Virtual Network Services Corp., Matter of

• Decision Date: 24 May 1990
• Docket Number: No. 89-2335,89-2335
• Citation: 902 F.2d 1246,20 B.C.D. 816
• Parties: , 58 USLW 2694, 22 Collier Bankr.Cas.2d 1667, 20 Bankr.Ct.Dec. 816, Bankr. L. Rep. P 73,416 In the Matter of VIRTUAL NETWORK SERVICES CORPORATION, Debtor-Appellee. Appeal of UNITED STATES of America.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 1246

902 F.2d 1246

102 A.L.R.Fed. 857, 58 USLW 2694, 22

Collier Bankr.Cas.2d 1667,

20 Bankr.Ct.Dec. 816, Bankr. L. Rep. P 73,416

In the Matter of VIRTUAL NETWORK SERVICES CORPORATION Debtor-Appellee Appeal of UNITED STATES of America.

No. 89-2335.

United States Court of Appeals Seventh Circuit.

Argued Feb. 22, 1990.

Decided May 14, 1990.

As Amended May 24, 1990.

Thomas R. Lamons, D. Patrick Mullarkey, Gary R. Allen, Debra J. Stefanik, Gary D. Gray, Joanne Rutkowski, U.S. Dept. of Justice, Tax Div., Washington, D.C., for appellant.

Stephen T. Bobo, Towbin & Zazove, Richard G. Smolev, Sheldon L. Solow, Chicago, Ill., for debtor-appellee.

Before BAUER, Chief Judge, and CUMMINGS, Circuit Judge, and PELL, Senior Circuit Judge.

PELL, Senior Circuit Judge.

In this appeal, we must decide whether the district court erred in holding, contrary to the bankruptcy court's judgment, that 11 U.S.C. Sec. 510(c)(1) empowers the bankruptcy court to equitably subordinate the Internal Revenue Service's (IRS) claim for non-pecuniary loss tax penalties ¹ to claims of other creditors in this Chapter 11 liquidation proceeding.

I. BACKGROUND

On September 23, 1986, Virtual Network Services Corporation ("VNS"), a long-distance telephone service company, filed for Chapter 11 relief. Shortly thereafter, and pursuant to bankruptcy court order, VNS became a debtor-in-possession, operating the business for the benefit of the creditors. See 11 U.S.C. Secs. 1107, 1108. VNS subsequently sold most of its operating assets, and filed an amended reorganization plan to liquidate the company. In response, the IRS filed a Proof of Claim against the estate for $625,118.78. The majority of this sum constituted a priority claim for employment and withholding taxes under 11 U.S.C. Sec. 507(a)(7); the remaining $63,022.79 represented pre-petition tax penalties which the IRS identified as a general unsecured claim. See 11 U.S.C. Sec. 507(a)(4).

VNS filed an objection with the bankruptcy court contending that the Government's non-pecuniary loss tax penalty claims ² should be subordinated to the claims of the other general unsecured creditors based on principles of equitable subordination. ³ The bankruptcy court ruled in favor of the IRS, concluding that equitable subordination principles did not operate in this case and that the claims were considered properly on a par status with the other general unsecured creditors' claims. VNS appealed to the district court. Following a thorough analysis of Sec. 510(c)'s equitable subordination provision, the district court reversed the bankruptcy court's judgment, and ordered equitable subordination in the bankruptcy court subordinating the IRS's claims to those of VNS's other general unsecured creditors. 98 B.R. 343. Now the Government appeals.

II. ANALYSIS

Our analysis of the district court's judgment reversing the decision of the bankruptcy court is governed by a de novo standard of review. See 28 U.S.C. Sec. 157(b)(2)(B) and Sec. 157(b)(1). Section 510(c)(1) ⁴ allows bankruptcy courts to reorder existing priorities among creditors "under principles of equitable subordination." As the district court noted in its judgment order, no definition of the phrase appears in the Bankruptcy Reform Act of 1978 ("the Act"). We, therefore, look to the legislative history of Sec. 510(c)(1) to determine whether that throws light on what meaning Congress intended for it, and its applicability here.

The IRS claims the district court erred in concluding that the legislative history of Sec. 510(c)(1) authorized equitable subordination in this case for essentially one reason: the historical meaning of equitable subordination. The IRS argues that when the drafters of the Act adopted the language in Sec. 510(c)(1), equitable subordination had a definite and established meaning; the IRS contends that in applying equitable subordination, courts at that time required some inequitable or wrongful conduct on the part of the creditor who sought par status with other general creditors. The IRS urges us to conclude that Congress did not intend for this "established meaning" to be changed by subsequent case law. Since the IRS has not acted inequitably in this case, it contends that the non-pecuniary loss tax penalty claims are not subject to equitable subordination under Sec. 510(c)(1).

