KEVIN J. CAREY, UNITED STATES BANKRUPTCY JUDGE.
Before the Court is an adversary complaint in which the United States of America, on behalf of the Internal Revenue Service (the "Government" or "IRS"), asks this Court 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. For the reasons that follow, the request to recharacterize the Series A Junior PIK Notes is denied, but the request to equitably subordinate the Series A Junior PIK Notes is granted. The requests to recharacterize or equitably subordinate the Series B Junior PIK Notes are both denied.
Scott Cable Communications, Inc. (the "Debtor" or "Scott Cable" or the "Company") filed a chapter 11 bankruptcy petition in the United States Bankruptcy Court for the District of Connecticut (Bridgeport) (the "Connecticut Bankruptcy Court") on October 1, 1998 (the "1998 Bankruptcy Case"). This 1998 Bankruptcy Case followed closely on the heels of a 1996 chapter 11 bankruptcy filing by Scott Cable and its affiliated holding companies in the United States Bankruptcy Court for the District of Delaware (the "1996 Bankruptcy Case").
The 1998 Bankruptcy Case included a prepackaged liquidation plan and contemplated a sale of substantially all of the Debtor's assets. On December 11, 1998, the Connecticut Bankruptcy Court denied confirmation of the prepackaged liquidation plan after determining that (i) the capital gains tax owing to the Internal Revenue Service 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 Scott Cable Commc'n, Inc., 227 B.R. 596 (Bankr. D.Conn.1998).
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 Indenture Trustee's secured claim under Bankruptcy Code § 502(a) on the grounds of recharacterization or, in the alternative, equitable subordination.
Some holders of the Junior PIK Notes moved to intervene as defendants in the adversary proceeding, including Media/Communications Partners, L.P., Chestnut Street Partners, Inc., Milk Street Partners, Inc., TA Investments, and Allstate Insurance Company.
This adversary case has been in the hands of four judges and three courts in two jurisdictions. There have been years of discovery and countless motions. A bench trial was held, spanning approximately 34 days over the course of nine months. A lengthy post-trial briefing process and numerous post-trial motions followed. The record is complete and this matter is ripe for adjudication.
This Court has jurisdiction over this adversary proceeding pursuant to 28 U.S.C. § 1334(b) and § 157(a). The Government's claims for recharacterization and equitable subordination of claims against the Debtor's bankruptcy estate are core matters pursuant to 28 U.S.C. § 157(b)(2)(B), the equitable subordination claim directly arises under Bankruptcy Code § 510(c), and both claims require this Court to determine the priority among entities asserting claims against a bankruptcy estate. Resolution of such claims by final order are integral to the objectives set by Congress when enacting the Bankruptcy Code.
Scott Cable, founded by Jim Scott, was a multi-system cable operator ("MSO") that was publicly traded before it was acquired in a leveraged buyout ("LBO") in 1988. (Government Negotiated Facts, D.I. 739, ("Stip. Facts—Gov.") ¶ 1.)
One such investor was Steven Simmons ("Simmons"), owner and officer of Simmons Communications, Inc., an entity that acquired and operated cable television companies. Simmons sought to acquire underperforming MSOs, expecting to increase their value by offering a greater selection of programs, improving management and marketing, and increasing the customer base. (Stip. Facts—Gov. ¶¶ 21-23.) The capital that Simmons Communications used to acquire cable systems was supplied primarily by investment funds and institutional investors. (Id. at ¶ 24.)
On April 17, 1987, Simmons sent a letter about his interest in acquiring Scott Cable to Richard Churchill ("Churchill") of T.A. Associates. (Pl. Ex. 2 at 871.) T.A. Associates was a venture capital firm that invested in technology oriented companies and media or communications companies. (Tr. 10/27/06, D.I. 777 ("Tr. D.I. 777") at 8:21-9:3 (Churchill Test.)).
On September 25, 1987, Scott Cable filed a Proxy Statement with the Securities and Exchange Commission (the "SEC"), which provided notice that a Special Meeting of Shareholders was to be held on October 23, 1987, to consider and vote on a proposal to approve the Agreement and Plan of Merger, dated as of June 12, 1987, as amended (the "Merger Agreement"), pursuant to which Simmons Communications Merger Corp. ("SCM" or the "Merger Corp."), a Texas corporation formed for the purpose of acquiring Scott Cable, would be merged with and into Scott Cable. (Pl. Ex. 15 at 2.) The Proxy Statement provided that the transaction would be structured as a sale of stock, stating, in part, as follows:
(Pl. Ex. 15 at 12.)
The Proxy Statement stated that the debt of Scott Cable, post-merger, would be increased significantly, and "in order to generate sufficient funds to satisfy its obligations, including interest and principal payments, and to meet its working capital and capital expenditure requirements, the Company will have to improve its results of operations and cash flow significantly above historical levels." (Id. at 28.) The Proxy Statement also stated that the proposed financing included, among other sources, $18,000,000 in Junior Subordinate Notes and $4,500,000 of equity contributions, essentially identical to the proposed term sheet between Churchill and Simmons. (Id. at 25.)
In 1987, some bondholders of old Scott Cable, whose bonds were to be assumed by the new, post-merger Scott Cable, filed a lawsuit in the United States District Court for the Southern District of New York, 87 CIV 7369, seeking to enjoin the proposed merger/acquisition of Scott Cable, alleging, among other things, "if the merger is consummated, the immediate effect thereof will be to render Scott Cable insolvent, undercapitalized, or otherwise unable to pay the amount due and owing by Scott Cable to plaintiffs and others under the indenture and the debentures ...." (Stip. Facts—Gov. ¶42.) The lawsuit was settled with a payment by Scott Cable to the bondholders, including payment of the bondholders' attorney fees and other professional fees associated with the lawsuit. (Id. at ¶ 43.) The lawsuit was dismissed with prejudice and no injunction was entered. (Id.)
The LBO was consummated on January 19, 1988, at which time Scott Cable was merged into Merger Corp which, subsequently, was renamed Scott Cable Communications, Inc. (Defendants' Negotiated and Agreed Facts, D.I. 713, "Stip. Facts-Def.," ¶ 3.)
Senior Bank Revolving Credit Agreement $ 56,767,000 8 Series A Zero Coupon Senior Secured Notes due 1/31/93 $ 23,000,000 Series B Zero Coupon Senior Secured Notes due 1/31/93 $ 7,000,000 Series C Zero Coupon Senior Secured Notes due 1/31/93 $ 3,000,000 Series D Senior Secured Notes due 1/31/93 $ 14,000,000 Senior Subordinated Zero Coupon Notes due 7/31/93 $ 8,000,000 Zero Coupon Note due 8/15/93 $ 5,000,0009 Subordinated Debentures due 4/15/01 $ 50,000,00010 Junior Subordinated Notes due 12/31/95 $ 18,000,000 ______________ $184,767,000
(Stip. Facts—Gov. ¶ 64; Stip. Facts—Def. ¶ 4.) A security agreement providing a first priority lien on all assets of Scott Cable was provided to the Banks and to the holders of the Series A, B, C, and D Zero Coupon Senior Secured Notes.
Post-merger, the stock of Scott Cable was owned by six intermediate holding companies: Simmons Communications U.S., Inc.; Simmons Communications of Texas, Inc.; Simmons Communications Central, Inc.; Simmons Communications East, Inc.; Simmons Communications West, Inc.; and Simmons Communications South, Inc. (together the "Holding Companies").
Because the LBO was structured as a stock purchase, and not an asset purchase, post-LBO Scott Cable inherited an adjusted tax basis in the assets of old Scott Cable that had been reduced to take into account depreciation deductions that had been claimed previously. (Stip. Facts— Gov. ¶ 86.) If the assets were sold subsequently at a price in excess of the adjusted tax basis, the sale would produce a taxable gain. (Id. at ¶ 87.)
As was originally proposed in the term sheet between Churchill and Simmons, the Junior Subordinated Notes issued in 1988 (the "1988 Junior Notes") had an aggregate principal value of $18 million, received from the following purchasers:
--------------------------------Purchaser Note Amount -------------------------------- MC Partners $10,440,000 -------------------------------- Allstate $6,000,000 -------------------------------- Chestnut Street $500,000 -------------------------------- TA Investors $480,000 -------------------------------- NE Ventures $400,000 -------------------------------- Milk Street $180,000 --------------------------------
(the "Junior Noteholders").
The Junior Subordinated Note Purchase Agreement dated January 19, 1988 between Scott Cable and the Junior Noteholders (Pl. Ex. 26) (the "Junior Note Agreement") placed certain restrictions upon Scott Cable. For example, the Junior Note Agreement restricted Scott Cable's ability to incur future debt, future
On the same date that the LBO was completed (January 19, 1988), Scott Cable, its subsidiaries, and the Holding Companies entered into a Management Agreement with Simmons Cable TV Management, Inc. ("Simmons Management"). (Stip. Facts—Def. ¶ 40; Def. Ex. 3.) The Management Agreement provided that Simmons Management would be responsible for the day-to-day operations of all of the community antenna television systems (the "Systems") owned by Scott Cable, its subsidiaries, or the Holding Companies, including, without limitation, management of personnel, maintenance, fee collection, marketing, purchases of goods and services, and all policy decisions with respect to the operation of the Systems (including financial planning, establishing rates and prices, subscriber growth, advertising, programming, and representation before governmental or regulatory agencies). (Stip. Facts—Def. ¶¶ 41-42; Def. Ex. 3).
Post-LBO, none of the Junior Noteholders had any direct management oversight with respect to Scott Cable (Tr. 10/19/06, D.I. 760, ("Tr. D.I. 760") at 49:2-5 (Wade Test.)), nor did they hold any seats on Scott Cable's Board of Directors (Stip. Facts—Def. ¶ 43-¶ 44).
The exit strategy of the Junior Noteholders and Simmons Communications in acquiring Scott Cable was to increase the Company's cash flow (which they anticipated would lead to an increase in its fair market value), and liquidate their investment in four to eight years. (Stip. Facts—Gov. ¶ 94.) Post-LBO through 1992, Scott Cable experienced solid growth in system revenue and cash flow. (Pl. Ex. 114 at 1318.) Independent audits of Scott Cable performed by Deloitte & Touche, LLP ("Deloitte") confirmed a positive operating cash flow.
However, changes in regulations related to the banking and cable industries reduced cable company values and thwarted the investors' goal. In 1989, the Comptroller of the Currency instituted changes in regulations adversely affecting "highly leveraged transactions." (Pl. Ex. 114 at 1317.) Because financing in the cable industry tended to be highly leveraged, the
The managers overseeing MC Partners' and Allstate's investments in Scott Cable maintained open and regular communications with Scott Cable about the Company's financial condition and performance. (Stip. Facts—Gov. ¶ 96-¶ 102.) Internal memoranda and testimony of representatives of MC Partners and Allstate show that the Junior Noteholders were concerned about a decrease in the value of Scott Cable. (Stip. Facts—Gov. ¶ 120-¶ 125; ¶ 130-¶ 133.) In July 1990, Simmons noted in a letter to Allstate that the Public Debentures were trading at the reduced price of approximately $.60 on the dollar and proposed that Scott Cable buy back the Public Debentures to reduce interest payments and total outstanding debt. (Stip. Facts—Gov. ¶ 113-¶ 116.) However, Scott Cable did not purchase the Public Debentures. (Stip. Facts—Gov. ¶ 118.)
As concern mounted over the Company's ability to pay its debt instruments that were due to mature in 1993, Scott Cable hired First Boston Corporation, an investment banking company, to assist in developing strategies to meet the Company's obligations, either through a sale of assets or refinancing. (Stip. Facts—Gov. ¶ 119-¶ 120, ¶ 126.) Simmons and the Junior Noteholders recognized that the first option—a sale of Scott Cable's assets—would not generate sufficient funds to pay the 1988 Junior Notes. In a report issued in October 1991, First Boston noted that the value of Scott Cable's assets might be sufficient to pay senior debt, but not to pay the Public Debentures and original equity, including the 1988 Junior Notes, which were listed in the report under the category of "Total Equity and Equivalents." (Stip. Facts—Gov. ¶ 146, ¶ 150-¶ 152.) An internal Allstate memo dated October 11, 1991 reached the same conclusion. (Stip. Facts—Gov. ¶ 128-¶ 133.)
