In re Harvard Industries, Inc.

• Decision Date: 17 June 2009
• Docket Number: No. 07-3006.,07-3006.
• Citation: 568 F.3d 444
• Parties: In re: HARVARD INDUSTRIES, INC., et al., Debtor. Harvard Secured Creditors Liquidation Trust, Appellant v. Internal Revenue Service, Appellee.
• Court: U.S. Court of Appeals — Third Circuit

568 F.3d 444

In re: HARVARD INDUSTRIES, INC., et al., Debtor.

Harvard Secured Creditors Liquidation Trust, Appellant v. Internal Revenue Service, Appellee.

No. 07-3006.

United States Court of Appeals, Third Circuit.

Argued September 11, 2008.

Filed June 17, 2009.

James N. Lawlor, Esq. (Argued), Wollmuth Maher & Deutsch LLP, Newark, NJ, for Appellant.

Kenneth L. Greene, Esq., Arthur T. Catterall, Esq., Rachel I. Wollitzer, Esq. (Argued), Tax Division, Department of Justice, Washington, D.C., for Appellee.

Before: McKEE, SMITH, and WEIS, Circuit Judges.

OPINION OF THE COURT

McKEE, Circuit Judge.

This tax dispute arose in the course of bankruptcy proceedings for Harvard Industries, Inc. and related entities (collectively "Harvard"). Its resolution requires us to determine the meaning of "specified liability losses" as that phrase is used in 26 U.S.C. § 172(f).¹ In the bankruptcy court, Harvard attempted to collect a federal tax refund for the 1986 tax year based upon three categories of "specified liability losses" incurred in the 1996 tax year that purportedly qualified for a special ten-year net operating loss carry-back pursuant to 26 U.S.C. § 172(b)(1)(C).² The bankruptcy court allowed the carry-back for each of the claimed expenses over the government's objection.

On appeal from the bankruptcy court, the district court ruled that (i) payments to a qualified pension plan that were made pursuant to a settlement agreement with the Pension Benefit Guaranty Corporation ("PBGC")³ did not "arise under Federal ... law" and were therefore not "specified liability losses" under § 172; (ii) losses incurred in relation to the manufacture of defective lock nuts were not "product liability" damages within the meaning of § 172, and hence were not "specified liability losses"; but (iii) payments made pursuant to a retrospective workers' compensation insurance policy were properly deductible as "specified liability losses" in the 1996 tax year. For the reasons that follow, we will affirm in part and reverse in part.

I. FACTUAL BACKGROUND

In 1986, Harvard earned profits of approximately $6.5 million and hence paid a total of $2,442,175 in federal income taxes. For the 1996 tax year, Harvard sustained a net operating loss of $41,399,563. On April 23, 1998, Harvard filed an Amended Corporation Income Tax Return in which it claimed a refund in the amount of $2,435,872 for the 1986 tax year based on a specified liability loss generated during the 1996 tax year that was purportedly eligible to be carried back ten years pursuant to § 172 of the Internal Revenue Code ("I.R.C.").⁴ In a Notice of Partial Claim Allowance dated February 23, 1999, the Internal Revenue Service ("IRS") allowed the carry-back for such losses as were attributable to Workers' Compensation payments, but denied the remainder of the claimed refund.

On March 5, 1999, Harvard filed a protest to the First Partial Disallowance and challenged the Service's basis for denying portions of its refund claim. Harvard also expanded the refund claim to include, among other things: (i) "product liability" payments in the amount of $3,829,807 which included forgiven accounts receivable and a settlement payment to one distributor in connection with defective lock-nuts manufactured by a Harvard operating division; and (ii) prior year pension payments in the amount of $6,000,000 (the "PBGC Payments").

The IRS issued a Second Notice of Partial Disallowance on October 1, 1999, denying Harvard's refund application for the lock-nuts and the PBGC payments. The IRS denied the claim related to the lock-nuts because: (i) Harvard's liability was based on breach of contract and breach of implied warranty of merchantability, as opposed to product liability; (ii) Harvard's customers suffered no physical or emotional harm due to the defective lock-nuts; (iii) costs incurred by Harvard were for repair and replacement of the lock-nuts. The IRS also determined that the pension payments were not eligible for a ten-year carry-back because the Code requires that the event giving rise to an eligible liability "under state or federal law" must occur at least three years before the tax year in question, 1996 in this case. The IRS's position was that because the payments were made pursuant to a settlement agreement with the PBGC in 1994, they did not meet the Code's requirements for eligible "special liability loss" carry-backs. The IRS also took the position that the formation of pension plans and the decision to enter a Settlement Agreement with the PBGC regarding additional funding requirements for the pension plans were voluntary decisions of Harvard, not "arising under federal law" as required by the Code. Rather, they "related to" an obligation under federal law, which is not enough to satisfy the "arising under" element required for the special carry-back provision of the Code. As we explain below, this ongoing dispute was ultimately brought before the bankruptcy court.

