When a bank fails and is liquidated by the Federal Deposit Insurance Corporation (FDIC), and then the bank’s holding company files for bankruptcy, a dispute frequently arises regarding ownership of tax refunds issued to a consolidated group (including the bank and the bank holding company) pursuant to consolidated tax returns. The parties to the dispute typically are the FDIC (derivatively through the failed bank) and the holding company’s bankruptcy estate. The majority view among the bankruptcy courts and the district courts is that the bank holding company wins, and its creditors (typically the bank holding company bondholders) receive pro rata shares of the refund. However, the Eleventh Circuit recently issued two opinions[1] that (1) held that the FDIC owns the tax refunds and (2) reached that conclusion based on reasoning that is at odds with both the reasoning of many opposite lower court rulings, as well as the reasoning of conflicting circuit court opinions.[2] Shortly thereafter, the Delaware bankruptcy court[3] distinguished both Eleventh Circuit opinions and held that the bankruptcy estate, and therefore its creditors, could look to the tax refund in partial satisfaction of their claims.
The Typical Fact Pattern
Typically, a bank holding company and its affiliated bank file consolidated tax returns. The bank holding company and the bank typically enter into a tax sharing agreement (TSA) “to take advantage of the beneficial tax treatment afforded to affiliated corporations that file consolidated tax returns, and to address inter-corporate tax policies and procedures.”[4] “Consolidated tax returns permit the [holding company] to utilize losses by one group member to reduce the consolidated group’s overall tax liability.”[5] Typically, the losses are generated largely, if not entirely, by the affiliated bank, but the bank holding company files the consolidated tax return for the group.[6] “[A] parent and its subsidiaries are free to provide for the allocation of tax refunds by contract.”[7]
The issue often arises in bankruptcy cases because the beneficial interests in the bank holding company and the affiliated bank, which are united prior to bankruptcy, are typically separated upon the failure of the bank. When a bank fails, the FDIC generally takes over its assets and becomes the receiver for the failed bank. The FDIC then becomes the party with the real economic interest in the bank’s assets. The bank holding company typically files a separate bankruptcy case when the FDIC takes over, or threatens to take over, a troubled affiliated bank. The FDIC recovers any tax refund arising from the consolidated tax return if the refund is property of the affiliated bank, while the bank holding company’s creditors[8] recover their pro rata share of the refund if the refund is property of the bank holding company.
How the Courts Determine Who Owns the Tax Refund
Where the bank and bank holding company have not entered into a TSA, then most courts look to the seminal opinion of Western Dealer Mgmt. Inc. v. England (In re Bob Richards Chrysler-Plymouth Corp.)[9] Most courts interpret Bob Richards as establishing
that in the absence of a written agreement expressly stating the rights and obligations of parties filing a consolidated tax return, a tax refund resulting solely from offsetting the losses of one member of a consolidated filing group against the income of that same member in a prior or subsequent year should inure to the benefit of that member. 473 F.2d at 265. As a result, the party receives the refund from the government only in its capacity as an “agent” for the consolidated group. Id. The absence of an express or implied agreement that the agent had any right to keep the refund meant the agent was under a duty to return the tax refund to the party that incurred the loss. Id.[10]
Thus, in the absence of a written TSA, in most cases the FDIC, as receiver for the failed affiliate bank, recovers the tax refund, or the bulk of it, since in most cases the losses, or the bulk of them, were incurred by the failed bank. The bank holding company receives the tax refund only as an “agent” for the consolidated group and not in its own right.
Although the FDIC regularly and unsuccessfully argues otherwise, most courts find the Bob Richards holding distinguishable and inapplicable where the parties entered into a TSA. “If an express written agreement is in effect, then the agreement controls the disposition of the tax refund.”[11] In such cases, the courts determine ownership of the tax refunds by interpreting and constructing the TSA using ordinary contract interpretation and construction principles.
In BankUnited, the bank holding company and affiliated bank entered into a TSA that, inter alia, provided for the affiliated bank to pay the taxes and distribute any refunds to the consolidated group members in accordance with the TSA. However, the holding company filed the consolidated group’s tax returns and was the recipient of the refund from the IRS. The Eleventh Circuit reversed the bankruptcy court and held that the tax refunds belonged to the affiliated bank, noting that although the TSA was ambiguous, it was “obvious” that the parties intended that the holding company would be required to turn over the refunds to the bank so that the bank could perform its obligations under the TSA. The holding company argued that the TSA created a debtor/creditor relationship between the bank and the holding company, because the bank’s only recourse if the holding company refused to turn over the refund was to sue the holding company for a money judgment. This meant, according to the holding company, that at most the bank would be a creditor, and not the owner, of the refund, since at most the bank had a right to payment of the amount of the refund (not the refund as a res that the holding company received in trust) that it could enforce through a money judgment. The court rejected this argument, reasoning that “[a] debtor-creditor relationship is created by consent, express or implied.”[12] The Court found no language in the TSA “from which it could reasonably be inferred that the parties agreed that the Holding Company would retain the tax refunds as a company asset and, in lieu of forwarding them to the Bank, would be indebted to the Bank in the amount of the refunds.”[13]
The TSA at bar in NetBank did not contain this unusual provision requiring the bank to pay and allocate refunds under the TSA, notwithstanding that the holding company filed the tax returns and received the refunds from the IRS. Instead, the TSA in NetBank contained the more common provision, whereby the bank holding company was required to file the tax returns, pay the taxes due and then distribute any refund in accordance with the TSA. Nevertheless, notwithstanding these differing TSA provisions, the NetBank court found the BankUnited reasoning “persuasive.”[14] The NetBank TSA stated that it was “intended to allocate the tax liability in accordance with the Interagency Statement on Income Tax Allocation in a Holding Company....” This Interagency Statement,[15] which many courts had found was not a binding statute or regulation, stated that consolidated groups should avoid entering into a TSA that would grant ownership to the parent of refunds attributable to the bank; in essence, the Interagency Statement would caution against adopting a TSA that would produce a result different from the result mandated by Bob Richards in the absence of a TSA. The NetBank court concluded that by incorporating this provision into the TSA, the parties evidenced an intention to abide by it, notwithstanding its lack of virility on its own, and that all tax refunds received by the parent holding company were received as agent for the group member that generated the losses upon which the refund was calculated — in this case, the bank.