The First Boston report also discussed that "[t]axes will have to be paid on any gain from asset sales with the amount dependent upon the Company's use of the mirror subsidiaries, the relevant stock or assets bases and the amount of existing NOLs."
The October 1991 First Boston report also discussed the option of a restructuring in which the equity holders would purchase the Public Debentures and/or the Scott Note at a discount. (Stip. Facts—Gov. ¶ 149.) Notes of internal discussions at MC Partners over a purchase of the Scott Note reflected concerns that the Public Debenture Holders might seek to equitably subordinate any payment of the Scott Note to the Public Debentures, or senior lenders might seek to require the Junior Noteholders to make an equity infusion, rather than purchase the Scott Note. (Id. at ¶ 156-¶ 157, ¶ 179-¶ 180.) In a May 1992 report, First Boston proposed "that all existing lenders and investors participate in an intermediate term recapitalization which will allow [the Company] to reduce leverage and better position itself for refinancing or sale at the end of 1995." (Pl Ex. 50 at A011207.) Subsequent discussions among First Boston, Simmons and the Junior Noteholders again proposed that the Junior Noteholders purchase the Scott Note due to concerns that, under the intercreditor agreement, Scott could block interest payments to the Public Debentures and "bring the house of cards down." (Stip. Facts—Gov. ¶ 189-194.) Moreover, a default on the Scott Note would trigger cross-defaults on the Public Debentures and, indirectly, in certain senior secured notes. (Id. at ¶ 229; Pl. Ex. 58 at A011405.)
MC Partners, Allstate and the management of Scott Cable determined that Scott Cable should remain as a going concern in the hope that, over the course of two or three years, cable system values would appreciate and a later refinancing or liquidation would provide a favorable recovery. (Id. at ¶ 215). In an internal memo dated June 17, 1993, prepared for the Allstate Venture Capital Division, Richard Doppelt (an Allstate investment manager) noted that Allstate had no choice but to agree to a recapitalization plan involving an extension of the maturity date for the 1988 Junior Notes and committing additional funds to purchase the Scott Note; otherwise, Allstate risked losing its investment. (Id. at ¶ 245-¶ 251.) Likewise, MC Partners' goal during the 1993 restructuring was "to do the minimum amount necessary to keep senior lenders at bay in hopes that, as market conditions improved ... over the next couple of years, that would enable us to then refinance" remaining debt without the need for additional asset sales or liquidating the company. (Id. at ¶ 259 quoting Churchill Dep. at 157.)
On or about June 30, 1993, Scott Cable entered into a series of agreements to restructure Scott Cable's finances (the "1993 Restructuring"). As part of the
The Junior Note Agreement was also amended. (Pl. Ex. 70.) The amendment extended the maturity date of the 1988 Junior Notes to November 15, 2003. (Stip. Facts—Def. ¶ 55.) Scott Cable replaced the 1988 Junior Notes with Junior Subordinated Notes Due 2003 (the "1993 Junior Notes") in the aggregate principal amount of $30,285,640.55, which reflected the original principal amount due to the Junior Noteholders and accrued interest due under the terms of the 1988 Junior Notes. No cash interest was paid on the 1988 Junior Notes. (Stip. Facts—Gov. ¶ 265.) No new money was required to be paid by holders of the 1988 Junior Notes for the 1993 Junior Notes. (Stip. Facts—Gov. ¶ 266.)
The Junior Noteholders also entered into a "Voting Agreement" with the Banks and the Senior Secured Noteholders dated June 30, 1993, which provided that if Scott Cable subsequently filed bankruptcy, the Junior Noteholders would vote only in favor of a proposed plan of reorganization that the Banks and the Senior Secured Noteholders favored. (Stip. Facts—Def. ¶ 59-¶ 60.) Otherwise, the Junior Noteholders were required to vote against any proposed plan of reorganization to which the Banks and Senior Secured Noteholders were opposed. (Id.). The Junior Noteholders entered into a similar Voting Agreement with the Subordinated Secured Noteholders. (Id. at ¶ 61.)
During the time leading up to the 1993 Restructuring, Simmons suggested the possibility of SCC Management entering into an incentive agreement with the Junior Noteholders. (Tr. 10/30/06, D.I. 778, 139:21-24 (Churchill Test.) ("Tr. D.I. 778").) On June 30, 1993, the same date the Junior Note Agreement was amended, the Junior Noteholders and Simmons Management entered into a management incentive agreement (the "1993 Management Incentive Agreement") pursuant to which the Junior Noteholders granted Simmons Management a portion of any recovery obtained on the 1993 Junior Notes. (Stip. Facts—Def. ¶ 67; Pl Ex. 68.) When negotiating the 1993 Management Incentive Agreement, the parties had no discussions about granting a security interest to the Junior Noteholders. (Tr. D.I. 778 at 139:25-140:8.) Rather, the agreement states that it was created because "the parties desire to provide for an incentive to the Manager to enhance the value of the cable television systems owned by Scott [Cable]." (Pl. Ex. 68 A0001; Stip. Facts—Def. ¶ 68.)
In November 1993, Simmons, who was the chief executive officer ("CEO"), chairman and a director of Scott Cable, as well as the president, CEO, and a director of Simmons Management, decided to retire. (Tr. D.I. 778 at 140:9-25; Pl Ex. 74.) Bruce Armstrong ("Armstrong"), who was then a director, president and chief operating officer of Scott Cable, was selected to be the new CEO, chairman and president of Scott Cable, and the new president and CEO of Simmons Management, with the approval of the Banks, Senior Secured
Armstrong and Simmons entered into an agreement in which Simmons transferred his interests in Simmons Communications and Scott Cable to Armstrong.
In September 1994, Armstrong hired HPC Puckett & Company ("HPC"), a cable television broker, to find a buyer for Scott Cable. (Stip. Facts—Gov. ¶ 295; Pl. Ex. 89 at 8238.) In a report dated January 26, 1995, H PC advised that it had entered into confidentiality agreements with 10 prospective purchasers and provided details of its discussions with a few of those MSOs about a potential stock purchase, merger, or other business venture with Scott Cable. (Stip. Facts—Gov. ¶¶ 299; Pl. Ex. 79 at 11121, 11126, 11181.) However, a pattern developed in which any potential buyers' interests waned after learning about the geographic spread of the systems and the low tax basis in the assets. (Pl. Ex. 89 at SCCB 8238.) For example, one operator, Classic Cable, initially offered to purchase Scott Cable for $120 million; but, after a more complete understanding of Scott Cable's tax situation, Classic Cable lowered its offer to $95 million. (Stip. Facts—Gov. ¶ 300-¶ 302; Pl. Ex. 89 at SCCB 8238.) Other offers were made in the range of $95-$100 million, but with a debt load of $148 million, the offers would result in no return to Junior Noteholders and an impaired return to Public Debenture Holders, and were rejected. (Pl. Ex. 89 at SCCB 8239.)
Scott Cable sold off separate cable systems to enable it to make principal payments to the Banks and the Insurance Companies, as required by the 1993 Restructuring. (Stip. Facts—Def. ¶ 75; Pl. Ex. 114 at 1318.) In January 1994, Scott Cable sold its cable system in Rancho Cucamonga, California for approximately $23 million. (Stip. Facts—Def. ¶ 75.) In February 1995, Scott Cable sold certain cable systems in Texas, Oklahoma and Missouri for $12.7 million. (Id. at ¶ 76.) The proceeds of those sales resulted in $33 million in principal payments to the Banks and Insurance Companies. (Id.)
As a result of the 1993 Restructuring, the Bank Loans and Senior Secured Notes were scheduled to mature on November 15, 1995, and the Senior Subordinated Notes were scheduled to mature on January 15, 1996. (Id. at ¶ 78.) By Spring 1995, Scott Cable had no potential buyer for the Company as a whole. Around that time, Armstrong was discussing potential tax consequences of a sale with the secured creditor of a different cable company. The secured creditor told Armstrong
On October 15, 1995, Scott Cable defaulted on an interest payment due to the Public Debenture Holders. (Stip. Facts— Gov. ¶ 338).
Scott Cable retained investment bankers Donaldson, Lufkin & Jenrette ("DLJ") as restructuring advisors. (Pl. Ex. 89 at SCCB 8239.) On November 2, 1995, Scott Cable met with its senior lenders and began negotiations to restructure and refinance the senior debt due to mature on the 15th of that month. (Pl. Ex. 93 at SCCB 8412.) The senior lenders agreed to a 90-day standstill agreement that postponed, until February 15, 1996, the lenders' exercise of their rights upon an event of default. (Id. at SCCB 8412.) The terms of the standstill agreement required Scott Cable: (1) to make a cash payment of $3 million; (2) to pay the previous quarter's interest in cash; (3) to pay, in cash and in advance, any interest that would be incurred during the standstill period; and (4) to obtain approval from senior lenders before paying any management fees during the standstill period. (Id.) The Junior Noteholders were not part of the negotiations and were told of the standstill agreement on November 8, 1995. (Id.) On November 15, 1995, with the standstill agreement in place, Scott Cable defaulted on its senior debt by failing to make the required payment. On November 16, 1995, Scott Cable notified the holders of the Public Debentures of the various defaults, the standstill agreement, and the Company's restructuring efforts. (Pl. Ex. 94; Stip. Facts—Gov. ¶ 371-¶ 372.)
Armstrong, Scott Cable's CEO, acknowledged that if the Company was liquidated in late 1995, the sale proceeds would be insufficient to pay all of the notes. (Stip. Facts—Gov. ¶ 410.) DLJ issued a report
An informal committee, consisting of the larger holders of the Public Debentures and Sandler Capital, which held a number of Public Debentures and a portion of the Unsecured Zero Coupon Notes (the "Informal Bondholders Committee"), was created to negotiate with Scott Cable.
On February 1, 1996, Scott Cable responded to the Informal Bondholders Committee's counter-proposal suggesting, among other things, changes to proposed interest rates and maturity dates. (Pl. Ex. 100, Att. C.) Scott Cable's response also proposed keeping Sandler Capital's interest in the Unsecured Zero Coupon Notes as part of the senior debt, granting second lien noteholders two of the five seats on the Board of Directors and the right to compel Scott Cable to sell after a period of four years. (Id. at 2.) On February 6, 1996, the Informal Bondholders Committee
On February 14, 1996, Scott Cable and the Holding Companies, now named ACE—Central, Inc, ACE—East, Inc., ACE—South, Inc., ACE—Texas, Inc., ACE—U.S., Inc., and ACE—West, Inc., (collectively the "Debtors") filed chapter 11 bankruptcy petitions in the Delaware Bankruptcy Court (the "1996 Bankruptcy Case"). (Stip. Facts—Def. ¶ 85.) An Official Committee of Unsecured Creditors (the "Creditors Committee") was formed, consisting of Home Box Office and holders of the Public Debentures (some of whom had served on the Informal Bondholders Committee. (Pl. Ex. 199 ¶ 4 n. 1; Stip. Facts—Def. ¶ 90.)) No Junior Noteholder or representative thereof was a member of the Creditors Committee. (Stip. Facts— Def. ¶ 92.)
Senior Secured Bank debt: $ 8.3 million
Senior Secured Notes: $ 23.1 million
Senior Subordinated Notes: $ 17.6 million
Unsecured Zero Coupon Notes: $ 13.3 million
Public Debentures: $ 55.0 million
1993 Junior Notes: $ 38.9 million
Trade Debt: $ 1.4 million
______________
$157.6 million
(Pl. Ex. 114 at 1311-1314.) A letter dated April 19, 1996 from the Creditors Committee's counsel to the Committee's members attached a chart showing the enterprise value of Scott Cable falling within a range of $105 million to $142.5 million. (Stip. Facts—Gov. ¶ 419, Pl. Ex. 103.) With Court approval, Scott Cable retained Waller Capital Company ("Waller Capital") as appraisers to determine the fair market value of the Company. (Pl Ex. 114 at 1346.) Waller Capital determined that the fair market value of Scott Cable's cable television systems as of June 30, 1996 was $142,251,000.00 (Id.)
