactions outside of bankruptcy often figures prominently in a potential debtor's strategic bankruptcy planning. However, the circumstances under which a sale and related transactions (e.g., mortgage recordation) qualify for the tax exemption have been a focal point of vigorous dispute in bankruptcy and appellate courts for more than a quarter century, resulting in a split on the issue among the federal circuit courts of appeal and, finally, the U.S. Supreme Court's decision late in 2007 to consider the question.
The Supreme Court resolved that conflict decisively when it handed down its long-awaited ruling on June 16, 2008. The missive, however, is decidedly unwelcome news for any chapter 11 debtor whose reorganization strategy includes a significant volume of pre-confirmation asset divestitures under section 363(b) of the Bankruptcy Code. The 7-2 majority of the Court ruled that section 1146(a) of the Bankruptcy Code establishes "a simple, bright-line rule" limiting the scope of the transfer tax exemption to "transfers made pursuant to a Chapter 11 plan that has been confirmed."
Tax-Free Transfers Under the Bankruptcy Code
Section 1146(a) of the Bankruptcy Code provides that "the issuance, transfer, or exchange of a security, or the making or delivery of an instrument of transfer under a plan confirmed under [the Bankruptcy Code], may not be taxed under any law imposing a stamp tax or similar tax." A "transfer" includes a sale of property or the grant of a mortgage lien. To qualify for the exemption, a transfer must satisfy a three-pronged test: (i) the tax must be a "stamp or similar" tax; (ii) the tax must be imposed upon the "making or delivery of an instrument of transfer"; and (iii) the transfer must be "under a plan confirmed" pursuant to section 1129 of the Bankruptcy Code.
Section 1146(a) of the Bankruptcy Code (changed from section 1146(c) as part of the 2005 bankruptcy amendments) serves the dual purpose of providing chapter 11 debtors and prospective purchasers with some measure of tax relief while concurrently facilitating asset sales in bankruptcy and enhancing a chapter 11 debtor's prospects for a successful reorganization. Several areas of controversy have arisen concerning the scope of the section 1146(a) tax exemption. One area of debate concerns whether, to be exempt from taxes, asset transfers must be made as part of a confirmed chapter 11 plan, or whether the exemption may apply to sale transactions occurring at some other time during a bankruptcy case (particularly if the sale is important to the eventual confirmation of a plan).
Chapter 11 of the Bankruptcy Code contemplates the sale of a debtor's assets under two circumstances. First, a plan of reorganization (or liquidation) may provide for the sale of individual assets or even the debtor's entire business. Approval of a sale pursuant to a plan is subject to all of the requirements governing plan confirmation. This means, for example, that creditors whose claims are "impaired" (adversely affected, such as by receiving less than full payment) have the opportunity to veto the sale if they vote in sufficient numbers to reject the plan as a whole and are otherwise successful in preventing it from being confirmed. Selling assets under a plan thus requires higher procedural hurdles and would occur only at the end of the case, when all of the terms of a chapter 11 plan have been developed.
Circumstances may dictate that waiting to sell assets until confirmation of a plan at the end of a chapter 11 case is impossible or imprudent. Accordingly, assets can also be sold at any time during a bankruptcy case under section 363(b) of the Bankruptcy Code. That provision authorizes a trustee or chapter 11 debtor-in-possession, subject to court approval, to "use, sell, or lease, other than in the ordinary course of business, property of the estate." A bankruptcy court will generally approve a proposed asset sale under section 363(b) if the business justification supporting the sale is sound. Section 363(b) sales are an invaluable tool for generating value for a bankruptcy estate that can be used to fund a plan of reorganization or pay creditor claims. Moreover, because assets can be sold free and clear of liens, claims, or other encumbrances under the circumstances delineated in section 363(f), value can be generated quickly (taking advantage of market opportunities) and without the need to resolve most disputes involving the property until sometime later in the case.
Still, courts are sometimes reluctant to use section 363 as a vehicle for selling all, or a substantial portion, of a debtor's assets outside the plan process. The reluctance arises because a significant-asset sale involving substantially all of the assets of the estate is a critical (probably the critical) aspect of the debtor's overall reorganization (or liquidation) strategy. While creditors have the right to object to a section 363(b) sale, they do not enjoy the more substantial protections of the chapter 11 plan-confirmation process, even though the transaction may be tantamount to, or dictate certain terms of, a chapter 11 plan.