Downey is the first, and as of this writing the only, published lower court opinion addressing BankUnited and NetBank. In Downey, Judge Christopher Sontchi held that pursuant to a TSA, the Downey bank holding company owned the disputed tax refunds. Judge Sontchi distinguished both BankUnited and NetBank. With respect to BankUnited, Judge Sontchi noted that the Downey TSA provided that the bank holding company, and not, as in BankUnited, the bank, was responsible for paying the taxes and distributing the tax refund pursuant to the TSA. Thus, unlike in BankUnited, Judge Sontchi concluded that the Downey bank holding company did not receive the tax refund as agent for the bank, since the holding company, and not the bank, had to distribute the refund to the consolidated group members pursuant to the TSA. With respect to NetBank, Judge Sontchi noted that the Downey TSA did not incorporate by reference the Interagency Statement, and thus, unlike in NetBank, the TSA did not evince an intention to adopt it and avoid allocating refunds other than to the consolidated group member that generated the losses upon which the tax refund was calculated.
It is ironic that the bankruptcy courts, so often falsely accused of rendering “result-oriented” opinions unfairly favoring debtors, appear to have applied contract construction rules rigorously and objectively, but nevertheless found their rigorous reasoning rejected by the Eleventh Circuit. A palpable sense emerges when reading BankUnited and NetBank that the Eleventh Circuit in both cases reacted viscerally, in substance responding to the numerous bankruptcy courts holding that disputed tax refunds belonged to the bank holding companies with an emphatic, “Are you kidding???” The court too easily dismissed or ignored language commonly appearing in TSAs that other courts (including Downey) had relied upon to find that the parties intended to create a debtor/creditor relationship and that the holding company, rather than the bank, owned the disputed tax refund at issue.
Further appeals on this issue are pending throughout the country and working their way up to the circuit courts of appeals. Hundreds of millions of dollars of tax refunds, and the expectations of the bank holding company capital markets, hang in the balance. Stay tuned.
[1] Zucker v. FDIC (In re BankUnited Fin. Corp), 727 F.3d 1100 (11th Cir. 2013) (hereinafter “BankUnited”) and FDIC v. Zucker (In re NetBank Inc.), 729 F.3d 1344 (11th Cir. 2013) (hereinafter “NetBank”).
[2] See, e.g., Superintendent of Ins. v. Ochs (In re First. Cent. Fin. Corp.), 377 F.3d 209 (2d Cir. 2004).
[3] Giuliano v. FDIC (In re Downey Fin. Corp.), 2013 Bankr. LEXIS 4220 *9 (Bankr. D. Del. Oct. 8, 2013) (hereinafter “Downey”).
[4] Downey at *9.
[5] Id.
[6] The Internal Revenue Code permits the “common parent” of an “affiliated group” of corporations to file a single consolidated income tax return. 26 U.S.C. §§ 1501 and 1504(a). The Department of the Treasury has promulgated certain regulations to address the filing of such consolidated returns, which generally allow payment of refunds to the parent on behalf of the consolidated group. Tax regulations concerning the payment of refunds to a holding company (or any other entity) are not determinative of the ultimate ownership of such refunds. See, e.g., 26 C.F.R. § 301.6402–7(j). See generally Siegel v. FDIC (In re IndyMac Bancorp), 2012 WL 1037481 *6 (Bankr. C.D. Cal. Mar 29, 2012), report and recommendation adopted, 2012 WL 1951474 (C.D. Cal. May 30, 2012).
[7] BankUnited, 727 F.3d at 1102-03.
[8] Typically the bank holding company creditors are predominately bondholders who are capital markets investors holding debt instruments commonly used in the banking industry known as trust preferred securities (TRUPs). Although not entirely accurate (specifically with respect to the relative priorities of TRUP debt and other debt owed by a bank holding company), a good summary of TRUP financing can be found at T. Eveson, Financial and Bank Holding Company Issuance of Trust Preferred Securities, 6 N.C. Banking Inst. 315 (2002). The interests of the capital markets in ensuring the stability of TRUP financing, and the deleterious effect on capital markets arising from cases such as BankUnited and NetBank that deprive holders of TRUP debt their pro rata recovery of the disputed tax refunds, cannot be overstated.
[9] 473 F.2d 262 (9th Cir. 1973).
[10] In re Vineyard Nat. Bank, 2013 WL 1867987 (Bankr. C.D. Cal. May 3, 2013); Downey at *28.
[11] Downey at *29 (citation omitted); BankUnited, 727 F.3d at 1347 n.3 (citations omitted).
[12] Id. at 1108.
[13] Id.
[14] NetBank, 729 F.3d at n.1.
[15] Interagency Policy Statement on Income Tax Allocation in a Holding Company Structure, 63 Fed. Reg. 64757, 64759 (Nov. 23, 1998).