After filing its bankruptcy case, Scott Cable began a campaign to refinance certain existing indebtedness. (Pl. Ex. 114 at 1321.) Initially, Scott Cable sought $65 million to replace all of the secured debt and the Unsecured Zero Coupon Notes on the effective date of a plan of reorganization. (Id.) The remaining indebtedness, including the Public Debentures and 1993 Junior Notes, would be restructured in a plan of reorganization. (Id.) After receiving inquiries from seven financial institutions, Scott Cable began negotiations with two institutions that expressed a strong interest in providing refinancing. (Id. at 1322.) At the conclusion of the process, Scott Cable obtained a commitment letter from Finova Capital Corporation ("Finova") dated September 19, 1996, in which Finova agreed to provide Scott Cable with a term loan of $57.5 million and a revolving loan of $10 million, with a term of five years from the date of closing, secured by a first lien on all of the assets of reorganized Scott Cable and a lien on the New Common Stock of reorganized Scott Cable. (Id. at 1322-23.)
The Creditors Committee and the Debtors engaged in restructuring negotiations, following closely along the lines of the pre-bankruptcy
Around May of 1996, DLJ prepared a presentation discussing the competing proposals between the Creditors Committee and the Debtors, and a proposed cram-down scenario for the Debtors. (Def. Ex. 98.) Each of the proposals assumed 1999 as the exit year in which Scott Cable would be sold. (Id.) The recovery analysis under the Creditors Committee's proposal predicted no recovery for the 1993 Junior Noteholders in the event of a stock sale in 1999, and limited recovery in the event of an asset sale in 1999. (Def. Ex. 98.)
In a letter to Creditors Committee dated April 19, 1996, counsel to the Creditors Committee recommended the following:
(Stip. Facts—Gov. ¶ 420; Pl Ex. 103 at 7.)
After receiving two extensions of the exclusive period in which only the Debtors can file a plan of reorganization and solicit acceptances, the Debtors filed a Disclosure Statement and Joint Plan of Reorganization on August 29, 1996 (the "Initial Plan"). (Pl. Ex. 109.) The cornerstone of the Initial Plan was the $67.5 million in refinancing provided by Finova, which would be used to pay the Senior Bank Loan, the Senior Secured Notes, the Senior Subordinated Notes, and the Unsecured Zero Coupon Notes in full on the plan's effective date. (Pl. Ex. 109 at 1477; Pl Ex. 115 at 2:21-2:24.) The Initial Plan provided that the Public Debenture Holders would receive restructured notes in the full amount of their allowed claims, secured by a second priority lien on Scott Cable's assets that was subordinate to the lien granted to Finova pursuant to the post-confirmation credit facility. (Pl. Ex. 109 at 1486.) The 1993 Junior Noteholders would receive restructured notes in the principal amount of $35 million, secured by a third priority lien on Scott Cable's assets that was subordinate to the liens granted to Finova and the Public Debenture Holders. (Id. at 1487.) The Initial Plan's treatment of the Public Debenture Holders and the 1993 Junior Noteholders was not consensual. (Tr. D.I. 778 at 165:12-165:20.)
Negotiations with the Creditors Committee intensified, not only between the Debtors and the Creditors Committee, but also between representatives of the 1993 Junior Noteholders and the Creditors Committee. (Pl. Ex. 114 at 1324; Tr. D.I. 778 at 165:17-165:20.) Points of negotiation included the Public Debenture Holders' requests for a current cash payment upon confirmation, input into post-confirmation corporate governance, and a deadline for the occurrence of a post-confirmation "transaction event" (such as a merger or sale of reorganized Scott Cable) (Id. 165:21-166:11). In addition, the Public Debenture Holders sought a share of the third priority secured notes to be issued post-confirmation to the 1993 Junior Noteholders. (Id. 166:16-167:4.)
The parties reached an agreement that was reflected in the Debtors' First Amended
The terms of the 1996 Plan provided that certain creditors would be treated as follows:
(Pl. Ex. 114 at 1306-07, 1327-31; 1385-87.)
The 1996 Disclosure Statement explains that no dividends are expected to be paid
Section VII.E. of the 1996 Disclosure Statement (which appeared only in the Second Amended Disclosure Statement) further provided:
(Pl. Ex. 114 at 1344-45.)
The officers of Scott Cable would continue as officers in reorganized Scott Cable, including retaining Bruce Armstrong as the Chief Executive Office of reorganized Scott Cable. (Pl. Ex. 114 at 1336.) Post-confirmation, the common stock of reorganized Scott Cable would be held by the Manager, i.e., Scott Cable Management Co., Inc. (New Class A Common Stock); the Junior PIK Noteholders (New Class B Common Stock); and the Senior PIK Noteholders (New Class C Common Stock). The five-member board of directors of reorganized Scott Cable would be elected annually as follows: two directors elected by the Manager, one director elected by the Junior PIK Noteholders, and two directors elected by the Senior PIK Noteholders. (Pl. Ex. 114 at 1399.)
The 1996 Disclosure Statement advised that DLJ estimated the enterprise value of Scott Cable as a whole fell within a range between $140 and $160 million. (Pl. Ex. 114 at 1346.) The 1996 Disclosure Statement also discussed the appraisal performed by the Debtors' court-approved appraiser, Waller, which determined that the fair market value of Scott's cable television systems as of June 30, 1996 was $142.251 million. (Id.) The Debtors believed the two appraisals were consistent. (Id.)
The Debtors asserted that the 1996 Plan met the Bankruptcy Code's "best interests" test, which the Debtors described as requiring "the Bankruptcy Court [to] find that the Plan provides to each member of each impaired Class of Claims and Interests a recovery which has a present value of the distribution which each such person would receive from its respective debtor if that debtor were instead liquidated under chapter 7 of the Bankruptcy Code." (Id. at 1348.) Exhibit C to the 1996 Disclosure Statement set forth a Liquidation Analysis to demonstrate that the distributions made to impaired creditors under the plan were greater than the distributions—if any— that those creditors would receive in a chapter 7 liquidation. (Id. at 1420-21.)
The Initial Plan and Disclosure Statement did not attach a Liquidation Analysis, but only included an Exhibit C stating that a Liquidation Analysis would be provided. (Pl. Ex. 109 at 1575.) The Liquidation Analysis attached to the First Amended Disclosure Statement described the distribution of "PreTax" Liquidation Proceeds to unsecured creditors as follows:
------------------------------------------------------------------------ Amount Available for Percent Recovery in Percent Recovery Unsecured Creditors (PreTax* ) Liquidation (PreTax) under Plan ------------------------------------------------------------------------ Class 6 (Zero Coupon) 100% 100% ------------------------------------------------------------------------ Class 7 [Public Indentures] 100% 100% ------------------------------------------------------------------------ Class 8 [1993 Junior Notes] 14% 100% ------------------------------------------------------------------------ Class 9 Other Unsecured 69% 100% ------------------------------------------------------------------------
LIQUIDATION ANALYSIS
I. Liquidation Value of Assets of Scott
A. Proceeds from Sale of Operating Businesses $142,251,000a
Before Applicable Discount 21,337,000b
_____________
Less: Applicable Discount $120,914,000
Cash on Hand 10,900,000c
_____________
$131,814,000
B. Costs and Fees of Scott Liquidation $ 1,800,000d
Selling Transaction Fees 1,500,000e
_____________
Chapter 7 Expenses $ 3,300,000
_____________
C. Liquidation Proceeds Available to Scott Creditors $ 128,514,000
II. Recovery By Scott Creditors
A. Liquidation Proceeds Available $128,514,000
B. Scott Liabilities
Secured Creditors 50,000,000
Administrative Expenses 2,000,000f
Tax Claims 43,965,000g
_____________
$ 32,549,000
C. Amount Available for Unsecured Creditors $ 32,549,000
Class 5 (Zero Coupon) ($13,307,105) $ 13,307,105
Class 6 [Public Debentures] ($55,087,153) $ 18,899,895
Class 7 [1993 Junior Notes] ($38,925,797) $ --0--
Class 8 (Other Unsecured) (1,140,000) $ 342,000
Total Unsecured Claims ($108,460,055) $ 32,549,000
The percent of recovery for unsecured creditors included in the 1996 Disclosure Statement's Liquidation Analysis was as follows:
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Percent Recovery in Percent Recovery
Liquidation under Plan
---------------------------------------------------------------------
Class 5 (Zero Coupon) 100% 100%
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Class 6 [Public Debentures] 34% 100%
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Class 7 [1993 Junior Notes] -0- 85%
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Class 8 (Other Unsecured) 30% 100%
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The Initial Plan provided for full payment of priority tax claims, but noted that the Debtors were unaware of the existence of any holders of Allowed Priority Tax Claims. (Pl. Ex. 109 at 1482, 1548.) The Initial Plan also included a section for "Certain Federal Income Consequences of the Plan," which provided—in all capital letters—and in part:
(Pl. Ex. 109 at 1505-06.) The 1996 Disclosure Statement did not change with respect to its treatment of priority tax claims, except to estimate that Allowed Priority Tax Claims paid on the Effective Date were expected to be less than $100,000.00 (Pl. Ex. 114 at 1327.) The language in the section for Certain Federal Income Consequences of the Plan, as quoted above, did not change. (Pl. Ex. 114 at 1351.)
At the time the petition was filed in the 1996 Bankruptcy Case, it was the practice of the U.S. Attorney's Office in Wilmington, Delaware to monitor chapter 11 filings for "large dollar cases," meaning those cases that involved assets of $50 million or more. (Tr. 11/3/2006, D.I. 782 (Tr. D.I. 782) at 30:1-30:19.) The 1996 Bankruptcy Case satisfied the "large dollar case" criterion and on February 26, 1996, the U.S. Attorney's Office opened a file for the 1996 Bankruptcy Case. (Id. at 30:25-31:16; Def. Ex. 193, 194.) On February 28, 1996, an Assistant United States Attorney ("AUSA"), filed a Notice of Appearance, Request for Matrix Entry and Request for Service of Notices and Documents on behalf of the Government. (Def. Ex. 9; Stip. Facts—Def. ¶ 93.)
Also on February 28, 1996, the AUSA sent a letter to the Internal Revenue Service Special Procedures Office in Wilmington, Delaware (the "Wilmington IRS Office") to advise that the 1996 Bankruptcy Case was filed and that it was the responsibility of that IRS office to file a timely proof of claim. (Def. Ex. 191.) On the same date, the AUSA sent a letter to the Assistant District Counsel in the IRS District Counsel's office in Washington, D.C. to advise that the 1996 Bankruptcy Case was a "large dollar case" filing. (Def. Ex. 192.)
On March 4, 1996, the Wilmington IRS Office opened a case on its Automated Insolvency System ("AIS") for the 1996 Bankruptcy Case. (Def. Ex. 25 at 627.) On June 8, 1996, Elizabeth Hennessey ("Hennessey"), a bankruptcy specialist with Wilmington IRS Office, noted in the A IS that the Debtors "were in full compliance pre-petition." (Def. Ex. 25 at 633.)
The AUSA began a leave of absence in June 1996 and, on June 12, 1996, filed a separate Notice of Appearance in the 1996 Bankruptcy Case on behalf of Miriam Howe, ("Howe"), an attorney with the District Counsel Office of the IRS in Washington, D.C. (Tr. D.I. 782 at 61:21-62:10; Def. Ex. 11.) Howe was transferred and, eventually, responsibility for the 1996 Bankruptcy Case was transferred to Sandra Jefferson, a Senior Attorney in the Office of Chief Counsel, Tax Exempt and Governmental Entities Division, located in Baltimore, Maryland. (Tr. D.I. 782 at 127:6-128:14; 129:9-130:13 (Jefferson Test.)) After speaking with Hennessey, on August 21, 1996, Jefferson wrote a memorandum to the District Director, Delaware-Maryland, and to William Spatz ("Spatz"), in the office of Assistant Chief Counsel, Washington, D.C. (the "IRS National Office"), to advise that the debtor entities did not owe any outstanding taxes and, therefore, the case would not be transferred to the Department of Justice to request an extension of the bar date. (Def. Ex. 12 and 13.)
