Bankruptcy: In re Webster Classic Auctions: is the door finally open for a practical application of section 1146(c)?

On average, 10,000 petitions for reorganization under Ch. 11 of the Bankruptcy Code are filed every year. (1) Of those companies filing petitions, only 25 percent are expected to have their plan for reorganization confirmed by a bankruptcy court. (2) When further analyzing a company's chance of emerging from Ch. 11 to become a thriving concern, the figure of success shrinks to about seven percent. (3) Although the reasons behind the failure to reorganize successfully vary, there is a constant theme: an insufficiency of funds necessary to achieve or carry out a plan for reorganization.

In an effort to clarify prior law and facilitate successful reorganizations, Congress enacted [section] 1146(c) as part of the Bankruptcy Reform Act of 1978 to give debtors tax relief by exempting post-petition transactions from taxes associated with the disposition or refinancing of real property interests. The objective of the exemption is simple: By limiting the financial obligations of transfers occurring under a reorganization plan, a greater portion of proceeds from the transactions are available to debtors, thereby increasing the likelihood that debtors will efficiently discharge their obligations and emerge from reorganization. Potentially, this exemption can be Of substantial importance to debtors with real property interests located in Florida. (4) Compared to other states, Florida has some of the highest tax rates in the nation on transfers of an interest to real property as well as the financing or securitization of real property interests. (5)

Section 1146(c) of the Bankruptcy Code provides that "the issuance, transfer, or exchange of a security, or the making or delivery of an instrument of transfer under a plan confirmed under [section] 1129 of this title, may not be taxed under any law imposing a stamp tax or similar tax." (6) The section reads simply enough: Once a plan of reorganization has been confirmed by the bankruptcy court, transfers by the debtor are exempt from taxation. The problem, however, is that the relief granted by the strict interpretation of the exemption may be too little, too late. Depending on the size and complexities of the debtor's business, the period between the filing of a Ch. 11 petition and the approval of the reorganization plan can extend for months or even years beyond the statutory timeframe of 120 days. This preconfirmation period is critical to a debtor's ability to rid itself of burdensome liabilities and liquidate its valuable assets into cash so that it may keep its business operational. Imaginative debtors, identifying the potential value of the exemption and recoguizing the impracticality of its strict application, have requested that courts liberally construe the otherwise plain meaning of the term "a plan confirmed" so that post-petition transactions occurring outside the confirmation of a plan of reorganization are nevertheless exempt from taxation.

Early Interpretation of 1146(c)

The seminal case that broadened the interpretation of the term "a plan confirmed" was In re Jacoby-Bender, 758 F. 2d 840 (2d Cir. 1985). In Jacoby-Bender, the disposition of real property occurred subsequent to the reorganization plan confirmed by the bankruptcy court, but was not specifically referenced in the plan. On appeal at the Second Circuit, the City of New York argued that the confirmed plan did not specifically authorize the sale, and thus the sale was not subject to the exemption, "because the plan did not mention any instrument of transfer and did not give the debtor the authority to make the specific sale." (7) Countering the city's argument as to the need for referencing the transaction in the plan, the Second Circuit noted the bankruptcy court's finding that %he plan's consummation depended almost entirely upon the sale of the building." (8) Disagreeing with the city's position, the court stated that the purpose of Congress enacting [section] 1146(c) was to "facilitate reorganizations through giving tax relief, a purpose served equally well when the reorganization plan leaves details to be settled in the future." (9) The court went on to note that [section] 1146(c) derived from [section] 267 of the bankruptcy act which involved transactions that "serve to execute or make effective a plan confirmed under Chapter X." (10) Since [section] 1146(c) "does not require that the reorganization plan include specifics" and the sale at issue was "necessary to the consummation of [the] plan," the court held that the sale was subject to the exemption, not a plan, the consummation of which, depends on the closing of the transaction in dispute. (11)

