PROCEDURAL RECOMMENDATIONS TO THE BANKRUPTCY CODE

The Bankruptcy Code contains numerous procedures governing the treatment and status of claims by and against the estate. The procedural treatment for two types of these claims is addressed in the following section. First, preference claims by the estate are designed to recover certain payments or other transfers of property within ninety days of the commencement of a case under the Bankruptcy Code. Preventing debtors from "preferring" certain creditors on the eve of bankruptcy and thus subverting a basic policy goal of the Code to foster equitable distribution among creditors is the policy rationale for the avoidance of preferences. The Commission's preference Recommendations focus on the treatment of small trade creditors under section 547 and clarifying the frequently litigated ordinary course of business exception.

Second, the treatment of tax claims requires a delicate balance of bankruptcy policy against the considerable power of a governmental unit to enforce its claim outside bankruptcy. Equality under the Bankruptcy Code requires similar treatment for similarly situated creditors. In this regard, tax policy sharply contrasts with bankruptcy policy. The Commission's Recommendations on the treatment of government tax claims address areas where these policies may be out of balance. In addition, while the Commission did not make a formal recommendation, a discussion of the police and regulatory exception to the automatic stay has been included in light of a recent proposed Congressional amendment to that section.

RECOMMENDATIONS

3.2.1   Minimum Amount to Commence a Preference Action under 11 U.S.C. § 547

11 U.S.C. § 547 should provide that $5,000 is the minimum aggregate transfer to a noninsider creditor that must be sought in a nonconsumer debt preference avoidance action.

3.2.2    Venue of Preference Actions under 28 U.S.C. § 1409

28 U.S.C. § 1409 should be amended to require that a preference recovery action against a noninsider seeking less than $10,000 must be brought in the bankruptcy court in the district where the creditor has its principal place of business. The Recommendation applies to nonconsumer debts only.

3.2.3    Ordinary Course of Business Exception under 11 U.S.C. § 547(c)(2)(B)

11 U.S.C. § 547(c)(2)(B) should be amended to provide a disjunctive test for whether a payment is made in the ordinary course of the debtor's business if it is made according to ordinary business terms. The ordinary course of business defense to a preference recovery action under section 547(c)(2) should provide as follows:

(2) to the extent that such transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee and such transfer was -

(A) made in the ordinary course of business or financial affairs of the debtor and the transferee; or

(B) made according to ordinary business terms[.]

3.2.4    Ad Valorem Tax Priority under 11 U.S.C. § 724(b)

11 U.S.C. § 724(b) should be amended to exempt from subordination properly perfected, nonavoidable liens on real or personal property of the estate arising in connection with an ad valorem tax. Section 724(b) should also require the trustee to marshal unencumbered assets of the bankruptcy estate and surcharge secured claims, if warranted by the circumstances, under 11 U.S.C. § 506(c) prior to subordinating any tax liens under the statute.

3.2.5    Burden of Proof for Tax Proceedings under 11 U.S.C. § 505

The Bankruptcy Code should be amended to clarify that the burden of proof/persuasion rules and concomitant presumptions in tax controversies which would be applicable under nonbankruptcy law are equally applicable in bankruptcy court determinations of tax liabilities under 11 U.S.C. §§ 502 and 505.

3.2.6    Exception of Tax Refund Setoffs under 11 U.S.C. § 362(b)

11 U.S.C. § 362(b) of the Bankruptcy Code should be amended to allow a governmental unit to setoff an income tax refund that arose prior to the commencement of a Chapter 7 or Chapter 13 case against an 'undisputed' income tax liability of an individual debtor that arose prior to the commencement of the case.

DISCUSSION

Procedural preference reforms start with the premise that although the theory and substance of the preference power are sound, the practice of preference recovery is somewhat flawed. The concern is whether section 547 leads to abusive preference recovery suits by bankruptcy trustees who bring actions indiscriminately, without properly analyzing the creditor's available defenses and because the litigation costs associated with defending these actions outweigh the settlement amount the trustee is willing to accept.

The tension, therefore, is to develop efficient procedures to restrain abusive litigation techniques by the trustee without interfering with the policy goals of the preference power itself. These policy goals can be summed up as equality of treatment of creditors and deterring the "race to the courthouse" by creditors attempting to improve their position vis-a-vis the debtor on the eve of bankruptcy. ⁽¹⁹⁴⁹⁾

In addition, the ordinary course of business exception has been clarified so that either a sufficient course of prepetition dealing between the parties or conformance with industry standards will satisfy its requirements.

The second set of Recommendations address the procedure governing the treatment of tax claims. Treatment of tax claims in bankruptcy requires consideration of both bankruptcy and tax policy. Government entities are usually one of many creditors in a given bankruptcy case. The equilibrium sought by the Bankruptcy Code is to balance the interests of all creditors as well as the debtor. Where these interests are unbalanced, narrowly-defined solutions are necessary in order to prevent a different imbalance from arising under another part of the Code. The Commission's tax Recommendations attempt to address certain perceived imbalances without creating new inequities.

3.2.1   Minimum Amount to Commence a Preference Action under 11 U.S.C. § 547

11 U.S.C. § 547 should provide that $5,000 is the minimum aggregate transfer to a noninsider creditor that must be sought in a nonconsumer debt preference avoidance action.

Preference reform proposals to the Commission have centered on the limited area involving smaller trade creditors from whom recovery of prepetition payments were sought by debtors in possession or trustees as avoidable preferences. In these instances there is, at times, a disincentive for such creditors to defend rather than settle the actions because the amount sought is small relative to the expense of defending against the preference action. This problem is exacerbated when the bankruptcy court is in a distant location, making it even more costly to defend. In addition, some creditors have noted that when Chapter 11 cases are converted to Chapter 7, a great deal of time has typically elapsed from the time of payment and the petition date to the date recovery is sought by the Chapter 7 trustee. In such instances, the demand may come as a surprise and long after the transaction was considered closed.

There is a dearth of scholarly analysis or data on preference abuses. For example, the perception of certain preference actions is that a trustee (or in rare instances, a debtor in possession) sends out a blanket complaint to virtually every creditor, particularly trade creditors, who received any payment within ninety days of the petition date. The trustee would have done little prior investigation other than to review the debtor's check register and would have made no effort to determine whether the creditors had any valid defenses. Given the relatively small amount of money at stake, it is rarely cost-effective for the creditor to contest the action, especially if the creditor is located in another jurisdiction at some distance from the bankruptcy court where the case is pending. As a result, those creditors are forced to settle the action regardless of its merits. This scenario can have perverse results if the preference recovery goes to pay the trustee and the trustee's professionals without any benefit flowing to unsecured creditors.

The American Bankruptcy Institute provided the Commission with the results of its survey of attorneys and credit managers canvassing a variety of preference experiences. ⁽¹⁹⁵⁰⁾ The survey results provided support for a number of solutions to the problems faced by smaller trade creditors. Specifically, the ABI report proposed, among other things, raising the minimum amount sought in a preference action to limit coercive preference litigation tactics. ⁽¹⁹⁵¹⁾

The Recommendation is an effort to protect smaller trade creditors who are most prone to abusive litigation tactics, and who are also least likely to have received a significant preference that would imperil the policies underlying the preference power. Raising the minimum aggregate transfer sought to $5,000 is consistent with current preference policies. Aggregate transfers of less than that amount are unlikely to create a substantial deviation from equality of treatment for creditors and it is doubtful that such a small transfer would pose a significant threat of premature scavenging of the estate's assets. The Recommendation does not affect the recovery of any transfer to an insider during the one year preference period. ⁽¹⁹⁵²⁾ By increasing the minimum aggregate transfer that must be sought in a preference recovery, the Recommendation increases the likelihood that any amounts recovered will benefit creditors and not simply the trustee and his professionals. The Recommendation is limited to nonconsumer cases because most of the complaints the Commission received focused on smaller preference actions against trade creditors in Chapter 7 or Chapter 11 business bankruptcy cases.

Competing Considerations. A $5,000 minimum may be too high given the small size of most business cases. In small business cases, a $5,000 preference floor may eliminate any preference litigation, because there are rarely transfers of that size. The Recommendation addresses this concern by applying the $5,000 minimum to aggregate transfers during the preference period. A sufficient number of small transfers could be sought in a preference action provided the aggregate is above $5,000. All amounts transferred below an aggregate of $5,000 will not be recoverable under the Recommendation. Recovery of preferences in small cases may represent the only assets available for distribution to unsecured creditors. This aspect of the Recommendation runs counter to the overall structure and policies of the Bankruptcy Code favoring maximization of the total assets of the estate and equality of treatment for all unsecured creditors.

The Recommendation may also encourage aggressive prepetition debt collection of amounts just under $5,000. The preference power is intended to deter precisely that type of debt collection. By raising the minimum amount, creditors may be encouraged to collect just under the minimum prior to a debtor's bankruptcy filing. The Recommendation is designed to discourage aggressive debt collection by applying an aggregate limit of $5,000. Single transfers of amounts less than $5,000 would, however, not be avoidable as preferences under the Recommendation.

3.2.2    Venue of Preference Actions under 28 U.S.C. § 1409

28 U.S.C. § 1409 should be amended to require that a preference recovery action against a noninsider seeking less than $10,000 must be brought in the bankruptcy court in the district where the creditor has its principal place of business. The Recommendation applies to nonconsumer debts only.

Section 1409(b) provides that a proceeding to recover a money judgment or property worth less than $1,000 must be commenced in the district court for the district in which the defendant resides. ⁽¹⁹⁵³⁾ Section 1409(b) further provides that if the proceeding to recover a money judgment or property is on a consumer debt of less than $5,000, the action must be commenced in the district court where the defendant resides. ⁽¹⁹⁵⁴⁾ The purpose of this provision is "to prevent unfairness to distant debtors of the estate, when the cost of defending would be greater than the cost of paying the debt owed."⁽¹⁹⁵⁵⁾

The increased cost of defending a small preference action in a distant forum has encouraged reform of the preference venue rules. Consistent with the efforts to protect smaller trade creditors from certain preference litigation tactics, actions against noninsiders seeking recovery of an amount below $10,000 should be commenced in the district where the creditor has its principal place of business. The purpose of this venue provision is to protect parties from "noneconomic" actions brought by trustees seeking to take advantage of the likelihood that it will cost the creditors more to litigate the action than the action itself seeks to recover.

The Recommendation raises the venue floor for nonconsumer debts only to $10,000. The Recommendation, however, leaves the current floor for consumer debts at $5,000. ⁽¹⁹⁵⁶⁾ By leaving the consumer level unchanged, trustees for consumer cases will not have to litigate in the creditor's forum unless the transfer is for less than $5,000. This discrepancy between actions on consumer debts and actions on nonconsumer debts is a change from the result under current law, but it is beneficial for a number of reasons. The Recommendation raises the litigation cost of bringing small preference claims by requiring the action to be brought in the defendant's forum. This increased burden will fall on those debtors or trustees seeking to recover nonconsumer debts (mostly business debtors) and not on those seeking to recover on consumer debts (mostly consumer debtors). Transfers on consumer debts are generally smaller and any increase in the amount under the venue provisions may make any preference or property recovery in these cases unlikely. The Recommendation is designed to target only those business cases where there are perceived abuses of the preference power.

Raising the limit will increase the costs to the estate of bringing these actions. ⁽¹⁹⁵⁷⁾ Hopefully, these increased costs will encourage debtors in possession and trustees to examine the merits more closely before commencing an avoidance action. Section 1409(b) generally was designed to deter "noneconomic" actions that cost more to defend than the action itself seeks. Creditor protection against blanket preference actions is furthered by raising the limit for invoking this provision. Increased costs may provide enough incentive for trustees and debtors in possession to look at the merits of each possible preference before commencing the action.

Competing Considerations. When a preference action is litigated, a trustee will often hire counsel to litigate it. Currently, only one venue applies to the vast majority of preference actions, enabling a trustee to hire one counsel to file one complaint against multiple preference recipients. The current system thus greatly reduces costs to the estate created by having to litigate multiple actions in multiple jurisdictions. It is also beneficial to the estate for the judge who is most familiar with the debtor and the case to hear the preference actions. Venue of preference actions balances the harm of increased costs to the estate with the harm suffered by creditors who must litigate in the debtor's forum. The positive effect of the Recommendation, however, is that if a trustee or debtor in possession has to litigate in the creditor's forum for all amounts between $5,000 and $10,000, the increased costs to the estate of bringing the action may encourage consideration of possible affirmative defenses, thus reducing abusive preference actions. The increased cost of preference litigation, however, will be borne by the unsecured creditors.