On August 29, 1996, Debtors' counsel served a copy of the Initial Plan upon the service list for Government Agencies that included the AUSA, the Wilmington IRS Office, an IRS office in Philadelphia, PA, and the Secretary of the Treasury, Washington, D.C., among others. (Def. Ex. 111.) Jefferson received a copy of the Initial Plan and Disclosure Statement on September 9, 1996, and forwarded a copy of those documents to Spatz on the same day. (Def. Ex. 14.) In her cover memorandum, Jefferson pointed out that that the IRS did not have any priority tax claims, but noted that such claims were not impaired under the Initial Plan. (Id.)
At that time, Spatz was already responsible for many other assignments, so Kathryn Zuba ("Zuba"), Spatz's supervisor at the National Office, assigned the 1996 Bankruptcy Case to Carol Campbell ("Campbell"). (Tr. 1/19/07, D.I. 787 (Tr. "D.I. 787") at 22:23-23:20 (Campbell Test.)) Campbell had never reviewed a large dollar bankruptcy case before the 1996 Bankruptcy Case. (Id. at 49:13-14.) On September 13, 1996, after reviewing Initial Plan and Disclosure Statement, Campbell prepared a brief memo, signed by Zuba, to other divisions of the IRS National Office, including Corporate, Financial Instruments and Products ("FI & P"), and Income Tax and Accounting ("IT & A"). (Def. Ex. 16.) In the memo, Campbell advises that no claim was filed because it was determined that the Debtors did not owe any taxes, points out sections of the Initial Plan and Disclosure Statement addressing "Federal Tax Consequences" and treatment of priority claims, and asks the divisions to provide any comments on the documents directly to Jefferson. (Id.) Neither Campbell nor Jefferson recall ever being contacted by another IRS division regarding the Initial Plan and Disclosure Statement. (Tr. D.I. 787 at 45:14-46:20 (Campbell Test.); Tr. 12/11/2006, D.I. 783 ("Tr. D.I. 783") at 28:2-29:9 (Jefferson Test.))
On October 16, 1996, Jefferson wrote a memorandum to Campbell advising that October 27, 1996 was the deadline for filing objections to the Initial Plan.
On October 23, 1996, Debtors' counsel served notice and a copy of the First Amended Disclosure Statement and Plan on Howe, at the Washington, D.C. address, and on the same Government Agencies service list, including the AUSA, the Wilmington IRS Office, an IRS Office in Philadelphia, PA, and the Secretary of the Treasury in Washington, D.C., among others.
On November 7, 1996, the Debtors served copies of the Second Amended Disclosure Statement, Second Amended Plan, Notice of Order approving the Second Amended Disclosure Statement and setting deadlines for voting, objections to confirmation and the confirmation hearing; and ballots upon Howe at the Washington, D.C. address, the Wilmington IRS Office, an IRS Office in Philadelphia, PA, and the Secretary of the Treasury in Washington, D.C., among others. (Def. Ex. 120.) In November 1996, Jefferson sent a memo and copy of the Second Amended Disclosure Statement and Plan to Campbell, advising that objections to plan confirmation had to be filed by November 27, 1996. (Def. Ex. 21.) The memo also advised that "[w]e do not intend to file objections since the Plan is unobjectionable and the IRS has not filed a proof of claim. However, we would still like the National Office's views concerning the future tax consequences of the Plan." (Id.) Campbell had no specific recollection of receiving the memorandum and documents, but assumed she did receive them. (Tr. D.I. 787 at 77:20-78:1.)
On December 6, 1996, the Court held a hearing on the confirmation of the Debtors' 1996 Plan. (Pl. Ex. 119.) At the hearing, Debtors' counsel advised the Court that the 1996 Plan was "overwhelmingly accepted by all classes entitled to vote on the plan." (Pl. Ex. 119 at 2:11-14; 3:22-4:1.) Debtors' counsel advised that three objections to the 1996 Plan had been filed: one by a Texas state controller (which was withdrawn), and two by creditors who would be paid in full on the Plan's effective date. (Pl. Ex. 19 at 4:2-14.) In response to the Court's request to run through the requirements of § 1129, Debtors' counsel read a proffer of Armstrong's testimony (Id. at 12-18), which included a proffer that the primary purpose of the plan was not the avoidance of taxes, but rather "to preserve and protect Scott's viable business operations, to maximize distributions to creditors, and to allow creditors to participate in distributions in excess of those which would be available if the chapter 11 cases were converted to cases under chapter 7 of the Bankruptcy Code" (Id. at 14:8-9) and a proffer that confirmation of the plan was not likely to be followed by the liquidation or need for further financial
The 1996 Plan became effective on December 18, 1996. (Pl. Ex. 148 at CTO975.) On the effective date, the following events occurred pursuant to the 1996 Plan: (i) Scott Cable closed on the $67.5 million credit facility with Finova; (ii) the Senior Secured Debt, Subordinated Secured Debt and the Unsecured Zero Coupon Notes were paid in full; (iii) holders of unsecured trade debt were paid in full; (iv) Scott Cable made certain payments to the Public Debenture Holders; (v) Scott Cable issued the Senior PIK Notes and the Junior PIK Notes; (vi) existing common stock was cancelled and the following new stock was issued: Class A common stock representing 1% of equity was issued to management; Class B common stock representing 24% of equity was issued to the 1993 Junior Noteholders; and Class C common stock representing 75% of equity was issued to the Public Debenture Holders. (Id. at CTO975, CTO978-79.) Neither the Public Debenture Holders, the 1993 Junior Noteholders nor management provided any new cash or assets to Scott Cable in exchange for the Senior PIK Notes, Junior PIK Notes or new stock. (Tr. D.I. 776 at 41:7-41:15.)
On December 18, 1996, the Indenture Trustee for the Junior PIK Notes, and Scott Cable executed an Indenture, a Security Agreement, as well as Subordination Agreements, with respect to the Junior PIK Notes. (Pl. Exs. 121, 123-126.) The Junior PIK Notes were divided into two groups: "Series A," consisting of 85% of the total amount available for payment, and "Series B," consisting of the remaining 15% of the total amount available for payment. (Pl. Ex. 126 at 3397.) Consistent with the 1996 Plan, the Series A Junior PIK Notes were distributed to the prior 1993 Junior Noteholders, and the Series B Junior PIK Notes were distributed to the prior holders of the Public Debentures.
After the effective date, Scott Management remained as management of Scott Cable, with Armstrong remaining as CEO. (Pl. Ex. 114 at 1336, 1377.) On the Effective Date, Scott Management and the Series A Junior PIK Noteholders entered into a new management incentive agreement (the "1996 Management Incentive Agreement"). (Pl. Ex. 122.) Under the terms of the 1996 Management Incentive Agreement, the Series A Junior PIK Noteholders agreed to allocate to Scott Management 21 1/2% of any recovery on the Series A Junior PIK Notes or Class B stock. (Id.)
In June 1995, the Federal Communications Commission extended regulatory rate relief to small cable operators, which allowed
After the 1996 Bankruptcy Case, Scott Cable, through its CEO Armstrong, again hired HPC to market the Company. (Id. at 67:21-68:2.) In the summer of 1997, HPC learned that Interlink Communications Partners, LLP ("Interlink") was interested in purchasing substantially all of the assets of Scott Cable. (Id. at 68:3-9; Pl. Ex. 147 at 10796.) Interlink offered initially to purchase Scott Cable's assets in a price range between $136 million and $143 million. (Pl. Ex. 196 at 8:25-9:6.) That offer was rejected as insufficient. (Id.) In October 1997, HPC returned with an offer of $150 million from Interlink, and Scott Cable's board of directors found the price sufficient to start negotiations in earnest. (Id. at 9:7-12.) Due to changes in the market around that time, the Company's board of directors decided that even Interlink's revised offer was too low, and decided to set the price for Scott Cable at $165 million. (Pl. Ex. 196 at 9:13-25.) In acknowledgement of Interlink's investment in the process, Scott Cable offered that price to Interlink prior to starting another marketing campaign, and Interlink accepted. (Id. at 10:1-14.)
Armstrong was aware that the proceeds from the sale to Interlink were not enough to pay the Junior PIK Notes and the tax obligations resulting from the sale. (Tr. D.I. 776 at 69:1-10.) As an officer of Scott Cable, Armstrong was concerned that he and other officers could be held personally liable for authorizing payment of the Junior PIK Notes rather than the taxes. (Id. at 69:1-70:8.) As a result, Armstrong considered a second bankruptcy filing to obtain a court order approving the sale and the payments. (Id.).
In April 1998, Scott Cable's board of directors met with bankruptcy counsel to review plan of reorganization alternatives that could, among other things, provide for closing of the purchase agreement with Interlink after entry of the confirmation order "to insure that tax liability triggered by the sale is not an administrative claim," and include "releases (and injunctive protections) for all officers and directors from all liability including, without limitation, claims of the Internal Revenue Service and state and local taxing authorities relating to tax liability triggered by the sale of assets." (Pl. Ex. 142.)
On July 10, 1998, Scott Cable and Interlink entered into an Asset Purchase Agreement (the "APA") pursuant to which Interlink agreed to purchase substantially all of Scott Cable's cable television systems and related assets for $165 million. (Pl. Ex. 147 at 10797, 10879-10948.) The APA provided that Scott Cable would seek to complete the sale through a chapter 11 bankruptcy plan. (Id. at 10922-24.) The APA provided that closing on the sale would occur "no sooner than sixty (60) days after the entry of the Confirmation Order." (Id. at 10902.)
On August 17, 1998, Scott Cable solicited approval of a pre-packaged liquidating chapter 11 plan by distributing a disclosure statement (the "1998 Disclosure Statement") and ballots to creditors in Class 1 (Finova), Class 2 (Senior PIK Notes) and Class 3 (Junior PIK Notes). (Id. at 10782-83.) The proposed plan of liquidation incorporated the terms, provisions and conditions of the A PA, including the requirement that closing of the sale occur after the entry of a Confirmation Order. (Id. at 10865 ¶ 8.17.) The 1998
(Id. at 10786-87.) In Section VIII titled "Tax Consequences To Debtor Arising From the Sale of the Sale Assets," the disclosure statement further explained that the sale of the Debtor's assets to Interlink would give rise to approximately $37.4 million of federal and state income tax liabilities that would not be paid. (Id. at 10834.) The 1998 Disclosure Statement also provided that, upon effective date of the plan, certain parties, generally, and taxing authorities, specifically, would be enjoined from bringing any action against the Debtor, its officers and directors, and that certain third party releases would be granted. (Id. at 10813-14.)
On October 1, 1998, Scott Cable filed a chapter 11 bankruptcy petition in the Bankruptcy Court for the District of Connecticut (the "1998 Bankruptcy") together with the 1998 Disclosure Statement and the prepackaged plan of liquidation (the "1998 Plan"). At a hearing on November 13, 1998, the Connecticut Bankruptcy Court approved the asset sale to Interlink, free and clear of all liens and encumbrances, under Bankruptcy Code § 363. (Pl. Ex. 196.)
The IRS objected to confirmation of the 1998 Plan, arguing that the plan failed to provide for payment of the capital gains tax arising from the sale as an administrative expense, provided for an injunction in violation of the Anti-Injunction Act (26 U.S.C. § 7421(a)) and because the 1998 Plan's principal purpose was to avoid taxes. In re Scott Cable Commc'n, Inc., 227 B.R. 596, 599 (Bankr.D.Conn. 1998) ("Scott I"). At a hearing on November 23, 1998 on the prepackaged plan and disclosure statement, the Connecticut Bankruptcy Court approved (without objection) the 1998 Disclosure Statement, but—based on the significant objections raised by the IRS—reserved judgment on the 1998 Plan. (Pl. Ex. 197 at 8.)