A Fork in the Road

Not buying into the logic of the Second Circuit's decision in Jacoby-Bender, the Third Circuit Court of Appeals took a more academic approach to the application of [section] 1146(c) to transactions occurring before a Ch. 11 plan is confirmed. In In re: Hechinger Investment Company of Delaware, Inc., 335 F. 3d 243 (3d Cir. 2003), the debtor filed a motion with the bankruptcy court requesting permission to sell its real estate interests and a declaration that the sales would be exempt from transfer taxes, even though the sales would close prior to the confirmation of its reorganization plan. (12) Summarizing the debtor's argument, the court simplified the issue before it to whether the term "under a plan confirmed" could be interpreted to include transfers that are necessary to effect the confirmation of the reorganization plan. (13) Adhering to the canons of statutory construction that tax exemption provisions are to be narrowly construed and that identical words used in the same act are intended to have the same meaning, the Third Circuit focused almost exclusively on the meaning of "under" in the phrase "under a plan confirmed." To solidify its position, the court relied on the various definitions of "under" as provided in Webster's Dictionary and Random House Dictionary. Based on its review, the court determined that the most appropriate interpretation of "under a plan confirmed" is a plan that has been authorized by the courts. (14)

Accordingly, Hechinger dismissed the progressive interpretation the debtor proffered under Jacoby-Bender, and instead embraced a temporal interpretation of [section] 1146(c). (15) For the Third Circuit, transactions occurring after a plan's confirmation are exempt, those that occur prior are not. Based on this rationale, if a debtor's plan has not been authorized, even if the transaction was a day away from the plan's confirmation, any and all transactions are susceptible to taxation.

In re: Webster Classic Auctions, Inc.

In the recent case of In re: Webster Classic Auctions, Inc., 318 B.R. at 216 (Bankr. M.D. Fla. 2004), the debtor filed a motion requesting that the Bankruptcy Court for the Middle District of Florida order the refund of the documentary stamp taxes paid to the Florida Department of Revenue on its sale of post-petition real property. The debtor in Webster seemingly faced an uphill battle: Not only was the transaction consummated prior to the submission of the debtor's reorganization plan, but the order approving the sale of the property made no mention of the application of [section] 1146(c) to the transaction, nor were there any findings regarding the necessity of the sale as part of the reorganization. Without precedent from the 11th Circuit regarding the application of [section] 1146(c) to preconfirmed transactions to rely upon, the bankruptcy court had to choose the practical interpretation of the Second Circuit in Jacoby-Bender and the bright line, temporal test of the Third Circuit in Hechinger.

Webster began its analysis of the applicability of [section] 1146 (c) by noting that the restrictive interpretation of the Third Circuit would reject a transaction even though it was contemplated in a submitted plan or disclosure statement simply because the transaction occurred at an arbitrary time before confirmation. (16) The court also noted that the Hechinger court, along with the Fourth Circuit in In re NVR, L.P., 189 F. 3d at 456-57, were both instances in which the appeals court reversed the bankruptcy court findings "perhaps implying [that] the sometimes academic exercise of statutory interpretation may be overshadowing the practical realities of bankruptcy reorganization." (17) Critical of this approach, the bankruptcy court stated "[t]hough appealing in its simplicity, this temporal interpretation largely ignores the [essense] of Ch. 11 reorganization cases." (18) Relying on the well articulated reasoning of the dissent to the Third Circuit's Hechinger holding, the court thought it best not to look to the timing of a transfer, but rather to the necessity of the transfer in relation to the proposed plan. Deferring to a more sensible application of the exemption in light of the sophistication of the reorganization process, the court believed that "inserting an artificial preconfirmation [versus] postconfirmation line of demarcation into the [Section] 1146(c) analysis fails to recognize the complexities the reorganizing debtor often faces." (19) Webster expounded on this need for practicality by finding that, rather than implying a temporal test, the "under a plan confirmed" language of [section] 1146(c) should instead be considered a mechanism for allowing all interested parties to address the debtor's election of the exemption and the transaction's relationship to the confirmation of the reorganization plan. In the view of Webster, the language was truly intended to provide "appropriate notice and opportunity for parties to understand there is a debtor in bankruptcy and the transfer in question involves the debtor's property and a taxable event." (20)

