In re Somerset Regional Water Resources, LLC, 021120 FED3, 19-1874

Docket Nº:19-1874
Attorney:Aurelius P. Robleto Robleto Law Counsel for Appellants Courtney S. Schorr McGuireWoods Counsel for Appellee
Judge Panel:Before: AMBRO, KRAUSE, and BIBAS, Circuit Judges
Case Date:February 11, 2020
Court:United States Courts of Appeals, Court of Appeals for the Third Circuit



No. 19-1874

United States Court of Appeals, Third Circuit

February 11, 2020

Submitted Under Third Circuit L.A.R. 34.1(a) on November 14, 2019

On Appeal from the United States District Court for the Western District of Pennsylvania (D.C. No. 3:18-cv-00204) District Judge: Honorable Marilyn J. Horan

Aurelius P. Robleto Robleto Law Counsel for Appellants

Courtney S. Schorr McGuireWoods Counsel for Appellee

Before: AMBRO, KRAUSE, and BIBAS, Circuit Judges



When a lender insists on collateral, it expects the collateral to be worth something. Larry Mostoller's company was in bankruptcy and about to fold. Its largest creditor was willing to lend another $1 million to keep it afloat, but only if Mr. Mostoller pledged a forthcoming personal tax refund as collateral. Everyone who negotiated the deal expected that the refund would amount to roughly $1 million-the net amount owed to Mr. Mostoller based on his company's substantial 2015 losses, which he could use to offset his taxable income in 2013, 2014, and 2015.

But now that Mr. Mostoller has the loan and the tax-refund check, he urges a reading of the agreement that he never mentioned during negotiations: that he pledged as collateral his refund on taxes that he paid for 2015 alone, excluding any refund on his 2013 and 2014 taxes. Yet he admits that his reading would make the collateral worthless.

The bankruptcy court rightly rejected Mr. Mostoller's novel reading of the agreement. Its description of the collateral was ambiguous, so the court enforced it as the parties understood it: to produce a million-dollar refund. Without that security, the lender would never have made so risky a loan. And because Mr. Mostoller owned almost the entire refund separately from his wife, the court properly rejected his argument that his pledge was unenforceable without her consent. So like the District Court before us, we will affirm.

I. Background

A. The bankruptcy

Mr. Mostoller solely owned Somerset Regional Water Resources, LLC (the Debtor), a water-transportation business that serviced oil and gas wells. The Debtor used to be profitable. But when oil prices plummeted in mid-to-late 2014, the oil and gas industry suffered. The Debtor and its customers were no exception. Its losses mounted and its balance sheet plunged into the red.

The Debtor's largest creditor was Somerset Trust Company, to which it owed more than $3 million. The Trust's loans were secured by a blanket lien on most of the Debtor's assets and a personal guarantee by Mr. Mostoller.

In late 2015, the Debtor faced a severe cash-flow shortage and the likely termination of one of its leases. To stop the bleeding, it voluntarily petitioned for reorganization under Chapter 11 of the Bankruptcy Code.

B. The emergency loan, its collateral, and the default

Chapter 11 lets struggling companies reorganize so that they can exit bankruptcy, keep operating, and pay as much as possible to their creditors. In re Armstrong World Indus., Inc., 432 F.3d 507, 518 (3d Cir. 2005). But the Debtor faced a dire liquidity crisis; it stood little chance of surviving a Chapter 11 reorganization without an immediate cash infusion. And because the Debtor was overleveraged, it would find it hard to attract new lenders in what little time it had.

The Trust, however, had a unique incentive to lend more: if a new loan could keep the Debtor afloat, it would more likely be able to repay the Trust in full. Still, to encourage new lending, the Debtor would have to pledge to the Trust substantial new collateral. But the Debtor had already pledged most of its assets to the Trust as security; it had little left to offer.

Thus, the Debtor's management turned to Mr. Mostoller to see if he would pledge some personal assets to secure a loan to save his business. To entice the Trust to lend more money, the Debtor's Chief Restructuring Officer proposed that Mr. Mostoller "assign his interests in the net proceeds of [an anticipated] federal tax refund." 3 App. 1179.

