Re-Examining First Day Trading Orders and Tax Status in Bankruptcy After Rodriguez.

• Author: Ravichandran, Arvind

How should a federal bankruptcy court decide which of a federally regulated thrift or an FDIC controlled bank gets a federal tax refund? The Supreme Court of the United States' answer in Rodriguez: Look to state law. (1) So unremarkable was this holding that it required approximately six pages of text and attracted no dissent or concurrence.

As the Supreme Court said, the decision was not really about tax refunds, but was instead an opportunity to instruct lower courts on making federal common law. (2) Indeed, the Tenth Circuit on remand reaffirmed its earlier decision almost entirely by citing to its earlier opinion. (3) But the Court's instructions and analysis cast serious doubt on the validity of a long-standing and critical aspect of many bankruptcy proceedings--the first day net operating loss trading order. It also requires re-evaluation of authorities related to preserving the non-taxpaying status of the debtor; a somewhat less common but related issue.

These authorities have generally analyzed the question of whether net operating losses or the tax status of a bankrupt entity is entitled to protection under the Bankruptcy Code by examining applicable provisions of the Internal Revenue Code ("I.R.C.") and relying on their own sense of fairness. The result is federal common law, in all but name, that largely protects net operating losses but not tax status. Examining these authorities reveals the precise concern Rodriguez identifies with the improper creation of federal common law--a body of law that is inconsistent and poorly grounded. Following Rodriguez, courts faced with these questions should more comprehensively analyze applicable state law in determining the treatment of net operating losses or the tax status in a bankruptcy proceeding. Moreover, relying on appropriate state law doctrines will allow private parties to rely on contract law to set forth their desired outcomes in bankruptcy. Ideally, this will all result in a firmer approach to these issues in bankruptcy.

That is what this Article is about. (4) First, it discusses the specific issue in Rodriguez and its history--the allocation of tax refunds in bankruptcy and the Bob Richards rule. Second, it discusses the legal history of first day trading orders to preserve net operating losses. Third, it re-examines these authorities in light of Rodriguez. Finally, it concludes by discussing the issues regarding the tax status of the debtor.

1. THE BOB RICHARDS "RULE" AND RODRIGUEZ

   Congress permits closely affiliated, commonly controlled domestic corporations the privilege of filing consolidated federal income tax returns. (5) This is a meaningful administrative privilege as it generally permits numerous corporations to file, pay tax and engage with the IRS on a unitary basis, rather than separately and individually. (6) But it is also a substantive privilege, as the consolidated return rules generally work to disregard the separateness of each entity insofar as they interact with each other. (7) Thus, consolidated entities may engage in transactions with one another without the immediate tax consequences that would arise if they were required to report on a separate basis. (8) Consolidated entities may share tax attributes, whereby losses of one entity offset gains of another. (9) The net result is that in many ways, several separate legal entities appear to the tax system as a single entity if they consolidate.

   The legal entities are still separate entities for other purposes, including bankruptcy, and inevitably circumstances intrude upon the consolidation fiction. Suppose Subsidiary and Parent are consolidated, and suppose Parent is the "agent" for the group before the IRS--that is, the single entity authorized to interact with the IRS on behalf of all entities in the group. (10) Subsidiary generates substantial losses, which are carried back to offset income earned by Subsidiary in a prior year, thereby resulting in a refund. The refund is paid to Parent as agent for the group. Subsidiary files for bankruptcy but Parent does not. (11) Are Subsidiary, and indirectly, Subsidiary's creditors, entitled to the refund because it arose from Subsidiary's own losses?

   1. BOB RICHARDS AND ITS PROGENY

      This is the question the Ninth Circuit faced in Bob Richards. (12) The court began by acknowledging the parties could have allocated the refund however they wished as a matter of contract because there is no principle requiring a tax savings to inure to the benefit of the company sustaining the loss. (13) However, the parties did not have a contract, express or implied. So the court next moved to the equitable doctrine of unjust enrichment. The court concluded that Parent would be unjustly enriched were it to keep a refund that related entirely to the earnings history of Subsidiary. (14) The court observed the "basically procedural" aspect of payment to Parent and went to explicitly recognize that "the Internal Revenue Service is not concerned with the subsequent disposition of tax refunds." (15)

      In other words, Bob Richards recognized there is no unique federal interest in the allocation of refunds, looked first to state contract law and found it unavailing, and then decided the matter on the basis of the state common law doctrine of unjust enrichment. Thus, the court applied primarily equitable principles under state law to reach what is a sensible result.

