Dismissal of Tax-Driven Bankruptcy Plan Affirmed

Bankruptcy & Insolvency

The Seventh Circuit affirmed a bankruptcy court’s refusal to confirm a bankruptcy plan and its dismissal of the bankruptcy proceeding because the principal purpose was to avoid taxes. The court said the filing was in bad faith and did not serve the proper purpose of bankruptcy law.

Background

South Beach Securities (South Beach), at the time it declared bankruptcy, was a shell corporation that had no employees or business activities, and its only “assets” were net operating losses. It had been a registered securities broker-dealer. Scattered Corporation, a securities firm that the Chicago Stock Exchange had driven out of the securities business after a prolonged legal battle, was the only creditor of South Beach. Leon Greenblatt, a Chicago businessman, controlled both South Beach and Scattered.

South Beach was wholly owned by NOLA, LLC, another company with no business operations. Its sole asset was the stock of South Beach. NOLA had three members. One was Greenblatt’s father; the others were the fathers of Scattered’s other two officers and directors. A company named Teletech managed NOLA. This was the sole function of Teletech, whose president and sole employee at the relevant time was Greenblatt. Through Teletech, and thus through NOLA, Greenblatt controlled South Beach.

In 2001, Greenblatt directed another corporation that he controlled, Loop Corporation, to lend South Beach $2.2 million, which he then had South Beach lend to NOLA (along with another $1 million of indeterminate origin) to enable NOLA to purchase the stock of a company called Health Risk Management, Inc. (HRM). Loop then sold the $2.2 million loan that it had made to South Beach to Scattered for $100,000, making Scattered a creditor of South Beach.

South Beach filed for bankruptcy under chapter 11 and submitted a plan of reorganization to the bankruptcy court. South Beach’s bankruptcy filings listed the stock in HRM as its sole asset and assigned the stock a value of zero. Under the plan, Scattered, the only real creditor of South Beach, would receive South Beach stock in satisfaction of its claim, and South Beach would be discharged.

South Beach did not list its net operating losses as an asset; however, the disclosure statement it filed with the bankruptcy court stated that the purpose of the bankruptcy was to monetize South Beach’s net operating losses. If the bankruptcy court approved the plan of reorganization, Scattered would become the owner of South Beach and theoretically could extract a tax benefit from South Beach’s net operating losses by transferring capital to South Beach to enable it to generate income against which to offset the net operating losses. The result would be to shield Scattered’s income from federal tax because South Beach’s income would be Scattered’s income.

The U.S. trustee for South Beach’s bankruptcy case, a Justice Department official who served as a watchdog over bankruptcy proceedings, opposed the company’s bankruptcy filing and reorganization plan. According to the trustee, under Bankruptcy Code Section 1129(d) (11 U.S.C. §1129(d)), the reorganization plan could not be confirmed because its principal purpose was to avoid tax. If not for the trustee, the case would have been nonadversarial.

The bankruptcy court rejected the plan of reorganization proposed by South Beach because it was not approved by a noninsider impaired class of creditors as required by Bankruptcy Code Section 1129(a)(10), and, as alleged by the trustee, its principal purpose was to avoid taxes (In re South Beach Securities, Inc., 376 B.R. 881 (Bankr. N.D. Ill. 2007)). For these purposes, an insider is defined in Bankruptcy Code Section 101(31)(B)(iii). Although Scattered approved the plan, the bankruptcy court found that South Beach had failed to prove that Scattered was not an insider under Section 101(31)(B)(iii) and that even if Scattered did not fall within the literal definition of that section, all the evidence suggested that Scattered’s relationship to South Beach was sufficiently close for Scattered to be considered an insider.

With respect to the avoidance of taxes, the court found that the disclosure statement South Beach filed in the case, which stated that the plan’s goal was to make use of South Beach’s net operating losses, was proof of a principal purpose to avoid taxes. In response to Greenblatt’s contrary testimony that the purpose of the plan was to avoid litigation, the court noted that there was no threatened or actual litigation and that even if pending litigation was taken into account, the argument failed because allowing a debtor to avoid taxes for the ultimate purpose of making them available for use in litigation would nullify Section 1129(d).

South Beach appealed the bankruptcy court’s decision to a district court, which affirmed the bankruptcy court’s decision (In re South Beach Securities, Inc., 421 B.R. 456 (N.D. Ill. 2009)). South Beach then appealed the case to the Seventh Circuit.

Seventh Circuit’s Opinion

The Seventh Circuit affirmed the district court’s holding that the bankruptcy court had properly refused to confirm South Beach’s reorganization plan and dismissed the company’s bankruptcy plan. However, it took a somewhat different approach in coming to this conclusion, focusing on the fact that South Beach’s bankruptcy filing was in bad faith and was in no way consistent with the purpose of bankruptcy law.

The court first noted that under its reading of the applicable tax law, South Beach’s reorganization plan would not achieve the tax results that Greenblatt sought; however, it further explained that a plan could not be confirmed if tax avoidance was the principal purpose of the plan, even if the tax avoidance objective could not be achieved or would be rejected by the IRS. The court stated that “[t]he object of bankruptcy is to adjust the rights of the creditors of a bankrupt company; it is not to allow a solvent company to try to lighten its tax burden.”

The court found that the plan had to be rejected because it was proposed in bad faith. It stated that a reorganization plan must have a true purpose and an actual possibility of preserving a bankrupt business as a going concern or of maximizing the property available to satisfy the business’s creditors. Looking at the facts of the case, the court described South Beach as a solvent corporation that Greenblatt had made insolvent for the sole purpose of acquisition by Scattered in a chapter 11 bankruptcy. According to the court, the absence of any real debt or real outside creditors showed that South Beach and Greenblatt had not filed the case in good faith and that it did not belong in bankruptcy court.

The court, however, did disagree slightly with the district and bankruptcy courts regarding Scattered’s status as an insider. It agreed with the legal principles that the lower courts applied to determine whether Scattered was an insider but it also took into consideration the purpose of Section 1129(a)(10), which is to prevent collusion between an inside creditor and the debtor to the detriment of the outside creditors. Because there was only an inside creditor in this case and thus no possibility of harm to outside creditors, the court concluded that the case was outside the scope of Section 1129(a)(10). However, the court found that the fact that Scattered would qualify as an insider was yet further evidence of why the plan did not serve the purpose of bankruptcy law and could not be affirmed.

Reflections

The Seventh Circuit found that Greenblatt’s “evasive and at times incredible” testimony in the case and his misuse of the bankruptcy process raised serious ethical and possibly legal concerns. In addition, the court held that both the appeal to the district court and the appeal to the Seventh Circuit were frivolous, and it invited the U.S. trustee to consider applying for sanctions for misconduct in the bankruptcy court and the district court against South Beach, Scattered, Greenblatt, and the attorneys and firms who worked on the case for them. It further ordered all the lawyers and firms involved in the appeal to the Seventh Circuit to show cause why the court should not sanction them for their conduct in the appeal.

In re South Beach Securities, Inc., No. 09-3079 (7th Cir. 5/19/10)