Daily Development for Thursday, November 18 2004
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin Kansas City, Missouri dirt@umkc.edu
BANKRUPTCY; CHAPTER 11;TRANSFER TAXES; SALE PRIOR TO PLAN CONFIRMATION: A sale
of real estate assets from a bankruptcy estate prior to plan confirmation
qualifies for the exemption from transfer taxes under sec. 1146(c) of the
Bankruptcy Code where the sale is integral to a Chapter 11 reorganization plan
that is subsequently confirmed.
In re: Beulah Church of God in Christ Jesus, Inc., 316 B.R. 41 (Bankr. S.D.
N.Y., Oct. 18, 2004).
In this Chapter 11 bankruptcy case, the debtor, which was owned by a church in
Brooklyn, became the owner of (or acquired and interest in) 24 properties in the
New York, Kings, Queens and Bronx Counties. The debtor became a participant in a
federal loan insurance program known as the "203(k) program," which guaranteed
private loans to not-for-profit entities for "rehabilitating housing stock."
Unfortunately the program was rife with corruption and abuse by contractors, in
concert with brokers and loan originators, and the debtor's mortgage loans from
the Residential Funding Corporation ("RFC") went into default.
The debtor, realizing that the properties' values had increased significantly
since the mortgages had originally been made, persuaded RFC to support the
debtor's plan to sell the properties, which sales the debtor believed would
yield sufficient proceeds to satisfy not only the RFC debt, but also pay all or
most of the unsecured debt and perhaps even result in some money left over for
the church. (According to the court, "assuming a successful sale process, the
case was put on track for eventual confirmation of a Chapter 11 plan.")
The debtor filed a motion for authorization to sell 23 of the 24 properties
either in bulk or individually at an auction (the mortgage on one of the
properties was reinstated). The motion also requested a declaration by the
bankruptcy court that the sale would be exempt from any sale or transfer tax
under sec. 1146(c). The court entered an order on February 4, 2004 approving the
sale, and scheduled the auction sale for April 5, 2004. The City of New York
then filed an objection on March 18, 2004, but acknowledged that the sale could
proceed if at least the amount of the transfer tax was escrowed in an
interest-bearing account. The debtor then filed its proposed Chapter 11 plan,
and its disclosure statement, one day before the scheduled court hearing on the
City's objection.
The proposed sale did not close because the buyer defaulted, but the debtor
immediately found a new buyer who agreed to pay a substantially higher purchase
price for a bulk sale of the properties. The debtor again moved the court for
approval of the sale, and the court entered an order to this effect. (In a
footnote, the court noted that if the debtor had not found a substitute buyer,
it would have granted a motion to lift the stay and the case likely would have
been converted to a Chapter 7 liquidation.) The debtor renewed its request for a
transfer-tax exemption, which issue the court specifically reserved for later
determination.
This sale successfully closed on July 30, 2004, which was the day before the
extension agreed to by the secured creditors, and the proceeds were more than
sufficient to pay off all of RFC's allowed claims. An amount equal to the
transfer taxes ($390,000) was placed in escrow pending the court's ruling on the
exemption. The court acknowledged that the debtor's plan had not yet been voted
on or confirmed, but stated that it "can see no major obstacle . . . to the
plan's eventual confirmation now that the results of the sale process are
known," and that "the Debtor's Chapter 11 plan provides for the payment of
administrative, priority, and general claims in full."
The City of New York argued that the properties were not sold under a "plan
confirmed" (as required under sec. 1146(c)), because the sale "was not
authorized by, provided for in, and did not occur pursuant to, a confirmed
chapter 11 plan." The debtor and RFC, on the other hand, argued that the sale
was exempt because it was "integral to plan confirmation, or confirmation occurs
because of the sale," i.e., under the correct interpretation of sec. 1146(c) the
exemption applies because the sale "is in view of, and/or in accordance with,
and subject to, the anticipated confirmation of a chapter 11 plan."
The court noted the split (gulf?) of existing court opinions on this issue (with
citations to all the relevant cases on both sides of the issue). The court first
addressed the question of statutory interpretation, and determined that both the
City's and the debtor's interpretations could apply. The court then focused on
the definition of the word "under" in sec. 1146(c), which the court found could
encompass many different meanings, including that "the exemption is subject to a
condition, which may be a condition subsequent, of plan confirmation, as long as
the transfer led to or was in view of a plan that was ultimately confirmed." The
court also found that the legislative history of sec. 1146(c) was uninformative
and inconclusive, and that "textual analysis" of other provisions of the
Bankruptcy Code was unhelpful.
