United States: Second Circuit's Significant Decision Could Impact Liquidating Trustees

In the case of United States of America v. Edward P. Bond, No. 12-4803 (2d. Cir. August 13, 2014), the United States Court of Appeals for the Second Circuit (the "Second Circuit") issued a decision that could have far-reaching effects on how liquidating chapter 11 bankruptcy cases will be handled in the future.

The facts of this case are relatively straightforward. In Bond, the court approved the creation of a liquidating trust in connection with the bankruptcy cases of PT-1 Communications, Inc. and its related subsidiaries (the "Debtors") pending in United States Bankruptcy Court for the Eastern District of New York (the "Bankruptcy Court'"). Edward P. Bond was eventually appointed as the liquidating trustee (the "Liquidating Trustee") for the liquidating trust, which was created upon confirmation of the Debtors' chapter 11 plan.

However, before the creation of the liquidating trust, the Internal Revenue Service filed an administrative expense claim in the Bankruptcy Court seeking an additional $2 million in interest and penalties for post-petition taxes due and owing from the Debtors' estates for the period from March 9, 2001 through December 31, 2001 (the "Stub Period"). The Debtors filed chapter 11 on March 9, 2001, which marked the commencement of the Stub Period. While the IRS's administrative expense claim was pending, the Debtors obtained confirmation of their plan, pursuant to which the liquidating trust was created. As part of the assets assigned to the liquidating trust, the Debtors assigned all of their rights and interest in and to any tax refunds due and owing the Debtors for the tax years 2004 and earlier. The plan was confirmed on November 23, 2004 and became effective on January 31, 2005.

Following his appointment, the Liquidating Trustee, pursuant to 11 U.S.C. § 505(a), filed a request for a federal income tax refund before the Bankruptcy Court. On March 14, 2005, the Liquidating Trustee also: (i) counterclaimed against the IRS in the Bankruptcy Court, objecting to the IRS's administrative expense claim; and (ii) sought a refund of the taxes paid during the Stub Period. In addition, in September of 2005, the Liquidating Trustee filed a refund request with the IRS, which, as noted by the Second Circuit, was still pending nearly nine years later.

Between 2006 and 2009, the Bankruptcy Court entered a series of decisions which, among other things, dismissed the IRS's administrative expense claim and granted summary judgment in favor of the Liquidating Trustee on account of his counterclaim for the tax refund. In particular, on April 29, 2011, the Bankruptcy Court "awarded" the Liquidating Trustee a $3.8 million refund plus interest for the Debtors' 2011 taxes. Bond, slip op. at 7. The Bankruptcy Court also denied the IRS's administrative expense claim and enjoined the IRS from exercising its rights of setoff or recoupment. Id.

Following the issuance of the Bankruptcy Court's decision, the IRS appealed to the United States District Court for the Eastern District of New York (the "District Court") arguing, among other things, that sovereign immunity "(i) foreclosed bankruptcy court jurisdiction over the refund counterclaim, and (ii) prevented the [IRS] from being bound by the anti-setoff and anti-recoupment provisions of the Plan." Id., at 8.

The District Court upheld the Bankruptcy Court's exercise of jurisdiction, and specifically ruled that § 505(a) "does not limit the bankruptcy court's ability to adjudicate tax disputes to only those brought by bankruptcy trustees." Id. (quoting United States v. Bond, 486 B.R. 9, 26 (E.D.N.Y. 2012)). However, the District Court vacated the portion of the Bankruptcy Court's order that bound the IRS to the anti-setoff/anti-recoupment provisions of the Debtors' plan.

After the District Court's decision, both parties filed appeals to the Second Circuit. In the Second Circuit Appeal, the IRS again challenged the proprietary of the Bankruptcy Court's exercise of jurisdiction concerning the tax refund request, and the Liquidating Trustee challenged the District Court's decision to permit the IRS to setoff and/or recoup its alleged administrative expense claim from the tax refund due and owing the Debtors' estates. In March 2013, the IRS withdrew its appeal but refused to pay the refund because it intended to "exercise the setoff and recoupment rights that the District Court had re-established." Id. at 9. As a consequence, only the Liquidating Trustee continued with his appeal.

On appeal, the Second Circuit first addressed the IRS's sovereign immunity argument. Noting that § 106(a)(1) of the Bankruptcy Code lists 59 provisions of the Bankruptcy Code where sovereign immunity is abrogated, the Second Circuit observed that § 505, which related to the determination of tax liabilities, is specifically listed therein. The Bond court then analyzed § 505(a)(1) of the Bankruptcy Code, which provides that:

[e]xcept as provided in paragraph (2) of this subsection, the court may determine the amount or legality of any tax, any fine or penalty relating to a tax, or any addition to tax, whether or not previously assessed, whether or not paid, and whether or not contested before and adjudicated by a judicial or administrative tribunal of competent jurisdiction.

11 U.S.C. § 505(a)(1).

The Second Circuit then addressed § 505(a)(2) of the Bankruptcy Code and observed that there were two conditions that must be satisfied before the Bankruptcy Court could exercise jurisdiction to determine a tax refund—namely: (i) that a "trustee" must properly request the tax refund from the government, and (ii) either the government must rule on the trustee's request or 120 days must elapse. Id. at 12-13. As used in § 505(a)(2), the term "trustee" means either a bankruptcy trustee, or a debtor-in-possession (per § 1107(a) of the Bankruptcy Code), and does not mean an entity such as the Liquidation Trustee.

Because only the Liquidating Trustee—and not the Debtors—requested the tax refund, the Second Circuit held that the IRS's sovereign immunity was not waived, and consequently, the Bankruptcy Court lacked subject matter jurisdiction to adjudicate the tax refund claim. Indeed, the Second Circuit stated "the failure of PT-1 (as debtor-in-possession) to file its refund claim with the IRS prior to Plan confirmation had a jurisdictional consequence that could not be cured by the Liquidating Trustee or a Plan provision." Id. at 15-16.

Perhaps recognizing the harshness of its decision, the Second Circuit made the following observations: (i) because the plan had transferred to the Liquidating Trustee the Debtors' rights to any tax refund, the Second Circuit noted that the Liquidating Trustee could still pursue the refund claim directly in a federal district court; and (ii) there is nothing in § 505(a) that would preclude a Liquidating Trustee from pursuing a tax refund claim, so long as the refund claim was first initiated by either a debtor-in-possession or a trustee. Id. at 18-19.

In light of the Second Circuit's strict construction of § 505(a) of the Bankruptcy Code, this decision should be reviewed by anyone who either acts as a liquidating trustee or represents liquidating trustees, and should serve as a blueprint for handling what arguably could be a sizeable asset of a debtor's estate.

If you have any questions about this Alert or would like more information, please contact Lawrence J. Kotler; William C. Heuer, Rudolph J. Di Massa, Jr.; Rosanne Ciambrone; Ron Oliner; any member of our Business Reorganization and Financial Restructuring Practice Group; or the attorney in the firm with whom you are regularly in contact.

Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.

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