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The Resurrection of the Eleventh Amendment in Chapter 9 Cases

By: Christopher J. Pedraita

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

Reversing the bankruptcy court, in In re City of San Bernardino, a district court recently held that the Eleventh Amendment barred a chapter 9 debtor’s claims against certain state agencies. In San Bernardino, the City of San Bernardino (the “City”) sought to protect funds, which the State of California (the “State”) demanded that the City remit to the State. The funds at issue in San Bernardino had been parceled out to the City’s redevelopment agency (“RDA”) and earmarked for redeveloping urban neighborhoods. In light of the fiscal emergency experienced by State in 2011, however, its legislature supplanted the existing RDAs with “successor agencies” to conclude all remaining matters of the RDAs, including returning the funds to the county auditor-controller that the RDAs had not already been committed to a project. As part of this process, the State ordered the City’ successor agency to return millions of dollars in tax revenues to the State’s Department of Finance (the “DOF”). If the successor agency failed to remit the funds to the DOF, the State warned that it could withhold tax revenue from the successor agency or the City. The warning prompted the City to commence adversary proceedings against the various state agencies seeking injunctive and declaratory relief to, among other things, prevent the State agencies from withholding tax revenue from the successor agency (and the City itself). The State agencies moved to dismiss the City’s complaint on several grounds, including that claims were barred under the Eleventh Amendment. While the bankruptcy court granted the State agencies’ motion to dismiss with leave to amend, believing that the City could show imminent injury if the state agencies withheld the tax money, the court rejected the state agencies’ Eleventh Amendment defense. In particular, the bankruptcy court ruled that when the subject of litigation was unquestionably within the court’s control state sovereign immunity could not prevent the adversary proceeding. On appeal, the district court reversed the bankruptcy court holding the Eleventh Amendment to apply in order to protect the State’s rights to run its own finances.

Judicial Estoppel: Essentially Locking a Litigation Trust into Representations Made During Prior Bankruptcy Proceedings

By: Sophie Tan

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

Recently, in Adelphia Recovery Trust v. Goldman Sachs & Co., the Second Circuit held that a fraudulent conveyance claim brought by a litigation trust, created to recover assets for the benefit of unsecured creditors of Adelphia Communications Corp. (“ACC”), was barred by the doctrine of judicial estoppel because the funds at issue were transferred from an account that the plaintiff’s predecessor-in-interest scheduled as an asset of one of the predecessor’s subsidiaries, not the predecessor itself. The litigation trust commenced a fraudulent conveyance claim against Goldman, Sachs & Co. under sections 548(a)(1)(A) and 550(a) of the Bankruptcy Code to recover certain payments made to Goldman from a concentration account held in the name of Adelphia Cablevision Corp. (“Adelphia Cablevision”), a subsidiary of ACC. Goldman later moved for summary judgment on the grounds that (1) the plaintiff lacked standing to assert the fraudulent conveyance claim because the payments were not transfers of ACC's property; and (2) the plaintiff failed to raise a material issue of fact as to whether the payments were made with an actual intent to hinder, delay or defraud ACC's creditors. In response, the litigation trust argued that “ACC was the real owner of, and payor from, the Concentration Account” because ACC exercised complete control over the collective cash of ACC and its subsidiaries in the concentration account. While the district court recognized that the money in the concentration account may have been attributed to ACC prior to the bankruptcy proceedings, the district court ruled that “the easy attribution of money to whatever entity may at the moment be convenient stopped with the bankruptcies.” Therefore, the district court granted Goldman’s motion for summary judgment, stating that “it [wa]s admitted by [the litigation trust’s] own revised pleading that the margin loan payments were not made by ACC but by Adelphia Cablevision LLC, an ACC subsidiary on whose behalf [the litigation trust] does not have standing to sue.” The Second Circuit affirmed, holding that the litigation trust did not have standing to sue because it was judicially estopped from arguing now that ACC owned the account.

No Exceptions: How Government Creditors are Not Exempt from Article 9’s Perfection Requirements

By: Thomas Sica

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

Recently, in Delphi Automotive Systems, LLC v. Capital Community Economic/Industrial Development Corporation, the Supreme Court of Kentucky held that a governmental-entity creditor must comply with Article 9 of the UCC’s perfection requirement in order to ensure that such creditor’s lien has priority over subsequent security interests. In Delphi, a governmental-entity creditor and a manufacturer entered into a “lease” covering certain equipment, which provided that the manufacturer would own the equipment upon making the final payment. A private creditor subsequently extended credit to the manufacturer and perfected a security interest in all of the manufacturer’s personal property to secure the loan. After the manufacturer defaulted on the loan, the private creditor filed an action to enforce its lien against all of the manufacturer’s personal property, including the “leased” equipment. First, the governmental creditor argued that the manufacturer did not own the equipment because it was leased. The court, however, swiftly dismissed this argument because the governmental creditor’s interest in the equipment was better defined as a security interest than an ownership interest. Second, the governmental creditor opposed the private creditor’s action, arguing that KRS § 355.9-109(4)(q) excused them from perfecting their security interest because the statute excluded “a transfer by a government or governmental subdivision or agency.” In response, the private creditor argued that KRS § 355.9-109(4)(q) did not excuse the governmental-entity creditor’s compliance with Article 9’s perfection requirements because that statute only applied to situations where the governmental unit was the debtor or borrower. The trial court ruled in favor of the governmental creditor and the intermediate appellate court affirmed. The Supreme Court of Kentucky, however, reversed and directed a verdict for the private creditor.