The interplay between section 363(b) and section 1146 has been a magnet for controversy. The phrase "under a plan confirmed" in section 1146(a) is ambiguous enough to invite competing interpretations concerning the types of sales that qualify for the tax exemption. Before the U.S. Supreme Court examined the issue, four federal circuit courts of appeal had an opportunity to weigh in on whether section 363(b) sales outside the context of a plan qualify for the section 1146 exemption. The remaining decision at the circuit level concerning section 1146 addressed whether transactions involving nondebtors may be exempt.
The Circuits Weigh In
The Second Circuit first addressed this issue more than 20 years ago in City of New York v. Jacoby-Bender, articulating the general rule that a sale need not take place as part of confirmation, so long as "consummation" of the plan depends on the sale transaction. Many lower courts have interpreted Jacoby-Bender to sanction tax-exempt, preconfirmation asset sales under section 363(b). Fourteen years later, the Fourth Circuit applied a restrictive approach to tax-exempt asset transfers in chapter 11, concluding in In re NVR LP that the term "under" should be construed as "[w]ith the authorization of" a chapter 11 plan. Explaining that the ordinary definition of "under" is "inferior" or "subordinate," the court observed that "we cannot say that a transfer made prior to the date of plan confirmation could be subordinate to, or authorized by, something that did not exist at the date of transfer—a plan confirmed by the court." The Fourth Circuit accordingly ruled that more than 5,000 real property transfers made by NVR during the course of its 18-month-long chapter 11 case did not qualify for the exemption.
In 2003, the Third Circuit Court of Appeals was the next to take up the gauntlet, and it effectively sided with the Fourth Circuit in taking a restrictive view of the section 1146 exemption in Baltimore County v. Hechinger Liquidation Trust (In re Hechinger Investment Company of Delaware, Inc.). Rejecting the expansive interpretation adopted by many lower courts in determining what constitutes a transfer "under" a confirmed plan of reorganization, the court of appeals held that real estate transactions consummated during the debtor's chapter 11 case were not exempt from transfer and recording taxes because the bankruptcy court authorized the sales under section 363, and they occurred prior to confirmation of a plan of reorganization.
The Eleventh Circuit addressed the scope of the section 1146 tax exemption in two rulings, both of which were handed down in the last four years. In the first of those decisions, In re T.H. Orlando Ltd., the court of appeals adopted an expansive approach to section 1146 in examining whether a transfer must involve the debtor and estate property to qualify for the section 1146 safe harbor. Examining the language of section 1146, the Eleventh Circuit concluded that a transfer "under a plan" refers to a transfer "authorized by a confirmed Chapter 11 plan," and a plan "authorizes any transfer that is necessary to the confirmation of the plan." It accordingly ruled that a refinancing transaction that did not involve the debtor or property of its estate, but without which the debtor would not have been able to obtain funds necessary to confirm a plan, was exempt from Florida's stamp tax under section 1146, "irrespective of whether the transfer involved the debtor or property of the estate."
The Eleventh Circuit had a second opportunity to examine the scope of section 1146 in 2007. In State of Florida Dept. of Rev. v. Piccadilly Cafeterias, Inc. (In re Piccadilly Cafeterias, Inc.), the court of appeals considered whether the tax exemption applies to a sale transaction under section 363(b) of the Bankruptcy Code. Piccadilly Cafeterias, Inc. ("Piccadilly"), a 60-year-old company that was once one of the nation's most successful cafeteria chains, filed a chapter 11 case in 2003 for the purpose of consummating a sale of substantially all of its assets under section 363(b) to Piccadilly Acquisition Corporation ("PAC").
In conjunction with its section 363(b) motion, Piccadilly requested a determination that the sale transaction was exempt from taxes under section 1146. The Florida Department of Revenue ("FDOR"), one of the relevant taxing authorities, opposed both the sale and the transfer tax exemption. Piccadilly also sought approval of a global settlement reached with the unsecured creditors' committee and a committee of its senior noteholders. The settlement resolved the priority of distribution among Piccadilly's creditors and, according to Piccadilly, was in many ways "analogous to confirmation of a plan."