On December 11, 1998, the Connecticut Bankruptcy Court issued a memorandum opinion and order denying confirmation of the 1998 Plan. Scott I, 227 B.R. at 604. The Court's main reasoning for denying confirmation of the plan was that it failed to satisfy the requirement under Bankruptcy Code § 1 129(d), which provides that a Court may not confirm a plan if the principal purpose of the plan is the avoidance
Id. at 604. The Court further held that the 1998 Plan could not be confirmed because its release provisions would prevent the IRS and other taxing authorities asserting claims for unpaid taxes against officers, directors and others defined as "Company Releasees" in violation of 26 U.S.C. § 7421, the Anti-Injunction Act. Id. at 602.
Failure to obtain confirmation of the 1998 Plan also meant that Scott Cable failed to satisfy a condition precedent to closing the APA. However, Scott Cable and Interlink agreed to extend the sale's closing date and, on January 7, 1999, entered into an amended APA. (Pl. Ex 197 at 10:24-11:5.) On January 14, 1997, the Connecticut Bankruptcy Court approved the Debtor's motion for authority to sell essentially all of its assets to Interlink pursuant to Bankruptcy Code § 363. (Pl. Ex. 197 at 32:8-33:3.)
The sale to Interlink closed on February 12, 1999, and the proceeds paid to Finova and the Senior PIK Notes. (Tr. D.I. 776 at 76:23-77:12; 78:12-24.) See also United States v. State Street Bank and Trust Co. (In re Scott Cable Commc'n, Inc. ("Scott II")), 259 B.R. 536, 542 (D. Conn. 2001). The remaining proceeds (approximately $30,291,296.00) were placed into an interest-bearing escrow account. The claims of the IRS (approximately $37.4 million) and the Junior PIK Noteholders (more than $49 million) remained unpaid. (Scott II, 259 B.R. at 541, 542.)
On November 19, 1998, the Government filed the instant adversary proceeding against the Indenture Trustee for the Junior PIK Notes seeking to recharacterize the Junior PIK Notes as equity. On December 17, 1998, the Government filed an amended complaint adding a claim for equitable subordination of the claims of the Junior PIK Noteholders to the claim of the IRS.
On December 14, 1998, Scott Cable filed a motion to intervene and a Rule 12(c) motion for judgment on the pleadings. On January 4, 1999, the Indenture Trustee filed a motion to dismiss the amended complaint. The Connecticut Bankruptcy Court determined that the Government's adversary proceeding was barred by the res judicata effect of the order confirming the 1996 Plan, but that decision was reversed by the Connecticut District Court. United States v. State Street Bank and Trust Co. (In re Scott Commc'n, Inc.), 232 B.R. 558 (Bankr. D.Conn. 1999) rev'd Scott II, 259 B.R. 536. The Connecticut District Court held that the Government's adversary proceeding was not barred by res judicata, deciding:
Scott II, 259 B.R. at 547-48 (citations omitted).
The Connecticut District Court remanded the adversary proceeding to the Connecticut Bankruptcy Court for further proceedings, and the Connecticut Bankruptcy Court, sua sponte, issued an order to show cause why the venue of the adversary proceeding should not be transferred to the Delaware Bankruptcy Court. United States v. State Street Bank and Trust Co. (In re Scott Cable Commc'n, Inc. ("Scott III")), 263 B.R. 6 (Bankr.D.Conn.2001).
On March 20, 2002, the Indenture Trustee moved for Joinder of Persons Needed for Just Determination seeking to join all Junior PIK Noteholders as defendants to the instant adversary proceeding (the "Joinder Motion"). (D.I. 77.) Before the Joinder Motion was decided, on August 28, 2002, MC Partners, Chestnut Street, Milk Street and TA Investors moved to intervene. (D.I. 100.) On October 4, 2002, the Court entered an order allowing the intervention. (D.I. 116.)
On December 6, 2002, the Court denied the Joinder Motion. (D.I. 160 at 6:14-18.) Instead of joining each Junior PIK Noteholder as a defendant to the adversary, the Court directed that notice of the adversary proceeding be given to the record holders of the Junior PIK Notes, along with the request that the notice be forwarded on to the beneficial owners of the Junior PIK Notes. (Id. at 7:13-10:2.) The Court directed that the notice should (i) attach a copy of the amended complaint; (ii) identify the substantial noteholders who had intervened in the case; (iii) briefly explain the two causes of action; (iv) explain that the interests of all Junior PIK Noteholders in defending the action, especially with respect to Count 2 seeking equitable subordination, may not be identical; and (v) advise that individual Junior PIK Noteholders have the option of moving to intervene in the adversary. (Id.) The Indenture Trustee sent notices regarding this adversary proceeding to the record holders and encouraged Series B Junior PIK Noteholders to intervene. (Tr. 12/14/2006, D.I. 786 at 154:21-155:6; 185:21-186:3.)
The Indenture Trustee moved for summary judgment, arguing, in part, that the relief sought in the complaint was barred by the Court's final order confirming the 1996 Plan. By Memorandum and Order dated December 12, 2003, the Court denied the Indenture Trustee's motion for summary judgment (D.I. 239, D.I. 240.)
Next, the Government moved for summary judgment. (D.I. 267.) After many extensions of the briefing schedule and the filing of cross-motions for summary judgment and other related motions, a "Notice of Completion of Briefing of Dispositive and Related Motions" was filed June 15, 2005. (D.I. 315.) At a hearing on July 22, 2005, my colleague, the Honorable Peter J. Walsh, held that the claims required a fact-intensive analysis and did not lend themselves to summary judgment. (D.I. 318.) He ordered that the matter be scheduled for a trial on the merits. (Id.)
On December 23, 2005, the Government moved that Judge Walsh, who had entered the Order confirming the 1996 Plan, should recuse himself from this case. (D.I. 321.) In its motion, the Government did not allege any bias on the part of Judge Walsh; rather, the Government argued that recusal was appropriate "at least to avoid the appearance of partiality under 28 U.S.C. § 455(a), due to actual and implicit findings in confirming the [1996 Plan] giving rise to the present debtor, Scott Cable Communications, Inc.—and possibly also because of personal knowledge of disputed evidentiary facts within the purview of § 455(b)(1)." (D.I. 322 at 1.) The Defendants opposed the recusal request. (D.I. 323, 324.) Although Judge Walsh determined that the recusal motion was untimely and without merit, he transferred the adversary proceeding to me, concluding that it was in the interest of judicial economy to remove a possibility for appeal and due to scheduling conflicts on his calendar for the start of the trial. (D.I. 328 at 2.)
The Government then filed a motion to re-transfer venue of the adversary proceeding back to the Connecticut Bankruptcy Court (D.I. 331), which was denied by Order dated April 11, 2006 (D.I. 410).
After numerous discovery motions and pre-trial motions, trial began on October 16, 2006, and continued on the following dates: October 17, 18, 19, 20, 23, 25, 26, 27, 30, 31, 2006; November 1, 2, 3, 2006; December 11, 12, 13, 14, 2006; January 19, 2007; February 12, 28, 2007; March 1, 2, 5, 6, 30, 2007; April 23, 2007; and May 10, 22, 23, 24, 25, 2007. Closing arguments were completed on June 22, 2007. Thereafter, the parties began their post-trial briefing, which introduced more rounds of motions. A certification that the record was complete was filed September 2, 2008. (D.I. 801.)
On March 10, 2009, approximately two years after the trial for the instant adversary proceeding had ended, the Connecticut Bankruptcy Court converted the 1998 Bankruptcy Case to chapter 7 and appointed Ronald Chorches as chapter 7 Trustee (the "Trustee"). (D.I. 804 at 2.) The Trustee filed a motion to substitute himself in the adversary proceeding in place of the Debtor, to realign himself as a plaintiff, to supplement the record, and to amend the Complaint to assert a fraudulent conveyance claim. (D.I. 839). The Trustee's motion was granted, in part, to allow the Trustee to be realigned as a plaintiff in this adversary proceeding, and to admit certain documents. However, the Trustee's request to amend the complaint to assert a fraudulent conveyance claim was denied. (D.I. 911).
On June 8, 2009, the Trustee filed an Objection to the Proof of Claim filed by State Street Bank and Trust Company, as Indenture Trustee for the Junior Subordinated PIK Notes (the "Claim Objection") in the Connecticut Bankruptcy Court. On June 25, 2009, U.S. Bank filed a motion to strike the Claim Objection (the "Motion to Strike"). The Trustee filed a Second Amended Claim Objection on November 5, 2009 (the "Amended Claim Objection").
On March 8, 2011, the Connecticut Bankruptcy Court approved an Agreed Order among the Trustee, U.S. Bank and the IRS to transfer the Claim Objection, Amended Claim Objection and Motion to Strike and related pleadings (the "Claim Objection Proceeding") to this Court for disposition. The Claim Objection Proceeding was docketed as Miscellaneous Proceeding 11-00105 in the Delaware Bankruptcy Court on March 16, 2011.
On March 29, 2011, without conceding the necessity of an adversary proceeding, the Trustee filed an adversary complaint in the Connecticut Bankruptcy Court asserting that the Debtor's granting of a lien to secure the Junior PIK Notes was a fraudulent conveyance pursuant to 11 U.S.C. § 544(b) and applicable New York state law. The adversary complaint was amended on March 31, 2011 (the "Amended Complaint").
On May 17, 2011, the Connecticut Bankruptcy Court entered a Consent Order to transfer the Amended Complaint to the Delaware Bankruptcy Court. The Amended Complaint was docketed as Miscellaneous Proceeding 11-00106 in the Delaware Bankruptcy Court on June 2, 2011.
By Memorandum and Order issued simultaneously with this Opinion, I granted the Motion to Strike the Trustee's Claim Objection and granted the Motion to Dismiss the Trustee's Amended Complaint.
The Government's Amended Complaint seeks a determination of the validity, priority and extent of the Junior PIK Noteholders' lien against Scott Cable's assets. The Amended Complaint contains two counts: Count One seeks to recharacterize the Junior PIK Notes as preferred equity instruments of Scott Cable, with no lien against Scott Cable's assets; and Count Two seeks to equitably subordinate the Junior PIK Noteholders' claim to the administrative claims of federal and state taxing authorities.
Recharacterization and equitable subordination are similar causes of action "grounded in bankruptcy courts' equitable authority to ensure `that substance will not give way to form, that technical considerations will not prevent substantial justice from being done.'" Cohen v. The KB Mezzanine Fund II, L.P. (In re SubMicron Sys. Corp.), 432 F.3d 448, 454 (3d Cir.2006) (quoting Pepper v. Litton, 308 U.S. 295, 305, 60 S.Ct. 238, 84 L.Ed. 281 (1939)). Although similar, each cause of action is distinct and must be treated separately. Id. "In a recharacterization action, someone challenges the assertion of a debt against the bankruptcy estate on the ground that the `loaned' capital was actually an equity investment." In re Insilco Techs., Inc. 480 F.3d 212, 217 (3d Cir. 2007). In other words, recharacterization is a determination as to "whether a debt actually exists." SubMicron, 432 F.3d at 454. An equitable subordination analysis, on the other hand, requires the court to review whether an otherwise "legitimate" creditor has engaged in inequitable conduct. Bayer Corp. v. MascoTech, Inc. (In re Autostyle Plastics, Inc.), 269 F.3d 726,-749 (6th Cir.2001).
The Defendants argue that the Government's claims are barred under a number of legal theories. I will address these threshold matters before addressing the merits of the case.