The IRS Can Offset Post-petition Tax Overpayments Against Pre-petition Tax Liabilities

By: Kyle J. TumSuden

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

Recently, in In re Pugh, the Bankruptcy Court for the Eastern District of Wisconsin modified the automatic stay to allow the IRS to offset the debtor’s post-petition claim for tax overpayment against the debtor’s pre-petition tax liability due to the IRS. In Pugh, the chapter 13 debtor confirmed her plan, which provided that she would be able to keep any federal or state tax refunds received during the term of the plan. Sometime after the debtor had filed, the IRS audited her pre-petition tax returns and discovered a tax liability for 2011. The debtor then filed a proof of claim on behalf of the IRS for the tax liability for 2011, and the IRS subsequently filed an amended proof of claim. In early 2014, the debtor filed her 2013 federal income tax return, claiming a refund based on an overpayment. The IRS did not remit the refund to the debtor and instead moved for an order modifying the automatic stay to allow the IRS to offset the debtor’s post-petition claim to a tax overpayment against pre-petition tax liabilities. The debtor responded that, pursuant to section 541(a)(7) of the Bankruptcy Code, the right to the refund was property of the estate because the 2013 tax refund did not exist at the time of the bankruptcy filing. In addition, the debtor argued that the 2011 tax obligation arose post-petition because, at the time of filing, she did not owe any taxes for 2011. The IRS, however, maintained that the overpayment for 2013 was not property of the debtor or the estate because under section 6402 of the Internal Revenue Code, the IRS was entitled to offset such funds against the tax liability for 2011. Therefore, the IRS argued that the debtor was entitled to a refund only if there was a net amount remaining after offset. Ultimately, the court granted the IRS’ order modifying the automatic stay, thereby allowing the IRS to offset the debtor’s post-petition tax overpayment for 2013 against the debtor’s pre-petition 2011 tax liability.

Breach of the Covenant of Good Faith Leads to Equitably Subordinated Debt and the Possibility of Losing Millions

By: Lauren Casparie

St. John’s Law Student

American Bankruptcy Institute Law Review Staff


In In re LightSquared, Inc.,[i] a bankruptcy court recently equitably subordinated the claim of an entity that the founder, chairman of the board, and controlling shareholder of a competitor of the debtor created in order to circumvent a credit agreement’s restrictions on transferring the debt to certain parties. In particular, the LightSquared court determined that the entity breached the implied covenant of good faith by effectively acquiring the debt on behalf of the competitor’s controlling shareholder.[ii] In LightSquared, the debtor entered into a credit agreement that restricted transferring the debt to certain disqualified companies and all natural persons.[iii] When a competitor company inquired about purchasing the debt, it discovered that the agreement’s schedules listed competitor as a disqualified company.[iv] Since the competitor could not purchase the debt directly, its controlling shareholder formed an investment vehicle for the exclusive purpose of buying the debt, thereby circumventing the credit agreement’s restrictions on transferring the debt, in order to give the competitor effective control over the debtor’s reorganization.[v] The investment vehicle was under capitalized, resulting in the creditor funding multiple purchases by transferring money from his personal account.[vi] Eventually, the investment entity purchased enough debt to give it a blocking position and the power to enforce certain rights during the debtor’s subsequent bankruptcy.[vii] After this purchase, rumors started to circulate that the controlling shareholder of the competitor was behind the purchasing.[viii] After hearing of these rumors, the debtor’s management strongly suspected that the controlling shareholder was behind the investment vehicle’s acquisition of the debt but never inquired into this suspicion.[ix] A month after obtaining a blocking position, the controlling shareholder made presentations to the competitor’s board of directors, informed them that he was behind the purchases of the debt, and proposed that the competitor submit a bid seeking to acquire the debtor’s assets.[x] Later, without informing the board of directors, the controlling shareholder submitted a bid on the competitor’s behalf for the debtor’s assets.[xi] This bid would have resulted in the investment entity being paid in full on the debt with an additional $140 million profit.[xii] Subsequently, the debtor filed for bankruptcy under chapter 11 of the Bankruptcy Code.[xiii]

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