Explaining its interpretation, the court provided its own criteria for determining the applicability of [section] 1146(c). (21) First, there must be a plan of reorganization in place, specifically contemplating the sale of real property and setting forth the requirements of [section] 1146(c). (22) The court stated that the plan need not provide the particulars of the transactions, but rather simply contemplate the sale of property as part of the reorganization. Second, the plan must ultimately be confirmed for the debtor to take advantage of the exemption. Finally, the court imposed its own interpretation of "under a plan confirmed" by holding that proper notice must be served on all relevant taxing authorities by including such notice in the required [section] 363(b) motion for the sale of such property. (23) Based on these criteria, the court denied the debtor's motion for refund due to the fact that no reorganization plan had been submitted before the closing of the transaction. (24)

Webster and the 11th Circuit

Understanding the importance of the [section] 1146(c) to a debtor's eventual emergence from Ch. 11, the Bankruptcy Court of the Middle District of Florida laid a practical blueprint for how courts should analyze the applicability of [section] 1146(c) to preconfirmation transfers. However, it remains to be seen if other courts, and in particular the 11th Circuit Court of Appeals, will adopt its criteria. One problem facing the 11th Circuit's approval of Webster's criteria is its holding in In re TH. Orlando, Ltd., 391 F.3d 1287 (11th Cir. 2004), published one week prior to the decision in Webster.

Although the transaction before the court in T H. Orlando, Ltd., was the refinance of a nondebtor's postconfirmation mortgage loan and the holding primarily addressed the right of third parties to claim exemption under [section] 1146(c), the issue before the court inherently depended upon the interpretation of what "under a plan confirmed" meant. Without engaging the decisions that broaden the interpretation of "under a plan confirmed," the 11th Circuit stated that "[where] the language of the statute is plain, our sole obligation is to enforce the statute according to its terms." (25) Following the rationale and holding of the Third Circuit, the court plainly declared that "[a] transfer 'under a plan' refers to a transfer authorized by a confirmed Ch. 11 plan." (26)

It remains to be seen if the Webster criteria will be embraced in light of the 11th Circuit's seemingly firm examination of the transaction occurring in TH. Orlando, Ltd., The facts of TH. Orlando, Ltd., are distinguishable from Webster so there is the possibility that the 11th Circuit could re-analyze the application of its holding if an issue involving a preconfirmation transfer is submitted for review. (27) Based on the varying opinions within and outside the circuit, it is only a matter of time before the 11th Circuit has an opportunity to give its interpretation of the applicability of [section] 1146(c) to preconfirmation transfers.

A Future Under Webster--Are Escrow Accounts the Answer?

If the decision in Webster is adopted by other courts in the 11th Circuit as the standard for determining the applicability of [section] 1146(c) to preconfirmation transaction, courts will face a complication inherent in the Webster criteria: How do you exempt a transaction that would occur before confirmation? One of the requirements of the court's holding is that the transaction must ultimately be approved by the bankruptcy court. If bankruptcy courts allow the exemption contemporaneously with a preconfirmation transaction, how are debtors and their counsel to address situations involving the transactions when the submitted plan is never confirmed? Does the debtor have the immediate obligation to pay the tax upon the failure of confirmation? is the Department of Revenue compelled to initiate action as a prelude to payment? Even more puzzling: What if the debtor no longer has sufficient funds to pay the tax or has entered into a separate obligation to apply the funds saved by the tax for its benefit or to the benefit of its creditors?