3.2.3    Ordinary Course of Business Exception under 11 U.S.C. § 547(c)(2)(B)

11 U.S.C. § 547(c)(2)(B) should be amended to provide a disjunctive test for whether a payment is made in the ordinary course of the debtor's business if it is made according to ordinary business terms. The ordinary course of business defense to a preference recovery action under section 547(c)(2) should provide as follows:

(2) to the extent that such transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee and such transfer was -


(A) made in the ordinary course of business or financial affairs of the debtor and the transferee; or

(B) made according to ordinary business terms[.]

The ordinary course of business exception currently requires the recipient of a transfer to show that (1) the underlying debt was "incurred in the ordinary course of business or financial affairs" of both parties; (2) the transfer was made "in the ordinary course of business or financial affairs" of both parties; and (3) the transfer was "made according to ordinary business terms."⁽¹⁹⁵⁸⁾ The test under section 547(c)(2) is clearly in the conjunctive, requiring all three elements in order to establish that a payment falls into this exception to the preference power. ⁽¹⁹⁵⁹⁾

The purpose of the ordinary course of business exception to preference recoveries is "to protect recurring, customary credit transactions that are incurred and paid in the ordinary course of the debtor and the debtor's transferee."⁽¹⁹⁶⁰⁾ Some confusion exists, however, whether a payment is made in the ordinary course of business if it deviates from industry standards but is otherwise ordinary between the parties. ⁽¹⁹⁶¹⁾ In fact, the trend has gone from requiring proof of ordinary course between the parties to requiring ordinary course between the parties and within the industry, which is the express language in the Code. ⁽¹⁹⁶²⁾ Some courts blur the distinction between course of conduct between the parties and industry standards, finding that only extremely aberrant transfers fall outside the exception. ⁽¹⁹⁶³⁾

The Recommendation adopts the view that the conduct between the parties should prevail to the extent that there was sufficient prepetition conduct to establish a course of dealing. ⁽¹⁹⁶⁴⁾ A disjunctive test telescopes the ordinary course inquiry on the course of conduct between the parties. In the event there is not sufficient prepetition conduct to establish a course of dealing, then industry standards should supply the ordinary course benchmark. ⁽¹⁹⁶⁵⁾ Quite often industry standards are extremely difficult to ascertain outside bankruptcy and difficult to prove in the context of preference litigation. Thus, it is more accurate to rely on the relationship between the parties.

Competing Considerations. It may be argued that debtors and creditors should not be encouraged to diverge from standard industry payment terms and manipulate their course of conduct prepetition. The current conjunctive requirements reinforce this policy goal. The Recommendation does not dissuade debtors and creditors from complying with industry standards, but rather focuses on the course of dealing to determine whether a transfer was made in the ordinary course of business.

The Recommendation, however, will protect large transactions between sophisticated parties, which may limit the equality of distribution in these cases. If the parties have sufficient prepetition conduct to establish a course of dealing, the Recommendation eliminates any argument that the course of dealing did not comply with industry standards, and therefore, that the transfer was not in the ordinary course of business, particularly where industry standards are difficult to ascertain. Preference litigation in this area should be simplified as a result of the Recommendation.

3.2.4    Ad Valorem Tax Priority under 11 U.S.C. § 724(b)

11 U.S.C. § 724(b) should be amended to exempt from subordination properly perfected, nonavoidable liens on real or personal property of the estate arising in connection with an ad valorem tax. Section 724(b) should also require the trustee to marshal unencumbered assets of the bankruptcy estate and surcharge secured claims, if warranted by the circumstances, under section 506(c) prior to subordinating any tax liens under the statute.

Section 724(b) lies at the intersection of bankruptcy policy and tax policy. The statute governs the order of distribution of both real and personal property subject to valid, nonavoidable federal, state, and local tax liens⁽¹⁹⁶⁶⁾ in a Chapter 7 case. Liens or encumbrances that arise prior to the commencement of the case and are not otherwise invalidated⁽¹⁹⁶⁷⁾ are recognized as a charge upon assets. ⁽¹⁹⁶⁸⁾ The general rule in a Chapter 7 liquidation case is that, upon any sale of property, the claims of secured creditors must be satisfied in full before any payment is made to claimants with a statutory priority⁽¹⁹⁶⁹⁾ or general unsecured creditors. ⁽¹⁹⁷⁰⁾ Section 724(b) deviates from the general rule that unsecured priority claims do not trump perfected secured claims. The statute governs the order of distribution of both real and personal property subject to valid, nonavoidable federal, state, and local tax liens. Under section 724(b), a trustee is required to subordinate valid tax liens below the costs of administration and a number of other priority claims. ⁽¹⁹⁷¹⁾ The provision enables unsecured priority claimants occupying the first through seventh rungs on the priority ladder "to step into the shoes of the tax collector"⁽¹⁹⁷²⁾ and to receive distributions from property of the estate even though the tax claim is properly allowed and secured. ⁽¹⁹⁷³⁾ The operation of section 724(b) also primes section 363(f)(3), which requires that property be sold for more than the aggregate liens on the property. ⁽¹⁹⁷⁴⁾

The subordination and amount distributable to priority claimants is, however, expressly limited to the extent of the tax lien, ⁽¹⁹⁷⁵⁾ with partial payment of the tax lien if the priority claims are less than the amount of the lien, and no payment is permitted if the priority claims are greater than or equal to the amount of the tax lien. ⁽¹⁹⁷⁶⁾To the extent that the tax lien is subordinated, it is treated as a special category of unsecured claim that is payable prior to any distribution to the general creditors. ⁽¹⁹⁷⁷⁾ In other words, certain priority claims are funded out of the secured tax claim in Chapter 7 cases to the extent of the tax lien. ⁽¹⁹⁷⁸⁾ A number of courts interpreting section 724(b) have held that a trustee is under no obligation to marshal unencumbered assets of the estate as a prerequisite to subordinating prior and otherwise valid tax liens. ⁽¹⁹⁷⁹⁾

Bankruptcy Code section 724(b) is derived from section 67c(3) of the former Bankruptcy Act. That section was enacted in response to the development of "spurious liens" under state law that were calculated "to distort the federally ordered scheme of distribution by depressing the position of priority claimants."⁽¹⁹⁸⁰⁾ The development and proliferation of taxes at all levels of government compounded the problem: "With little formality and frequently without any of the normal attributes of a lien interest, these [tax] claims were raised to the dignity of statutory liens. If all statutory liens, regardless of what they were in substance, were treated as liens in bankruptcy the order of federally created priorities would be completely disrupted."⁽¹⁹⁸¹⁾ Congress recognized that such tax liens, especially in small cases, represented an acute example of where the assets of the bankruptcy estate may be entirely consumed to the exclusion of certain priority claims. ⁽¹⁹⁸²⁾ Thus, section 67c(3) was enacted to provide that statutory liens on "personal property" would be subordinated to insure that two categories of claims would be satisfied: the costs of administration incurred in a liquidation case and certain wage claimants. ⁽¹⁹⁸³⁾ Indeed, the legislative history reveals that:

It would be grossly unfair for the bankruptcy court and the attorneys who have labored to wind up the bankrupt's affairs and to accumulate an estate for distribution to receive nothing for this labor. It is also socially desirable that the claims of the wage earner who is normally entirely dependent upon his wages for the necessity of life should be paid to the extent of the restriction in [the priority statute] before the estate is subject to the heavy burden of all tax liens. ⁽¹⁹⁸⁴⁾

The "sole" concern of Congress in enacting section 67c(3) was to guarantee the payment of the costs of administration in a Chapter 7 case and small wage claimants. ⁽¹⁹⁸⁵⁾ Because section 67c(3) subordinated tax liens only on "personal property," the provision did not represent a significant threat to tax revenues. ⁽¹⁹⁸⁶⁾

Section 724(b), as enacted, expanded prior law by subordinating tax liens on both personal and real property. ⁽¹⁹⁸⁷⁾ In addition, valid tax liens are subordinated to a number of priority claimants beyond those subordinated under Bankruptcy Act section 67c(3). ⁽¹⁹⁸⁸⁾ The legislative history to the Code refers to both types of tax liens that are subordinated beyond those liens subordinated under the Bankruptcy Act. ⁽¹⁹⁸⁹⁾ Additionally, some courts expand section 724(b) further to permit administrative claimants in a superseded Chapter 11 case to subordinate tax liens after conversion of the case from Chapter 11 to Chapter 7. ⁽¹⁹⁹⁰⁾

Section 724(b) does not disturb the relative positions of senior and junior consensual lienholders as well as unsecured creditors. ⁽¹⁹⁹¹⁾ If higher priority unsecured claims equal or exceed the amount of the tax lien, the once-secured tax claim may become completely unsecured and the lien is effectively extinguished. As a result, both higher priority unsecured claims and junior lienholders can realize upon the collateral to the exclusion of senior tax claimants. ⁽¹⁹⁹²⁾ The ability of state and local governments to provide essential public services rests on their ability to generate revenue through taxation. Section 724(b) may undermine that support, especially for local governments whose source of revenue is derived almost exclusively from the taxation of real property.

Prior to 1994, a number of circuit courts held that the automatic stay prevented statutory liens from attaching to property for taxes accruing after the bankruptcy filing. Congress responded in 1994 by amending section 362 in order to allow local governments to utilize their lien attachment authority and secure the payment of property taxes. ⁽¹⁹⁹³⁾ This amendment created a glitch in the result under section 724(b). As a result of the recent amendment to section 362(b)(9), section 724(b) has the anomalous result of allowing unsecured claims for taxes and penalties incurred by the estate and entitled to priority under sections 507(a)(1) and 503(b)(1)(B)-(C) to trump prior and perfected tax liens. ⁽¹⁹⁹⁴⁾

An amendment similar to the Recommendation was recently introduced in the Senate. ⁽¹⁹⁹⁵⁾ The difference between the amendment proposed in the Senate and the Recommendation is that the Senate amendment permits the payment of "claims for wages, salaries and commissions entitled to priority under section 507(a)(3) or claims for contributions to an employee benefit plan entitled to priority under 507(a)(4)" from property secured by a tax lien. ⁽¹⁹⁹⁶⁾ Another difference between the Recommendation and the pending legislation is that the Recommendation requires a trustee to marshal the assets prior to subordinating any tax lien. The Senate bill requires a trustee to marshal only before subordinating a tax lien "which has arisen by virtue of state law."⁽¹⁹⁹⁷⁾ Under the proposed bill, federal tax liens may thus be subordinated prior to the trustee marshaling all unencumbered assets.

The second portion of the Recommendation requires the trustee to "marshal" all of the unencumbered assets of the estate and surcharge all secured parties before subordinating a tax lien under section 724(b). In furtherance of the Bankruptcy Code's goal of equality of distribution, the trustee (or the debtor in possession) is given a number of tools in order to unwind prepetition transfers and bring those assets back into the estate for distribution under the Bankruptcy Code. ⁽¹⁹⁹⁸⁾ While the authorities are divided on the issue, some courts have found that there is absolutely no requirement that the Chapter 7 trustee exhaust all unencumbered funds of the bankruptcy estate in the payment of administrative expenses and other specified priority claims before paying priority claims by resort to subordination of tax liens under section 724(b). Indeed, some courts have held that the trustee is under no obligation to marshal assets as a prerequisite to subordinating an otherwise valid tax lien since Congress intended to impose the burden of administration, to some extent, on taxing authorities. ⁽¹⁹⁹⁹⁾

As previously outlined, the proliferation of administrative and other priority claims over the years by numerous amendments to the Bankruptcy Code has expanded the operation of section 724(b) far beyond its original design. ⁽²⁰⁰⁰⁾

Competing Considerations. As the legislative history to the enactment of the statute clearly reveals, the provision subordinating tax liens was originally designed, in large part, to ensure that those who work for the bankruptcy estate in a liquidation case get paid. ⁽²⁰⁰¹⁾ Amendment of section 724(b) may decrease the pool of assets available to satisfy administrative expenses and other priority claims. In high risk cases, it may be difficult to find competent professionals to administer the case or the debtor's employees may be reluctant to remain and assist a liquidation for fear of not being compensated. Similar to all other creditors, tax creditors benefit from the quick and efficient administration of bankruptcy estates and should bear the cost of administration along with the other creditors.