The bankruptcy court approved the sale of Piccadilly's assets to PAC for $80 million and held that the sale was exempt from stamp taxes under section 1146. It also approved the global settlement. Shortly after the sale order became final, Piccadilly filed a liquidating chapter 11 plan, which the bankruptcy court ultimately confirmed over FDOR's objection. FDOR also commenced an adversary proceeding against Piccadilly seeking a declaration that the $39,200 in stamp taxes otherwise payable in connection with the sale was not covered by section 1146. Both Piccadilly and FDOR sought summary judgment.
The bankruptcy court granted summary judgment to Piccadilly, ruling that the asset sale was exempt from stamp taxes under section 1146. The court reasoned that the sale of substantially all of Piccadilly's assets was a transfer "under" its confirmed chapter 11 plan because the sale was necessary to consummate the plan. The district court upheld that determination on appeal. However, it noted in its decision that the parties had addressed their arguments to whether, in general, section 1146 exempts stand-alone sale transactions under section 363(b) from tax, rather than whether the tax exemption applied specifically to the sale of Piccadilly's assets. Thus, the district court concluded that specific application of the exemption to the sale of Piccadilly's assets was an issue not properly before it. Even so, the court expressly affirmed the bankruptcy court's implicit conclusion that section 1146 may apply "where a transfer is made preconfirmation."
FDOR fared no better on appeal to the Eleventh Circuit. Noting that "[t]his court has yet to squarely address whether the [section 1146] tax exemption may apply to pre-confirmation transfers," the court of appeals briefly recounted the history of this issue at the appellate level, concluding that "the better reasoned approach" is found in Jacoby-Bender and T.H. Orlando, which looks "not to the timing of the transfers, but to the necessity of the transfers to the consummation of a confirmed plan of reorganization." According to the Eleventh Circuit, the language of section 1146 can plausibly be read to support either of the competing interpretations proffered by the parties. Even so, given the statutory ambiguity, lawmakers' intentions under section 1146 can be divined by reference to other provisions of the Bankruptcy Code that expressly and unambiguously create temporal restrictions, while section 1146 does not. If Congress includes specific language in one part of a statute "but omits it in another section of the same Act," the Eleventh Circuit emphasized, "it is generally presumed that Congress acts intentionally and purposely in the disparate inclusion or exclusion."
Finally, the court of appeals observed, "the strict temporal construction of [section 1146] articulated by the Third and Fourth Circuits ignores the practical realities of Chapter 11 reorganization cases." Even transfers expressly contemplated in a plan, the Eleventh Circuit explained, "will not qualify for the tax exemption unless they occur after the order confirming the plan is entered." According to the court, it is just as likely that a debtor may be required to close on a sale transaction as a condition precedent to the parties' willingness to proceed with confirmation. Rejecting the restrictive approach taken by the Third and Fourth Circuits, the Eleventh Circuit held that the section 1146 tax exemption "may apply to those pre-confirmation transfers that are necessary to the consummation of a confirmed plan of reorganization, which, at the very least, requires that there be some nexus between the pre-confirmation sale and the confirmed plan."
The Supreme Court granted FDOR's petition for certiorari on December 7, 2007. The Court, in its only bankruptcy decision thus far in 2008, handed down its ruling on June 16, 2008.
The Supreme Court's Ruling
Writing for the 7-2 majority, Justice Clarence Thomas observed, "While both sides present credible interpretations of § 1146(a), [FDOR] has the better one." He acknowledged that Congress could have used more precise language in the statute to remove any ambiguity concerning its scope. Even so, Justice Thomas characterized the interpretation espoused by Piccadilly (and adopted by the Eleventh Circuit) as less plausible because it "places greater strain on the statutory text than the simpler construction advanced by [FDOR] and adopted by the Third and Fourth Circuits."