The answer may very well be the placement of the funds in controversy into escrow. To ensure proper application, the funds could either be placed with the court or with a third party escrow agent, such as a financial institution or a title insurance company. By placing the funds in escrow, both the debtor and the taxing authority can be assured that the funds will be available simply upon the confirmation or denial of confirmation of the reorganization plan. (28) Moreover, the use of escrows would bring structure to the process of determining entitlement and would promote judicial economy; a court's deliberation as to whether disbursement was warranted would be limited to establishing whether preordained conditions had been satisfied. (29) The use of escrows also ensures that the debtor will endeavor to work through the planning process in a reasonable and timely manner in order to collect the benefits of the exemption.

Policy Consideration--Further Broadening of Webster

If the decision in Webster becomes the standard for determining the use of [section] 1146(c) to preconfirmation transactions with the natural accompaniment of escrows, practitioners and judges should ask themselves: Why stop at applying the exemption to preconfirmed transactions? why not open [section] 1146(c) and the escrow process to all transactions subject to taxation that occur after the filing for relief under Ch. 11? Certainly, the bankruptcy court would have jurisdiction to place the disputed portion of the proceeds from a post-petition transaction by virtue of [section] 363(b) of the Bankruptcy Code. If the intent behind [section] 1146(c) is to facilitate successful reorganization, then why limit a debtor's transactions to those occurring after the submittal of a plan when such an event is truly arbitrary in light of the ultimate confirmation of the debtor's plan?

Under this approach, the other criteria set forth in Webster could apply (including a finding by the court that the transaction is necessary to the confirmation of the plan) with the eventual confirmation of the plan of reorganization being the final determining factor. Such an application of [section] 1146(c) would further promote the concept of fund availability endorsed by the Webster court as well as the bankruptcy court in Hechinger which reasoned: "a 'transfer that is necessary to effect the confirmation of a plan' is a plan without which it would be impossible or at least difficult to pay a debtor's creditors and thus difficult to gain the creditor's approval of a proposed plan." (30) By applying this standard, there would be more money for creditors, thereby facilitating the reorganization process, which is the ultimate intent behind the creation of [section] 1149(c).

(1) See Dr. Gordon Bermant and Ed Flynn, Bankruptcy by the Numbers, Executive Office for United States Trustees, at www.usdoj.gov/ust/press/articles/ abi_032002.htm.

(2) See id.

(3) See John C. Murray, Bankruptcy Facts, at www.firstam.com/faf/html/cust/jmbankfacts.html (relying on the 2001 statistical analysis of PricewaterhouseCoopers).

(4) The exemption also benefits those transactions subject to Florida's documentary stamp tax that do not involve the transfer or encumbrance of a real property interest, such as the transfer of a security or the giving of an unsecured promissory note. See FLA. ADMIN. CODE, ch. 12B-4.

(5) The documentary stamp tax rate for transfers of a real property interest is $.70 on each $100 of consideration paid or to be paid. See FLA. SWAT. [section] 201.02(1) (2004). The documentary stamp tax rate on promissory notes or other written obligations to pay money is $.35 for each $100 of the obligation evidenced by the document. See FLA. SWAT. [section] 201.08(1)(b) (2004). A nonrecurring intangible tax, which has a rate of $2 on each $1,000 of the just value of a note or other obligation for payment of money which is secured by a mortgage or other lien on Florida real property. See FLA. SWAT. [section] 199.133(1) (2004).

(6) 11 U.S.C [section] 1146(c) (1979) (amending 11 U.S.C. 8267 (1938)).

(7) Jacoby-Bender, 758 F.2d at 841.

(8) Id. at 841.

(9) Id.

(10) Id. at 842.

(11) Id.

(12) See Hechinger, 335 F. 3d at 246.

(13) See id. at 252.

(14) See id. at 253. Although the majority routinely looked to the use of the term "under" throughout the Code, it failed to give any credence to the dissent's attempt to relate the Code's use of the term "authorized" in lieu of the term "under" to denote a temporal requirement: "The dissent points to provisions of the Bankruptcy Code in which the term 'authorized' is used and argues that if Congress had meant 'under a plan' to mean 'authorized by a plan,' it would have used the latter phrase. Dissent at 25. We reject this argument. There can be no doubt that 'under' may mean 'authorized by.' In some contexts, the mere word 'under' may be sufficient to convey this meaning, whereas in others an explicit reference to the concept of legal authority may be necessary." Id. at 253 n.3.