For these reasons, it is appropriate for Congress to determine the relative priority of tax claims as part of a comprehensive bankruptcy statute, notwithstanding that Congress or state legislatures have accorded secured status to certain tax claims to enhance the tax authority's collection capabilities outside of bankruptcy. The fact that Congress has on several occasions lowered the general tax priority under section 507(a) with the result that section 724(b) subordinates otherwise secured tax claims to new claims having a higher priority is not in itself a reason for amending subordination under section 724(b). It is a reason for reexamining the general tax priority under section 507(a).

Two additional considerations must be weighed when making a fundamental policy decision with respect to section 724(b). First, tax claims already receive significant protection by virtue of their elevated position on the priority ladder. Second, most tax obligations are nondischargeable in individual cases. ⁽²⁰⁰²⁾ Other secured creditors are protected by section 523(a) and do not lose the benefit of valid liens simply because of the advent of bankruptcy, nor are tax liens only subordinated when they relate to nondischargeable taxes. The Recommendation is designed to restore the balance for ad valorem tax claimants in light of the treatment for other secured creditors under the Bankruptcy Code.

While these reasons may justify priming a tax lien claim generally, the Recommendation carves out ad valorem tax claims from this treatment. The requirement that trustees marshal assets and surcharge creditors may increase the administrative costs, though no data on increased costs to the estate is available. In the event administrative costs increase, any attendant benefit recovered by the estate will be used to pay the trustee's and the trustee's professionals' fees incurred to marshal those assets and surcharge the secured creditors.

3.2.5    Burden of Proof for Tax Proceedings under 11 U.S.C. § 505

The Bankruptcy Code should be amended to clarify that the burden of proof/persuasion rules and concomitant presumptions in tax controversies which would be applicable under nonbankruptcy law are equally applicable in bankruptcy court proceedings to determine tax liabilities under 11 U.S.C. §§ 502 and 505.

Bankruptcy courts have jurisdiction under section 505 to hear and determine the amount or legality of "any" unpaid tax claim, regardless of whether or not the tax and its concomitant fines and penalties have been previously assessed or contested. ⁽²⁰⁰³⁾ The jurisdictional grant contained in section 505(a)(1) is sufficiently broad to include the determination or legality of any type of tax liability "whether or not paid" or previously adjudicated by a judicial or administrative tribunal of competent jurisdiction. ⁽²⁰⁰⁴⁾ Courts have construed the statute and its concomitant policy objective to permit the prosecution in a bankruptcy forum of a de novo appeal from an unpaid tax assessment. ⁽²⁰⁰⁵⁾

Section 505(a)(2) contains a limitation on the jurisdiction of the bankruptcy court to determine the amount or legality of a tax claim and resolve tax disputes. Under that section, a bankruptcy court is not permitted to redetermine the merits of a tax claim or question of tax liability that has been contested before the commencement of the bankruptcy case in a state, federal or quasi-judicial tribunal. ⁽²⁰⁰⁶⁾ Section 505(b), by contrast, provides a trustee or debtor in possession with the ability to obtain a determination of any postpetition tax liability which arises during the pendency of the case. ⁽²⁰⁰⁷⁾

The Bankruptcy Code is structured to achieve a relatively expeditious resolution with respect to disputes over the amount, validity and character of claims to the bankruptcy estate. Without this broad mandate to resolve claims against the estate, it would be difficult for the bankruptcy court to accomplish this goal. In order to resolve all claims against the estate, the Bankruptcy Code and the Bankruptcy Rules provide a detailed claims procedure. A proof of claim executed and filed in accordance with section 501 of the Bankruptcy Code and applicable Bankruptcy Rules constitutesprima facie evidence of the amount and validity of the claim. ⁽²⁰⁰⁸⁾ Upon objection to the claim and admission of probative evidence sufficient to rebut the prima facie validity of the claim, the burden shifts to the claimant who bears the ultimate burden of persuasion with respect to the amount and validity of its claim. ⁽²⁰⁰⁹⁾ This claim assertion and objection process is the same for all creditors.

Significantly, within the claim allowance framework of the Bankruptcy Code, the courts already recognize an exception to the general rule that the claimant has the ultimate burden of proof. When the facts are peculiarly within the knowledge of one party, then the burden of proving an issue lies with the knowledgeable party. ⁽²⁰¹⁰⁾ In other words, even within the context of present law, the court, using its equitable powers, may shift the burden of proof in the interests of justice.

In fora other than a bankruptcy court, however, the burden of persuasion to refute the validity of the government's tax claim generally falls upon the taxpayer, not the government. ⁽²⁰¹¹⁾ Consequently, bankruptcy courts must determine whether the claim of a taxing authority should be treated like all other claims. In other words, whether the taxing authority (like every other creditor in bankruptcy) must prove that it has a valid claim, or whether the debtor, debtor in possession, or trustee is required to persuade the bankruptcy court that the taxing authority does not have a valid claim. ⁽²⁰¹²⁾

The courts are in substantial and direct conflict over whether the burden of proof in a tax matter is borne by the IRS or by the debtor. The Courts of Appeals for the Third, Fourth and Seventh Circuits have ruled that the Bankruptcy Code and Rules do not alter the burden of proof rules for tax claims under nonbankruptcy law. ⁽²⁰¹³⁾ Accordingly, those courts have placed the burden on the debtor-taxpayer in a claims contest. The Courts of Appeals for the Fifth, Sixth, Ninth and Tenth Circuits have reached the opposite conclusion, finding that the government should be treated the same as every other creditor in the claims objection process. ⁽²⁰¹⁴⁾ The confusion in this area can perhaps be best illustrated by the fact that the Court of Appeals for the Eighth Circuit has weighed in on both sides of the issue. ⁽²⁰¹⁵⁾ Lower courts are equally divided. ⁽²⁰¹⁶⁾ In fact, two commentators, in analyzing the cases have identified not two, but four separate principles for allocating the burden of proof. ⁽²⁰¹⁷⁾

The allocation of the burden of proof in many tax controversies is often determinative, as indicated by the above litigation over allocation of that burden. Consequently, the burden may have a substantive effect on the tax claim rather than simply a claims resolution procedure under the Bankruptcy Code. Indeed, "[i]n resolving disputed claims against the bankruptcy estate, it is important to understand that the Bankruptcy Code, in most instances, while providing a forum and procedures for an expedient dispute resolution, does not endeavor to supplant the substantive law under which the claim against the estate arose."⁽²⁰¹⁸⁾ To the contrary, it is axiomatic under the Bankruptcy Code that the validity of a creditor's claim is determined by the rules of nonbankruptcy law. ⁽²⁰¹⁹⁾

The same burden of proof and persuasion is placed on every creditor asserting a claim in a bankruptcy case. Notwithstanding this implicit congressional directive, there is no statutory provision or expression in the legislative history evidencing an intent by Congress that the burden under tax law should be displaced in bankruptcy. Nor is there any indication in bankruptcy law that tax claims should receive different treatment. The result is relatively clear: When a taxpayer seeks relief under the bankruptcy laws, it is able to garner a different process for the determination of its tax liability. ⁽²⁰²⁰⁾ The uniform treatment of tax claims through an adherence to nonbankruptcy law burdens and presumptions serves to reduce uncertainty, discourages bankruptcy filings for tax liability forum-shopping reasons, and prevents a party from receiving a different process for determination of its tax claim not otherwise obtainable outside of bankruptcy.

The government's position as a tax creditor in a claims contest is different from other creditors in a normal debtor-creditor relationship. It is generally the debtor or the debtor in possession who has access to all of the relevant records, information and knowledge required to substantiate or contest the validity of a tax claim. As such, "[t]he common law rule placing the burden on the party with access to the facts seems particularly applicable in a self-assessment system which provides for the taxpayer to make the initial determination of liability" and bolsters the record-keeping requirement the Internal Revenue Code imposes upon taxpayers. ⁽²⁰²¹⁾ To the extent one creditor is prevented from being able to prove its claim due to lack of information, other creditors benefit to the detriment of that creditor. The Recommendation is designed to protect tax creditors from that result.

Competing Considerations. Under the Bankruptcy Code and Rules, every creditor must file a proof of claim supporting its claim. ⁽²⁰²²⁾ There is appeal to the premise adopted by those courts that all creditors should be subject to the same proof requirements under the Bankruptcy Code. Fundamental bankruptcy policy compels equal procedural treatment of creditors.

Shifting the burden of proof to the debtor does more than meets the eye. A number of cases have held that the taxing authority gets the benefit of the presumption of validity for its tax claim without filing supporting documentation. ⁽²⁰²³⁾ The debtor may not be in a position to know the basis for the taxing authority's position and therefore may not know the extent of the burden she must meet. Under present practice, notwithstanding that a taxing authority has a minimum 180-day period for filing a proof of claim, ⁽²⁰²⁴⁾ the taxing authority may file an estimated proof of claim disallowing all deductions because it has not completed its own review. The notion that placing the burden of proof on the debtor mirrors the situation outside of bankruptcy is erroneous, since outside of bankruptcy the tax process is likely to require the taxing authority to mail a notice of deficiency or to make an assessment setting forth the adjustments that the taxing authority proposes to make. Placing the burden of proof on the debtor in bankruptcy prior to the time that a notice of deficiency has been mailed or an assessment has been made puts the debtor under a greater burden than she would bear outside of bankruptcy.

The rationale for the Recommendation that the debtor has all of the relevant tax information and therefore the debtor should bear the burden of proof under section 505 is less powerful when the taxing authority is litigating against a bankruptcy trustee or the creditors. Under these circumstances, the trustee or the creditors have even less information than the government and usually enjoys an equally hostile relationship with the debtor. The shift of the burden to such parties under these circumstances is inequitable and any attendant losses will be borne by the other creditors.

The Recommendation recognizes the unique nature of tax claims and attempts to conform bankruptcy procedure to the rules outside of the bankruptcy process. ⁽²⁰²⁵⁾

3.2.6    Exception of Tax Refunds Setoffs under 11 U.S.C. § 362(b)

11 U.S.C. § 362(b) of the Bankruptcy Code should be amended to allow a governmental unit to setoff an income tax refund that arose prior to the commencement of a Chapter 7 or Chapter 13 case against an 'undisputed' income tax liability of an individual debtor that arose prior to the commencement of the case.

Section 362(a) of the Bankruptcy Code provides for a broad, automatic stay upon the filing of a bankruptcy petition under any chapter of the Code. ⁽²⁰²⁶⁾ The stay enjoins further litigation, lien enforcement, and other conduct (formal or informal), judicial or otherwise, that attempt to collect prepetition claims. ⁽²⁰²⁷⁾ The automatic stay applies to "all entities," including governmental units. ⁽²⁰²⁸⁾ Bankruptcy courts are empowered to award sanctions for violations of the stay. ⁽²⁰²⁹⁾ Without the power to award sanctions for violations of the stay, bankruptcy courts would be powerless to enforce its provisions, which benefit creditors and the debtor alike by preserving the status quo as of the commencement of the case.

