Supreme Court Rejects New Arguments Based on Old Bankruptcy Act

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Oct 2000

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While there are undoubtedly bankruptcy lawyers with 20 or more years of experience who have never seen
a case under the Bankruptcy Act of 1898, the Act continues to cast its shadow over current law. Last year's
leading Supreme Court decision, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… of America v. 203 North LaSalle St. Partnership, 526 U.S. 434, 143
L.Ed.2d 607, 119 S.Ct. 1411 (1999)</a>, struggled with (or ducked, depending on your point of view) the
question of whether the courts had created a new value exception (or corollary, depending on your point
of view) to "cramdown" in reorganization cases under the Bankruptcy Act. In each of the two most recent
Supreme Court cases dealing with bankruptcy law, the petitioner tried to build its legal argument on the
foundation of practice under the Bankruptcy Act, but in both cases, as it turned out, that attempt was
unsuccessful.

<h3>Was Surcharge a Common Practice Under the Bankruptcy Act?</h3>

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Underwriters Insurance Co. v. Union Planters Bank, __ US __, 120 S.Ct. 1942, 147 L.Ed.2d
1 (2000)</a>, (commonly called the "Hen House" case), was highly anticipated by bankruptcy practitioners.
Hen House Interstate Inc. operated restaurants and service stations. When Hen House filed under chapter
11, its primary pre-petition secured lender, Union Planters Bank (respondent in the Supreme Court
proceedings), agreed to lend an additional $300,000 to finance the bankruptcy proceedings, on top of the
more than $4 million it was already owed. The Union Planters debt was secured by virtually all of the
assets of Hen House.

During the course of the chapter 11 case, Hen House obtained workers' compensation insurance from
Hartford Underwriters Insurance Co. (petitioner in the Supreme Court proceedings) without initially
disclosing to Hartford that Hen House was in chapter 11. Although Hen House repeatedly failed to pay the
monthly premiums due on the workers' compensation policy, Hartford did not cancel the policy.
Ultimately, Hen House was unable to reorganize under chapter 11, and its bankruptcy case was converted
to liquidation under chapter 7. When it became clear that the Hen House bankruptcy estate did not have
sufficient unencumbered funds to pay the insurance premiums, Hartford attempted to recover the amount
due for insurance from Union Planters Bank under a provision of the <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Code (11 U.S.C. §506(c)</a>)
that permits a secured creditor's collateral to be surcharged for the costs of preserving it.

Specifically, §506(c) states, "The trustee may recover from property securing an allowed secured claim the
reasonable, necessary costs and expenses of preserving, or disposing of, such property to the extent of any
benefit to the holder of such claim." Hartford argued that this provision entitled it to recover, from the
bank's collateral, the unpaid premiums because Union Planters received a benefit from the preservation of
the going-concern value of its collateral through the continued operation of the Hen House business.
Alternatively, Hartford argued that such a benefit could be presumed because Union Planters had consented
to the post-petition financing order.

Whether or not the bank actually received such a benefit was an issue contested in the courts below,
but not, however, before the Supreme Court. The only issue before the Court in the Hen House case was
one of standing: whether, under §506(c), a creditor with an unpaid claim for expenses of administering
the bankruptcy estate, like Hartford, could cause the secured creditor's collateral to be surcharged, or
whether the statutory right to surcharge was limited to bankruptcy trustees (and chapter 11
debtors-in-possession, which have the rights and powers of a trustee under <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §1107</a>).

In its decision, the Court acknowledged that "Section 506(c)'s provision for the charge of certain
administrative expenses against lienholders continues a practice that existed under the <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Act of
1898." 120 S.Ct. at 1948</a>. Although the Bankruptcy Act did not contain a provision directly analogous to
§506(c), the bankruptcy courts had developed the practice of surcharging collateral based on "an equitable
principle that where a court has custody of property, costs of administering and preserving the property are
a dominant charge." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… S.Ct. at 1948-49</a>.

Hartford cited a number of cases decided under the Bankruptcy Act in which lower courts had permitted
parties other than the bankruptcy trustee to pursue such charges on collateral. Hartford also cited decisions
of the Supreme Court itself authorizing individual claimants to seek recovery from secured assets.<a href="#1" name="1a">1</a>

The court distinguished its own "early" decisions on the grounds that Wilson and Burnham arose out
of the equity receivership law that predated even the Bankruptcy Act and that New York Dock was an
admiralty case. As for the lower-court Bankruptcy Act cases cited by Hartford, the court doubted that "these
proceedings establish a bankruptcy practice sufficiently widespread and well recognized to justify the
conclusion that the allowance of recovery from collateral by non-trustees is the type of 'rule' that...Congress
was aware of when enacting the Code," citing, among more recent Supreme Court decisions, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… States
v. Ron Pair Enterprises Inc., 489 U.S. 235, 109 S.Ct. 1026, 103 L. Ed. 2d 290 (1992)</a>.

In the end, the Court concluded that delving into the history of bankruptcy surcharge was unnecessary
because the statutory language of §506(c) "leaves no room for clarification by pre-Code practice." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… S.Ct.
at 1949</a>. If §506(c) had created a right of surcharge without specifying the party entitled to enforce that
right, it might be a different case. Here, however, the statute clearly conferred the right on a specific party:
the trustee. The Court concluded, "Pre-Code practice cannot transform §506(c)'s reference to 'the trustee'
to 'the trustee and other parties in interest.'" <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 1950</a>. Accordingly, the Eighth Circuit court below had
correctly reversed a bankruptcy court order permitting surcharge of Union Planters Bank's collateral for
the benefit of Hartford.