In analyzing the legislative history, we begin, as did the district court, by noting that the history of the passage of the Bankruptcy Reform Act is unique. Representative Edwards, the House floor manager and the Chairman of the subcommittee introducing the House Amendments on September 28, 1978, stated, "[This] ... is the culmination of over 8 years' work by a congressional commission, two congressional committees, and numerous outside groups. The amendment accomplishes the substantial reform of the bankruptcy laws for the first time in 40 years." 124 Cong.Rec. H11,089-H11,117 (daily ed. Sept. 28, 1978), reprinted in 1978 U.S.Code Cong. & Admin.News 5787, 6436. Only a few members of Congress were involved in the negotiations of the final versions of the bill. See Klee, Legislative History of the New Bankruptcy Code, 28 DePaul L.Rev. 941 (1979). And although the "eleventh-hour" hearings secured passage of the Act, they resulted in a document representing compromises which were previously unevaluated by congressional committee. See Kennedy, Foreward: A Brief History of the Bankruptcy Reform Act, 58 N.C.L.Rev. 667, 676-77 (1980).

Particularly, the committees in charge of evaluating Sec. 510 did not prepare a final report on the section. See Wald, Justice in the Ninety-fifth Congress: An Overview, 64 A.B.A.J. 1854, 1855 (1978). A review of the earlier committee reports reveals, as Representative Edwards noted, that Sec. 510(c)(1) represented a compromise in the language used between the House and Senate versions. See, e.g., S.Rep. No. 989, 95th Cong., 2d Sess. 74 (1978), reprinted in, 1978 U.S.Code & Cong.Admin.News 5787, 5860; H.R.Rep. No. 595, 95th Cong., 1st Sess. 359 (1978), reprinted in, 1978 U.S.Code & Cong.Admin.News 5963, 6315. In addition, as the district court explained, the earlier committee reports could not assess the language of Sec. 510(c)(1) as enacted at that final congressional session. Finally, members of Congress relied extensively on Representative Edwards and Senator DiConcini, the sponsor and co-sponsor of the House and Senate bills, respectively, to inform them of the numerous compromises recommended prior to final passage of the bill. Accordingly, the district court concluded that the committee reports were inconclusive on the meaning of the term "equitable subordination." Upon our examination, we are persuaded that the committee reports are necessarily inconclusive as to the meaning of "equitable subordination" as enacted in Sec. 510(c)(1).

Also for the reasons above, in analyzing Sec. 510(c)(1), the district court chose to rely on statements made during the final hearings by Representative Edwards and Senator DiConcini. Looking to Representative Edwards' comments to Congress regarding Sec. 510(c)(1) specifically, we note he stated that,

"It is intended that the term "principles of equitable subordination" follow existing case law and leave to the courts development of this principle. To date, under existing law, a claim is generally subordinated only if [the] holder of such claim is guilty of inequitable conduct, or the claim itself is of a status susceptible to subordination, such as a penalty...."

124 Cong.Rec. H11,089-H11,117 (daily ed. Sept. 28, 1978), reprinted in, 1978 U.S.Code & Cong.Admin.News 5787, 6452. Senator DiConcini's statements mirror those made by Representative Edwards. See 124 Cong.Rec. S17,403-S17,434 (daily ed. Sept. 28, 1978), reprinted in, 1978 U.S.Code & Cong.Admin.News 5787, 6521. Based on these statements, the district court concluded that the legislative history of Sec. 510(c)(1) favors a broad reading of the "principles of equitable subordination" and authorizes equitable subordination "as the courts develop[ ] those principles."

It is true that when Congress adopted the language in Sec. 510(c)(1), equitable subordination was imposed virtually only where there was some wrongful conduct on the part of the creditor. See, e.g., Pepper v. Litton, 308 U.S. 295, 304-05, 60 S.Ct. 238, 244, 84 L.Ed. 281 (1939). As both the IRS and VNS are aware, however, equitable subordination of tax penalty claims did not occur prior to passage of the Act because under the then-existing law, the Bankruptcy Act of 1898, 11 U.S.C. Sec. 93(j), noncompensatory penalty claims owed to the Government were specifically disallowed. See In re Kline, 403 F.Supp. 974 (D.Md.1975), aff'd, 547 F.2d 823 (4th Cir.1977). More telling than this, though, is the Second Circuit's opinion in In re Stirling Homex Corp., 579 F.2d 206 (2nd Cir.1978), which was decided more than three months prior to passage of the Act. After exploring the equitable jurisdiction of the bankruptcy courts, and the courts' power to equitably subordinate claims in bankruptcy, the Second Circuit explicitly ordered subordination of claims made by defrauded shareholders who had not acted wrongfully. Id. at 212-13. In addition, the court specifically discussed the thrust of the versions of Sec. 510(c)(1) (formerly numbered Sec. 510(b)) that persuaded it to rule in favor of subordination; the Court concluded that any thing other than equitable subordination in that case "would ... violate [the court's] sense of simple fairness...." Id. at 215. We think it is eminently not unreasonable to think that the principal managers of the bill were aware of this decision and its implications prior to passage of the section. With this decision, the Government's position on the historical and established meaning of "equitable subordination" is incorrect.

In addition, under Sec. 510(c)(1), a number of courts have provided for equitable subordination without making...