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Equitable Subordination Relief Granted; Recharacterization Relief Denied

U.S. v. State Street Bank and Trust Co., as Trustee for Junior Subordinated Secured PIK Notes, et al. (In re Scott Cable Communications, Inc.), Adv. Proc. No. 01-4605 (KJC), 2014 WL 5298031 (Bankr. D. Del. Oct. 15, 2014).

This recent and lengthy 90-page Opinion by the Honorable Kevin J. Carey arises from the chapter 11 proceedings of Scott Cable Communications, Inc. (“Scott Cable” or the “Company”) and concerns an adversary complaint in which the United States of America, on behalf of the Internal Revenue Service (the “Government” or the “IRS”), sought to recharacterize or equitably subordinate certain secured notes issued in 1996 as part of a chapter 11 reorganization plan.  The secured notes were issued to two classes of creditors and known as “Series A Junior PIK Notes” and “Series B Junior PIK Notes.”  Pursuant to the Order, the Government’s request to recharacterize the Series A Junior PIK Notes as preferred equity instruments of Scott Cable was denied, but the Government’s request to equitably subordinate the Series A Junior PIK Notes to the administrative claims of federal and state taxing authorities was granted.  The Government’s request to recharacterize or equitably subordinate the Series B Junior PIK Notes was denied.

Scott Cable was a multi-system cable operator acquired in a leveraged buyout (“LBO”) in 1988.  On October 1, 1998, Scott Cable filed a chapter 11 petition (the “1998 Bankruptcy Case”) in the Bankruptcy Court for the District of Connecticut (Bridgeport) (the “Connecticut Bankruptcy Court”). This 1998 Bankruptcy Case followed closely on the heels of a 1996 chapter 11 filing by Scott Cable and its affiliated holding companies in Delaware (the “1996 Bankruptcy Case”).  The plan confirmed in the 1996 Bankruptcy Case provided for the distribution of secured Junior PIK Notes to certain creditors who had previously held only unsecured public subordinated debentures (“Public Debentures”) and unsecured junior subordinated notes.

The 1998 Bankruptcy Case included a prepackaged liquidation plan and contemplated a sale of substantially all assets to purchaser Interlink.  The Connecticut Bankruptcy Court denied confirmation of that plan after determining that (i) the capital gains tax owing to the IRS as a result of the proposed sale (which was scheduled to occur post-confirmation) was an administrative expense claim; and (ii) that the principal purpose of the prepackaged plan was to avoid payment of taxes.  See In re ScottCable Commc’n, Inc., 227 B.R. 596 (Bankr. D. Conn. 1998).  The Court later approved a sale of substantially all assets to Interlink outside of a plan.  On November 19, 1998, the Government filed an adversary complaint in the Connecticut Bankruptcy Court against State Street Bank & Trust Co., as Indenture Trustee to the holders of Junior Subordinated Secured PIK Notes (the “Junior PIK Notes”), seeking to disallow the secured claim under section 502(a) on the grounds of recharacterization or, in the alternative, equitable subordination.  In connection with those proceedings, the Connecticut District Court held that the IRS was not barred from bringing the adversary proceeding because the IRS did not receive notice reasonably calculated, under the circumstances, to inform the IRS that its rights might be affected by the 1996 Plan.  In 2001, the Connecticut Bankruptcy Court transferred the adversary proceeding to the Delaware Bankruptcy Court. United States v. State Street Bank and Trust Co. (In re Scott Cable Commc’n, Inc.), 263 B.R. 6 (Bankr. D. Conn.  2001).  The 1998 case was later converted to a chapter 7 case, and the Court granted the chapter 7 trustee’s motion to, among other things, be realigned as a plaintiff in this litigation

As a threshold matter, Defendants argued that the Government’s claims were barred under a number of legal theories, including res judicata, waiver, estoppel, laches, and unclean hands.  Judge Carey undertook a detailed analysis of each of these defenses and ultimately rejected each.  Judge Carey also rejected Defendants’ argument that the Government’s adversary proceeding was a collateral attack to revoke the order confirming the 1996 Plan which, pursuant to Bankruptcy Code § 1144, was untimely.  Judge Carey rejected this argument, finding that section 1144 was inapplicable.  With respect to equitable mootness, the Defendants argued that the Government’s claims were equitably moot, since it would be inequitable to reverse all of the distributions made pursuant to the order confirming the 1996 Plan.  The Government argued that the relief it sought did not include revoking the 1996 Plan confirmation order or undoing transactions made to other classes of creditors thereunder.  Judge Carey agreed with the Government and concluded that the relief sought in the adversary proceeding was not barred by the equitable mootness doctrine.  Finally, Defendants argued that the Government lacked standing to bring the adversary proceeding, as claims for recharacterization and equitable subordination are generally brought by a debtor or other estate representative.  The Government argued that an individual creditor may bring an action for equitable subordination under section 510(c).  Because a chapter 7 trustee had been appointed and joined the litigation as a plaintiff, Judge Carey concluded that the Defendants’ standing argument was moot.