The court distinguished two of the leading cases supporting the City's position,
In re NVR, L.P., 189 F.3d 442 (4th Cir. 1999), and In re Hechinger Co. of Del.,
Inc., 335 F.3d 243 (3d Cir. 2003), finding that they "did not have occasion to
consider a situation like the Debtor's, where the sales at issue were
specifically pursued in view of a filed plan." The court refused to apply a
"bright-line" test, instead preferring a "practical or functional"
interpretation of the language "under a plan" in sec. 1146(c).
The court dismissed the City' interpretive argument that tax exemptions should
be strictly construed and that federal laws that interfere with state taxation
should be narrowly construed, reasoning that such interpretive aids should be
"used with caution," and that the Bankruptcy Code's goal of facilitating
reorganizations could be harmonized with the policy of narrowly construing tax
exemptions.
The court, in ruling that the sale of the debtor's properties was exempt from
transfer taxes under sec. 1146(c), summed up its findings as follows:
"Focusing on the role of the particular transfer at issue in enabling the
debtor's plan, rather than on a temporal test, recognizes the realities of how
distressed businesses are restructured in chapter 11. For example, it is just as
likely that a debtor may need to arrange a financing or to close a sale as a
condition precedent to the parties' willingness to proceed with plan
confirmation as it is for the parties to agree on the terms of a plan, obtain
information and then see what the sale of a key asset or a proposed financing
will bring."
Reporter’s Comment 1: To the reporter, the court's decision represents a
sensible, reasonable, practical -- and correct -- analysis of the issue.
Numerous bankruptcy courts have examined the language in § 1146(c), which states
that only transfers occurring "under a plan confirmed" are exempt from taxation.
Unfortunately, as noted by the court in the Beulah Church case, the court
decisions in this area have not been consistent.
Reporter’s Comment 2: Governmental tax authorities have, in some cases (such as
In re Hechinger) argued that the property transfer occurred prior to
confirmation of the plan and should not be entitled to the § 1146(c) exemption.
The issue that has been raised is whether this specific language applies only to
a transfer that occurs subsequent to court approval and confirmation of the
plan, or whether it can also be construed to apply to a transfer that is part of
a bankruptcy plan that has been submitted and is an essential component of the
plan confirmation, but is not approved and confirmed by the court until after
the transfer of the property. The resolution of this issue is of utmost
importance to bankruptcy trustees and debtors in possession because (as noted
cogently by the court in In re Beulah church and in the dissent in the Third
Circuit's ruling in In re Hechinger) it is often necessary, in order to pay
current debts and to fund the Chapter 11 reorganization plan, !
that t
he debtor be able to sell assets as quickly as possible during the course of the
bankruptcy proceeding before they begin to lose value. As stated by the
bankruptcy court in In re GST Telecom, Inc., 2002 U.S. Dist. LEXIS 18745 (D.
Del., July 29, 2002), "Given the reality of business and bankruptcy practice,
adopting a rule that requires all bankruptcy transfers to occur
post-confirmation would seem to frustrate section 1146(c)'s stated purpose of
facilitating reorganization in a large number of cases."
Reporter’s Comment 3: The majority of courts reject the holding of the Fourth
Circuit in NVR, and the trend of recent bankruptcy court decisions has been to
extend the benefit of the § 1146(c) exemption to sales of real property that
occur prior to, but in accordance with, a subsequently confirmed Chapter 11
bankruptcy plan. I agree wholeheartedly with the dissent in In re Hechinger
(referred to with approval by the court in the In re Beulah Church). In his
vigorous dissent, Judge Nygaard argued that § 1146(c) is ambiguous and that the
word "under" should not be narrowly construed to mean only "authorized," i.e.,
it could be read to mean "in accordance with" in order to apply to both
pre-confirmation and post-confirmation transfers. Judge Nygaard further argued
(convincingly, in my humble opinion) that the Bankruptcy Code, as a remedial
statute, should be liberally construed so as not to impede reorganization and to
provide relief to debtors when compelled by business circum!
stance
s to sell assets under a plan ultimately approved by the bankruptcy court.