<h3>Who Had the Burden of Proving Claims Under the Bankruptcy Act?</h3>

Practice under the Bankruptcy Act also figured prominently as an issue in another decision announced
concurrently with the Hen House case—<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Illinois Department of Revenue ___ U.S. ___, 120 S.Ct.
1951, 147 L. Ed.2d 13 (2000)</a>. That decision arose out of a claim by the state of Illinois for unpaid use
taxes. The alleged tax liability was initially assessed against a corporation that failed to pay the taxes before
going out of business. The state, therefore, also issued a Notice of Penalty Liability against the president
of the corporation, who subsequently sought bankruptcy protection. The Illinois Department of Revenue
filed a claim in the bankruptcy case for the amount assessed in the Notice of Penalty Liability. The
bankruptcy trustee (Raleigh) objected to the claim.

Under Illinois law, if a corporation fails to pay taxes, its controlling officers become liable for them if
the failure to pay taxes was willful, and the state's determination of the amount due is "prima facie evidence
of a penalty due" from the officer. Furthermore, under Illinois law, once the state issues a Notice of Penalty
Liability against a corporate officer, the burden of proof, both as to the production of evidence and
persuasion, rests on a designated corporate officer who wants to contest the imposition of liability. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… S.Ct.
at 1954</a>.

It appears that no evidence was produced in the trial court directly addressing the bankrupt debtor's
involvement in the tax affairs of the corporation. Accordingly, it appears to have been the trustee's position
that, in bankruptcy cases, the burden of proof ultimately rests on the claimant and that, because there was
no proof that the failure to pay taxes was willful, the claim should be disallowed. The state of Illinois, on
the other hand, appears to have taken the position that, under state law, the burden of challenging the tax
liability rested on the taxpayer and that, because the trustee had not overcome the presumption created by
the Notice of Penalty Liability, the claim should be allowed.

As in the Hen House case, the petitioner (here, the trustee) attempted to harken back to practice under
the Act to support his position. The trustee argued that, under the Bankruptcy Act, courts "almost
uniformly" placed the burden of proving a claim in bankruptcy on the creditor. Because the Bankruptcy
Code generally incorporates pre-Code practice in the absence of explicit revision, the trustee argued, the
court should follow the pre-Code practice even when this would reverse the burden of proof imposed
outside of bankruptcy. The Court did not disagree with the basic principles advanced by the trustee, but
rather refused to accept the fundamental factual premise of his argument. The Court was not persuaded
that the trustee had correctly characterized pre-Code practice. "While some pre-Code cases put the burden
of proof on the taxing authorities, others put it on the trustee, and still others cannot be fathomed," Justice
Souter wrote for the Court.

<blockquote><blockquote>
<hr>
<big><center>
...no evidence was produced in the trial court directly addressing the bankrupt debtor's involvement in the tax affairs of the corporation.
</center></big>
<hr>

</blockquote></blockquote>

The Court also rejected the trustee's argument that "allowance" of claims in bankruptcy is a question
of federal, not state, law. To support this argument, the trustee cited the Supreme Court's decision in
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Bondholders Protective Committee v. Green, 329 U.S. 156, 67 S.Ct. 237, 91 L. Ed. 162 (1946)</a>.
The court explained, however, that when it suggested in Vanston that "allowance" of claims was a federal
question, it was referring to "the ordering of claims" and that Vanston concerned "distribution of assets, not
validity of claims in the first instance." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 120 S.Ct. at 1957</a>. The Court noted that Vanston also held
that "[w]hat claims of creditors are valid and subsisting obligations is to be determined by reference to state
law." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 329 U.S. at 161</a>. Where, as here, the burden of proof goes to the validity of the claim, the
burden of proof is "a substantive aspect of the claim," an "essential element of the claim itself" and should
be determined by reference to applicable state law. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 120 S.Ct. at 1955, 1957</a>. In other words,
determining the priority of a claim for distribution of bankruptcy estate assets is a matter of federal law, but
whether the claim is valid in the first instance should be determined in accordance with state law (including,
for this purpose, state law rules regarding the burden of proof).

Under these principles, in the determination of the validity of its tax claim, the state was entitled in
bankruptcy to the same presumptions and advantages with respect to the burden of proof as it would have
had outside of bankruptcy. In this regard, the case is ultimately a reconfirmation of the principle enunciated
by the Supreme Court in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. United States, 440 US 48, 57, 99 S.Ct. 914, 59 L.Ed.2d 136 (1979)</a>, as
well as in Vanston: The basic federal rule in bankruptcy is that state law governs the substance of claims.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> See, e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… E. & St. L. R. Co. v. Wilson, 138 U.S. 501, 11 S.Ct. 405, 34 L. Ed. 1023
(1891)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Bowen, 111 U.S. 776, 4 S.Ct. 675, 28 L. Ed. 596 (1884)</a>; and <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… York Dock Co. v. S.S. Poznan, 274 U.S. 117, 47 S.Ct. 482, 71 L.Ed. 482 (1927)</a>. <a href="#1a">Return to article</a>

Journal Authors

Lawrence Peitzman

Journal Date

Sunday, October 1, 2000 - 12:00