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Following Through on Promises

Posted on Mar. 23, 2020

The case of In re Somerset Regional Water Resources, LLC, et al, No. 19-1874 (3d Cir. 2020) triggered in me a culturally insensitive response. Growing up in Richmond, Virginia in the 1950s I was exposed to all sorts of sayings and cultural norms that do not fit well into 2020. For the most part I think have little difficulty moving past the things I learned that were flat out wrong or were very culturally insensitive. For example, in my Virginia history textbooks in the 4th and 7th grade when I was learning about the wonderful specialness of Virginia within the context of American and world history, I got to read about the happy slaves that came over from Africa. Virginia is a great and special place but the history books it purchased for public school consumption in the 1950s and 1960s did not make it special in a good way.

Virginia was a segregated society in my childhood and youth. African American children were prevented by law from attending school with me until I reached the 10th grade. I can remember many aspects of society that segregation impacted such as water fountains labeled “For Whites.” Outside of my office now is a picture with a sign such as this, reminding me daily of past practices and laws that have thankfully moved into our history books and out of our lives. I do not mean to suggest we have entered a post-racial society, but it is a society quite different than the one of my childhood and on this issue one that has greatly improved.

This case immediately brought to my mind a childhood phrase that I had not thought about in several decades. The phrase is “Indian giver.” Hopefully, most of my readers have not heard it and are puzzled by it. It was used by children, and perhaps adults,in the 1950s in Richmond to refer to someone who promised to give something but who reneged on the promise. Given the history of treaties between European settlers and native Americans, it would seem that the phrase should have been “White Man giver,” but it was not. Thankfully, this offensive phrase seems lost to history but my childhood memories were rekindled in reading the case. Rather than simply repress the memory of the phrase, I thought I would try to talk about it in a culturally sensitive way.  I apologize to anyone offended by the fact that I had this memory and chose to talk about it.

On to the case itself.

A chapter 11 bankruptcy was filed by the LLC listed above in the case caption, its sole owner, Larry Mostoller, and his wife, Connie Mostoller. The debtors’ largest lender agreed to lend another $1 million needed to keep the business afloat if Mr. Mostoller pledged a forthcoming personal tax refund as collateral for the loan. In the negotiations all parties expected the refund to be about $1 million. The refund would be generated by large business losses allowing the debtor to take them back to prior profitable years, 2013, 2014 and 2015, thereby obtaining a refund through the net operating losses.

The debtor got the loan and got the refund but then argued to the court, in an effort to avoid giving the creditor the refund, that the pledge of the refund related only to 2015 and not to the two other years. The debtor admitted that the interpretation of the agreement he urged the court to accept would render the collateral worthless but he, apparently was not bothered by that. Not surprisingly, the creditor was bothered by this attempt to reform the agreement and keep it from receiving repayment of the loan.

The debtor lost the reformation argument in the bankruptcy court and the district court before continuing to pursue it before the Third Circuit. If nothing else, his argument was good for the legal economy.

The cash infusion failed to save the company and the loan went into default. Shortly after default Mr. Mostoller refused to file a refund claim for 2015 but did file claims for 2013 and 2014 which were the years really generating the refund from the carryback of the losses. The Third Circuit’s opinion states that he testified that he “agree[d] that [the] Trust [aka the lender] gets half of the tax refund, minus the federal taxes due,” with the other half going to his wife. At some point the trust agree to that proposal; however, when the refund came, he sought the whole amount. In support of this position, the debtor made three arguments: (1) the bankruptcy court lacked subject-matter jurisdiction to decide the dispute; (2) the agreement unambiguously limited the refund to 2015; and (3) the refund was owned by Mr. and Mrs. Mostoller as tenants by the entirety preventing the trust from reaching it since the agreement was only between Mr. Mostoller and the trust.