Automatic stay protection is not, however, unlimited. Section 362(b) sets forth a number of self-executing exceptions for certain types of actions that justify a departure from the rule. ⁽²⁰³⁰⁾ In the absence of an exception, creditors seeking to enforce their prepetition rights or otherwise proceed against the debtor or property of the bankruptcy estate must seek court-ordered relief from the automatic stay. ⁽²⁰³¹⁾ The breadth of the automatic injunctive power of the stay requires certain automatic exceptions to its provisions. These exceptions are narrowly-tailored to preserve the estate without hindering, for example, the exercise of a government's police and regulatory power. ⁽²⁰³²⁾

The right of setoff is equitable in origin and designed to facilitate the adjustment of mutual obligations, thereby avoiding "the absurdity of making A pay B when B owes A."⁽²⁰³³⁾ Setoff is a "common law right, which belongs to every creditor, to apply the unappropriated moneys of his debtor, in his hands, in extinguishment of the debts due to him."⁽²⁰³⁴⁾ The historical antecedents of setoff rights are long and venerable. ⁽²⁰³⁵⁾ However, the right of setoff also arguably creates an "unrecaptured preference."⁽²⁰³⁶⁾

Section 553(a) of the Bankruptcy Code preserves setoff rights in bankruptcy. ⁽²⁰³⁷⁾ Additionally, section 506(a) provides that a creditor who holds a valid setoff right is treated as a secured creditor to the extent of that right. ⁽²⁰³⁸⁾ Although the Code recognizes the right of creditors to setoff mutual, prepetition obligations, a creditor's ability to exercise that right is expressly made subject to the automatic stay. ⁽²⁰³⁹⁾

In a significant number of consumer cases, individual debtors are entitled to receive income tax refunds for prepetition periods while, at the same time, are in arrears on prepetition tax obligations for different taxable periods. The validity and amount of the tax claims are generally not disputed by the trustee or taxpayers in most instances. The taxing authorities in such circumstances where there is no dispute have valid setoff rights under nonbankruptcy law and, absent the intervention of bankruptcy, routinely adjust the mutual obligations between the parties and apply income tax refunds against other tax liabilities in the ordinary course. ⁽²⁰⁴⁰⁾ Setoff of tax claims outside bankruptcy provides both an inexpensive and efficient means of reconciling tax liabilities and refunds. Setoff rights thus grant significant collection leverage to taxing authorities. The result in bankruptcy, however, is different. ⁽²⁰⁴¹⁾

After a consumer debtor files for relief under the Bankruptcy Code, a taxing authority is required to seek relief from the automatic stay on a case-by-case basis if it wants to offset a refund against past due taxes even if its claim is not disputed. The cost to the government of prosecuting often uncontested and routine motions as a prerequisite to enforcing an undisputed, mutual obligation is substantial. The additional penalties and interest that continue to accrue in individual cases due to the government's inability promptly to apply income tax refunds against prior period tax obligations in the ordinary course also can cause individual debtors undue hardship because of the nondischargeable nature of many tax claims.

The Recommendation grants taxing authorities the ability to setoff an income tax refund that arose prepetition against a Chapter 7 or Chapter 13 debtor against an undisputed income tax liability. The Recommendation would reduce the burden on federal, state, and local governments, conserve judicial resources now expended on resolving routine motions, facilitate prompt administration of bankruptcy cases, and reduce debtor hardship. Indeed, a number of districts have, by local rule or standing order, authorized governmental units to setoff income tax refunds against tax claims as a matter of course, thus obviating the need for a formal motion and hearing. ⁽²⁰⁴²⁾ As a result of the adoption of the Recommendation, such local rules and standing orders will no longer be necessary, and should be repealed in the interest of uniformity. The Tax Advisory Committee considered this Recommendation and a number of other options. ⁽²⁰⁴³⁾

Competing Considerations. Exceptions to the stay must be narrowly tailored to accomplish their objective without nullifying the effect of the automatic stay. Specific setoff exceptions to the automatic stay already exist. ⁽²⁰⁴⁴⁾ Outside these limited exceptions, all creditors must seek relief from the automatic stay prior to a effecting a setoff on a prepetition debt. Arguably, taxing authorities should not be treated differently from other creditors. In addition, disputes over improper setoffs are costly and those costs will be borne by the other creditors. To the extent the governmental unit is a state government, under Seminole, these disputes may have to be brought in state court and will be even costlier to litigate. ⁽²⁰⁴⁵⁾

The Recommendation is designed to mitigate these competing concerns. Setoff under the Recommendation is limited to income tax claims of federal, state and local taxing authorities who have valid, prepetition setoff rights in individual cases filed under Chapter 7 or 13 and is applicable only if the prepetition tax claim of the government is truly undisputed.

Police and Regulatory Exception under 11 U.S.C. § 362(b)(4) & (b)(5)

In conjunction with its review of issues relating to governmental entities, the Commission discussed a proposal to expand the police and regulatory exception under section 362(b)(4) and (b)(5). ⁽²⁰⁴⁶⁾ The Commission considered a number of alternative proposals to amend the police and regulatory exception in section 362(b)(4) and(b)(5). ⁽²⁰⁴⁷⁾ The Commission did not recommend any change to current law. This discussion is provided to illuminate the issues raised by a proposed amendment to the police and regulatory power in the Bankruptcy Code as part of the Chemical Weapons Implementation Act of 1997, which is pending at the time of the Commission's Report. ⁽²⁰⁴⁸⁾

The filing of a bankruptcy petition creates an automatic stay under section 362(a) that enjoins the initiation or continuation of civil actions that affect the debtor or property of the estate. This automatic stay applies to all parties, including government entities. A government entity that seeks to proceed with an action against the debtor or property of the estate has two potential options. First, the Bankruptcy Code provides exceptions to the automatic stay for certain types of government actions; an action that fits one of these exceptions can proceed without leave of the bankruptcy court. Second, for actions outside the scope of those exceptions, the government can seek permission from the bankruptcy court to go forward by bringing a motion for relief from the automatic stay. ⁽²⁰⁴⁹⁾

Section 362(a)(1) of the Bankruptcy Code provides that the filing of a bankruptcy petition stays "the commencement or continuation, including the issuance or employment of process, of a judicial, administrative, or other action or proceeding against the debtor that was or could have been commenced before the commencement of a case under this title, or to recover a claim against the debtor that arose before the commencement of the case under this title."⁽²⁰⁵⁰⁾ Section 362(b)(4) provides an exception to section 362(a)(1) and permits a government unit to commence or continue an action against a debtor to enforce such government unit's police or regulatory power without obtaining permission from the bankruptcy court. ⁽²⁰⁵¹⁾ The legislative history indicates that Congress created this carve-out to permit the continuation of proceedings by governmental units to "stop violation of fraud, environmental protection, consumer protection, safety, or similar police or regulatory laws."⁽²⁰⁵²⁾

The language of section 362(b)(4) does not give government entities unlimited ability to go forward without bankruptcy court permission. Because section 362(b)(4) provides an exception only to actions that fall under section 362(a)(1), a literal interpretation would imply that section 362(b)(4) exempts only actions against the debtor, not against property of the estate. Taking the literal reading one step further, section 362(b)(4) would appear to stop short of permitting the actual exercise of control over property of the estate, which generally is stayed under section 362(a)(3). ⁽²⁰⁵³⁾

The circuit courts and some lower courts, that have addressed this issue have not adopted the literal construction. Some courts interpret this provision to provide broad automatic authorization for police and regulatory actions to proceed against both a debtor and property of the estate, as is illustrated by the recent decision of the Court of Appeals for the Sixth Circuit in Javens v. City of Hazel Park. ⁽²⁰⁵⁴⁾

InJavens, the court found that the automatic stay did not prevent a municipality from condemning and demolishing three of the debtor's buildings without bankruptcy court permission. ⁽²⁰⁵⁵⁾ The court rejected the debtors' argument that the government had acted in violation of the automatic stay under section 362(a)(3) by destroying the buildings. By interpreting the section 362(a)(1) and (a)(2) provisions as effectively permitting a government unit to exercise of control over property of the estate, the Sixth Circuit found the language in these sections and section 362(a)(3) to be a distinction without a difference. ⁽²⁰⁵⁶⁾ The Javens court concluded that the police and regulatory exceptions "are not intended to be limited to non-destructive exercises of governmental power. Many governmental actions clearly within the police or regulatory power destroy some or all of the value that property has to an estate."⁽²⁰⁵⁷⁾ The Sixth Circuit relied in part on the fact that numerous police and regulatory statutes are in rem actions that require control over property to enforce; thus, it concluded that section 362(a)(1), and, consequently section 362(b)(4), were not limited to in personam actions. ⁽²⁰⁵⁸⁾

Other courts have adopted a similar interpretation and have concluded that section 362(b)(4) permits government agencies to exercise control over property of the estate to enforce police or regulatory powers without seeking bankruptcy court permission. ⁽²⁰⁵⁹⁾

However, some lower courts have read section 362(b)(4) literally and thus have held that section 362(a)(3) stays government attempts to exercise control over property of the estate. ⁽²⁰⁶⁰⁾ Courts taking this view expect government entities to seek relief from the stay before controlling or seizing property.

Even if section 362(b)(4) extends to actions to control property of the estate, as the weight of the case law suggests, it only extends to those actions that are "police and regulatory."⁽²⁰⁶¹⁾ As the phrase has been interpreted, "police and regulatory" does not refer only to actions dealing with imminent and identifiable harm or urgent public necessity. ⁽²⁰⁶²⁾ However, government agencies cannot use section 362(b)(4) to enforce contractual rights without seeking automatic stay relief, ⁽²⁰⁶³⁾ nor can they revoke a license as a means to collect a debt from the debtor or to advance the pecuniary interest of the government or a third party without permission in advance from the bankruptcy court. ⁽²⁰⁶⁴⁾

A government agency could, however, revoke a license for noncompliance with safety standards. The bankruptcy court is not expected to look behind every exercise of police and regulatory authority to determine its legitimacy, ⁽²⁰⁶⁵⁾ but can assess whether a government unit has exercised its police and regulatory power in bad faith. ⁽²⁰⁶⁶⁾ Police and regulatory power is thus limited to government actions taken as keeper of the peace or as regulator, but not as general creditor. By limiting government action under the automatic stay to these specific functions, the Bankruptcy Code preserves equality of treatment of all creditors.

Courts generally use one of several similar tests to discern the nature of the government's action. Using the "pecuniary purpose test," a court assesses whether a proceeding relates primarily to the protection of the government's pecuniary interest. ⁽²⁰⁶⁷⁾ A government unit protecting its interests as a creditor is not exercising a police or regulatory power and therefore the action is stayed under the Bankruptcy Code. The "public policy test" focuses on whether the proceedings are intended to effectuate public policy or whether they are adjudications of private rights. ⁽²⁰⁶⁸⁾

The scope of police and regulatory actions and the application of section 362(b)(4) regarding property of the estate is even less clear in the context of civil forfeiture actions. Civil forfeiture actions are in rem actions for remedial civil sanctions. ⁽²⁰⁶⁹⁾ Unlike criminal forfeiture actions, they are not predicated on the outcome of a criminal trial. Federal and state statutes authorize government agents to seize property, including fungible property. ⁽²⁰⁷⁰⁾ The government entity must simply initiate a civil forfeiture proceeding. A forfeiture judgment is a final adjudication of rights of all claimants to the property and establishes the government's unencumbered title to the property. The government's title to the property ultimately relates back to the date of the original offense, although relation back does not occur until the final adjudication proceeding. ⁽²⁰⁷¹⁾ Many forfeiture statutes enable co-owners and lienholders to file claims in the forfeiture action. However, not all statutes authorizing forfeitures have "innocent owner" defenses. ⁽²⁰⁷²⁾ In addition, there generally is no formal recognition of claims of unsecured creditors in judicial forfeiture proceedings.

The law is not settled on whether civil forfeiture actions initiated prepetition can go forward without bankruptcy court permission under section 362(b)(4). The answer is partly dependent on whether property seized prepetition is property of the estate at all, ⁽²⁰⁷³⁾ although that has not been the central inquiry in the few published opinions that have discussed this issue. Assuming that the bankruptcy estate holds at least some interest in property seized prepetition, discussions of whether forfeiture proceedings are excepted from the automatic stay primarily have focused on whether a forfeiture proceeding is a police or regulatory action that properly fits the scope of the section 362(b)(4) exception. ⁽²⁰⁷⁴⁾ This issue has considerable significance to other creditors of the debtor's estate, particularly when the government is seizing cash or an asset of substantial value. The question in these cases essentially boils down to whether these assets will be distributed to creditors pro rata or whether the assets properly belong to the government.