With respect to recharacterization, the Government sought to recharacterize the Junior PIK Notes as equity and asked the Court to consider the facts surrounding the issuance of those notes upon confirmation of the 1996 Plan.  Defendants asserted that the Court should review the circumstances occurring at the outset of the financial relationship between the parties which, for the Series A Junior PIK Notes, was initial issuance of the Junior Notes as part of the 1988 LBO, and, for the Series B Junior PIK Notes, was the issuance of the Public Debentures.  The Government argued that the Junior PIK Notes issued pursuant to the 1996 Plan were an entirely new transaction between the parties.  Consistent with the Third Circuit’s direction in SubMicron, Judge Carey concluded that a recharacterization analysis of the 1996 Junior PIK Notes must be considered in light of the entire relationship of the parties, with particular emphasis on parties’ intent at the initial funding.  See Cohen v. The KB Mezzanine Fund II, L.P. (In re SubMicron Sys. Corp.), 432 F.3d 448 (3d. Cir. 2006).  For the Series A Junior PIK Notes, the focus of the Court’s recharacterization analysis was therefore on the initial issuance of the Junior Notes as part of the 1988 LBO. For the Series B Junior PIK Notes, the Court’s recharacterization analysis was focused on the issuance of the original Public Debentures.  Based on a consideration of the parties’ contract, the parties’ actions, and the economic reality of the surrounding circumstances, Judge Carey determined that the parties intended the issuance of the 1988 Junior Notes as part of the LBO to be debt; that the Junior PIK Notes in the 1996 plan remained debt; and that the Government’s claim for recharacterization of the Series A and Series B Junior PIK Notes must therefore be denied.

Alternatively, the Government asked the Court to equitably subordinate the Junior PIK Noteholders’ secured claim to the administrative claims of federal and state taxing authorities for purposes of distributing the proceeds from the 1998 sale of Scott Cable to Interlink.  Equitable subordination is a remedy provided in section 510(c).  Here, the Court relied on Winstar’s three-factor test in its analysis:  (1) the claimant must have engaged in some type of inequitable conduct; (2) the misconduct must have resulted in an injury to the creditors of the bankrupt or conferred an unfair advantage on the claimant; and (3) equitable subordination of the claim must be consistent with the provisions of the Code.  See Schubert v. Lucent Tech., Inc. (In re Winstar Commc’n, Inc.), 554 F.3d 382, 411 (3d Cir. 2009).  With respect to the Series A Junior PIK Notes, Judge Carey granted the Government’s request for relief in the form of equitable subordination.  In reaching this conclusion, Judge Carey applied the first of Winstar’s three factors and found inequitable conduct in the plan between Scott Cable’s management and the Series A Holders to convert the Series A Holders’ subordinated unsecured debt into secured debt by issuing secured notes through the 1996 Plan.  The Court found that the parties had done so in order to enable the Series A Holders to gain an unfair advantage over the IRS by preventing collection of the capital gains tax, which all parties knew would arise at a later time as it was intended that the assets of the Company would be sold.  Judge Carey noted that the parties determined to grant this lien in the context of a chapter 11 plan in order to obtain the comfort of a confirmation order which included language to inhibit future challenges to the lien transfer.  Judge Carey further noted that this process had allowed the parties to claim that the IRS received notice of the granting of the lien and, further, blame the IRS for not discovering the scheme due to the IRS’s failure to thoroughly review a disclosure statement, which did not contain direct notice but rather scattered clues, in a case in which the IRS was not even a claimant.  With respect to the second Winstar factor, the Court found that the inequitable conduct described above had clearly resulted in both injury to creditors or unfair advantage to the claimants. “The [G]overnment was injured by the attempted impairment of its right to an administrative tax claim based upon the less than arm’s-length negotiations between Scott Management and the Series A Holders. Moreover, the scheme devised by the Series A Holders enabled them to obtain an unfair advantage over the IRS by using the 1996 Bankruptcy Case to ‘leap-frog’ ahead of the IRS’s claim.”  In considering the final Winstar factor, Judge Carey noted that the Government was asserting its rights as an administrative tax claimant in the 1998 Bankruptcy and that subordination of the Series A Junior PIK Notes to the administrative tax claims would actually restore the priorities set by Congress. With respect to the Series B Junior PIK Notes, Judge Carey denied the Government’s request for relief in the form of equitable subordination, finding that the Government had failed to meet its burden of proving gross and egregious conduct by the Series B Holders.

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