Even assuming that the language of section 1146(a) is sufficiently ambiguous to warrant further inquiry, Justice Thomas wrote, the ambiguity must be resolved in FDOR's favor. He rejected Piccadilly's argument that if Congress had intended to limit section 1146(a) to post-confirmation transfers, it would have made its intent plain by including an express temporal limitation in the language of the provision, as it has done elsewhere in the statute. He similarly found unavailing Piccadilly's contention that, based upon other provisions in the Bankruptcy Code, the term "under" preceding "a plan confirmed" in section 1146(a) should be read broadly to mean "in accordance with" rather than "authorized by." It was unnecessary for Congress to include more specific temporal language in section 1146(a), Justice Thomas wrote, "because the phrase 'under a plan confirmed' is most naturally read to require that there be a confirmed plan at the time of the transfer."
The justice also emphasized that, even if the Court were to adopt Piccadilly's broad construction of "under" in section 1146(a), it would be unavailing because Piccadilly had not even submitted a chapter 11 plan to the bankruptcy court at the time its assets were sold under section 363(b). Adopting Piccadilly's approach, Justice Thomas observed, would make the tax exemption depend on "whether a debtor-in-possession's actions are consistent with a legal instrument that does not exist—and indeed may not even be conceived of—at the time of the sale." According to Justice Thomas, even reading section 1146(a) in context with other provisions of the statute, "we find nothing justifying such a curious interpretation of what is a straightforward exemption." Contextually speaking, he explained, section 1146(a)'s placement in a subchapter of the Bankruptcy Code entitled "postconfirmation matters" further undermines Piccadilly's argument that the provision was intended to cover pre-confirmation asset transfers.
Justice Thomas then turned to various arguments made by FDOR based upon traditional canons of statutory construction, including the following: (i) Congress's failure to clarify section 1146, despite having amended the Bankruptcy Code several times since 1979 (most recently in 2005, after the rulings in NVR and Hechinger), indicates that lawmakers saw no reason to modify the provision, as interpreted by the Fourth and Third Circuits; and (ii) federal interference with the administration of a state's taxation scheme is discouraged, such that, consistent with the "federalism canon," articulated by the Supreme Court in California State Board of Equalization v. Sierra Summit, Inc., courts should proceed carefully when asked to recognize an exemption from state taxation that Congress has not clearly expressed. He found the latter to be "decisive" in determining how section 1146(a) should be applied.
Piccadilly's effort to evade the federalism canon, Justice Thomas wrote, "falls well short of the mark because reading § 1146(a) in the manner Piccadilly proposes would require us to do exactly what the canon counsels against." Moreover, he emphasized, Piccadilly premised its entire argument on the idea that section 1146(a) is ambiguous, a foundation that the federalism canon expressly renders inadequate to support any finding that Congress has clearly expressed its intention to provide a transfer tax exemption for pre-confirmation transfers.
Justice Thomas also rejected Piccadilly's contention that section 1146(a) should be interpreted "liberally" in keeping with: (i) chapter 11's twin objectives of preserving going concerns and maximizing property available to satisfy creditors; and (ii) the "remedial" nature of chapter 11 and the Bankruptcy Code as a whole. Far from having a single remedial purpose, Justice Thomas wrote, "Chapter 11 strikes a balance between a debtor's interest in reorganizing and restructuring its debts and the creditors' interest in maximizing the value of the bankruptcy estate." According to Justice Thomas, the Bankruptcy Code also accommodates state interests in regulating property transfers by generally leaving the determination of property rights in estate assets to state law. "Such interests often do not coincide," he observed, concluding that in this case, "[w]e therefore decline to construe the exemption granted by § 1146(a) to the detriment of the State."
Finally, Justice Thomas addressed Piccadilly's argument that construing section 1146(a) to exempt only post-confirmation transfers would amount to an "absurd" policy and ignore the practical realities of chapter 11 cases that increasingly involve pre-confirmation sales as part of a reorganization strategy. Agreeing with the Fourth Circuit's reasoning in NVR that Congress struck a reasonable balance in section 1146(a) by making the tax exemption available only in cases where the debtor has successfully confirmed a plan, Justice Thomas wrote, "[W]e see no absurdity in reading § 1146(a) as setting forth a simple, bright-line rule instead of the complex, after-the-fact inquiry Piccadilly envisions." Furthermore, he concluded that "it is incumbent upon the Legislature, and not the Judiciary, to determine whether § 1146(a) is in need of revision."