The Court of Appeals for the Third Circuit held that a civil forfeiture action resulting from the seizure of cash was excepted from the automatic stay under section 362(b)(4). ⁽²⁰⁷⁵⁾ The Third Circuit explicitly rejected narrow interpretations of "police and regulatory" and reasoned that "a civil forfeiture action is an action by a governmental unit to enforce its police or regulatory power to combat the problem of illicit drugs" though neither the debtor nor her associates faced drug- related charges in this case. ⁽²⁰⁷⁶⁾ Several other courts have endorsed the Third Circuit's holding. ⁽²⁰⁷⁷⁾

Some courts have concluded that civil forfeiture actions are not within the ambit of the government's police and regulatory power when they do not vindicate or secure the public welfare. ⁽²⁰⁷⁸⁾ Courts also have expressed concern that in the context of a bankruptcy proceeding, civil forfeiture actions do not punish the debtor, but instead punish the unsecured creditors of the bankruptcy estate. Some civil forfeiture proceedings have been described as "actions against property of the estate that resulted in a decrease of the property of the estate which will ultimately punish the creditors by enriching the seizing agency at the expense of the creditors."⁽²⁰⁷⁹⁾

In addition, some courts have found that the section 362(b)(4) exception applies only to actions against the debtor, and not to in rem civil forfeiture actions against property. Unlike the Sixth Circuit, these courts take a narrow and literal view of the police and regulatory exception. As such, these courts expect that government entities will seek relief from the stay before going forward in their actions against property. ⁽²⁰⁸⁰⁾

As part of the Chemical Weapons Implementation Act, which passed in the Senate on May 23, 1997, section 362(b) was proposed to be amended as follows:

(1) by striking paragraphs (4) and (5); and
(2) by inserting after paragraph (3) the following:
"(4) under paragraph (1), (2), (3), or (6) of subsection (a) of this section, of the commencement or continuation of an action or proceeding by a governmental unit or any organization exercising authority under the Convention on the Prohibition of the Development, Production, Stockpiling and Use of Chemical Weapons and on their Destruction, opened for signature on January 13, 1993, to enforce such governmental unit's or organization's police and regulatory power, including the enforcement of a judgment other than a money judgment, obtained in an action or proceeding by the governmental unit to enforce such governmental unit's or organization's police or regulatory power."⁽²⁰⁸¹⁾

The language of section 603 would replace the current language of sections 362(b)(4) and (5). The Chemical Weapons legislation included this amendment because:

[t]he international body which oversees enforcement of the Chemical Weapons Convention is non-governmental and therefore is not covered under the exemption. This means that under current law a bankruptcy court could issue an injunction preventing any inspection for, or seizure of, chemical weapons. If this law had not been changed, the United States would come into noncompliance with the treaty. ⁽²⁰⁸²⁾

Given the language of the amendment, it apparently affects not only actions in connection with the Chemical Weapons Convention, but rather, would except from the stay all governmental units - federal, state, or local - and all types of actions against the debtor and against the debtor's property that may be considered police and regulatory. ⁽²⁰⁸³⁾ This legislation has been referred to the House Committee on the Judiciary.

The police and regulatory exception applies to the automatic stay only; the court retains the power to stay a police or regulatory action under section 105. ⁽²⁰⁸⁴⁾ The discretion of the court to enjoin police and regulatory actions is not without limitation: "[a]lthough there are limited circumstances in which a bankruptcy court may stay a state police power exercise under § 105, there must be a finding of serious conflict between the continuance of the state action and the policies of the bankruptcy code. "⁽²⁰⁸⁵⁾ Another limitation is the fourth prong of the Rule 65 standard, requiring the court to find "that the granting of the injunction will not disserve the public."⁽²⁰⁸⁶⁾ Where an injunction is sought against an ongoing state criminal prosecution, or a legitimate tax collection action, courts have acknowledged that public policy strongly supports allowing the nonbankruptcy action to proceed. ⁽²⁰⁸⁷⁾

The Commission also discussed the use of section 105(a) to enjoin governmental entities from exercising their police and regulatory powers. Section 105(a) permits the bankruptcy court to "issue any order, process, or judgment that is necessary or appropriate to carry out the provisions" of title 11. Power under section 105 is similar in nature to the All Writs Power granted to Article III courts under 28 U.S.C. § 1651. ⁽²⁰⁸⁸⁾ The pertinent legislative history of section 105 provides that "the court has ample other powers to stay actions not covered by the automatic stay. Section 105, of proposed title 11, derived from Bankruptcy Act section 2a(15), grants the power to issue orders necessary or appropriate to carry out the provisions of title 11."⁽²⁰⁸⁹⁾ Section 105 can be used to fill in gaps in section 362, but "whatever equitable powers remain in the bankruptcy courts must and can only be exercised within the confines of the Bankruptcy Code. ⁽²⁰⁹⁰⁾

While applied sparingly, courts have used section 105 to enjoin actions that otherwise would not be stopped by the automatic stay. For example, it may be appropriate to halt an action against a third party, such as a principal of the debtor, that would have a significant effect on the bankruptcy estate and the parties that the estate protects, such as creditors, employees, and shareholders. ⁽²⁰⁹¹⁾ Courts generally do not apply such power freely. ⁽²⁰⁹²⁾

The majority of courts use the traditional Rule 65 standard to gauge whether to issue an injunction under section 105. ⁽²⁰⁹³⁾ While some courts suggest that a section 105 injunction should have a different premise based on the goals that underlie the bankruptcy system, ⁽²⁰⁹⁴⁾ other commentators agree with the tendency of the courts to apply strictly Rule 65. ⁽²⁰⁹⁵⁾

Failure to establish the Rule 65 prerequisites has resulted in a denial of injunctive relief. ⁽²⁰⁹⁶⁾ The traditional test has been modified by some courts to more closely fit the relevant inquiry in a bankruptcy case. ⁽²⁰⁹⁷⁾ Modification of the traditional standard has yielded a more flexible standard in some cases, leading courts to conclude that certain requirements, e.g., the lack of an adequate remedy at law, may be unnecessary when considering whether to enjoin certain activities. ⁽²⁰⁹⁸⁾

The cases reflect many instances where bankruptcy policy is rightfully subordinated to police and regulatory considerations. ⁽²⁰⁹⁹⁾ Section 105 injunctions in the police and regulatory context also are subject to Younger abstention considerations. ⁽²¹⁰⁰⁾ When courts have enjoined police and regulatory actions, on rare occasions, they have done so to provide protection to collective interests that may not be considered in the other action. In such instances, the bankruptcy court equilibrates a variety of competing interests, including employees, other creditors, and shareholders. The burdens faced by the estate under these circumstances are usually overwhelming and require action by the court, such as to prevent the immediate loss of thousands of jobs as well as a portion of municipal transportation, or to prevent the debtor's immediate compliance with a possibly invalid but extremely burdensome claims procedure. The grounds for injunctions of police and regulatory actions have included: extraordinary circumstances, ⁽²¹⁰¹⁾ significant or unwarranted threat to estate assets as determined under the traditional preliminary injunction standards, ⁽²¹⁰²⁾ and bad faith prosecution. ⁽²¹⁰³⁾ Section 105 injunctions also have been issued, usually in conjunction with section 362, to stay an action that actually was pecuniary in nature. ⁽²¹⁰⁴⁾

Implications of Seminole Tribe of Florida v. Florida⁽²¹⁰⁵⁾

The background of the Seminole opinion as well as its broader effects are discussed at length in the Seminole section of the report. ⁽²¹⁰⁶⁾ This discussion focuses specifically on the effect of the proposed amendments to the police and regulatory exception under section 362(b)(4) and (b)(5). In Seminole, the Supreme Court held that the Eleventh Amendment prevents Congress, acting pursuant to its Article I powers, from abrogating a state's sovereign immunity by subjecting it to suit in federal court. ⁽²¹⁰⁷⁾ The bankruptcy implication is that a state, unless it waives its Eleventh Amendment sovereign immunity, is not subject to the jurisdiction of the bankruptcy court when it is a creditor or other party in interest in a bankruptcy case. ⁽²¹⁰⁸⁾

The proposed amendments discussed above will not broaden the implications of Seminole and state sovereign immunity under the Eleventh Amendment. The Eleventh Amendment shields states from suit by private parties in federal court. By its terms, the Eleventh Amendment does not increase a state's authority to act, it merely selects the relevant state court as the forum where private parties must enforce a state's compliance with either state or federal law.

However, if the exceptions to the automatic stay are expanded to give greater authority for government units to obtain property of the estate without seeking court permission in advance, this may lead to more frequent litigation over whether the state has properly exercised the power at issue. These actions will be brought in state court, unless the state has waived its Eleventh Amendment sovereign immunity, though what is required for a valid state waiver has been questioned by a recent Fourth Circuit case. ⁽²¹⁰⁹⁾ Ex parte Young relief for a stay violation is unlikely, because the debtor or the trustee will rarely know that a state official is about to take action. ⁽²¹¹⁰⁾ Disputes over whether a particular act was in violation of the stay - by definition - take place after the conduct has already occurred. Thus, the hurdles for pursuing police and regulatory violations against nonconsenting state agencies will be much higher than for pursuing the same actions against federal or local agencies.

If a state, purportedly acting pursuant to its police and regulatory power, is able to take a critical piece of the debtor's business, the effect may be to shut down the debtor's business, jeopardizing going concern value and jobs, further impairing the claims of other creditors, and resulting in a liquidation of the assets. The proposed amendments expand the range of actions that a government unit (including a state government) may take without seeking relief from the automatic stay. Depending on the development of Seminole in the bankruptcy context, the potential consequences of expanding unilateral action by governmental units could be complicated further by shifting some of the litigation -- where state governments are involved -- to the state courts. All other government units, other than states, will still be subject to bankruptcy court review if their actions overstep the automatic stay exceptions discussed above.

Bankruptcy is a delicate system, balancing a variety of competing interests. Permitting one party, in this case states, to operate outside this system threatens the usefulness of bankruptcy cases and proceedings for both debtors and creditors. Given this significant downside, requiring a state to get a determination in close cases that a particular act is covered by the police and regulatory exception does not seem inequitable or unduly burdensome, even after Seminole.

Notes:

¹⁹⁴⁹  See Charles Jordan Tabb, Rethinking Preferences, 43 S.C. L. REV. 981, 986 (1992) ("Two rationales for preference law predominate: equality and deterrence -- namely maximization of the value of the debtor's assets. These two policy goals conflict at times -- as in the case of an ordinary course transfer shortly before bankruptcy. The distinction between good and bad preferences follows naturally from the identification of deterrence as the predominant purpose of preference law;" arguing for the repeal of the ordinary course of business exception). Return to text

¹⁹⁵⁰ AMERICAN BANKRUPTCY INSTITUTE TASK FORCE ON PREFERENCES, PREFERENCE SURVEY REPORT (May 1997) (hereinafter "Preference Report"). Return to text

¹⁹⁵¹ Id. at 25. Return to text

¹⁹⁵² 11 U.S.C. § 547 (b)(4)(B) (1994). Return to text

¹⁹⁵³ 28 U.S.C. § 1409(b) (1994). Return to text

¹⁹⁵⁴ Id. Return to text

¹⁹⁵⁵ 1 COLLIER ON BANKRUPTCY ¶ 3.02, 3-139 (Lawrence P. King, et al. eds., 15th ed. 1996) (citing H.R. REP. NO. 95-595, at 446 (1977)). Return to text

¹⁹⁵⁶ The Bankruptcy Code defines consumer debt as a "debt incurred by an individual primarily for a personal, family, or household purpose." 11 U.S.C. § 101(8) (1994). Return to text

¹⁹⁵⁷ The Commission Recommendation on National Admission in Section 3.3.4    may reduce some of the cost of litigating preference claims in distant venues. Return to text

¹⁹⁵⁸ 11 U.S.C. § 547(c)(2) (1994). Return to text

¹⁹⁵⁹ 4 COLLIER ON BANKRUPTCY ¶ 547.10 at 547-52 (Lawrence P. King et al. eds., 15th ed. 1996). Return to text

¹⁹⁶⁰ Id.; see also Tabb, supra, note 1949, at 989 ("upholding preferences made after the onset of insolvency. . . . is inconsistent with the fundamental tenet of equality of distribution that undergirds a bankruptcy or other collective proceeding that deals with an insolvent debtor."). Return to text

¹⁹⁶¹ Compare Lovett Jr. v. St. Johnsbury Trucking, 931 F.2d 494, 498 (8th Cir. 1991) ("Late payments may be held to be made in the ordinary course of business, when such payment practices were well-established between the parties.") with Lawson v. Ford Motor Co. (In re Roblin Indus., Inc.), 78 F.3d 30, 39-40 (2d Cir. 1996) (citations omitted) ("[T]he thrust of § 547(c)(2)(C) . . . is clear . . . . [O]nly when a payment is ordinary from the perspective of the industry will the ordinary course of business defense be available for an otherwise voidable preference."). The ABI Preference Report also proposed clarifying the ordinary course of business defense, recognizing the difficulty in deciding which transactions are "ordinary course" transactions. Preference Report, supra, note 1950, at 27. Return to text

