Burden v. U.S.

• Decision Date: 26 October 1990
• Docket Number: No. 90-1147,90-1147
• Citation: 917 F.2d 115
• Parties: -5792, 59 USLW 2288, 90-2 USTC P 50,598, 24 Collier Bankr.Cas.2d 187, 20 Bankr.Ct.Dec. 1937 In re BURDEN, Wilfred, H., a/k/a Burden, Wilfred, H., Jr., t/a Burden's Janitorial Service & Supply Company v. The UNITED STATES of America, Appellant.
• Court: U.S. Court of Appeals — Third Circuit

Page 115

917 F.2d 115

66 A.F.T.R.2d 90-5792, 59 USLW 2288, 90-2

USTC P 50,598,

24 Collier Bankr.Cas.2d 187, 20 Bankr.Ct.Dec. 1937

In re BURDEN, Wilfred, H., a/k/a Burden, Wilfred, H., Jr.,

t/a Burden's Janitorial Service & Supply Company v. The UNITED STATES of America, Appellant.

No. 90-1147.

United States Court of Appeals, Third Circuit.

Argued July 31, 1990.

Decided Oct. 26, 1990.

Robert W. Metzler (argued), Shirley D. Peterson, Gary R. Allen, Gary D. Gray, Tax Div., Dept. of Justice, Washington, D.C., for appellant.

James L. Davis (argued), Paul R. Ober & Associates, Reading, Pa., for appellee.

Before HIGGINBOTHAM, Chief Judge, and SCIRICA and ALITO, Circuit Judges.

OPINION OF THE COURT

A. LEON HIGGINBOTHAM, Jr., Chief Judge.

This is a Chapter 13 bankruptcy case. The Internal Revenue Service ("IRS") appeals from the judgment of the District Court for the Eastern District of Pennsylvania, which affirmed the Bankruptcy Court's ruling that a claim for nonpecuniary loss tax penalties may be subordinated to the claims of other general unsecured creditors, absent a showing of misconduct by the government. ¹ 109 B.R. 107 (1989).

Because the district court automatically subordinated the tax penalties without weighing the equities of the various claims, we will reverse and remand.

I.

Wilfred H. Burden, debtor and appellee, was assessed federal income and employment taxes, related penalties, and interest for various tax periods from 1980 to 1985. When the debtor failed to pay all of the amounts assessed against him, the IRS filed four separate notices of tax lien. ²

On June 30, 1987, the debtor filed for protection under Chapter 13 of the Bankruptcy Code. In response, on July 28, 1987, the IRS timely filed a proof of claim in the amount of $57,930.17, of which $51,903.32 was subsequently secured. Of the secured amount $10,655.64 was assessed for penalties and $18,862.68 for interest. The remaining unsecured portion of the claim includes $1,384.67 in penalties and $3,510.19 in taxes. The issue before us on appeal concerns the penalty portion (secured and unsecured) of the total liabilities, which amounts to $12,040.31. ³

On March 30, 1989, the debtor filed a timely objection to the IRS' proof of claim. The parties were able to resolve all of the issues in contention raised by the debtor's objection except one, namely, that in its proof of claim, the IRS failed to subordinate the pre-petition penalties (totalling $12,040.31) to the claims of other general unsecured creditors. The parties did agree that only $52,000 in assets were available to compensate the secured creditors, some having interests prior to those of the IRS.

In response to the debtor's objection, on August 1, 1989, the bankruptcy court entered an order that modified the IRS' proof of claim. Pursuant to Sec. 510(c) of the Bankruptcy Code, the court subordinated the pre-petition penalties portion to the claims of other general non-subordinated unsecured claims. The IRS filed a timely appeal to the bankruptcy court's order. The district court affirmed the bankruptcy court's final order.

The IRS filed a timely appeal before this court contending that 1) equitable subordination does not permit the automatic subordination of nonpecuniary loss tax penalties; 2) Sec. 510(c) on its face precludes class subordination; 3) the invocation of equitable subordination requires a showing of inequitable conduct; 4) Sec. 510(c) requires a notice and fair hearing for all claims; and 5) the automatic subordination of nonpecuniary loss tax penalties would diminish the purpose and effect of such IRS penalties.

Our review of the district court's order affirming the bankruptcy court's order is plenary. See Universal Minerals, Inc. v. C.A. Hughes & Co., 669 F.2d 98, 101-03 (3d Cir.1981).

II.

The issues raised in this appeal require us to address the following concerns: 1) whether Sec. 510(c) permits equitable subordination of penalties; 2) whether automatic subordination of penalties is proper; and 3) whether creditor misconduct is a necessary prerequisite for subordination. The Supreme Court has recognized that "[i]n the exercise of its equitable jurisdiction the bankruptcy court has the power to sift the circumstances surrounding any claim to see that injustice or unfairness is not done in administration of the bankrupt estate." Pepper v. Litton, 308 U.S. 295, 307-08, 60 S.Ct. 238, 245-46, 84 L.Ed. 281 (1939). ⁴ The Ninth Circuit has held that the essential purpose of subordination "is to undo or to offset any inequality in the claim position of a creditor that will produce injustice or unfairness to other creditors in terms of the bankruptcy results." In re Westgate-California Corporation, 642 F.2d 1174, 1177 (9th Cir.1981) (quoting In re Kansas City Journal-Post Co., 144 F.2d 791, 800 (8th Cir.1944)); see In re Lockwood, 14 B.R. 374, 381 (E.D.N.Y.1981).