Constitutional Argument re Scope of Bankruptcy Court Jurisdiction

Each of the courts looking at these arguments had little trouble knocking them down. The constitutional issue of the bankruptcy court’s scope created quite a stir in the early 1980s after the passage of the 1978 Bankruptcy Code. The issue went to the Supreme Court in the case of Northern Pipeline Construction Company v. Marathon Pipe Line Company, 458 U.S. 50 (1982). The Supreme Court did limit the scope of bankruptcy courts in that case and laid the foundation for future disputes concerning that scope. Central to the outcome of that case was whether a dispute falls within the bankruptcy court’s statutory jurisdiction over core proceedings and whether the dispute could only have arisen in bankruptcy. Here, the court found that the dispute fell within the bankruptcy court’s statutory jurisdiction found in 28 U.S.C.157(b)(2) because 157(b)(2)(D) confers jurisdiction over “orders in respect to obtaining credit.” The court also found that without the loan order by the bankruptcy court the debtor could not have obtained the emergency financing it needed and could not have continued to survive.

Interpretation of Agreement

With respect to the interpretation of the agreement, the Circuit Court, following the lead of the lower courts and following Pennsylvania contract law, found the relevant provision of the contract ambiguous. It also found that given the facts surrounding the negotiations the interpretation of the lender best resolved the ambiguity in the agreement. The court spends several pages parsing through the language of the agreement and the negotiations surrounding the agreement in order to reach this result.  This case really turns on this issue and the court was correct in addressing it fully. Because of the fact-specific nature of the inquiry, I do not feel as though this aspect of the decision advanced the law very far but it did clearly explain why the arguments made by the debtor did not work.

Tenancy by the Entireties

Finally, the court addressed the tenancy by the entireties argument. For states like Pennsylvania that give full weight to the common law interpretation of tenancy by the entireties, creditors of one party must be careful. The IRS fought battles regarding the impact of tenancy by the entireties ownership for decades before the Supreme Court resolved most of the issues in United States v. Craft, 535 U.S. 274 (2002). See prior discussions of Craft here and here. Here, the Third Circuit, a court well-versed in tenancy by the entireties law, looks at the tax refunds at issue in the context of the state property rights laws and federal tax law. It finds that “federal tax law provides that spouses’ ownership of a refund depends on how they owned the income that generated that refund understate property law.” We have talked about a slightly different but similar issue of splitting refunds here and here.

The Court gave no indication that it follows the blog but it walked through the issue of the ownership of joint refunds in appropriate fashion. It first cited Ragan v. Commissioner, 135 F.3d 329, 333 (5th Cir. 1998) where that court explained that a joint return does not create “new property interests for the husband or wife in each other’s income tax overpayment.” The 5th Circuit held that because the income on the return at issue belonged to the husband alone, the wife had no interest in the refund. The Court then cited several other Circuit Court decisions before holding that “we now join our sister circuits in adopting this rule.” After announcing that it adopted the prevailing law of the circuits around the country with respect to federal law treatment of federal tax refunds, the Third Circuit then looked at the facts of the Mostollers’ case with respect to Pennsylvania law.

In Pennsylvania, tenancy by the entirety requires the parties be married (no problem here) plus the “four unities of time, title, possession and interest.” It explained that satisfying these unities requires that the spouses must “(1) have their interests vest at the same time, (2) obtain their title by the same instrument, (3) have an undivided interest in the whole, and (4) own interests of the same type, duration and amount.” None of the unities existed here and they never merged their separate interests into a tenancy by the entireties interest. So, the debtor must turn over half of the refund to the lender.

Conclusion

Maybe the Third Circuit could have issued a per curiam affirmance and did not need to spend 20 pages recounting the facts and laying out the resolution of the law. The tenancy by the entireties argument seems to have been an issue of first impression in the Third Circuit, perhaps driving the decision to write out in detail why Mr. Mostoller could not go back on his agreement. The case provides some insights on the constitutional limits of bankruptcy courts to decide cases and the appropriate method for determining ambiguous agreements. Mostly, it provides an equitable result in a situation in which someone tried to act inequitably, and get the court’s blessing, in a court of equity.

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