Section 1146(c) of the Bankruptcy Code provides that the transfer of property "under a plan confirmed" under chapter 11 may not be "taxed under any law imposing a stamp tax or similar tax." Congress enacted this provision of the Bankruptcy Code to encourage reorganization through the chapter 11 process by providing tax relief to debtors who decide to sell assets in connection with their chapter 11 plan. The reduction in tax obligations further assists in producing successful reorganization plans by encouraging debtors to dispose of unnecessary assets and by enhancing the amount of money that will ultimately be available for distribution to creditors under the plan. In a surprisingly anti-creditor, anti-reorganization decision by the Third Circuit, these purposes and policies were seriously undermined in favor of state and local taxing authorities.

The Hechinger Decision

Hechinger Investment Company of Delaware Inc. was a leading provider of home and garden supplies with approximately 200 locations nationwide. Hechinger and its related debtor affiliates (collectively, "Hechinger") filed their voluntary petitions for chapter 11 relief on June 11, 1999, in an attempt to reorganize. Hechinger's reorganization efforts were ultimately unsuccessful, and on Sept. 9, 1999, Hechinger announced it would cease operations and liquidate. As part of this liquidation, Hechinger filed two motions seeking authorization to sell substantially all of its assets, including its interest in certain real property located in Baltimore County, Prince Georges County and Montgomery County in the state of Maryland. Among the relief requested in Hechinger's motions was a ruling that the transfer of the Maryland real estate would not be subject to the payment of transfer and recording taxes, as provided in §1146(c) of the Bankruptcy Code, because the sales were necessary to reduce Hechinger's indebtedness, improve its liquidity and facilitate the formulation and ultimate confirmation of a chapter 11 plan.

Maryland and several Maryland municipalities (the taxing authorities) objected to the sale motions on numerous grounds, including that the motions were suits against a state that were barred by the Eleventh Amendment and that the plain language of §1146(c) limited the section's applicability only to sales conducted as part of a confirmed chapter 11 plan and not pre-confirmation transfers of realty.

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The bankruptcy court determined that the language of §1146(c) was ambiguous and that Hechinger's reading of the statute was more consistent with the congressional intent of promoting successful chapter 11 plans.

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The taxing authorities argued that the plain language of §1146(c) expressly limited its application to those transfers that are made pursuant to the terms of a confirmed chapter 11 plan.² They relied on the Fourth Circuit's decision in NVR Homes Inc. v. Clerk of the Circuit Court for Anne Arundel Co. (In re NVR LP), 189 F.3d 442 (4th Cir. 1999), cert. denied, 528 U.S. 1117 (2000), which held that the tax exemption under §1146(c) applies only to transfers that are made after the date of plan confirmation, regardless of whether the pre-confirmation transfer was made in furtherance of, contemplated in or ratified by the plan. The taxing authorities urged the court to construe §1146(c) as establishing a purely temporal test, whereby a transfer is a taxable event if it takes place prior to confirmation, and a sale is exempt from transfer taxes if it takes place after confirmation. Conversely, Hechinger argued that the statutory language, "under a plan confirmed," does not restrict the timeframe in which a sale must occur and that whether a transfer meets this standard should be examined factually on a case-by-case basis.

The Bankruptcy Court Decision

The bankruptcy court overruled the taxing authorities' objections and approved Hechinger's transfers of the Maryland real estate, including the requested exemption from transfer and recordation taxes.

In its decision, the bankruptcy court determined that the language of §1146(c) was ambiguous and that Hechinger's reading of the statute was more consistent with the congressional intent of promoting successful chapter 11 plans. In the court's view, the purpose of §1146(c) would be undermined if its application were limited solely to post-confirmation transfers because debtors often conduct sales during the pre-confirmation period, and there would be no rational basis for Congress to create a tax benefit for all debtors and then simultaneously limit that benefit to a small subset of debtors on an ostensibly arbitrary basis. The bankruptcy court also noted that a narrow reading of §1146(c) would provide a counterproductive incentive for debtors to retain unnecessary assets until confirmation and would thus reduce the potential of distributions to creditors.

The bankruptcy court concluded that the condition necessary for the statutory tax exemption is the ultimate confirmation of a chapter 11 plan and not the timing of the sale. The bankruptcy court went so far as to conclude that pre-confirmation sales are exempt from transfer taxes even if the chapter 11 plan that is ultimately confirmed is a liquidation plan and not a reorganization plan. The bankruptcy court reached this conclusion based on the express language of the statute, which simply requires a "plan" to be confirmed.

The District Court Decision

The taxing authorities appealed the bankruptcy court's decision to the U.S. District Court for the District of Delaware, which affirmed the bankruptcy court's decision on all issues. Adopting the bankruptcy court's reasoning, the district court noted that limiting the scope of §1146(c) to post-confirmation transfers would undermine the purpose of the statute. The district court further noted that courts should not narrowly construe a statute so as to undermine its clear legislative purpose. Accordingly, the district court held that the §1146(c) exemption from transfer taxes applies to all sales conducted by a debtor throughout the course of a chapter 11 bankruptcy, provided that such sales are necessary to confirmation. The district court observed that the restriction in §1146(c) to transfers that are necessary or essential to confirmation ensures that the bankruptcy court can retain jurisdiction over the determination of whether or not particular transfers are necessary to confirmation. In the Hechinger case, the court concluded that the sales were "clearly necessary" to the plan because the proceeds were to be used to fund the plan. In contrast, the court noted that the Fourth Circuit's decision in In re NVR Homes was focused on the temporal aspects of the transfers rather than the critical issue of whether the transfers were necessary to confirmation of a chapter 11 plan. As a result, the district court affirmed the bankruptcy court's decision. The taxing authorities subsequently appealed the district court decision to the U.S. Third Circuit Court of Appeals.

