Real Property Transfers and Bankruptcy Tax Exemptions In re Hechinger and 11 U.S.C. Section 1146(c)

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Sep 2003

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Section 1146(c) of the Bankruptcy Code provides that the transfer of property
"under a plan confirmed" under chapter 11 may not be "taxed
under any law imposing a stamp tax or similar tax." Congress enacted this
provision of the Bankruptcy Code to encourage reorganization through the
chapter 11 process by providing tax relief to debtors who decide to sell assets
in connection with their chapter 11 plan. The reduction in tax obligations
further assists in producing successful reorganization plans by encouraging
debtors to dispose of unnecessary assets and by enhancing the amount of money
that will ultimately be available for distribution to creditors under the plan.
In a surprisingly anti-creditor, anti-reorganization decision by the Third
Circuit, these purposes and policies were seriously undermined in favor of
state and local taxing authorities.

<h3>The Hechinger Decision</h3>

Hechinger Investment Company of Delaware Inc. was a leading provider of home and garden
supplies with approximately 200 locations nationwide. Hechinger and its
related debtor affiliates (collectively, "Hechinger") filed their
voluntary petitions for chapter 11 relief on June 11, 1999, in an attempt to
reorganize. Hechinger's reorganization efforts were ultimately unsuccessful,
and on Sept. 9, 1999, Hechinger announced it would cease operations and
liquidate. As part of this liquidation, Hechinger filed two motions seeking
authorization to sell substantially all of its assets, including its interest
in certain real property located in Baltimore County, Prince Georges County and
Montgomery County in the state of Maryland. Among the relief requested in
Hechinger's motions was a ruling that the transfer of the Maryland real
estate would not be subject to the payment of transfer and recording taxes, as
provided in §1146(c) of the Bankruptcy Code, because the sales were
necessary to reduce Hechinger's indebtedness, improve its liquidity and
facilitate the formulation and ultimate confirmation of a chapter 11 plan.

Maryland and several Maryland municipalities (the taxing authorities) objected to the
sale motions on numerous grounds, including that the motions were suits against
a state that were barred by the Eleventh Amendment and that the plain language
of §1146(c) limited the section's applicability only to sales
conducted as part of a confirmed chapter 11 plan and not pre-confirmation
transfers of realty.

<blockquote><blockquote>
<hr>
<big><center>
The bankruptcy court determined that the language of §1146(c) was ambiguous
and that Hechinger's reading of the statute was more consistent with the
congressional intent of promoting successful chapter 11 plans.
</center></big>
<hr>
</blockquote></blockquote>

The
taxing authorities argued that the plain language of §1146(c) expressly
limited its application to those transfers that are made pursuant to the terms
of a confirmed chapter 11 plan.<a href="#2" name="2a">2</a> They relied on the Fourth Circuit's
decision in <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
Homes Inc. v. Clerk of the Circuit Court for Anne Arundel Co. (In re NVR LP), 189 F.3d 442 (4th Cir. 1999), cert. denied, 528 U.S. 1117 (2000)</a>, which held that
the tax exemption under §1146(c) applies only to transfers that are made
after the date of plan confirmation, regardless of whether the pre-confirmation
transfer was made in furtherance of, contemplated in or ratified by the plan.
The taxing authorities urged the court to construe §1146(c) as
establishing a purely temporal test, whereby a transfer is a taxable event if
it takes place prior to confirmation, and a sale is exempt from transfer taxes
if it takes place after confirmation. Conversely, Hechinger argued that the
statutory language, "under a plan confirmed," does not restrict the
timeframe in which a sale must occur and that whether a transfer meets this
standard should be examined factually on a case-by-case basis.

<h3>The Bankruptcy Court Decision</h3>

The bankruptcy court overruled the taxing authorities' objections and
approved Hechinger's transfers of the Maryland real estate, including the
requested exemption from transfer and recordation taxes.