Attempting to resurrect one of their oldest arguments, the Defendants contend that the doctrine of res judicata bars the Government from bringing this adversary proceeding. The Defendants argue that the IRS, as a party in interest in the 1996 Bankruptcy Case, is bound by the order confirming the 1996 Plan and cannot challenge the issuance of the Junior PIK Notes. In response, the Government argues that the law of the case doctrine precludes the Defendants from re-raising the res judicata defense. In Scott II, the Connecticut District Court determined that the principles of res judicata did not bar the IRS from bringing the adversary proceeding because the IRS did not receive notice reasonably calculated, under the circumstances, to inform it that its rights might be affected by the 1996 Plan. Scott II, 259 B.R. at 548. The IRS asserts that the Connecticut District Court's decision is the law of the case on this issue.
"The law of the case doctrine `limits relitigation of an issue once it has been decided' in an earlier stage of the same litigation." Hamilton v. Leavy, 322 F.3d 776, 786-87 (3d Cir.2003) quoting In re Continental Airlines, Inc., 279 F.3d 226, 232 (3d Cir.2002). "The purpose of this doctrine is to promote the `judicial system's interest in finality and in efficient administration.'" Hayman Cash Register Co. v. Sarokin, 669 F.2d 162, 165 (3d Cir. 1982) quoting Todd & Co., Inc. v. S.E.C., 637 F.2d 154, 156 (3d Cir.1980).
"[T]he law of the case doctrine does not restrict a court's power but rather governs its exercise of discretion." In re City of Philadelphia Litig., 158 F.3d 711,
The Defendants argue that the law of the case doctrine does not prevent this Court from reconsidering their res judicata defense due to (1) new facts uncovered during discovery and at the trial; (2) new defendants who intervened in this adversary after the Scott II decision; and (3) new facts which establish that the Connecticut District Court's opinion in Scott II is manifestly unjust.
The Defendants argue that the Scott II Court decided the res judicata issue on a motion for summary judgment, without a fully developed factual record. As a result of the extensive discovery process and testimony of IRS employees at the trial, more detailed information has come to light regarding the Government's review of the 1996 Plan documents. The Defendants contend that the newly discovered facts require a new analysis of the res judicata defense.
The new facts that the Defendants ask the Court to consider include: (i) the number of Government employees who were forwarded copies of the various versions of Scott Cable's plans and disclosure statements during the 1996 Bankruptcy Case for review and comment; (ii) internal memos noting that the IRS did not intend to file an objection to the 1996 Plan because it was "unobjectionable" and the IRS had not filed a proof of claim; and (iii) internal IRS manuals, which instruct IRS lawyers to assess whether a bankruptcy case raises "postconfirmation issues" or whether a plan could create "adverse tax consequences." The inference the Defendants want the Court to draw from the new facts is that the IRS understood the future tax consequences of the 1996 Plan and found the plan "unobjectionable." I do not agree that such an inference arises here.
The Defendants further argue that the new facts change the res judicata analysis because those facts show that the IRS should have known that adverse tax consequences could arise from the 1996 Plan and should have objected prior to confirmation of the 1996 Plan. However, I disagree with the Defendants' assertion that the new facts concerning the IRS's conduct, if they had been available to Connecticut District Court, would have changed the outcome of the previous decision.
After a close review of the 1996 Plan and 1996 Disclosure Statement, the Scott II Court held, as a matter of law, that those documents failed to provide the IRS with the requisite notice that the 1996 Plan could affect the IRS's future pecuniary interests. The Connecticut District Court determined that the documents did not disclose "that an intended or possible consequence of the plan was that under certain scenarios the IRS would be precluded from, or limited in any way in, pursuing a claim against Reorganized Scott once the [1996 Plan] was confirmed." Scott II, 259 B.R. at 546. The Scott II Court noted that the 1996 Disclosure Statement purported to describe "certain federal income tax consequences of the plan," but made no mention of those intended or potential tax consequences, and, in particular, did not
Regardless of the Government's actions or inactions, the Scott II Court concluded that the 1996 Plan and Disclosure Statement were not reasonably calculated to inform even a sophisticated party-in-interest like the IRS that its pecuniary interests could be affected by the 1996 Plan. The "new facts" cited by the Defendants do not change this conclusion of law.
The Defendants argue that those Defendants who intervened after Scott II was decided are not bound by that decision, relying on the Third Circuit Court's decision in Hamilton, 322 F.3d at 787 ("the law of the case doctrine should not be read so rigidly that it precludes a party from raising an argument that it had no prior opportunity to raise" (internal quotations omitted)). Hamilton, however, is distinguishable. In Hamilton, the plaintiff amended the complaint to add new defendants after the court ruled that the earlier-named defendants had violated the plaintiff's Eighth Amendment rights. The Third Circuit determined that the law of the case did not prevent the new defendants from arguing that they did not violate the plaintiff's Eighth Amendment rights. Id. The issue was a factual one particular to each defendant.
In contrast, the intervening defendants here seek to re-litigate a previously decided legal issue and the result does not change with respect to individual defendants. "[P]ermission to intervene does not carry with it the right to relitigate matters already determined in the case, unless those matters would otherwise be subject to reconsideration." Arizona v. California, 460 U.S. 605, 615, 103 S.Ct. 1382, 1389, 75 L.Ed.2d 318 (1983). See also Galbreath v. Metropolitan Trust Co. of Calif., 134 F.2d 569, 570 (10th Cir.1943) ("[O]ne who intervenes in a suit in equity thereby becomes a party to the suit, and is bound by all prior orders and adjudications of fact and law as though he had been a party from the commencement of the suit.")
Finally, the Defendants argue that the law of the case should not be applied here because the new facts show that Scott II was clearly erroneous and, if allowed to stand, would be manifestly unjust. See Philadelphia Litig., 158 F.3d at 718. However, for the reasons stated above, the decision of the Scott II Court was a legal determination about the lack of adequate notice to the IRS in the 1996 Plan and 1996 Disclosure Statement. Additional facts in the record before this Court do not alter this legal conclusion and do not render the decision "clearly erroneous" or "manifestly unjust."
Because the Scott II Court's decision regarding the lack of reasonable notice given to the IRS is the law of the case, other defenses raised by the Defendants that are grounded on the Government's failure to object to the 1996 Plan—in particular, waiver, equitable estoppel, and laches—must also be rejected.
The Defendants further claim that the Government's proceeding should be barred by the doctrine of unclean hands,
"To prevail on an `unclean hands' defense, the defendant must show fraud, unconscionability, or bad faith on the part of the plaintiff." Sonowo v. U.S., 2006 WL 3313799, 3 (D.Del. Nov. 13, 2006) citing S & R Corp. v. Jiffy Lube Int'l, Inc., 968 F.2d 371, 377 n. 7 (3d Cir.1992). The Third Circuit Court of Appeals has recognized that "the primary principle guiding application of the unclean hands doctrine is that the alleged inequitable conduct must be connected, i.e., have a relationship, to the matters before the court for resolution." New Valley Corp. v. Corporate Prop. Assoc. 2 and 3 (In re New Valley Corp.), 181 F.3d 517, 525 (3d Cir. 1999). "As an equitable doctrine, application of unclean hands rests within the sound discretion of the trial court." Id.
This record does not reflect conduct that would support a finding of fraud, unconscionability or bad faith by the IRS in Scott II. Further, the Scott II Court's decision of inadequate notice was not based upon the actions or inactions of the IRS, but upon the 1996 Plan documents' failure to provide full and fair disclosure.
The Defendants also contend that the Government's adversary proceeding is a collateral attack to revoke the order confirming the 1996 Plan which, pursuant to Bankruptcy Code § 1144, is untimely. Bankruptcy Code § 1144 provides:
11 U.S.C. § 1144 (emphasis added).
Id. at 733 (citations and internal quotations omitted). On remand, the bankruptcy court in Genesis held that § 1144 did not bar the fraud claims against the non-debtor co-defendants, noting: "there ought to be a remedy to redress the harms suffered and a mechanism to divest the alleged tortfeasors of their ill-gotten gains, at least where doing so would not affect innocent parties." In re Genesis Health Ventures, Inc., 355 B.R. 438, 445 (Bankr.D.Del.2006).
The Government was not a plan participant in the 1996 Bankruptcy Case. The Government did not name Scott Cable as a defendant to its action (although it later intervened) and, further, is not trying to "redivide" the pie created by the 1996 Plan. The Government's claims contest the priority of payments among competing creditors in the 1998 Bankruptcy Case. As discussed above, the Connecticut District Court has held that the Government did not have adequate notice of the 1996 Plan's possible future effect on its pecuniary interests and, therefore, the matter was not adjudicated as part of the confirmation of the 1996 Plan.
Moreover, the relief sought by the Government does not disturb the 1996 Plan distributions to any plan participants. The confirmed 1996 Plan constitutes an enforceable contract between Scott Cable and its creditors, equity security holders and others. See In re Accuride Corp., 439 B.R. 364, 367 (Bankr.D.Del.2010) citing 11 U.S.C. § 1141(a). The Debtors complied with that contract by distributing Junior PIK Notes to the 1993 Junior Noteholders and the Public Debenture Holders. The Government's current challenge to the Junior PIK Noteholders' liens is similar to challenging a pre-bankruptcy security agreement granted by a debtor to a secured creditor. Because this adversary proceeding involves a 1998 plan participant questioning priorities under the 1998 Plan, I conclude that Bankruptcy Code § 1144 is not applicable.
The Defendants next argue that the Government's claims are equitably moot, since it would be inequitable to reverse all of the distributions made pursuant to the order confirming the 1996 Plan. The Government reiterates that the relief it seeks does not include revoking the 1996 Plan confirmation order or undoing transactions made to other classes of creditors under the 1996 Plan.
The equitable mootness doctrine states that an action should "be dismissed as moot when, even though effective relief could conceivably be fashioned, implementation of that relief would be inequitable." In re Continental Airlines, Inc., 91 F.3d 553, 559 (3d Cir.1996) ("Continental I"). "Equitable mootness . . . does not ask whether a court can hear a case, but whether it should refrain from doing so because of the perceived disruption and harm that granting relief would cause." Samson Energy Resources Co. v. Semcrude, L.P. (In re Semcrude, L.P.), 728 F.3d 314, 316 (3d Cir.2013). "[E]quitable mootness is most often applied in the context of an appeal, but it applies with equal force to actions brought to revoke a plan of reorganization." Almeroth v. Innovative Clinical Solutions, Ltd. (In re Innovative Clinical Solutions, Ltd.), 302 B.R. 136, 141 (Bankr.D.Del.2003).
The Third Circuit has decided that an equitable mootness analysis should consider (i) whether a confirmed plan has been substantially consummated; and (ii) if so, whether granting the relief requested in the appeal will (a) fatally scramble the plan and/or (b) significantly harm third parties who have justifiably relied on plan confirmation. Semcrude, 728 F.3d at 321. The Defendants argue that the 1996 Plan was substantially consummated and that it is too late to "unscramble the egg" and all of the transactions completed years ago with a number of parties not before this Court. The Defendants also assert that application of the equitable mootness doctrine is particularly relevant in this matter to preserve of the finality of confirmation orders.
The relief sought in this adversary proceeding is not barred by the equitable mootness doctrine. As discussed above, the Government's claims do not seek to unravel the entirety of distributions made pursuant to the 1996 Plan. The outcome of this adversary affects the lien given to one series of notes issued under the 1996 Plan, and the holders of those notes are Defendants before the Court, or received notice and an invitation to intervene in this proceeding. Semcrude, 728 F.3d at 321 (If a plan is substantially consummated, a court should next consider "whether granting relief will require undoing the plan as opposed to modifying it in a manner that does not cause its collapse.") The equities in this case do not favor dismissal.
The Defendants next argue that the Government lacks standing to bring the instant proceeding, arguing that claims for recharacterization or equitable subordination are generally brought by a debtor or other estate representative. See Bezanson v. Bayside Enter., Inc. (In re Medomak Canning), 922 F.2d 895, 902 (1st Cir.1990) ("The Trustee is ordinarily the appropriate party to seek equitable subordination on behalf of the estate and unsecured creditors. Generally, an unsecured creditor may assert equitable subordination only where the Trustee has refused to do so and the court grants an unsecured creditor leave to contest a claim.") The Defendants point out that the Government did not seek permission to pursue its claims.