(15) See id. at 256-57.

(16) Webster also noted the similarity of the holding in Hechinger to that of the Fourth Circuit in In re NVR, L.P., 189 F. 3d 442 (4th Cir. 1999) (holding that lower courts have misinterpreted Jacoby-Bender to apply to transfers necessary for the confirmation of a plan instead of the consummation of a plan).

(17) Webster, 318 B.R. at 219.

(18) Id. at 218.

(19) Id.

(20) Id.

(21) The court would go on to further detail its criteria: "[a]ssuming all of the criteria are met, a Court must still determine whether the sale meets all of the other requirements found in 363(b) and 1146(c)." Id.

(22) Presumably, the transactions referenced in the first requirement of Webster include refinances.

(23) In a footnote to the third requirement, the court went on to provide that the [section] 363(b) motion is not the only vehicle to provide appropriate notice to taxing authorities, but rather the most convenient. See id. at 219 n.3.

(24) Oddly enough, a similar rationale and holding is found in a Southern District of New York decision a month and a half before Webster. In In re Beulah Church of God in Christ Jesus, Inc., 316 B.R. 41 (Bankr. S.D.N.Y. 2004), the court held that the sale of debtor's real estate assets prior to plan confirmation qualifies for the exemption from transfer taxes under 81146(c) of the Bankruptcy Code where the sale is integral to the debtor's Ch. 11 reorganization plan and is subsequently confirmed. Explaining its rationale, the bankruptcy court stated that: "Focusing on the role of the particular transfer at issue in enabling the debtor's plan, rather than on a tomporal test, recognizes the realities of how distressed businesses are restructured in Ch. 11. For example, it is just as likely that a debtor may need to arrange a financing or to close a sale as a condition precedent to the parties' willingness to proceed with plan confirmation as it is for the parties to agree on the terms of a plan, obtain information and then see what the sale of a key asset or a proposed financing will bring.... It is reasonable to conclude that Congress did not intend to impose an arbitrary and illogical temporal distinction on sales necessary or integral to a chapter 11 plan." Id. at 46.

(25) TH. Orlando, Ltd., 391 F. 3d at 1291.

(26) Id.

(27) "[A]lthough they addressed this court's decision in In re Jacoby-Bender Inc., 758 F. 2d 840 (2d Cir. 1985), neither NVR nor Hechinger nor the other courts that have categorically refused to apply section 1146(c) to any pre-confirmation transfers were bound, as is this Court, by Jacoby-Bender." Beulah Church, 316 B.R. at 47.

(28) Issues always arise when considering the role of a third party escrow agent: Are the funds placed in an interest bearing account? Who has the right to any accrued interest? Is the transaction insurable at the time of recording of the instrument of conveyance? These questions and many more are succinctly addressed in John C. Murray's article, Transfer-Tax Considerations in Real Estate Bankruptcy Proceedings. See John C. Murray, Transfer-Tax Considerations in Real Estate Bankruptcy Proceedings, 38 REAL PROP. PROB. & TR. J. 377 (Summer 2005).

(29) There is plenty of precedent for the use of escrows in [section] 1146(c) disputes. In Beulah Church, the court ordered the portion of the proceeds for the sale of the disposition earmarked for payment of transfer taxes be held in escrow pending the confirmation of the reorganization plan. The City of New York filed its objection to the sale, but acknowledged that the sale could proceed if at least the amount of the transfer tax was escrowed in an interest-bearing account. See Beulah Church, 316 B.R. at 42. so See Hechinger, 335 F. 3d at 252.

Walter C. Little is an associate in the Tampa office of Foley & Lardner, LLP Mr. Little concentrates his practice in the areas of real estate and finance.

This column is submitted on behalf of the Business Law Section, Mark J. Wolfson, chair, and Hans Christian Beyer, editor.