¹⁹⁶² See In re Excello Press, Inc., 967 F.2d 1109, 1114 (7th Cir. 1992) (court noted that prior to 1987, the test under section 547(c)(2)(B) & (C) required the same showing of course of dealing between the parties and that after 1987, the majority view is that satisfaction of both prongs is required). Return to text

¹⁹⁶³ See, e.g., In re Tolona Pizza Prod. Corp., 3 F.3d 1029, 1033 (7th Cir. 1993) ("'[O]rdinary business terms' refers to the range of terms that encompasses the practices in which firms similar in some general way to the creditor in question engage, and that only dealing so idiosyncratic as to fall outside that broad range should be deemed extraordinary and therefore fall outside the scope of [section 547(c)(2)(C)]"). Return to text

¹⁹⁶⁴ This view has already been adopted by some courts. See, e.g., Fiberlite Corp. v. Molded Acoustical Products (In re Molded Acoustical Products, Inc.), 18 F.3d 217, 220 (3d Cir. 1994) ("[S]ection 547(c)(2)(C) countenances a greater departure from that range of terms the longer the pre-insolvency relationship between the debtor and creditor was solidified"). Return to text

¹⁹⁶⁵ A recent article proposed this amendment to address the problem of determining "industry standards." See Timothy M. Lupinacci, Analyzing Industry Standards in Defending Preference Actions: Equitable Purpose in Search of Statutory Clarity, 5 J. BANKR. L. & PRAC. 129, 168 (Jan./Feb. 1996) (concluding that the statute should be amended consistent with the Recommendation and that "[t]he legislative history should limit industry standard analysis to the situation in which the parties have no course of dealings prior to the payments made during the preference period."). Return to text

¹⁹⁶⁶ A lien is a property interest protected by the Fifth Amendment of the Constitution. See generally, Wright v. Union Cent. Life Ins. Co., 311 U.S. 273, 279 (1940); Louisville Joint Stock Land Bank v. Radford, 295 U.S. 555, 584-85 (1935). Return to text

¹⁹⁶⁷ See, e.g., 11 U.S.C. §§ 544, 545 (1994). Return to text

¹⁹⁶⁸ See id. § 101(37). Included among the liens that remain as a recognized charge upon assets are "statutory liens" such as tax liens. See id. § 101(53). Return to text

¹⁹⁶⁹ It is the rare Chapter 7 case in which a debtor has sufficient assets to pay all creditor claims in full. The Bankruptcy Code, out of this necessity, creates a "pecking order" or system of "priorities" which is designed to assure payment to certain classes of claims, to the extent possible, by requiring that they be paid first and in full before unsecured, nonpriority claims are entitled to any distribution. Section 507 specifies the nature of the claims entitled to priority treatment and the relative order in which they are to be paid. See 11 U.S.C. § 507(a)(1)-(9) (1994)(according priority status to such claims including all section 503(b) administrative expense claims, wage and pension claims, gap-period claims, claims of grain producers and fisherman, consumer deposits, and certain familial obligations). As a general rule, priority claims are subordinate to claims that are secured by a perfected lien against the debtor's property. Return to text

¹⁹⁷⁰  11 U.S.C. §§ 363(f)(3), 725 (1994). Property of the estate can be sold free and clear of liens generally only if the sale price is greater than the aggregate value of all liens on the property. Id. § 363(f)(3). Thus, administrative expenses and other priority claims generally may not be charged against valid liens which must be satisfied out of the assets to which they attach. See In re Goffena, 175 B.R. 386, 389 (Bankr. D. Mont. 1994). Cf. 11 U.S.C. § 506(c) (1994) (setting forth an equitable exception to this rule). Return to text

¹⁹⁷¹ 11 U.S.C. § 724(b) (1994). Section 724(b) provides:

(b) Property in which the estate has an interest and that is subject to a lien that is not avoidable under this title and that secures an allowed claim for a tax, or proceeds of such property, shall be distributed--

(1) first, to any holder of an allowed claim secured by a lien on such property that is not avoidable under this title and that is senior to such tax lien;

(2) second, to any holder of a claim of a kind specified in section 507(a)(1), 507(a)(2), 507(a)(3), 507(a)(4), 507(a)(5), 507(a)(6), or 507(a)(7) of this title to the extent of the amount of such allowed tax claim that is secured by such tax lien;

(3) third, to the holder of such tax lien, to any extent that such holder's allowed tax claim that is secured by such tax lien exceeds any amount distributed under paragraph (2) of this subsection;

(4) fourth, to any holder of an allowed claim secured by a lien on such property that is not avoidable under this title and that is junior to such tax lien;

(5) fifth, to the holder of such tax lien, to the extent that such holder's allowed claim secured by such tax lien is not paid under paragraph (3) of this subsection; and

(6) sixth, to the estate.

Id. (emphasis added). See C. RICHARD MCQUEEN & JACK F. WILLIAMS, TAX ASPECTS OF BANKRUPTCY LAW & PRACTICE, § 9:39 (3d ed. 1997) (providing several examples of the application of section 724(b)). Return to text

¹⁹⁷² H.R. REP. NO. 95-595, at 382 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6338. Return to text

¹⁹⁷³ 124 CONG. REC. H11,014 (daily ed. Sept. 28, 1978) (remarks of Rep. Edwards); 124 CONG. REC. S17,431 (daily ed. Oct. 6, 1978) (remarks of Sen. DeConcini). Section 724(b) serves as a vehicle by which the lien interest of a taxing authority can be invaded in order to create equity for the bankruptcy estate. Indeed, section 724(b) effectively enables a trustee to administer property that is otherwise without value to the bankruptcy estate due to the existence of liens that in aggregate equal or exceed its fair market value (and, therefore, generally abandoned pursuant to section 554) in order to generate a pool of funds from which priority claims can be paid. See Morgan v. K.C. Machine & Tool Co. (In re K.C. Machine & Tool Co.), 816 F.2d 238, 246-47 (6th Cir. 1987) (holding that otherwise burdensome property should not be abandoned since the administration of the property would secure a fund in an amount equal to the tax liens from which to satisfy the fees of lawyers incurred in the previous Chapter 11 case); Marc Stuart Goldberg, P.C. v. City of New York (In re Navis Realty, Inc.), 193 B.R. 998, 1003 (Bankr. E.D.N.Y. 1996) (opining that section 724(b)(2) applies even if there is no equity in the property to be distributed). Return to text

¹⁹⁷⁴ See In re Oglesby, 196 B.R. 938, 942 (E.D. Va. 1996); In re Grand Slam USA, Inc., 178 B.R. 460, 463-64 (E.D. Mich. 1995); King v. Board of Supervisors (In re A.G. Van Metre, Jr., Inc.), 155 B.R. 118 (Bankr. E.D. Va. 1993), aff'd, 16 F.3d 414 (4th Cir. 1994) (Table). Return to text

¹⁹⁷⁵ 11 U.S.C. § 724(b)(2) (1994). Return to text

¹⁹⁷⁶  Hargrave v. Township (In re Tabone, Inc.), 175 B.R. 855, 859 (Bankr. D.N.J. 1994); In re Healthco Int'l, Inc., 174 B.R. 174, 177 (Bankr. D. Mass. 1994) (noting that subordination under section 724(b) can be "full or partial subordination"). Return to text

¹⁹⁷⁷  11 U.S.C. § 724(b)(5) (1994). Return to text

¹⁹⁷⁸ McQUEEN & WILLIAMS, supra note 1971, § 9:39, at 9-63. Return to text

¹⁹⁷⁹ See, e.g., Wurst v. City of New York (In re Packard Properties, Ltd.), 112 B.R. 154, 158-59 (Bankr. N.D. Tex. 1990). Return to text

¹⁹⁸⁰ S. REP. NO. 89-1159 (1966), reprinted in 1966 U.S.C.C.A.N. 2456, 2457. Return to text

¹⁹⁸¹ Id. Return to text

¹⁹⁸² Id. See 4 COLLIER ON BANKRUPTCY ¶ 724.03, at 724-6-7 (Lawrence P. King et al. eds., 15th ed. 1996). Return to text

¹⁹⁸³  S. REP. NO. 89-1159 (1966), reprinted in 1966 U.S.C.C.A.N. 2456, 2457, 2460. See 4 COLLIER ON BANKRUPTCY ¶ 67.27[1] 367 (James Wm. Moore ed., 14th ed. 1978). Section 67c(3) amended the Chandler Act by eliminating the requirement of actual possession as the standard for priming statutory liens on personal property. Return to text

¹⁹⁸⁴  S. REP. NO. 89-1159 (1966), reprinted in 1966 U.S.C.C.A.N. 2456, 2462. Return to text

¹⁹⁸⁵ Id.; see also California State Dept. of Employment v. United States, 210 F.2d 242, 244 (9th Cir. 1954). Return to text

¹⁹⁸⁶ The legislative history to the Code, as buttressed by the Report of the Commission on the Bankruptcy Laws of the United States, reveals that the drafters intended to limit the reach of the statute and exempt ad valorem taxes on real property from subordination. See H.R. REP. NO. 95-595 at 382 (1977) (referring generally to "liens" on property), reprinted in 1978 U.S.C.C.A.N. 5963, 6338; S. REP. NO. 95-989, at 96 (1978) (referring to liens on personal property only), reprinted in 1978 5787, 5882; H.R. Doc. No. 137, 93d Cong., 1st Sess. 212 (1973), reprinted in A & P Legislative History, at 476. Return to text

¹⁹⁸⁷ See H.R. REP. NO. 95-595, at 382 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6338 (indicating that section 724(b) was derived from section 67c(3), "without substantial modification in result"). Return to text

¹⁹⁸⁸  The substantial expansion of the categories of priority claims since the inception of our bankruptcy laws has, over the years, led to a continued erosion of the secured position of taxing authorities. See, e.g., 11 U.S.C. §§ 507(a)(7) (according priority status to certain familial obligations), 503(b)(3)(F) (1994) (according priority status to the expenses of members of a creditors' committee incurred in connection with committee service) (added to the Code by the Bankruptcy Reform Act of 1994, Pub. L. No. 103, 108 Stat. 4106). Return to text

¹⁹⁸⁹ The legislative history on section 724(b) refers to both the subordination of personal property tax liens as well as the subordination of all tax liens. Compare S. REP. NO. 95-989,at 96 (1978), reprinted in 1978 U.S.C.C.A.N. 5787, 5882 (section 724(b) " retains the rule of present bankruptcy law . . . that a tax lien on personal property, if not avoidable by the trustee, is subordinated in payment to unsecured claims having a higher priority than unsecured tax claims.") with H.R. REP. No. 95-595, at 382 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6338 ("section 724(b) subordinates tax liens to administrative expense and wage claims"); H.R. DOC. NO. 95-137, at 212 (1977). Return to text

¹⁹⁹⁰ See, e.g., Morgan v. K.C. Machine & Tool Co. (In re K.C. Machine & Tool Co.), 816 F.2d 238 (6th Cir. 1987). Return to text

¹⁹⁹¹ H.R. REP. NO. 95-595, at 382 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6338. Return to text

¹⁹⁹² Challenges to the constitutionality of stripping taxing authorities of their liens under section 724(b) have failed. See, e.g., Wurst v. City of New York (In re Packard Properties, Ltd.), 112 B.R. 154, 157 (Bankr. N.D. Tex. 1990). Return to text

¹⁹⁹³  See 11 U.S.C. §§ 362(b)(9), (18) (1994). Return to text

¹⁹⁹⁴ See, e.g., Marc Stuart Goldberg, P.C. v. City of New York (In re Navis Realty, Inc.), 193 B.R. 998, 1005 (Bankr. E.D.N.Y. 1996). Return to text

¹⁹⁹⁵ The Investment in Education Act of 1997, S. 1149, 143 CONG. REC. S8823, *8827, 1997 WL 541068 (September 4, 1997). Return to text

¹⁹⁹⁶ Id. at *S8828. Return to text

¹⁹⁹⁷ Id. Return to text

¹⁹⁹⁸ The trustee (or the debtor in possession under section 1107(a)) has a number of tools at her disposal, including the powers of a judicial lien creditor and a bona fide purchaser of real property under section 544(a). In addition, the trustee has standing to raise state law causes of action under section 544(b). Return to text

¹⁹⁹⁹ See, e.g., Wurst v. City of New York (In re Packard Properties, Ltd.), 112 B.R. 154, 158-59 (Bankr. N.D. Tex. 1990). But see, e.g., In re Buzzworm, Inc., 178 B.R. 503, 511 (Bankr. D. Colo. 1994); In re Dowco Petroleum, Inc., 137 B.R. 207, 210 (Bankr. E.D. Tex. 1992);In re Granite Lumber Co., 63 B.R. 466, 473 (Bankr. D. Mont. 1986) (opining that priority claims may be satisfied with funds intended to satisfy lienholders under section 724(b) only when no funds are available from estate property under section 726). Return to text

²⁰⁰⁰  See 11 U.S.C. §§ 348(d), 726(a), (b) (1994). See, e.g., Morgan v. K.C. Machine & Tool Co. (In re K.C. Machine & Tool Co.), 816 F.2d 238 (6th Cir. 1987). The dissent inMorgan aptly noted that section 724(b) may operate to extinguish a secured tax lien, a prior perfected property right, and redistribute public funds to

a group of Chapter 11 administrative creditors, mainly Detroit law firms, who had no prior security or other perfected property interest in any of the property of the bankrupt. The lawyers, whose unsecured accounts arose in the administration of the [case] after the [taxing authority] had perfected its liens, are given public tax funds. Such a result may raise serious constitutional questions . . . .

