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American Bankruptcy Institute Law Review Staff

 

 

Finding that it would violate the absolute priority rule, the United States Bankruptcy Court for the Western District of North Carolina, in In re Carolina Internet, Ltd., held that an insolvent S corporation may not pay post-petition taxes on behalf of its shareholders because a corporation’s creditors have priority over its shareholders.[1] That approach highlights the problems bankruptcy creates for pass-through entities such as S corporations, because the benefits of successful post-petition operations flow to the creditors while the tax consequences of those operations are borne by the shareholders.

 

American Bankruptcy Institute Law Review Staff

 

 

Broadly construing section 105(a) of the Bankruptcy Code (the “Code”), the First Circuit, in Malley v. Agin, upheld a surcharge against the value of an otherwise exempt asset as an appropriate remedy for a chapter 7 debtor’s fraudulent concealment of assets.[1] The debtor intentionally failed to disclose $25,000 in assets, which violated his specific disclosure obligations under section 521 of the Code, as well as his general obligation to be forthright and honest with the court.[2] The bankruptcy court sanctioned the debtor by denying the debtor’s discharge pursuant to section 727 of the Code.[3] In addition, the bankruptcy court used its general equitable powers under section 105(a) to surcharge the concealed amount, plus the cost of untangling the fraud, against the value of an otherwise exempt asset—a truck used in the debtor’s business.[4] On direct appeal to the First Circuit, the debtor challenged the bankruptcy court’s surcharge order on the grounds that it exceeded the court’s equitable power under section 105(a).[5]

American Bankruptcy Institute Law Review Staff

 

 

Adopting a textualist approach, the U.S. Supreme Court, in Hall v. United States,[1] ruled that capital gains liability resulting from the debtors’ post-petition sale of their farm was not “incurred by the estate”[2] and therefore not dischargeable under chapter 12 of the Bankruptcy Code (“Code”).[3] After filing for chapter 12 bankruptcy protection, the debtors, Lynwood and Brenda Hall, sold their farm and incurred income tax liability as a result.[4] The Halls proposed a plan of reorganization under which they classified the resulting income tax liability as a dischargeable general unsecured claim and the IRS objected. The IRS argued that the taxes were the debtors’ independent responsibilities and were neither collectible nor dischargeable in bankruptcy.[5] The Court agreed with the IRS and held that the tax is neither a collectible nor dischargeable administrative expense under a chapter 12 plan of reorganization.[6]

American Bankruptcy Institute Law Review Staff

 

 

In In re Heritage Highgate, Inc.,[1] the Third Circuit held that the fair market value of property as of the confirmation date controls whether or not a lien is fully secured.[2]  Additionally, the court held that lien stripping is permissible in a chapter 11 reorganization.[3] The debtors, Heritage Highgate and Heritage-Twin Ponds II, were real-estate developers working on a project that was financed by a group of banks (the “Bank Lenders”) and other entities collectively known as Cornerstone Investors (“Cornerstone”).[4]  Both the Bank Lenders and Cornerstone secured their investments with liens on substantially all of the debtors’ assets but Cornerstone’s claims were contractually subordinated to the Bank Lenders’.[5] After selling a quarter of the project’s planned units, the debtors filed a chapter 11 petition.  The debtors’ joint proposed plan of reorganization proposed paying secured claims in full and paying 20% of the unsecured claims with funds obtained through the sale of the project’s remaining units.[6]  These estimated recoveries were based on the debtors’ appraisal, which valued the project at $15 million.[7] During the course of the case, the debtors continued to build and sell units and, with the consent of its secured lenders, used the sale proceeds to fund ongoing operating losses.[8] As a result, the fair market value of the project was reduced to approximately $9.54 million as of the time of plan confirmation, which was less than the Bank Lender’s $12 million secured claim.[9] Cornerstone argued their $1.4 million claim should still be fully secured and to hold otherwise would constitute impermissible lien stripping.[10] The bankruptcy court disagreed and determined that the proper method of valuing Cornerstone’s secured claim was the fair market value of the project as of the time of plan confirmation.[11]  Therefore, Cornerstone’s claim was unsecured.[12]