The Government argues, in response, that an individual creditor may bring an action for equitable subordination under Bankruptcy Code § 510(c) which, unlike §§ 544(b), 545, 547, 548 and 549, does not grant such powers to a trustee. See Matter of Vitreous Steel Products Co., 911 F.2d 1223, 1231 (7th Cir.1990) (deciding that a creditor has standing under § 510(c) since, in some instances, equitable subordination will not benefit all unsecured creditors equally.)
At this point in the litigation, however, a chapter 7 trustee has been appointed and has joined the litigation as a plaintiff. The standing argument is rejected as moot.
I conclude that the Defendants' threshold defenses and objections have no merit and, therefore, I will consider the Government's claims for recharacterization and equitable subordination.
The recharacterization of debt to equity is a fact-specific inquiry, and many courts have relied upon multi-factor tests to analyze the issue. SubMicron, 432 F.3d at 455-56. Often the tests are borrowed from tax cases seeking to recharacterize debt as equity for tax liability purposes, such as the 11-factor test used by the Sixth Circuit Court of Appeals.
The Third Circuit recognized that the multi-factor tests include pertinent factors, but determined that "[n]o mechanistic scorecard suffices" for a recharacterization inquiry. SubMicron, 432 F.3d at 456. Instead, the Third Circuit decided that:
SubMicron, 432 F.3d at 456 (emphasis added). See also Friedman's Liquidating Trust v. Goldman Sachs Credit Partners, L.P. (In re Friedman's Inc.), 452 B.R. 512, 519 (Bankr.D.Del.2011) (reading SubMicron to require a recharacterization analysis to focus on the overarching inquiry of the parties' intent, rather than a multi-factor test).
The Government seeks to recharacterize the Junior PIK Notes as equity and asks the Court to consider the facts surrounding the issuance of those notes upon confirmation of the 1996 Plan. The Defendants disagree, however, and assert 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.
In SubMicron, the Third Circuit determined that "the focus of the recharacterization inquiry is whether `a debt actually exists,' . . . or, put another way, we ask what is the proper characterization in the first instance of an investment." SubMicron, 432 F.3d at 454 quoting AutoStyle Plastics, 269 F.3d at 748 (emphasis added). In this context, the SubMicron Court noted, the term re characterization is actually misleading. Id. at n. 7 citing Citicorp Real Estate, Inc. v. PWA, Inc. (In re Georgetown Bldg. Assocs. Ltd P'ship), 240 B.R. 124, 137 (Bankr.D.D.C.1999) ("The debt-versus-equity inquiry is not an exercise in recharacterizing a claim, but of characterizing the advance's true character.") (emphasis in original); In re Cold Harbor Assocs., L.P., 204 B.R. 904, 915 (Bankr. E.D.Va.1997) ("Rather than recharacterizing the exchange from debt to equity, . . . the question before this Court is whether the transaction created a debt or equity relationship from the outset."). Accordingly, in characterizing an instrument as debt or equity, a court must focus its inquiry to a point at the very beginning of the parties' relationship. See AutoStyle, 269 F.3d at 748-49 ("Recharacterization is appropriate where the circumstances show that a debt transaction was actually an equity contribution ab initio") (internal quotations omitted).
The Government argues that the Junior PIK Notes issued pursuant to the 1996 Plan were an entirely new transaction between the parties because, unlike the 1993 Restructuring that simply amended an already-existing agreement, the 1996 Plan provided creditors with a new instrument subject to a new agreement. In those terms, the Government is correct, but only in form, not substance.
Consistent with the Court's direction in SubMicron, I conclude that a recharacterization analysis of the 1996 Junior PIK Notes must be considered in light of the entire relationship of the parties,
The 1988 Junior Notes and the Junior Note Agreement included many provisions that are typical for debt instruments. The 1988 Junior Notes had a fixed maturity date and fixed rate of interest. The Junior Note Agreement specified a number of events of default. Should certain events of default occur, the Junior Note Agreement provided that the notes immediately became due and payable and the Junior Noteholders could exercise all rights and remedies provided for in the Notes, the Junior Note Agreement or at law or equity. The Junior Note Agreement also restricted some of Scott Cable's actions; for example, Scott Cable's ability to incur future debt or future liens, to enter into any transaction of merger, acquisition or consolidation, or to enter into certain transactions with any officer, director or shareholder — all of which are ordinary protections for a lender.
The documents also include provisions that sometimes tend to indicate funding is equity, rather than debt. For example, the 1988 Junior Notes deferred payment of interest until maturity. Compare Off'l Comm. v. Highland Capital Mgmt. L.P. (In re Moll Indus., Inc.), 454 B.R. 574, 582 (Bankr.D.Del.2011) (a transaction that defers repayment of interest indicates a transaction may be intended as equity) with AutoStyle, 269 F.3d at 750-51 (deferral of interest payments on its own does not prove the parties intended the debt transaction to be equity). In addition to payment of interest at a fixed rate, the 1988 Junior Notes had a contingency interest feature that provided for an additional payment on the notes' maturity based upon a percentage of the increase in fair market value of Scott Cable, if any, but the contingent interest was capped at a certain amount. Courts have also viewed the absence of a sinking fund for repayment to be evidence that funds were capital contributions. AutoStyle, 269 F.3d at 753. Furthermore, an agreement to subordinate repayment of funds to claims of all other creditors indicates that advances were equity, rather than debt. AutoStyle, 269 at 752.
The general form and overall content of the 1988 Junior Notes and the Junior Note Agreement weigh in favor of finding that the Junior Notes represent debt of Scott Cable. The deferred interest rate and subordination provisions indicate that the Noteholders were understood to be at the end of the line, but that they expected repayment pursuant to fixed terms on or before the maturity date. Even the contingency interest feature supports this finding—rather than tying repayment
The Government argues that the Defendants' actions contradicted any "debt" provisions in the documentation. For example, despite being labeled as "notes," there is evidence that internal reports of the noteholders or of consultants to Scott Cable included the 1988 Junior Notes (and the 1993 Junior Notes) in categories labeled "equity" or "equity and equivalents." These internal reports are not controlling on this issue. Documentation available to outsiders, for example the annual Deloitte & Touche, LLP audited financials, always included the 1988 Junior Notes under "Notes and Loans Payable."
The Government also argues that the maturity date in the 1988 Junior Notes was meaningless, since it was continually extended without payment. A willingness to postpone repayment of the indebtedness has been viewed by some courts as a characteristic of equity. See Slappey Drive Ind. Park v. U.S., 561 F.2d 572, 582 (5th Cir.1977) (Failure to insist upon timely repayment or satisfactory renegotiation indicates an expectation to recover more than the announced interest rate); Flint Indus., Inc. v. Comm'r, 82 T.C.M. (CCH) 778, 2001 WL 1195725, * 12 (U.S. Tax Ct.2001) ("Evidence that a creditor did not intend to enforce payment or was indifferent as to the exact time the advance was to be repaid belies an arm's-length debtor-creditor relationship"); Aquino v. Black (In re AtlanticRancher, Inc.), 279 B.R. 411, 437 (Bankr.D.Mass.2002) (Despite proper documentation, the creditor never made any effort to collect the note, thus treating it as an investment).
In the above cases, the creditors chose not to collect the indebtedness, waiting instead until the company had "plenty of cash" (Slappey, 561 F.2d at 582) or deciding not to foreclose and collect, because doing so would put the company out of business (AtlanticRancher, 279 B.R. at 437). In this case, the evidence shows that demanding payment at the point of maturity would have been futile since Scott Cable had insufficient funds or value available to pay the subordinated debt. At that point, the Defendants had only a Hobson's Choice: extend the maturity date and possibly recover funds in the future or force a liquidation and, most likely, receive no payment. The evidence in this case also shows that—at the time the 1988 Junior Notes were issued—Simmons Communications and the 1988 Junior Noteholders expected that internal changes would increase the Company's revenues and allow the 1988 Junior Noteholders to obtain full payment on the Notes in four to eight years. Outside forces, such as increased regulation of cable companies in 1992, prevented the parties from realizing that goal.
The Government also argues that evidence demonstrated that the Junior
The Government claims that the 1993 and 1996 Management Incentive Agreements created an identity of interest between management and the Junior Noteholders/Series A Holders. Court have considered "identity of interest" as a sign of equity when there is an exact correlation between the ownership interests of the equity holders and their proportionate share of the alleged loan. AutoStyle, 269 F.3d at 751. Here, there was no such proportionality. "Identity of interest" also occurs when the interests of the shareholder/lenders and the corporation are so entwined that an arm's-length relationship is unlikely. Fin Hay Realty Co. v. United States, 398 F.2d 694, 698 (3d Cir.1968). Any identity of interest created by the Management Incentive Agreements did not exist at the outset of the parties' relationship.
Overall, the conduct of the Junior Noteholders is consistent with creditors who seek repayment of a debt. As the Company's finances became distressed, the Junior Noteholders actively sought more information and input to prevent the indebtedness from being wiped out. The subordinated position of the Junior Noteholders caused them to fall within a number of factors that are usually identified with equity, but the Court's job is to evaluate the factors, not just count them. I conclude that the Junior Noteholders' conduct throughout the parties' relationship is consistent with that of a lender—albeit a subordinated lender with no security.
To determine whether a transaction is debt or equity, a court should also consider the economic circumstances in which the funds were provided to the company. Courts may question whether a prudent lender would have extended credit to the debtor under similar circumstances. Moll Indus., 454 B.R. at 584. See also
In a debt/equity analysis, courts also consider whether the debtor was undercapitalized when the transaction took place. The Government argues that the Junior Noteholders held equity, not debt, because Scott Cable was undercapitalized when the Junior Noteholders initially obtained their notes upon completion of the LBO, and Scott Cable remained severely undercapitalized through the issuance of the Junior PIK Notes as part of the 1996 Plan. "[W]hen a corporation is undercapitalized, a court is more skeptical of purported loans made to it because they may in reality be infusions of capital." SubMicron, 432 F.3d at 457 quoting AutoStyle, 269 F.3d at 746-47. See also Flint, 2001 WL 1195725 at * 14 ("Inadequate or `thin' capitalization is strong evidence of a capital contribution where: (1) [t]he debt-to-equity ratio was initially high; (2) the parties realized that it would likely go higher; and (3) substantial portions of these funds were used for the purchase of capital assets and for meeting expenses needed to commence operations.") Courts will also examine the proposed source for repayment of interest and principal to a lender.
Fischer v. U.S., 441 F.Supp. 32, 39 (E.D.Pa.1977) (emphasis added).
In this case, the record shows that Scott Cable was thinly capitalized after the LBO and the Proxy Statement filed in connection with the transaction noted that the Company needed to improve its operations and cash flow "significantly above historic levels" to meet its obligations. However, the evidence also shows that the parties expected that Scott Cable would experience a growth in system revenue and cash flow to enable the Junior Noteholders to receive payment within four to eight years of the LBO. There was evidence that Scott Cable enjoyed an increase in revenues for a short period post-LBO, but changes in regulations related to the banking and cable industries caused the Company to lose value, jeopardizing payment of subordinated creditors, like the Junior Noteholders.
The facts surrounding the issuance of the 1988 Junior Notes as part of the LBO leads me to conclude that the parties intended
The issuance of the Junior PIK Notes in 1996 cannot be viewed as an entirely new transaction, but as a continuance of the Junior Note indebtedness that had its genesis in the 1988 LBO. The Junior PIK Notes reflect all indicia of indebtedness, including the issuance of notes with payment at a fixed interest rate (although payment of interest was deferred) and a maturity date of five years and seven months after the 1996 Plan's effective date. Moreover, issuance of the Junior PIK Notes was accompanied by the grant of a security interest. On the other hand, the holders of the Junior PIK Notes were also given Class B Common Stock and the ability to elect one member to the Board of Directors. The liquidity crisis faced by Scott Cable in 1996 was clear and known to the parties. The liquidation analysis attached to the final 1996 Plan projected no recovery for Junior Noteholders in the event of a liquidation.