Id. at 248 (Merritt, J., dissenting). Return to text

²⁰⁰¹ See generally H.R. REP. NO. 95-595, at 186-87 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6147 ("Those who must wind up the affairs of the debtor's estate must be assured of payment, or else they will not participate in the liquidation or distribution of the estate."). Return to text

²⁰⁰² See 11 U.S.C. §§ 507(a)(8), 523(a)(1) (1994). It should be noted, however, that more tax claims are dischargeable in Chapter 13. See 11 U.S.C. § 1328 (1994). Return to text

²⁰⁰³  Section 505(a)(1) provides:

Except as provided in paragraph (2) of this subsection, the court may determine the amount or legality of any tax, any fine, or penalty relating to a tax, or any addition to tax, whether or not previously assessed, whether or not paid, and whether or not contested before and adjudicated by a judicial or administrative tribunal of competent jurisdiction.

11 U.S.C. § 505(a)(1) (1994). See McQUEEN & WILLIAMS, supra note 1971, § 3:14. Return to text

²⁰⁰⁴ See infra note 2006. See generally Perry v. District of Columbia, 314 A.2d 766, 766 (D.C.), cert. denied, 419 U.S. 836 (1974) (noting that the jurisdictional prerequisite to a judicial review of a tax assessment under the law of the District of Columbia hinges upon the actual payment of the disputed tax assessment together with interest and penalties). Return to text

²⁰⁰⁵ See, e.g., Laptops Etc. Corp. v. District of Columbia (In re Laptops Etc. Corp.), 164 B.R. 506 (Bankr. D. Md. 1993) (ruling that the taxing authority's sales-tax assessment, as affirmed by the Department of Revenue postpetition, was an unconstitutional violation of the Commerce Clause and without force and effect; claims disallowed). By virtue of section 505(a), a bankruptcy court may even determine the validity of a debtor's tax liability, if any, irrespective of whether it had previously granted relief from the automatic stay to permit the continuation of a tax court proceeding on the same issue. See, e.g., United States v. Wilson, 974 F.2d 514, 517 (4th Cir. 1992), cert. denied, 507 U.S. 945 (1993); In re Swann Gasoline Co., 46 B.R. 640, 642 (Bankr. E.D. Pa. 1985) (noting that even if relief from the automatic stay were afforded in order to permit a state court to make determinations of tax liability, such determinations would not have res judicata or collateral estoppel effect as to the bankruptcy court's own determination of liability under section 505(a)). Return to text

²⁰⁰⁶  Section 505(a)(2) provides in pertinent part:

(2) The court may not so determine--

(A) the amount or legality of a tax, fine, penalty, or addition to tax if such amount or legality was contested before and adjudicated by a judicial or administrative tribunal of competent jurisdiction before the commencement of the case under this title . . . .

11 U.S.C. § 505(a)(2) (1994). Return to text

²⁰⁰⁷ See id. § 505(b) ("A trustee may request a determination of any unpaid tax liability of the estate for any tax incurred during the administration of the case . . . ."). Return to text

²⁰⁰⁸  See FED. R. BANKR. P. 3001(f). See 11 U.S.C. § 502(a) (1994) (providing that a claim is "deemed allowed" unless a party in interest objects). See also Whitney v. Dresser, 200 U.S. 532, 535-36 (1906) (opining that it is the objection, not the claim, which is heard in a claims contest and that the claim in bankruptcy is regarded as having a certain standing); 4 COLLIER ON BANKRUPTCY ¶ 502.02[2][f], at 502-19 (Lawrence P. King et al. eds., 15th ed. 1996) ("Unless the trustee, as objector, introduces evidence as to the invalidity of the claim or the excessiveness of its amount, the claimant need offer no further proof on the merits of the claim."). Return to text

²⁰⁰⁹ The burden of proof in bankruptcy is a shifting one:

[A] claim is prima facie valid if it alleges facts sufficient to support a legal liability to the claimant; if the objector then produces evidence to refute at least one of the allegations essential to the claim's legal sufficiency, the burden of going forward shifts back to the claimant to prove the validity of the claim by a preponderance of the evidence.

3 COLLIER ON BANKRUPTCY ¶ 502.01, at 502-18 n.19 (Lawrence P. King et al. eds., 15th ed. 1996) (citing In re Allegheny Int'l, Inc., 954 F.2d 167 (3d Cir. 1992)). One rationale for imposing the ultimate burden of persuasion upon the claimant in a dispute with the trustee or debtor-in-possession is that, from a purely procedural standpoint, the filing of a proof of claim is tantamount to the filing of a complaint in a civil action. See Nortex Trading Corp. v. Newfield, 311 F.2d 163 (2d Cir. 1962). As such, the claimant in a bankruptcy proceeding is essentially in the same posture as a plaintiff in a nonbankruptcy proceeding, who is generally assigned the burden of proving its claim against the defendant. In re Premo, 116 B.R. 515, 518 (Bankr. E.D. Mich. 1990). Also, placing the burden of proof on the claimant assures equality of treatment with respect to all holders of claims by requiring each person having a claim to file a proof of claim with the court and to bear the burden of substantiating it if it is contested. Return to text

²⁰¹⁰ Waterman Steamship Corp. v. Aguiar (In re Waterman Steamship Corp.), 200 B.R. 770, 775 (Bankr. S.D.N.Y. 1996). Return to text

²⁰¹¹ "[T]he usual procedure for recovery of debts is reversed in the field of taxation. Payment precedes defense, and the burden of proof, normally on the claimant, is shifted to the taxpayer." Bull v. United States, 295 U.S. 247, 260 (1935). Accord United States v. Janis, 428 U.S. 433, 440 (1976), reh'g denied, 429 U.S. 874 (1977); Helvering v. Taylor, 293 U.S. 507, 515 (1935); Welch v. Helvering, 290 U.S. 111, 115 (1933). See, e.g., T. CT. RULE PRAC. & PROC. 142(a); D.C. CODE ANN. § 47-2010 (1990) (providing for a presumption of taxability and allocating the burden to the taxpayer to prove that a receipt is not subject to sales taxation). In proceedings before the Tax Court, the Court of Federal Claims or a district court, it is incumbent upon the taxpayer, as the party seeking a redetermination of liability, to discharge the burden of proof by a preponderance of the evidence. Moreover, when an assessment has been formally made by the taxing authority, it carries with it a presumption of correctness which must be overcome by the taxpayer. See Psaty v. United States, 442 F.2d 1154 (3d Cir. 1971); United States v. Molitor, 337 F.2d 917 (9th Cir. 1964). Return to text

²⁰¹² Elmer Dean Martin III, Burden of Persuasion: The Overlooked Defense to Tax Claims, 21 CAL. BANKR. J. 117 (1993); see McQUEEN & WILLIAMS, supra note 1971, § 7:25. Return to text

²⁰¹³ See, e.g., United States v. Charlton, 2 F.3d 237, 239 (7th Cir.), reh'g en banc denied, 1993 U.S. App. LEXIS 32378 (1993); IRS v. Levy (In re Landbank Equity Corp.), 973 F.2d 265 (4th Cir. 1992); Resyn Corp. v. United States, 851 F.2d 660 (3d Cir. 1988). "[U]pon review of the code and its legislative history, we find nothing which suggests that this dispute between a taxpayer and the IRS should be decided in a manner any different from that in which the case would be determined outside the bankruptcy context." Levy, 973 F.2d at 270-71. Return to text

²⁰¹⁴ See, e.g., Franchise Tax Bd. v. MacFarlane (In re MacFarlane), 83 F.3d 1041 (9th Cir. 1996), cert. denied, 117 S. Ct. 1243 (1997); Placid Oil Co. v. IRS (In re Placid Oil Co.), 988 F.2d 554 (5th Cir.), reh'g denied, 4 F.3d 992 (5th Cir. 1993);In re Fullmer, 962 F.2d 1463 (10th Cir. 1992);In re Fidelity Holding Co., 837 F.2d 696 (5th Cir. 1988); Industrial Comm'r v. Highway Constr. Co. (In re Highway Constr. Co., 105 F.2d 863 (6th Cir. 1939) (pre-Code case). Return to text

²⁰¹⁵ Compare Gran v. IRS (In re Gran), 964 F.2d 822 (8th Cir. 1992); Paschal v. Blieden, 127 F.2d 398 (8th Cir. 1942)(Act case) (imposing the burden on the government) with In re UNECO, Inc., 532 F.2d 1204 (8th Cir. 1976)(Act case) (imposing the burden on the debtor-taxpayer). Return to text

²⁰¹⁶ Compare In re Wilhelm, 173 B.R. 398, 401-02 (Bankr. E.D. Wis. 1994); In re Premo, 116 B.R. 515, 524 (Bankr. E.D. Mich. 1990) (refusing to recognize an exception to the rule allocating the burden of ultimate persuasion upon the creditor for tax authorities in the context of a hearing on an objection to a claim);In re Federated Dep't Stores, Inc., 135 B.R. 950, 958 (Bankr. S.D. Ohio 1992), aff'd, 171 B.R. 603 (S.D. Ohio 1994)with Abel v. United States (In re Abel), 200 B.R. 816, 819 (E.D. Pa. 1996);In re Thinking Machs. Corp., 203 B.R. 1 (Bankr. D. Mass. 1996) (concluding that Bankruptcy Rule 3001(f) places the ultimate burden of proof and persuasion upon the government, improperly permits a tax litigant to shift the burden of proof by merely filing bankruptcy); In re Ford, 194 B.R. 583, 588-89 (S.D. Ohio 1995); Cobb v. United States (In re Cobb), 135 B.R. 640, 641 (Bankr. D. Neb. 1992) (concluding that Bankruptcy Rule 3001(f) does not allocate the burden of proof but simply establishes that a proof claim constitutes evidence: "The Rule, in effect creates a presumption which must be overcome by debtor. Once the presumption is overcome . . ., the proof of claim no longer constitutes evidence--the bubble is burst. The burden of proof is to then be allocated by applicable non-bankruptcy law."). Return to text

²⁰¹⁷ Henderson and Goldring, FAILING AND FAILED BUSINESSES, § 1013.4 (1997). Return to text

²⁰¹⁸ Internal REV. Serv. v. Levy (In re Landbank Equity Corp.), 973 F.2d 265, 270 (4th Cir. 1992) (citing Report of the Commission on the Bankruptcy Laws of the United States, H.R. DOC. NO. 137, 93d Cong., 1st Sess. Pt. I 68-71, 76-78 (1973)). The United States Supreme Court has found that "presumptions (and their effects and burden of proof) are 'substantive,'" not procedural. See Dick v. New York Life Ins. Co., 359 U.S. 437, 446 (1959). Return to text

²⁰¹⁹ See Grogan v. Garner, 498 U.S. 279, 283-84 & n.9 (1991). The United States Supreme Court has opined that it is imperative to

distinguish between the standard of proof that a creditor must satisfy in order to establish a valid claim against the bankrupt estate and the standard that a creditor who has established a valid claim must still satisfy in order to avoid dischargeability. The validity of a creditor's claim is determined by rules of state law [defined] expansively . . . to refer to all nonbankruptcy law that creates substantive claims. . . . [H]owever, the issue of nondischargeability has been a matter of federal law governed by the terms of the Bankruptcy Code.