Prior to the enactment of the Bankruptcy Act of 1978, subordination of tax penalty claims did not occur because noncompensatory penalty claims owed to the government were specifically disallowed. See Simonson v. Granquist, 369 U.S. 38, 40, 82 S.Ct. 537, 538, 7 L.Ed.2d 557 (1962) (a congressional purpose of section 57(j) ⁵ is to bar all claims against a bankrupt except those based on "pecuniary" loss); In re Kline, 403 F.Supp. 974, 977 (D.Md.1975) ("claims for 'penalties' shall not be allowed against the bankrupt estate"), aff'd, 547 F.2d 823 (4th Cir.1977); 30 Stat. 561, amended by 11 U.S.C. Sec. 93(j), amended by 11 U.S.C. Sec. 724(a) (West Supp.1990). Section 510(c)(1) of the Bankruptcy Act of 1978 explicitly allows bankruptcy courts to reorder existing priorities among creditors "under principles of equitable subordination." See In re Virtual Network Services Corp., 902 F.2d 1246 (7th Cir.1990); In re Merwede, 84 B.R. 11 (D.Conn.1988). ⁶ However, whether section 510(c)(1) allows bankruptcy courts to subordinate nonpecuniary loss tax penalties is an issue of first impression in this circuit. ⁷ The Bankruptcy Act does not explicitly define the phrase "equitable subordination" and therefore it is necessary to draw inferences of congressional intent from the legislative history of the Act. Although numerous bankruptcy courts have considered this issue, only recently have Courts of Appeals considered whether Sec. 510(c)(1) permits equitable subordination of nonpecuniary loss tax penalties. See Schultz Broadway Inn v. United States of America, 912 F.2d 230 (8th Cir.1990); Virtual Network Services Corp., 902 F.2d at 1250. In Virtual Network Services Corp., the Seventh Circuit held that Sec. 510(c) empowers the bankruptcy court to equitably subordinate the IRS claim for nonpecuniary loss tax penalties to claims of other creditors in a Chapter 11 liquidation proceeding. ⁸ In reviewing the legislative history to determine Congressional intent, the Seventh Circuit concluded that "the committee reports are necessarily inconclusive as to the meaning of 'equitable subordination' as enacted in Sec. 510(c)(1)." Id. at 1248. However, the court considered statements of Representative Edwards and Senator DiConcini, sponsor and co-sponsor of the House and Senate bills, respectively, ⁹ in conjunction with the Second Circuit's holding in In re Stirling Homex Corp., 579 F.2d 206 (2d Cir.1978) cert. denied, 439 U.S. 1074, 99 S.Ct. 847, 59 L.Ed.2d 40 (1979). In Stirling Homex Corp., which was decided prior to the enactment of the Bankruptcy Act of 1978, the Second Circuit explicitly adopted subordination of claims of defrauded shareholders who had acted wrongfully. 902 F.2d at 212-15. The stockholders in Stirling Homex were allegedly defrauded by the corporation when they purchased their stock certificates. However, the court did not decide whether the stockholders were creditors within the meaning of the Bankruptcy Act. Id. at 212. The court explicitly noted that it was proceeding on "the more narrow question whether it was inequitable for [the bankruptcy court] to subordinate the claims by the stockholders to those made by ordinary creditors" and it concluded that it was not. Id. ¹⁰

Based on its review, the court in Virtual Services Network Corp. rejected the government's position that nonpecuniary loss tax penalty claims are not subject to equitable subordination under Sec. 510(c). Id. at 1248-49. The district court's reasoning in the case at bar is consistent with the Seventh Circuit's reasoning. However, the district court interpreted the legislative history of Sec. 726(a)(4), as opposed to Sec. 510(c)(1), to conclude that subordination of tax penalties has long been considered appropriate by Congress. ¹¹ Section 726(a)(4), which applies to Chapter 7 actions, explicitly subordinates nonpecuniary loss tax penalties. The district court concluded that the legislative history allows courts flexibility in applying the principles of equitable subordination in Chapter 13 cases as well as in Chapter 7 cases.

The IRS contends in this case that there is no specific provision, such as 11 U.S.C. Sec. 726, allowing subordination of nonpecuniary loss tax penalties under Chapter 13, and that, in any event, Congress did not intend such a result in Chapter 13 cases. The debtor asserts that Congress intended the bankruptcy courts to develop the concept of equitable subordination and thereby to expand the traditional doctrine of subordination. Therefore, according to the debtor, the court has the power to subordinate nonpecuniary loss tax penalties in Chapter 13 cases.

We are persuaded by the Seventh Circuit's reasoning that the congressional statements and the legislative history of Sec. 510 indicates that Congress intended the courts to develop the principles of equitable subordination. Virtual Network Services Corp., 902 F.2d at 1249-50. Given this authority, we conclude that Sec. 510(c) permits bankruptcy courts to subordinate nonpecuniary loss tax penalties and therefore uphold the district court's determination that...