The 7-2 majority of the court accordingly reversed the Eleventh Circuit's judgment and remanded the case below for further proceedings consistent with its ruling. Chief Justice Roberts and Justices Scalia, Kennedy, Souter, Ginsburg, and Alito joined in the majority opinion. Justice Breyer, joined by Justice Stevens, filed a dissenting opinion.
In his dissent, Justice Breyer wrote that the language of section 1146(a) is "perfectly ambiguous" as to whether a transfer can qualify for the tax exemption if it is "under a plan" that at the time of the transfer "either already has been or subsequently is 'confirmed.' " Explaining that none of the text-based arguments "point clearly in one direction rather than the other," and that the canons of interpretation "offer little help," Justice Breyer reasoned that, in the absence of any clear guidance, the appropriate inquiry should be why and for what reasonable purpose Congress insisted upon temporal limits.
According to Justice Breyer, the majority's temporal restriction would not serve in any way either chapter 11's basic objectives or the specific purpose of section 1146(a) (i.e., to encourage and facilitate bankruptcy asset sales). From the perspective of these purposes, he wrote, "[I]t makes no difference whether a transfer takes place before or after the plan is confirmed." In either case, the tax exemption puts money in the hands of creditors or the estate that would otherwise be paid to taxing authorities. Moreover, Justice Breyer emphasized, "In both instances the confirmation of the related plan assures the legitimacy (from bankruptcy law's perspective) of the plan that provides for the assets transfer."
Confining the tax exemption to post-confirmation transfers, Justice Breyer explained, clearly "inhibits the statute's efforts to achieve its basic objectives." According to him, deferring asset sales until the end of a chapter 11 case to avoid paying transfer taxes could result in "far more serious harm" to creditors or the reorganized debtor due to the loss of "extra revenues that a speedy sale might otherwise produce." Faulting the majority for failing to consider the statutory language in light of its basic purpose in applying the canons of construction, Justice Breyer advocated a less rigid construction of section 1146(a)'s requirements:
What conceivable reason could Congress have had for silently writing into the statute's language a temporal distinction with such consequences? The majority can find none. It simply says that the result is not "absurd" and notes the advantages of a "bright-line rule." . . . I agree that the majority's interpretation is not absurd and do not dispute the advantages of a clear rule. But I think the statute supplies a clear enough rule - transfers are exempt when there is confirmation and are not exempt when there is no confirmation. And I see no reason to adopt the majority's preferred construction (that only transfers completed after plan confirmation are exempt), where it conflicts with the statute's purpose.
Given the prevalence of pre-confirmation section 363(b) asset sales in chapter 11 cases as a means of generating value for the estate and creditors, Piccadilly is decidedly unwelcome news. It may, in fact, portend a shift in chapter 11 reorganization strategies where asset sales are anticipated. If obtaining a section 1146 tax exemption is important, Piccadilly may result in a debtor's deferring major asset divestitures to the end of the case, while at the same time potentially formulating and seeking confirmation of a chapter 11 plan on a much accelerated basis.
Prior to the Supreme Court's ruling in Piccadilly, a majority of lower courts had sided with the Second and Eleventh Circuits and adopted the more liberal interpretation that section 1146 applies to pre-confirmation asset sales under section 363(b). Although this approach was by no means universally accepted among lower courts, the law laid down by Piccadilly invalidates the practice followed by a significant majority of bankruptcy courts.
City of New York v. Jacoby-Bender, 758 F.2d 840 (2d Cir. 1985).
In re NVR LP, 189 F.3d 442 (4th Cir. 1999).
Baltimore County v. Hechinger Liquidation Trust (In re Hechinger Investment Company of Delaware, Inc.), 335 F.3d 243 (3d Cir. 2003).
State of Florida v. T.H. Orlando Ltd. (In re T.H. Orlando Ltd.), 391 F.3d 1287 (11th Cir. 2004).
State of Florida Dept. of Rev. v. Piccadilly Cafeterias, Inc. (In re Piccadilly Cafeterias, Inc.), 484 F.3d 1299 (11th Cir.), cert. granted, 128 S. Ct. 741 (2007), rev'd and remanded, 2008 WL 2404077 (June 16, 2008).
California State Board of Equalization v. Sierra Summit, Inc., 490 U.S. 844 (1989).
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