Id. (footnote inserted & citations omitted). Return to text

²⁰²⁰  Section 505(a)(2) precludes a bankruptcy court from determining the amount or legality of any tax claim if the merits of a tax claim or question of liability has been contested prior to the commencement of the bankruptcy case where the nonbankruptcy law burdens and presumptions are applicable. 11 U.S.C. § 505(a)(2) (1994). Return to text

²⁰²¹ 15 COLLIER ON BANKRUPTCY ¶ TX5.03[5], at TX5-24 (Lawrence P. King et al. eds., 15th ed. 1996). Return to text

²⁰²² See, e.g., 11 U.S.C. § 501 (1994); FED. R. BANKR. P. 3001 (listing requirements for a proof of claim). Return to text

²⁰²³ In re Los Angeles International Airport Hotel Assoc., 106 F.3d 1479 (9th Cir. 1997) (citing cases). Return to text

²⁰²⁴ 11 U.S.C. § 502(b)(9) (1994). Return to text

²⁰²⁵ See, e.g., 11 U.S.C. §§ 507(a)(8), 523(a)(1) (1994).

In a broad sense, the goals of rehabilitating debtors and giving equal treatment to private voluntary creditors must be balanced with the interests of governmental tax authorities who, if unpaid taxes exist, are also creditors in the proceeding.

Since tax authorities are creditors of practically every taxpayer, another important element is that tax collection rules for bankruptcy cases have a direct impact on the integrity of Federal, State and local tax systems. These tax systems, generally based on voluntary assessment, work to the extent that the majority of taxpayers think they are fair. This presumption of fairness is an asset which should be protected and not jeopardized by permitting taxpayers to use bankruptcy as a means of improperly avoiding their tax debts. To the extent that debtors in a bankruptcy are freed from paying their tax liabilities, the burden of making up the revenues thus lost must be shifted to other taxpayers.

S. REP. NO. 95- 989, at 13-14 (1978), reprinted in 1978 U.S.C.C.A.N. 5787, 5799-5800. Return to text

²⁰²⁶ 11 U.S.C. § 362(a) (1994). Return to text

²⁰²⁷ The rationale for the imposition of the automatic stay has been expressed as follows:

The stay provides the debtor with relief from the pressure and harassment of creditors seeking to collect their claims. It protects property that may be necessary for the debtor's fresh start and, in terms of a Chapter 11 debtor, provides breathing space to permit the debtor to focus on its rehabilitation or reorganization. In addition, the stay provides creditors with protection by preventing the dismemberment of a debtor's assets by individual creditors levying on the property. This promotes the bankruptcy goal of equality of distribution.

3 COLLIER ON BANKRUPTCY ¶ 362.03, at 362-13 (Lawrence P. King et al. eds., 15th ed. 1996) (citing H.R. REP. NO. 95-595, at 340 (1977); S. REP. NO. 95-989, at 54-55 (1978)). Return to text

²⁰²⁸ 11 U.S.C. § 362(a) (1994). See id. § 101(15), (27). Return to text

²⁰²⁹ Id. § 105, 362(h). Return to text

²⁰³⁰ Id. § 362(b)(1)-(18). Return to text

²⁰³¹ Id. § 362(d) (providing that the bankruptcy court may fashion relief in appropriate circumstances "after notice and a hearing" by "terminating, annulling, modifying or conditioning" the stay). See FED. R. BANKR. P. 4001. Return to text

²⁰³² See 11 U.S.C. § 362(b)(4) & (5) (1994). Return to text

²⁰³³ Studley v. Boylston Nat'l Bank, 229 U.S. 523, 528 (1913). "'In the absence of a recognition of the right to a setoff, the creditor might be forced to pay in full the amount owed to the debtor, but be limited to no more than a pro rata recovery of his claim against the debtor. The process of imposing this loss on an otherwise innocent party has historically been thought to be improper.'" In re Braniff Airways, Inc., 42 B.R. 443, 448 (Bankr. N.D. Tex. 1984) (quoting NORTON BANKR. L. & PRAC. § 33.01). Return to text

²⁰³⁴ Gratiot v. United States, 40 U.S. (15 Pet.) 336 (1841). Return to text

²⁰³⁵ See 5 COLLIER ON BANKRUPTCY ¶ 553.02[2], at 553-10 (Lawrence P. King et al. eds., 15th ed. 1996).

[A] right of setoff is a remedy that has long been recognized and enforced in the commercial world at large, as well as under everyone of the nation's bankruptcy acts. . . . The Bankruptcy Code recognizes the significance of the right and continues the practice of preserving it, in part as a matter of essential fairness, but importantly in recognition of the right as part of the bundle of substantive rights that may comprise a creditor's claim.

Id. Return to text

²⁰³⁶ John C. McCoid II, Setoff: Why Bankruptcy Priority, 75 VA. L. REV. 15, 17 (1989) (arguing that the right of setoff, though limited in bankruptcy, is at "odds with the principle of creditor equality" and unsecured creditors with a right of setoff should be treated differently from other unsecured creditors). Return to text

²⁰³⁷ Section 553 of the Code provides in pertinent part:

Except as otherwise provided in this section and in sections 362 and 363 of the title, this title does not affect any right of a creditor to offset a mutual debt owing such creditor to the debtor that arose before the commencement of the case under this title against a claim of such creditor against the debtor that arose before the commencement of the case . . . .

11 U.S.C. § 553(a) (1994). It is significant to note that § 553 does not itself create any right of setoff; rather, the provision merely recognizes and preserves the right of setoff if such a right exists under nonbankruptcy law. Four conditions must generally exist in order for the Code to recognize the right of a creditor to setoff an obligation it owes to one that it is owed: (1) the creditor must hold a "claim" against the debtor that arose prior to the commencement of the case; (2) the creditor must owe a "debt" to the debtor that also arose prior to the commencement of the case; (3) the claim and debt must be "mutual;" and (4) the claim and debt must each be valid and enforceable. 5 COLLIER ON BANKRUPTCY ¶ 553.01[1], at 553-7 (Lawrence P. King et al. eds., 15th ed. 1996). Return to text

²⁰³⁸ 11 U.S.C. § 506(a) (1994). Return to text

²⁰³⁹  Id. § 362(a)(7). The United States Supreme Court has recently ruled that while the act of setoff is subject to the automatic stay, placing an "administrative freeze" on an account in order to preserve the right to setoff does not violate the statutory stay. See Citizen's Bank of Maryland v. Strumpf, 116 S. Ct. 286 (1995). For a discussion of Strumpf in the tax context, see McQUEEN & WILLIAMS, supra note 1971, at § 5:15. Return to text

²⁰⁴⁰ See I.R.M. § 57(13)3.142(3)(b). Indeed, tax overpayments are routinely and systematically credited by the Internal Revenue Service against outstanding tax liabilities outside the context of bankruptcy. See 26 U.S.C. § 6402(a) (1994). A notice that the overpayment is credited against a tax liability is automatically issued to taxpayers by the Internal Revenue Service. Return to text

²⁰⁴¹ When the Internal Revenue Service receives notice of a bankruptcy proceeding:

routine offsets by the computer at the [IRS] Service Center are prevented by input of a freeze code. The actions taken by the IRS with respect to the overpayment vary depending upon the judicial district. In most judicial districts, the overpayment is simply frozen and remains so until court action is initiated by the IRS or the debtor and/or trustee. IRS instructions provide that these cases may be referred to counsel for lifting of the automatic stay so the amount can be collected by setoff during the pendency of the bankruptcy.

FINAL REPORT OF THE TAX ADVISORY COMMITTEE TO THE NATIONAL BANKRUPTCY REVIEW COMMISSION, App.at 63 (Aug. 1997) [hereinafter Tax Advisory report]. This Report can be found in the Appendix. Return to text

²⁰⁴²  See, e.g., BANKR. CT. D. ARIZ. GEN. ORDER NO. 8 (automatically modifying the automatic stay so that the IRS can make setoffs against tax refunds in the ordinary course of business in Chapter 13 cases); BANKR. CT. D. S.D. IND. L. RULE B-6011 (IRS can setoff prepetition tax claims against prepetition tax refunds, subject to review on motion of party in interest); BANKR. CT. D. MINN. L. RULE 1210 (refunds can be setoff against income taxes in the ordinary course of business in any chapter); BANKR. CT. E.D.N.C. L. RULE 4001.1 (refunds can be setoff against taxes due the United States in Chapter 7 and Chapter 13 cases); BANKR. CT. M.D.N.C. L. RULE 4001 (refunds or overpayments may be setoff against federal or state taxes due in Chapter 7 and Chapter 13 cases); BANKR. CT. D. MD. L. RULE 25 (IRS and state taxing authorities can effectuate setoffs against tax refunds owed to individual debtors in Chapter 7, 12, or 13 cases, provided the claim is filed and the claim is not disputed or has not been disallowed by another court). Return to text

²⁰⁴³ The Tax Advisory Committee considered and voted on several options in addition to the current Recommendation with respect to the setoff of tax refunds and the automatic stay including: (i) a proposal that would modify the automatic stay to permit the Internal Revenue Service to effectuate a setoff of tax refunds against prepetition tax claims and postpetition nondischargeable tax claims; (ii) a proposal that no change in the law is necessary; and (iii) a proposal that would overrule all standing orders providing automatic relief from the stay and render the stay apply to setoffs. TAX ADVISORY REPORT, supra, note 2041, at 63-66. Return to text

²⁰⁴⁴ See 11 U.S.C. § 362(b)(6) (1994) (permitting a limited setoff right to certain securities contract counter parties); and 11 U.S.C. § 362(b)(7) (1994) (limited setoff right for repo participants). Return to text

²⁰⁴⁵ For a complete discussion of the effect of the Supreme Court's decision in Seminole Tribe of Florida v. Florida, see Report, at 3.4. Return to text

²⁰⁴⁶ The Commission had three separate discussions on this issue. The first took place on September 18, 1996 in Santa Fe, New Mexico where the Commission met in conjunction with the annual bankruptcy meeting of the National Association of Attorneys General. The second discussion took place in San Diego, California on October 19, 1996, and the third discussion took place in Detroit, Michigan on June 20, 1997. Return to text

²⁰⁴⁷ At the Commission's meeting in Santa Fe, New Mexico, in September, 1996, government representatives including representatives of the Department of Justice, the National Association of Attorneys General, the Securities and Exchange Commission, as well as representatives of individual state attorneys general, highlighted certain gaps in the application of section 362(b)(4). Specifically, the government representatives argued that some courts do not permit a governmental unit to "exercise control over property of the estate." For example, a governmental unit would have to seek court permission before it could revoke a debtor's license for an ongoing infraction. In response, the Commission considered a proposal to amend section 362(b)(4) to except from the automatic stay the exercise of control over property of the estate in a police or regulatory action. The proposal provided a specific amendment to section 362(b)(4):

11 U.S.C. § 362(b)(4) should be amended to read as follows:

(b) the filing of a petition under section 301, 302, or 303 of this title, or of an application under section 5(a)(3) of the Securities Investor Protection Act of 1970, does not operate as a stay -

. . .

(4) under subsection (a)(1) of this section, of the commencement or continuation of an action or proceeding by a governmental unit to enforce such governmental unit's police and regulatory power, including an act to exercise control over property of the estate.

The Department of Justice and Karen Cordry, Bankruptcy Counsel for the National Association of Attorneys General, submitted an alternative proposal to the Commission that would amend section 362(b)(4) to include the following acts -

• the commencement or continuation of a proceeding against the debtor (included under current section 362(b)(4));
• the enforcement against the debtor or property of the estate of a judgment obtained prepetition (included under current section 362(b)(5));
• any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate (additional provision);
• any act to collect, assess, or recover a claim against the debtor that arose before the commencement of the case (additional prov