Practice Pointers from the Second Circuit: A Prohibited Power Grab Can Be “Taxing”

Contributed by Erika del Nido
Today we bring you the sequel to last year’s four-part series on United States v. Bond — the tale of three related telecommunications corporations (which we will refer to as the “PT-1 debtors”) whose chapter 11 cases spawned a series of tax-related disputes. Now, the Second Circuit has weighed in, and its decision serves as an important reminder to drafters of chapter 11 plans that a plan cannot bestow powers on parties that the Bankruptcy Code does not.
After the PT-1 debtors commenced their chapter 11 cases, they filed their tax returns and reported payment in full. The United States government then asserted an administrative expense claim for interest and penalties against the PT-1 debtors. Prior to resolution of the government’s claim, the United States Bankruptcy Court for the Eastern District of New York confirmed the PT-1 debtors’ joint chapter 11 plan. The plan created a liquidating trust designed to pay unsecured creditors from its assets, including “all rights in and to any tax refunds due to the Debtors for tax years ending prior to January 1, 2005.” Edward P. Bond was appointed as trustee of the liquidating trust. Notably, no chapter 11 trustee ever had been appointed, and the PT-1 debtors operated as debtors in possession. After confirmation, the liquidating trustee filed a claim for a federal income tax refund in the bankruptcy court and subsequently filed the same request with the IRS.
In the dispute between the liquidating trustee and the government, the bankruptcy court granted The liquidating trustee a complete victory — the court dismissed the government’s claims, denied the government’s request for setoff and recoupment rights because a plan provision extinguished them, rejected the government’s argument that sovereign immunity barred the liquidating trustee’s request for a refund, and awarded the liquidating trustee a $3.8 million refund plus interest.
On appeal to the United States District Court for the Eastern District of New York, the government argued that, due to sovereign immunity, the bankruptcy court lacked jurisdiction over the refund claim, and the government could not be bound by the provisions of the plan barring setoff and recoupment. The district court affirmed the award of the refund to the liquidating trustee, but reversed with respect to the setoff rights.
Both the government and the liquidating trustee appealed to the United States Court of Appeals for the Second Circuit. The liquidating trustee argued that the government lacked setoff rights, and the government argued that the liquidating trustee was not entitled to the tax refund. After some procedural maneuvering, the sole issue before the Second Circuit on appeal was whether the bankruptcy court had jurisdiction to adjudicate the tax refund claim asserted against the IRS by the liquidating trustee.
The Second Circuit noted that section 106(a)(1) of the Bankruptcy Code provides that sovereign immunity is abrogated as to section 505 of the Bankruptcy Code, which grants jurisdiction to bankruptcy courts to adjudicate tax disputes. Absent such a statutory waiver of sovereign immunity, courts lack jurisdiction to adjudicate actions brought against the United States. Pursuant to section 505(a)(2)(B) of the Bankruptcy Code, however, one of the conditions that must be fulfilled before the bankruptcy court has jurisdiction to determine tax refunds is that the “trustee” must properly request the tax refund from the government. The Second Circuit held that this condition was not satisfied because the liquidating trustee was not a “trustee,” as such term is used in the Bankruptcy Code, for three reasons. First, section 1104(a) of the Bankruptcy Code provides that a trustee must be appointed “before confirmation of a plan,” and the liquidating trustee was appointed pursuant to the plan and after confirmation. Second, section 1123(b)(3) of the Bankruptcy Code “makes clear” that a “debtor,” “trustee,” and appointed “representative of the estate” are different parties. Third, the Bankruptcy Code establishes the powers of a trustee or debtor in possession, whereas a liquidating trustee’s powers are established by the confirmed chapter 11 plan.
Strictly construing section 505(a)(2)(B) of the Bankruptcy Code, the Second Circuit found that, although the bankruptcy court had authority to confirm a plan that assigned the refund claim to a liquidating trust and that appointed the liquidating trustee, the bankruptcy court lacked jurisdiction to adjudicate such claim unless a bankruptcy trustee (or a debtor in possession) first filed a refund claim with the IRS. The bankruptcy court cannot expand its own jurisdiction through provisions in a chapter 11 plan of reorganization. The Second Circuit summarized its rationale as follows: “Thus the jurisdiction of the bankruptcy court is premised on the action of an entity that draws its authority directly from the Code itself (i.e., a debtor or bankruptcy trustee), rather than on the action of an entity (such as the Liquidating Trustee) whose authority derives from a Chapter 11 plan over which a bankruptcy court has full control, and the Congress none.”
The Second Circuit noted that its decision did not leave the liquidating trustee without a remedy. Although the PT-1 debtors, as debtors in possession, could have filed a claim for a refund with the IRS prior to confirmation (which did not occur), the liquidating trustee, in the ordinary course, may still pursue the claim directly in federal district court.
The Second Circuit’s opinion in Bond offers two practice tips to drafters of chapter 11 plans. First, plan provisions must be consistent with the Bankruptcy Code. Drafters cannot use a plan to accomplish something for which statutory authority is lacking. Second, debtors in possession should mind the clock because certain tasks (such as requesting an IRS refund) that might be easily accomplished pre-confirmation may become more complicated or even foreclosed post-confirmation.