Reporter’s Comment 4: One commentator has suggested that applying the § 1146(c)
exemption to pre-confirmation sales of real estate results in the imposition of
an "extra-statutory limitation" that is not contained in § 1146(c), and raises
the following questions, none of which are answered by reference to the
Bankruptcy Code or existing case law:
"Should the standard be whether the transfer is necessary for confirmation? Or
merely helpful? . . . What level of proof is necessary? Who bears the burden of
proof? And what evidence is relevant?" Karen Cordry, The Incredible Expanding §
1146(c), 21 ABI J. 10, 48 (2003).
Reporter’s Comment 5: A potential problem also could arise when a
pre-confirmation sale has occurred and no transfer tax has been paid because the
plan-confirmation order or sale order provided that the transfer was subject to
the § 1146(c) exemption. If the reorganization plan is ultimately withdrawn,
dismissed or otherwise not confirmed by the bankruptcy court (or the case is
converted to a Chapter 7 liquidation proceeding), the only remedy for the taxing
authority may be to bring an action to attempt to recoup the unpaid transfer tax
(together with applicable interest and penalties). But the bringing of such an
action could be impractical, expensive and time-consuming.
The court in In re Beulah Church noted, in a footnote, that in recent years
courts have attempted to deal with this issue by requiring the debtor to escrow
an amount at least equal to the disputed taxes, pending plan confirmation. The
bankruptcy reorganization plan, or the bankruptcy court order approving the plan
or the transfer of real property, should specifically provide that an amount
equal to the transfer tax otherwise imposed on the transfer be escrowed with the
court or a third party (such as a bank or title insurance company). For example,
in In re 310 Assocs., L.P., 282 B.R. 295, 298 (S.D.N.Y. 2002), the bankruptcy
court's order approving the transfer agreement between the debtor and the
purchaser provided as follows:
". . . As soon as practicable after the Closing, the Debtor shall be, and hereby
is, authorized to deposit in a separate, interest bearing escrow account, monies
from the Account (as defined hereinbelow [sic], earmarked "310 Associates, L.P.
- City 1146(c) taxes," the sum of $100,000, or such other amount as may be
necessary (the "Escrowed Funds") to pay any City real property transfer tax or
any other applicable City stamp or similar tax, and any potential interest and
or penalties thereon that may be due on the recordation of any documents or
instruments reflecting the sale of the Assets subject to this Order."
. . . .
. . . If a Plan of Reorganization in this case ultimately is not confirmed, the
City may apply to this Court for appropriate relief, and this Order is without
prejudice to the right of the City in such eventuality."
One commentator has noted that, with respect to Chapter 11 bankruptcy
proceedings filed in Delaware involving transfers of real property:
"Delaware courts have begun requiring the debtor to escrow funds sufficient to
pay the taxes as a condition of allowing such sales to be treated as exempt. But
this 'solution' raises as many questions as it answers. Who should hold such an
escrow? Is the government entitled to interest on the taxes withheld? Can the
debtor treat the escrow as cash collateral and use it if it provides adequate
protection? The Code, of course, has no answers or insights on these issues."
Karen Cordry, The Incredible Expanding § 1146(c), 21 ABI J. 10, 48 (2003).
Reporter’s Comment 6: About a year ago I authored an article in the ABA's Real
Property, Probate and Trust Journal on transfer-tax issues in bankruptcy cases,
in which I discuss in detail the issue of pre-confirmation v. post confirmation
transfers (including the relevant case law in this area), as well as issues such
as the scope of the sec. 1146(c) exemption, constitutional challenges to the
exemption under the doctrine of sovereign immunity, and practical considerations
(including the escrow of contested funds with a title insurer). The article also
includes sample language addressing these issues to include in Chapter 11
bankruptcy orders and plans. (The sec. 1146(c) exemption only applies with
respect to Chapter 11 bankruptcy plans.) See John C. Murray, "Transfer-Tax
Considerations in Real Estate Bankruptcy Proceedings," 38 Real Prop. Prob. & Tr.
J. 377 (Summer 2003).
The Reporter for this item is Jack Murray of First American Title Insurance
Company.
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