      Since Bob Richards, other courts have faced the same question. The Tenth Circuit followed Bob Richards on similar facts in Barnes v. Harris. (16) The Fifth Circuit did also. (17) The Eleventh Circuit addressed the issue in two cases. (18) Although both cases involved a tax sharing agreement that was ambiguous on its face, the court applied state law to determine that the clear intent of the parties was to establish an agency relationship between Parent and Subsidiary. (19) Although not expressly relying on Bob Richards, both decisions cited aspects of the Bob Richards decision favorably in footnotes. (20) Somewhere along the way, the Bob Richards decision began to be characterized as a federal common law "rule"--namely that Subsidiary is entitled to a refund unless the parties unambiguously allocate the refund to Parent. (21)

      The Sixth Circuit faced an unusual circumstance in FDIC v. AmFin Financial Corp. (22) There, the trial court found the tax sharing agreement unambiguously provided that Parent was not an agent of Subsidiary with respect to the refund and instead could retain the proceeds of the refund for its own account. (23) The Sixth Circuit reversed, concluding that the tax sharing agreement was in fact ambiguous and that several terms the district court relied on for its conclusion did not in fact unambiguously create a debtor-creditor relationship. (24)

      The Sixth Circuit then proceeded to discuss and dismiss the Bob Richards "rule." In particular, the court objected that the Bob Richards rule is an illegitimate creation of federal common law because there is no unique federal interest or policy that would conflict with the use of state law. (25) This odd attack on Bob Richards was noted in the concurring opinion of Judge Gilman, who observed that the apparent dismissal of the Bob Richards rule was likely unnecessary and perhaps incorrect. (26) In particular, because it was not clear whether the contract was ambiguous or whether the intent of the parties could be determined, the court could have simply remanded the case for further consideration. (27) Indeed, the Bob Richards issue was probably not ripe in the absence of a final determination as to what the parties' tax sharing agreement actually intended.

      The Tenth Circuit faced the issue again in Rodriguez v. FDIC, where the parties had entered into a tax allocation agreement. (28) The Tenth Circuit cited Bob Richards and Barnes as setting forth the federal common law basis on which it would rest its decision: did the agreement unambiguously allocate the refund to Parent? (29) After a detailed review, the Tenth Circuit concluded that the agreement indeed unambiguously provided that Subsidiary was entitled to the refund and Parent received the refund as a mere agent. (30) Happily, this was the same outcome as the default Bob Richards "rule." The trustee of Parent (it had also filed for bankruptcy in the meantime) appealed the decision to the United States Supreme Court.

   2. RODRIGUEZ

      This confusing array of cases, characterizations and pseudo-circuit splits set the stage for Supreme Court review. The Court took up Rodriguez for the explicit purpose of deciding the fate of Bob Richards. (31) In a unanimous opinion so brief it could almost be quoted in full, the Court held the Bob Richards rule to be an improper exercise in federal common lawmaking and instructed lower courts to decide such questions based on state law.

      In particular, the Court emphasized that federal common lawmaking must be "necessary to protect uniquely federal interests." (32) And while the federal government may have an interest in how it treats taxes of a consolidated group and the manner in which it remits refunds to the group, it could not have any interest "in determining how a consolidated corporate tax refund, once paid to a designated agent, is distributed among group members." (33) The Court further refreshed its prior statements that Congress "generally left the determination of property rights in the assets of a bankrupt's estate to state law" (34) and that the I.R.C. generally "creates no property rights." (35) Indeed, the Court regarded the putative federal nature of the tax refund as a red herring--just because it derives from a federal tax process, the refund itself is merely property in the form of a specified amount of money. Fundamentally, corporations are creatures of state law and state law is "well equipped to handle disputes involving corporate property rights." (36) Although admitting "special exceptions to these usual rules sometimes...