Supreme Court to Tackle a Bankruptcy Tax Refund Circuit Split

To resolve a split of circuits, the Supreme Court has granted certiorari to decide whether state or federal law governs the ownership of tax refunds when a subsidiary generated the losses but the government pays the refund to the bankrupt corporate parent.

The issue came to the fore in the wake of the banking crisis beginning some 10 years ago. A bank would fail and be taken over by the Federal Deposit Insurance Corporation, or FDIC. The bank’s parent holding company often would end up in bankruptcy. 

The parent and subsidiary typically would have a prebankruptcy tax allocation agreement, or TAA, calling for the parent holding company to file a consolidated tax return for the corporate group. Usually, the failed bank would have incurred the losses giving rise to a tax refund. However, the Internal Revenue Service would pay the refund to the parent corporation as the entity that filed the tax return.

When the tax refund arrives from the IRS, does the bankrupt parent keep the cash, or does it go to the FDIC as receiver for the failed bank? That’s where the courts are split.

The Two Results

Courts resolved the question by employing two conflicting methodologies leading to different results. 

The first group of courts employ state law to decide who keeps the refund. Sometimes, the TAA would create a valid trust or agency arrangement under state law. In those cases, the refund would not be property of the bankrupt estate of the parent holding company. Consequently, the refund would end up in the hands of the FDIC.

When the TAA did not create a trust or agency relationship, the first group of courts would conclude that the TAA resulted in a debtor/creditor relationship between the parent and the subsidiary. In those cases, the first group of courts would conclude that the FDIC had nothing more than an unsecured claim against the bankrupt parent. Creditors of the bankrupt parent, sometimes bondholders, would benefit because the parent might otherwise have precious few assets aside from the tax refund.

The second group of courts employ the so-called Bob Richards rule, derived from a Ninth Circuit opinion in 1973. In re Bob Richards Chrysler-Plymouth Corp., 473 F.2d 262 (9th Cir. 1973). Those courts adopted a presumption — evidently a creation of federal common law — that the subsidiary with the losses is presumptively entitled to the refund absent a TAA that clearly gives the refund to the parent.

Under the same set of facts, the FDIC would come out on top in courts following the Bob Richards presumption.

The split worked out like this: The Fifth, Ninth and Tenth Circuits follow Bob Richards. Naturally, the FDIC does too.

The Second, Third, Sixth and Eleventh Circuits reject Bob Richards and employ state law to decide who owns the refund and whether the TAA creates an unsecured debtor/creditor relationship.

The Case on Certiorari

In the case to be heard in the Supreme Court, the parent holding company ended up in chapter 7 with a trustee. The bank subsidiary was taken over by the FDIC, as receiver. The bank subsidiary’s losses resulted in a $4 million tax refund payable to the parent under a TAA. 

The bankruptcy court in Colorado granted summary judgment in favor of the holding company’s trustee. Finding that the TAA did not create a trust or agency under Colorado law, the bankruptcy court believed the parent and subsidiary had a debtor/creditor relationship under the TAA, meaning that the parent was the owner of the tax refund.

The district court reversed, believing that the Tenth Circuit had previously adopted Bob Richards. The Tenth Circuit affirmed, ruling that the case was governed by federal common law, not state law, unless the TAA unambiguously specified where the refund would go. Because the TAA did not unambiguously favor the holding company, the refund went to the FDIC as receiver.

Citing the split of circuits, the bankruptcy trustee filed a petition for certiorari in April. The justices of the Supreme Court considered the petition at two conferences and granted certiorari on June 27. The case will be argued in the term to begin in October. The date for argument has not been set as yet.

How Will the Justices Rule?

In recent years, the Supreme Court has often resolved bankruptcy cases based on textualism, limitations on the powers of federal courts or deference to state law.

In Butner v. U.S., 440 U.S. 48 (1979), the Supreme Court ruled that state law determines the nature and extent of a debtor’s property interests. If the justices adhere to Butner, they may invoke state law, reverse the Tenth Circuit, overrule Bob Richards, and reinstate the judgment of the Colorado bankruptcy court giving the refund to the parent holding company.

The bankruptcy trustee also argues that courts adopting Bob Richards disregarded the rules for creating federal common law. According to the trustee, the Supreme Court requires a “significant conflict between some federal policy or interest and the use of state law” before a court is entitled to create federal common law. O’Melveny & Myers v. FDIC, 512 U.S. 79, 87 (1994).

Of course, the bankruptcy trustee sees no significant conflict with federal policy and thus no reason to adopt the Bob Richards presumption. 

It is not entirely clear to this writer that the Supreme Court will reach the Bob Richards issue. Arguing on behalf of the FDIC, the U.S. Solicitor General contends that the Tenth Circuit applied Colorado law in concluding that the refund belonged to the FDIC. If the justices are persuaded that the Tenth Circuit invoked state law and did not rely on the Bob Richards presumption, the Court might dismiss the certiorari petition as having been improvidently granted. 

The Significance of the Outcome

Obviously, the outcome in the Supreme Court will be significant in the liquidation of banks by the FDIC. In chapter 11 reorganizations of large non-bank companies with multiple debtors, the ruling by the high court will affect valuations underpinning the treatment of creditor classes under chapter 11 plans.