A. Losses Related to Defective Lock-Nuts

Elastic Stop Nut of America ("ESNA"), an operating division of Harvard, manufactured lock-nuts for use in commercial and military aircraft engines and airframes. Harvard sold the lock-nuts to various distributors, who resold them to aircraft manufacturers. Military and commercial specifications required that the lock-nuts be baked for 23 hours in order to withstand extreme temperatures during use. Failure to comply with this requirement could result in a condition called "hydrogen embrittlement" which could cause the lock-nuts to crack and fail.

In 1993, it was discovered in the course of an internal investigation that certain of Harvard's lock-nuts were defective because they had not been baked for 23 hours as required. When the defect was discovered, Harvard informed its customers and stopped shipping the lock-nuts pending further investigation. Prior to the time Harvard stopped shipping the lock-nuts, there were no reported instances in which the failure of an ESNA lock-nut caused an accident or resulted in personal injury or property damage. In some cases, efforts were made to recall and rework some of the lock-nuts. However, several distributors who had received the defective lock-nuts refused to pay for them because they could not be resold and/or had to be recalled.

Harvard's largest customer—Harco— filed suit against Harvard based on the sale of defective lock-nuts, alleging: (1) breach of contract; (2) breach of implied warranty of merchantability; (3) breach of the implied covenant of good faith and fair dealing; (4) fraud; (5) negligent misrepresentation; and (6) civil RICO violations. The suit was ultimately settled in an agreement dated April 22, 1996. Pursuant to that agreement, Harvard paid Harco $820,000 and Harco agreed to "release and discharge" Harvard from "any and all claims asserted" in Harco's complaint. Harvard then entered into settlement agreements with other distributors, whereby ESNA forgave a total of $3,009,807 in receivables for the lock-nuts. Harvard subsequently claimed that it should be allowed to treat all these expenses as "product liability" losses eligible for a ten-year carry-back.

B. PBGC Settlement Pension Payments

Harvard filed for Chapter 11 bankruptcy in May of 1991.⁵ Thereafter, the bankruptcy court confirmed a plan of reorganization which required Harvard to pay all holders of allowed unsecured claims 100 cents on the dollar by 1994. In order to meet its obligations under the plan, Harvard sought to obtain $100 million in financing by offering senior unsecured notes.

However, the PBGC was concerned about the issuance of the notes. Harvard's pension plans had a "substantial amount of unfunded benefit liabilities" due to erroneous actuarial assumptions underlying pension plan contributions for 1992 and 1993. The PBGC therefore took the position that the note offering might provide "sufficient basis for the PBGC to seek termination of one or more of [Harvard's] pension plans pursuant to section 4042(a)(4) of ERISA, [29 U.S.C. § 1342(a)(4)]." Negotiations followed in which the PBGC and Harvard reached a settlement agreement. Pursuant to that agreement, Harvard made a $ 6 million additional contribution to its pension plans in 1996 and agreed to pay an additional $1.5 million for each of twelve consecutive quarters thereafter.⁶

The PBGC Settlement Agreement contains restrictions on the amount and use of the proposed Senior Notes. Harvard warranted in the agreement that: "as of the date of execution of this Settlement Agreement there are no past due minimum funding contributions owed to any of" its pension plans, and the PBGC agreed that it would not institute proceedings to terminate any of taxpayer's pension plans "as a result of the Senior Notes offering."

C. Workers' Compensation Payments

From April 1988 to April 1992, Harvard annually purchased insurance policies from the Wausau Insurance Company ("Wausau"). The policies included insurance for general liability, workers' compensation and automobile insurance. Harvard describes the Wausau workers' compensation polices as "retrospective insurance plans." Pursuant to these policies, Harvard paid an initial premium at the beginning of each policy year based on actuarial assumptions about the amount of claims that would be paid. Once Harvard paid its premium to Wausau, Wausau had access to these funds and used them to pay claims covered by the policy.

At the end of each policy year, adjustments were made to the premium based on the difference between the actual amount paid out on claims and the expected claim amounts that had been estimated based on actuarial assumptions. Even after the policy years expired, as claims arising in those years were paid, Harvard could be required to submit additional payments. Wausau periodically sent reports to Harvard concerning claim activity. By comparing year to year reports, Wausau could determine if Harvard had to make additional...