A taxpayer is entitled to a refund if he pays more taxes than he has to. See 26 U.S.C. § 6402(a) (2012). And Mr. Mostoller had overpaid over several years. As an S Corporation, the Debtor was a pass-through entity for tax purposes. See 26 U.S.C. § 1363(a) (2012). Its taxable income and losses passed through to Mr. Mostoller, its sole owner. See id. § 1366(a)(1)(A). He filed his taxes jointly with his wife in 2013, 2014, and 2015. In 2013 and 2014, when the Debtor was thriving, the Mostollers had paid millions of dollars in federal taxes on that income.

But by 2015, the business was struggling. Under a provision of the Internal Revenue Code in effect at the time, he could file amended 2013 and 2014 tax returns to carry back the Debtor's 2015 losses, which would offset his taxable income for those two years and trigger a refund. 26 U.S.C. § 172(a), (b)(1)(A)(i) (2012), repealed in relevant part by The Tax Cuts and Jobs Act, Pub. L. No. 115-97, tit. I, § 13302(b), 131 Stat. 2054, 2122 (2017). Because the Debtor had lost millions of dollars in 2015, the Debtor, the Trust, and their advisors expected that Mr. Mostoller would get a net tax refund of close to $1 million. And the parties understood that Mr. Mostoller could pledge this amount as collateral for an emergency loan.

In the hasty negotiations that followed, the parties reached an agreement. Mr. Mostoller was involved in the negotiations and signed the agreement. In paragraph 6 of that agreement, he pledged as collateral "any rights or interest in the 2015 Federal tax refund due to him individually, but attributable to the operating losses of the Debtor." 2 App. 56-57 ¶ 6. In exchange, the Trust would lend the Debtor $1 million.

Without that valuable collateral, the Trust would not have lent the Debtor more money. The tax refund was "a central part of [the] collateral package" and was "insisted upon by [the] Trust." 3 App. 1068. But the agreement left open the details about executing the tax filings needed to trigger the expected refund. The parties expected that an accountant would handle these details later. Soon after the parties struck the deal, the bankruptcy court approved the agreement and entered it on its docket as a consent order (the Loan Order). 2 App. 51-75.

But even this cash infusion could not save the Debtor. It soon defaulted on the emergency loan. Without a new source of financing to keep the business afloat, the Debtor converted its bankruptcy from a Chapter 11 reorganization to a Chapter 7 liquidation.

C. The tax-refund dispute

Right after the Debtor defaulted on the emergency loan, Mr. Mostoller tried to hang onto the collateral that he had pledged. At first, he apparently refused to file his 2015 tax return and amended 2013 and 2014 tax returns, which were needed to generate the tax refund. So the Trust moved to compel him to do that. At the hearing on this motion, Mr. Mostoller told the bankruptcy court that he had filed those tax returns. And he testified that he "agree[d] that [the] Trust gets half of the tax refund, minus the federal taxes due," with the other half going to his wife. 3 App. 969. The Trust later agreed to that proposal.

But when the tax refund came, Mr. Mostoller tried to keep all of it for himself. His accountant received the $1.12 million refund check from the IRS and followed the bankruptcy court's order by promptly depositing it with the court. Yet when the Trust moved to claim Mr. Mostoller's share of the pledged collateral, he cross-moved, seeking the entire refund.

In briefing on those motions, Mr. Mostoller argued for the first time that paragraph 6 of the Loan Order was limited to any tax refund owed to him because of income offset in the 2015 tax year and did not include any refund from income offset in prior tax years. In the alternative, he argued that because he and his wife owned the refund as tenants by the entirety under Pennsylvania law, and because his wife had not signed the Loan Order, the Trust could not seize the refund proceeds.

In response, the Trust argued that paragraph 6 is ambiguous, that extrinsic evidence from the negotiations showed that refunds derived from offsetting the Mostollers' 2013 and 2014 income against the Debtor's 2015 losses were included, and that the Mostollers' property interests in the refund were separate. In support, the...

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