In its decision, the bankruptcy court determined that the language of
§1146(c) was ambiguous and that Hechinger's reading of the statute
was more consistent with the congressional intent of promoting successful
chapter 11 plans. In the court's view, the purpose of §1146(c) would
be undermined if its application were limited solely to post-confirmation
transfers because debtors often conduct sales during the pre-confirmation
period, and there would be no rational basis for Congress to create a tax
benefit for all debtors and then simultaneously limit that benefit to a small
subset of debtors on an ostensibly arbitrary basis. The bankruptcy court also
noted that a narrow reading of §1146(c) would provide a counterproductive
incentive for debtors to retain unnecessary assets until confirmation and would
thus reduce the potential of distributions to creditors.

The
bankruptcy court concluded that the condition necessary for the statutory tax
exemption is the ultimate confirmation of a chapter 11 plan and not the timing
of the sale. The bankruptcy court went so far as to conclude that
pre-confirmation sales are exempt from transfer taxes even if the chapter 11
plan that is ultimately confirmed is a liquidation plan and not a
reorganization plan. The bankruptcy court reached this conclusion based on the
express language of the statute, which simply requires a "plan" to
be confirmed.

<h3>The District Court Decision</h3>

The
taxing authorities appealed the bankruptcy court's decision to the U.S.
District Court for the District of Delaware, which affirmed the bankruptcy
court's decision on all issues. Adopting the bankruptcy court's
reasoning, the district court noted that limiting the scope of §1146(c) to
post-confirmation transfers would undermine the purpose of the statute. The
district court further noted that courts should not narrowly construe a statute
so as to undermine its clear legislative purpose. Accordingly, the district
court held that the §1146(c) exemption from transfer taxes applies to all
sales conducted by a debtor throughout the course of a chapter 11 bankruptcy,
provided that such sales are necessary to confirmation. The district court
observed that the restriction in §1146(c) to transfers that are necessary
or essential to confirmation ensures that the bankruptcy court can retain
jurisdiction over the determination of whether or not particular transfers are
necessary to confirmation. In the Hechinger case, the court concluded that the sales were "clearly necessary"
to the plan because the proceeds were to be used to fund the plan. In contrast,
the court noted that the Fourth Circuit's decision in In re NVR
Homes was focused on the temporal aspects
of the transfers rather than the critical issue of whether the transfers were
necessary to confirmation of a chapter 11 plan. As a result, the district court
affirmed the bankruptcy court's decision. The taxing authorities
subsequently appealed the district court decision to the U.S. Third Circuit
Court of Appeals.

<h3>Third Circuit Decision</h3>

After
determining that it was not required to reach the question of whether the
bankruptcy court's orders violated the Eleventh Amendment, the Third
Circuit turned to the issue of the proper interpretation of §1146(c).
Section 1146(c) provides that "[t]he issuance, transfer or exchange of a
security, or the making or delivery of an instrument of transfer under a plan
confirmed under §1129 of this title, may not be taxed under any law
imposing a stamp tax or similar tax." In their briefs, the parties did
not dispute that the subject real estate transfers involved "the making or
delivery of...instrument[s] of transfer" or that the transfer and
recording taxes were "stamp" or "similar"" taxes.
Rather, at issue was the statutory interpretation of whether the sales were
carried out "under" a confirmed plan and the temporal significance
of the term "under" as used in the statute. The Hechinger
Liquidating Trust, which had been substituted for Hechinger as appellee in this
matter after the plan was confirmed, argued that the sales had already occurred
"under" a plan, even though a plan had not yet been confirmed at
the time of the sales, because the transfers were necessary to promote
confirmation of a plan, and the subsequently confirmed chapter 11 plan
retroactively authorized the transfers.

In
its statutory interpretation of §1146(c), the Third Circuit began by
stating that although the preposition "under" has many different
meanings, in this context the most natural meaning of the phrase "under a
plan confirmed" is "authorized by." The court explained that "[w]hen
an action is said to be taken 'under' a provision of law or a
document having legal effect, what is generally meant is that the action is
‘authorized' by the provision of law or legal document." The
court reasoned that this interpretation of "under" fits best with
the remaining language of §1146(c), and it is consistent with the meaning
of "under a plan confirmed" as the phrase is found in §365(g)
of the Code.