Third Circuit Decision

After determining that it was not required to reach the question of whether the bankruptcy court's orders violated the Eleventh Amendment, the Third Circuit turned to the issue of the proper interpretation of §1146(c). Section 1146(c) provides that "[t]he issuance, transfer or exchange of a security, or the making or delivery of an instrument of transfer under a plan confirmed under §1129 of this title, may not be taxed under any law imposing a stamp tax or similar tax." In their briefs, the parties did not dispute that the subject real estate transfers involved "the making or delivery of...instrument[s] of transfer" or that the transfer and recording taxes were "stamp" or "similar"" taxes. Rather, at issue was the statutory interpretation of whether the sales were carried out "under" a confirmed plan and the temporal significance of the term "under" as used in the statute. The Hechinger Liquidating Trust, which had been substituted for Hechinger as appellee in this matter after the plan was confirmed, argued that the sales had already occurred "under" a plan, even though a plan had not yet been confirmed at the time of the sales, because the transfers were necessary to promote confirmation of a plan, and the subsequently confirmed chapter 11 plan retroactively authorized the transfers.

In its statutory interpretation of §1146(c), the Third Circuit began by stating that although the preposition "under" has many different meanings, in this context the most natural meaning of the phrase "under a plan confirmed" is "authorized by." The court explained that "[w]hen an action is said to be taken 'under' a provision of law or a document having legal effect, what is generally meant is that the action is ‘authorized' by the provision of law or legal document." The court reasoned that this interpretation of "under" fits best with the remaining language of §1146(c), and it is consistent with the meaning of "under a plan confirmed" as the phrase is found in §365(g) of the Code.

The court further stated that "[e]ven if the language of §1146(c) is ambiguous, however, two important canons of construction support [the court's] interpretation." First, tax exemption provisions are to be strictly construed. Second, federal laws that interfere with a state's taxation scheme are to be narrowly construed in favor of the state. Because §1146(c) provides for a tax exemption and it was interfering with Maryland's provision of property taxation powers, §1146(c) had to be construed in the taxing authorities' favor.

The Third Circuit rejected the alternative interpretation of "under a plan confirmed" advanced by the Hechinger Liquidating Trust—i.e., "necessary for the confirmation of a plan" that is eventually confirmed. The court found no precedent to define "under" to mean "necessary for the confirmation of" and rejected the Hechinger Liquidating Trust's position. The Third Circuit also disagreed with the trust's reading of In re Jacoby-Bender Inc., 758 F.2d 840 (2nd Cir. 1985), explaining that the case did not support the proposition that §1146(c) protects pre-confirmation transfers that are necessary or essential to the subsequent confirmation of a plan.

Consequently, agreeing with "the only other court of appeals that has decided the issue," NVR Home, the Third Circuit held that a transfer is made "under a plan confirmed under §1129" only when the sale is authorized by the terms of a previously confirmed chapter 11 plan.

Dissenting Opinion

In a well-drafted dissenting opinion, Judge Nygaard disagreed with the majority's finding that the phrase "under a plan confirmed" places a temporal restriction on the qualifying transaction. Rather, he opined that §1146(c) can and should be read to create an exemption with respect to property transferred merely "under a plan confirmed," regardless of when the plan is confirmed. Judge Nygaard substantiated his position by indicating that a remedial statute such as the bankruptcy law should be liberally construed. He further noted that what is essential to the eligibility of transfers under §1146(c) is that the transfer is an essential or important component of the plan process. If Congress sought to encourage plan confirmation through §1146(c), the exemption should be construed in light of its purpose. If Congress had intended to limit the application of the exemption temporally, it would have created a brightline test.

Conclusion

In the aftermath of the Hechinger decision, the transfer tax exemption codified in §1146(c) is now to be mechanically applied only to sales "authorized by the terms of a previously confirmed chapter 11 plan." In fact, the Third Circuit did not even require that the transfer be related to the debtor or its estate, much less requiring that the transfer be essential to the debtor's reorganization or liquidation. Notwithstanding that application of this section to pre-confirmation sales properly comports with both the clear legislative history of the statute and practical experience, the Third Circuit adopted a formulaic position that is easy to apply but effectively eviscerates the exemption.

A sound reading of the legislative history of §1146(c) and the policy considerations underpinning the exemption militate in favor of a substantive determination of the appropriateness of the exemption to any given transfer—as opposed to a temporally formulaic application of the calendar. The Third Circuit's failure to give any weight to the plan's ultimate confirmation has the effect of minimizing the potential benefit of the §1146(c) exemption, even as to taxpayers deserving of the exemption.

The practical implications of the Hechinger decision remain to be seen. Before Hechinger, the regular practice of bankruptcy courts was to approve transfer-tax exemptions on pre-confirmation sales when the transactions were clearly made in furtherance of the reorganization or liquidation, a practice that the Third Circuit gave insufficient significance. The Third Circuit accomplished its goal of creating a brightline rule regarding the application of the §1146(c) tax exemption, so, as with every brightline rule (especially a brightline rule relating to taxes), it can be expected that lawyers will simply devise ways to restructure their transactions to fall within the newly imposed requirement that the transfer occur post-confirmation. With regard to transactions in which this is impracticable, the burden created by the sweeping proclamation in Hechinger will unfortunately fall on the shoulders of creditors.

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Footnotes

¹ The author gratefully acknowledges the assistance of William R. Firth III and Adam Hiller in the preparation of this article. Return to article

² The taxing authorities also asserted that the bankruptcy court's orders violated the Eleventh Amendment; however, both the bankruptcy and district courts rejected this argument. Return to article