Forget Partying Like It’s 1999; the Ninth Circuit Wants to Adjudicate Like It’s 1998

Contributed by Kyle J. Ortiz
1998 was an amazing year: Google was founded (Google it: it’s true); Sammy Sosa and Mark McGwire rewrote the baseball record books (primarily with asterisks); a Winter Olympics was held (nobody watched); the Yankees won the World Series (well, not good news for Red Sox fans); the United States announced its first budget surplus in 30 years (whew, debt problems over); and the Europeans agreed to a single currency – the Euro (what could go wrong).  Good news for those nostalgic for such times, the Ninth Circuit recently held in In re Wilshire Courtyard, Case No. 11-60065 (9th Cir. Sept. 10, 2013) that a bankruptcy court could bring back a little piece of 1998 by reopening a case closed that year.
In late 1997, Wilshire, a debtor-partnership that owned two commercial office buildings in Los Angeles defaulted on over $350 million of secured debt and filed for chapter 11.  The debtors negotiated a chapter 11 plan where, in exchange for releasing the secured indebtedness and contributing $23 million, the secured creditors received 99% of the equity of the reorganized entity and the proceeds of a new $100 million dollar loan.  The plan also provided that the debtor would convert from a California partnership into a Delaware LLC and continue to operate the property, while the old partners retained the remaining 1% stake in the reorganized entity.  Critical to the current dispute, as a consequence of the plan, the individual partners of the partnership had over $200 million in partnership debt forgiven.  The bankruptcy court confirmed the plan on April 14, 1998, the case closed in October 1998, and those involved moved on to other things (like worrying about the impending Y2K catastrophe).
The seeds for the reopening of the case over a decade later were sown when the individual partners reported cancellation of debt income on their 1998 tax returns.  In 2002, after an audit, the California Franchise Tax Board (“CFTB”) alleged that the chapter 11 plan was a disguised sale and that the debtor and ultimately the individual partners should have reported capital gains income instead of cancellation of debt income and sent notices of assessment to the individual partners asserting that the partners collectively owed $13 million in unpaid income tax.
After the partners and the CFTB spent years litigating the issue in various administrative settings without resolution, in May 2009, the reorganized LLC filed a motion to reopen the bankruptcy case arguing that the CFTB was collaterally attacking the confirmed plan and that the assessment was precluded by the plan.  The CFTB objected to the motion to reopen asserting that the bankruptcy court lacked subject matter jurisdiction over the matter.  The bankruptcy court reopened the case, ordered that the individual partners be joined to the proceeding, and granted summary judgment on the tax issue in favor of the reorganized LLC and the individual partners.  The bankruptcy court asserted that it had postconfirmation subject matter jurisdiction because the case required interpretation of the confirmed plan.  The court specifically pointed to a finding in the confirmation order that it said meant that the “plan was not a sale for any purpose.” It also noted that the individual partner income tax attributes derive from the plan and confirmation order, and status of the property interests at the partnership level, and, therefore, the bankruptcy court had jurisdiction with respect to these matters affecting the individual partners.  The CFTB appealed.
On appeal, the Bankruptcy Appellant Panel for the Ninth Circuit sided with the CFTB and held that the bankruptcy court lacked subject matter jurisdiction over the dispute.  The BAP stated that under 28 U.S.C. § 1334(b): “the district courts [and by reference pursuant to 28 U.S.C. § 157, the bankruptcy courts] shall have original but not exclusive jurisdiction of all civil proceedings arising under title 11, or arising in or related to cases under title 11.”  The BAP held that the bankruptcy court lacked subject matter jurisdiction under all three jurisdictional provisions.  The debtors and the individual partners appealed to the Ninth Circuit. The Ninth Circuit granted the appeal solely with regard to the jurisdictional question.
Although the Ninth Circuit agreed with the BAP that the bankruptcy court had neither “arising under” nor “arising in” subject matter jurisdiction over the dispute, the Ninth Circuit overturned the BAP’s finding that the bankruptcy court lacked “related to” jurisdiction.
Bankruptcy Court Did Not Have “Arising Under” or “Arising In” Jurisdiction
The Ninth Circuit first held that the bankruptcy court lacked “arising under” jurisdiction because the relief sought was “not created by title 11.”  The Ninth Circuit then held that the bankruptcy court lacked “arising in” jurisdiction because such jurisdiction only exists over matters “which would have no existence outside of a bankruptcy case,” and neither the BAP nor the Ninth Circuit found that the present matter owed its existence to the bankruptcy case.  Notably, the Ninth Circuit held that this was the case even though the matter was a result of the bankruptcy case, explaining that “the fact that a matter would not have arisen had there not been a bankruptcy case does not ipso facto mean that the proceeding qualifies as an ‘arising in’ proceeding . . . . Had Wilshire negotiated a similar deal with its creditors outside of bankruptcy, the same dispute with CFTB over whether to categorize the income as cancellation of debt income or capital gains may have arisen.”  Thus, to have “arising in” jurisdiction requires a dispute that could not have arisen but for the bankruptcy case.
“Related To” Jurisdiction Standard in the Ninth Circuit
The Ninth Circuit, in Fietz v. Great W. Savings (In re Fietz), 852 F.2d 455, 457 (9th Cir. 1988), adopted the “related to” jurisdictional test set forth by the Third Circuit in Pacor, Inc. v. Higgins, 743 F.2d 984, 994 (3d Cir. 1984).  Under the Pacor/Fietz test, a bankruptcy court has “related to” jurisdiction over a matter if (i) “the outcome of the proceeding could conceivably have any effect on the estate being administered in bankruptcy,” (ii) if “the outcome could alter the debtor’s rights, liabilities, options, or freedom of action,” or (iii) if the proceeding impacts “the handling and administration of the bankrupt estate.”
Subsequently, after noting that the Pacor/Fietz test was “somewhat overbroad in a post-confirmation context,” the Ninth Circuit in In re Pegasus Gold Corp., 394 F.3d 1189, (9th Cir. 2005) held that  post-confirmation “related to” jurisdiction is determined by the “close nexus” test, which asks whether a matter affects the “interpretation, implementation, consummation, execution, or administration of the confirmed plan.”
BAP’s Interpretation of Ninth Circuit Law Regarding the Close Nexus Test
The BAP held that the bankruptcy court had misapplied the “close nexus” test because it concluded a close nexus existed simply because the matter called for interpretation of the plan. The BAP found this definition of the “close nexus” test too broad and held that a “close nexus” sufficient to give rise to postconfirmation “related to” jurisdiction only exists where “the outcome of the issues before the bankruptcy court . . . potentially impact[s] the debtor, the estate, or the implementation of the plan of reorganization.”
Applying this more stringent application of the close nexus test, the BAP held that the bankruptcy court lacked “related to” jurisdiction over the present matter because the tax consequences for the individual partners did not impact the debtor, the estate, or the implementation of the plan.
Ninth Circuit Reaffirms That Close Nexus Test is a Broad Standard
The Ninth Circuit, however, found the BAP’s interpretation of the “close nexus” test too narrow and improperly conflated the Pacor/Fietz test and the Pegasus Gold  test.  The Ninth Circuit then confirmed that that a “bankruptcy court’s related to jurisdiction is very broad” and emphatically reaffirmed Pegasus Gold, stating:

We reaffirm that a close nexus exists between a post-confirmation matter and a closed bankruptcy proceeding sufficient to support jurisdiction when the matter affect[s] the interpretation, implementation, consummation, execution, or administration of the confirmed plan.

Having clarified the scope of the Pegasus Gold close nexus test, the Ninth Circuit turned to the dispute before it and rejected the “CFTB’s argument that jurisdiction was lacking because the bankruptcy case had been long since closed by the time the tax dispute began.”  The Ninth Circuit noted that the time lag between the case closing and the dispute arising was not dispositive because the close nexus test extends postconfirmation jurisdiction to matters “that likely would have affected the implementation and execution of the plan if the matter had arisen contemporaneously.”  To hold otherwise would allow parties to “refashion” the “economic realities” of a deal retroactively.  In the present matter, the reorganized LLC and the individual partners asserted that the debt cancellation was an essential part of the plan and that without it the plan would not have been feasible.  The Ninth Circuit held that the determination of whether the debt cancellation really was a key element of the plan, required interpretation of the plan and confirmation order “to determine the essential character of . . . the deal the parties struck,” and therefore, a sufficiently close nexus existed to create related to jurisdiction for the bankruptcy court to hear the matter.
The Wilshire decision makes clear that the Ninth Circuit interprets the close nexus test broadly.  Thus, anyone who can demonstrate that a matter affects the interpretation or implementation of a confirmed plan can potentially reopen a closed case, regardless of how long ago the case was closed and regardless of whether there are any effects on the reorganized debtor.  Consequently, those looking to travel back in time to revisit closed cases in 1998, or any other year, will find the Ninth Circuit relatively accommodating following Wilshire.