The
court further stated that "[e]ven if the language of §1146(c) is
ambiguous, however, two important canons of construction support [the
court's] interpretation." First, tax exemption provisions are to
be strictly construed. Second, federal laws that interfere with a state's
taxation scheme are to be narrowly construed in favor of the state. Because
§1146(c) provides for a tax exemption and it was interfering with
Maryland's provision of property taxation powers, §1146(c) had to be
construed in the taxing authorities' favor.

The
Third Circuit rejected the alternative interpretation of "under a plan
confirmed" advanced by the Hechinger Liquidating Trust—i.e., "necessary for the confirmation of a
plan" that is eventually confirmed. The court found no precedent to
define "under" to mean "necessary for the confirmation
of" and rejected the Hechinger Liquidating Trust's position. The
Third Circuit also disagreed with the trust's reading of <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=7…
re Jacoby-Bender Inc., 758 F.2d 840 (2nd Cir.
1985)</a>, explaining that the case did not support the proposition
that §1146(c) protects pre-confirmation transfers that are necessary or
essential to the subsequent confirmation of a plan.

Consequently,
agreeing with "the only other court of appeals that has decided the
issue," NVR Home, the Third
Circuit held that a transfer is made "under a plan confirmed under
§1129" only when the sale is authorized by the terms of a previously
confirmed chapter 11 plan.

<h3>Dissenting Opinion</h3>

In a well-drafted dissenting opinion, Judge Nygaard disagreed with the
majority's finding that the phrase "under a plan confirmed"
places a temporal restriction on the qualifying transaction. Rather, he opined
that §1146(c) can and should be read to create an exemption with respect
to property transferred merely "under a plan confirmed," regardless
of when the plan is confirmed. Judge Nygaard substantiated his position by
indicating that a remedial statute such as the bankruptcy law should be liberally
construed. He further noted that what is essential to the eligibility of
transfers under §1146(c) is that the transfer is an essential or important
component of the plan process. If Congress sought to encourage plan
confirmation through §1146(c), the exemption should be construed in light
of its purpose. If Congress had intended to limit the application of the
exemption temporally, it would have created a brightline test.

<h3>Conclusion</h3>

In the aftermath of the Hechinger decision,
the transfer tax exemption codified in §1146(c) is now to be mechanically
applied only to sales "authorized by the terms of a previously confirmed
chapter 11 plan." In fact, the Third Circuit did not even require that
the transfer be related to the debtor or its estate, much less requiring that
the transfer be essential to the debtor's reorganization or liquidation.
Notwithstanding that application of this section to pre-confirmation sales
properly comports with both the clear legislative history of the statute and
practical experience, the Third Circuit adopted a formulaic position that is
easy to apply but effectively eviscerates the exemption.

A sound reading of the legislative history of §1146(c) and the policy
considerations underpinning the exemption militate in favor of a substantive
determination of the appropriateness of the exemption to any given
transfer—as opposed to a temporally formulaic application of the
calendar. The Third Circuit's failure to give any weight to the
plan's ultimate confirmation has the effect of minimizing the potential
benefit of the §1146(c) exemption, even as to taxpayers deserving of the
exemption.

The practical implications of the Hechinger decision remain to be seen. Before Hechinger, the regular practice of bankruptcy courts was to
approve transfer-tax exemptions on pre-confirmation sales when the transactions
were clearly made in furtherance of the reorganization or liquidation, a
practice that the Third Circuit gave insufficient significance. The Third
Circuit accomplished its goal of creating a brightline rule regarding the
application of the §1146(c) tax exemption, so, as with every brightline
rule (especially a brightline
rule relating to taxes), it can be expected that lawyers will simply devise
ways to restructure their transactions to fall within the newly imposed
requirement that the transfer occur post-confirmation. With regard to
transactions in which this is impracticable,
the burden created by the sweeping proclamation in Hechinger will unfortunately fall on the shoulders of
creditors.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> The author gratefully acknowledges the assistance of William R. Firth III and Adam Hiller in the preparation of this article. <a href="#1a">Return to article</a>

<a name="2">2</a> The taxing authorities also asserted that the bankruptcy court's orders violated the Eleventh Amendment; however, both the bankruptcy and district courts rejected this argument. <a href="#2a">Return to article</a>

Journal Authors

David B. Stratton

Journal Date

Monday, September 1, 2003 - 12:00

Bankruptcy Rule

2003