The Government argues that a multi-factor recharacterization analysis supports its position that the 1996 Junior PIK Notes should be characterized as equity issued by the reorganized Scott Cable, rather than debt. However, in SubMicron the Third Circuit decided that it was appropriate to review later advances by an existing lender in light of the ongoing relationship and recognizing that "when existing lenders make loans to a distressed company, they are trying to protect their existing loans and traditional factors that lenders consider (such as capitalization, solvency, collateral, ability to pay cash interest and debt capacity ratios) do not apply as they would when lending to a financially healthy company." SubMicron, 432 F.3d at 457 quoting the District Court SubMicron opinion, 291 B.R. at 325. This rationale has been followed in subsequent recharacterization cases. Moll Indus., 454 B.R. at 583-84 (citing SubMicron); Radnor Holdings, 353 B.R. at 839 (same).
The Series A Junior PIK Noteholders had the ability to elect one member of a five-member board for reorganized Scott Cable, which is not enough to control the Company. However, the Series B Junior PIK Noteholders (who were also the Senior PIK Noteholders) had the ability to elect two members to reorganized Scott Cable's five-member board. Presumably, then, the Series A Holders and Series B Holders, together, could control reorganized Scott Cable's board. However, the SubMicron Court determined that an existing lender's participation on the board of a distressed company after its loan is in jeopardy does not support an equity characterization. SubMicron, 432 F.3d at 457-58. See also Radnor Holdings, 353 B.R. at 839-40.
Overall, the circumstances surrounding the issuance of the Junior PIK Notes in the 1996 Plan, especially when viewed in light of the parties' prior debt relationship, indicate that the Junior PIK Notes remained debt. The Government's claim for recharacterization of the Series A and Series B Junior PIK Notes will be denied.
Alternatively, the Government asks the Court to equitably subordinate
11 U.S.C. § 510(c). The Third Circuit has described equitable subordination as "a `remedial rather than penal' doctrine designed `to undo or to offset any inequality in the claim position of a creditor that will produce injustice or unfairness to other creditors in terms of the bankruptcy results.'" Schubert v. Lucent Tech., Inc. (In re Winstar Commc'n, Inc.), 554 F.3d 382, 411 (3d Cir.2009) quoting Citicorp Venture Capital, Ltd. v. Comm. of Creditors Holding Unsecured Claims, 323 F.3d 228, 233-34 (3d Cir.2003). Courts have further described § 510(c) as follows:
In re Mid-American Waste Sys., Inc., 284 B.R. 53, 68 (Bankr.D.Del.2002) quoting Burden v. United States, 917 F.2d 115, 117 (3d Cir.1990) in turn, quoting Pepper v. Litton, 308 U.S. 295, 307-08, 60 S.Ct. 238, 245-46, 84 L.Ed. 281 (1939).
The party seeking to subordinate a claim has the initial burden of coming forward with material evidence to overcome the prima facie validity accorded to proofs of claim. Mid-American Waste, 284 B.R. at 69. Then, the burden shifts to the claimant to demonstrate the fairness of its conduct. Id. The burden on the claimant is not only to prove the good faith of the parties to the transaction, but also to show the inherent fairness from the point of view of the debtor corporation and those with interests therein. Id.
In Winstar, the Third Circuit adopted the widely-used three-factor test that must be satisfied before deciding whether equitable subordination of a claim is appropriate: (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 Bankruptcy Code. Winstar, 554 F.3d at 411 (internal punctuation omitted) quoting Benjamin v. Diamond (In re Mobile Steel Co.), 563 F.2d 692, 699-700 (5th Cir.1977). See also, e.g., In re Sentinel Mgmt. Group, Inc., 728 F.3d 660, 669 (7th Cir.2013) (citing three-factor test); Henry v. Lehman Commercial Paper, Inc. (In re First Alliance Mortg. Co.), 471 F.3d 977, 1006 (9th Cir. 2006) (same); Estes v. N & D Prop., Inc. (In re N & D Prop., Inc.), 799 F.2d 726, 731 (11th Cir.1986) (same).
In this case, the facts surrounding the grant of security interests to the Series A and the Series B Junior PIK Noteholders
The type of misconduct that will satisfy the first prong varies depending on whether the alleged bad actor is an "insider" of the debtor. When the claimant is an insider, the standard for finding inequitable conduct is much lower. Mid-American Waste, 284 B.R. at 70. "A claim arising from the dealings between a debtor and an insider is to be rigorously scrutinized by the courts." Winstar, 554 F.3d at 412 quoting Fabricators, Inc. v. Technical Fabricators, Inc. (In re Fabricators, Inc.), 926 F.2d 1458, 1465 (5th Cir.1991).
The Code defines an "insider" of a corporate debtor as including "(i) director of the debtor; (ii) officer of the debtor; (iii) person in control of the debtor; (iv) partnership in which the debtor is a general partner; (v) general partner of the debtor; or (vi) relative of a general partner, director, officer, or person in control of the debtor." 11 U.S.C § 101(31)(B). A party may also be considered a "nonstatutory insider," even without actual control of the debtor, when there is a close relationship between debtor and creditor and when transactions between them were not conducted at arm's length. Winstar, 554 F.3d at 396-97 citing Anstine v. Carl Zeiss Meditec AG (In re U.S. Medical, Inc.), 531 F.3d 1272, 1277 (10th Cir.2008). See also 5-547 Collier on Bankruptcy ¶ 547.03[6] (Alan N. Resnick & Henry J. Sommer, eds., 16th ed. rev. 2014) ("The consideration of insider status focuses on two factors: (1) the closeness of the relationship between the parties; and (2) whether the transaction was negotiated at arm's length.") (discussing "insider" as used in 11 U.S.C. § 547(b)(4)(B)).
The Government urges that this Court consider the holders of the Series A Junior PIK Notes "insiders" of Scott Cable, because representatives of MC Partners and Allstate: (i) had regular communications with the management of Scott Cable to learn about the Company's financial performance; (ii) received financial information, restructuring plans and information about negotiations with other creditors from management that was not available to others; and (iii) generally provided advice to management on Scott Cable's financial affairs. Moreover, the Government contends that the 1993 and 1996 Management Incentive Agreements provided Scott Cable's management with an interest in providing for a recovery on the Junior PIK Notes that may not have always aligned with the best interests of the Company. Finally, the Government points out that, after confirmation of the 1996 Plan, the Series A Junior PIK Noteholders obtained the ability to elect a representative to Scott Cable's Board of Directors.
The Defendants argue that the Series A Holders were not insiders of Scott Cable because activities such as monitoring the Company's business and attending board meetings are not sufficient to show control over the day-to-day operations. Radnor Holdings, 353 B.R. at 840-41.
I agree that the Series A Holders were not statutory insiders. However, the 1993 and 1996 Management Incentive Agreements created an alignment of interests between Scott Cable's management and the Series A Holders that provided a closeness that would affect the Company's dealings with the Series A Holders and prevent a true arm's-length relationship between the entities. All of the Series A Holders (i.e., MC Partners, TA Investors,
"Courts have generally recognized three categories of misconduct which may constitute inequitable conduct for insiders: (1) fraud, illegality, and breach of fiduciary duties; (2) undercapitalization; or (3) claimant's use of the debtor as a mere instrumentality or alter ego." Mid-American Waste, 284 B.R. at 70. The Government argues that fraudulent transfer, illegality, aiding and abetting management's breach of fiduciary duty and undercapitalization are all present in this case.
The inequitable conduct in this case was 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 for the purpose of enabling the Series A Holders to gain an unfair advantage over the IRS by preventing collection of the capital gains tax that all parties knew would arise at a later time since it was already intended that the assets of the Company were expected to be sold.
The specific factual findings that support this conclusion of inequitable conduct by the Series A Holders (previously, the Junior Noteholders) are as follows:
The Defendants argue that there is nothing inequitable in obtaining a lien to secure repayment of indebtedness. I agree that obtaining a security interest— without more—is not inequitable conduct. Fabricators, 926 F.2d at 1468. However, other courts have recognized that obtaining a lien for the purpose of gaining an advantage over other creditors may be inequitable, depending on the circumstances surrounding that act. Fabricators, 926 F.2d at 1468 (finding misconduct, when an insider obtained liens "not merely [as] an isolated act, but one step interconnected with a series of actions by [the insider] to gain an advantage over the position of other creditors."); Estes v. N & D Prop., Inc. (In re N & D Prop., Inc.), 799 F.2d 726, 732 (11th Cir.1986) (finding misconduct based on an insider's actions to encumber the debtor's assets and obtain a priority in the impending bankruptcy proceedings was inequitable to consumer creditors); Fluharty v. Wood Prod., Inc. (In re Daugherty Coal Co., Inc.), 144 B.R. 320, 327 (N.D.W.V.1992) (finding misconduct when an insider obtained liens "without going through the appropriate formalities" covering the only significant assets owned by the debtor, and effectively "leap-frogging" over other creditors); and Rodolakis v. Chertoff (In re 1236 Dev. Corp.), 188 B.R. 75, 84 (Bankr.D.Mass.1995) (finding misconduct when an insider secured his capital contributions with a lien against the debtor's assets, thereby gaining an unfair advantage and harming the debtor and its creditors).
The Defendants also argue that the transaction was not inequitable because they provided value to Scott Cable in exchange for the secured Series A Junior PIK Notes in the form of (i) agreeing to receive Junior PIK Notes in an amount that was only 85% of the amount of their allowed claim; (ii) receiving PIK interest; (iii) extending the maturity date for payment; and (iv) the tangible and intangible benefits of agreeing to a consensual plan confirmation. Based upon the evidence in the record regarding the value of the Scott Cable at the time the liens were granted, I cannot agree that the Series A Holders provided anything but minimal value to the Debtors in exchange for the secured Series A Junior PIK Notes. The Junior PIK Notes were in the total amount of the 1993 Junior Noteholders' claims, but the 1993 Junior Noteholders and the Public Debenture Holders negotiated among themselves to transfer 15% of the Junior PIK Notes to the Public Debenture Holders. Moreover, the Junior Notes had no value. At the time the 1996 Plan was being proposed and confirmed, the 1993 Junior Noteholders and management knew that the value of Scott Cable's assets was insufficient to pay anything to the 1993 Junior Noteholders. The liquidation analysis attached to the final 1996 Disclosure Statement showed that a liquidation of Scott Cable's assets, and payment of the capital gains tax, would result in no distribution on the 1993 Junior Notes. Had the IRS received adequate notice regarding the 1996 Plan's grant of a security interest to displace its ability to collect future capital gains taxes, it could have raised an objection to the 1996 Plan that would have had merit.
The second factor of the equitable subordination analysis requires a finding that the inequitable conduct resulted in an injury to creditors or unfair advantage to the
"A claim or claims should be subordinated only to the extent necessary to offset the harm which the bankrupt and its creditors suffered on account of the inequitable conduct." Winstar, 554 F.3d at 413 quoting Mobile Steel, 563 F.2d at 701. In some equitable subordination cases, it is difficult to quantify the harm caused by the inequitable conduct. In this case, the harm is equal to the amount of the tax claims that lost their priority. Subordinating payment of the Series A Junior PIK Notes to the unpaid administrative tax claims would offset the harm caused by the inequitable conduct.
The final factor in an equitable subordination analysis requires the Court to determine whether subordination of a particular claim is consistent with the Bankruptcy Code. As noted by my colleague, the Honorable Brendan Linehan Shannon:
Elway Co., LLP v. Miller (In re Elrod Holdings Corp.), 421 B.R. 700, 715-16 (Bankr.D.Del.2010). Here, the Government is asserting its rights as an administrative tax claimant in the 1998 Bankruptcy Case. Subordination of the Series A Junior PIK Notes to the administrative tax claims actually restores the priorities set by Congress by preventing otherwise subordinated unsecured debt from gaining an unfair advantage of prior payment of administrative tax claims. 11 U.S.C. § 507(a)(8).
The Defendants argue that equitable subordination of the Junior PIK Notes would be inconsistent with a number of provisions of the Bankruptcy Code: namely, §§ 1101, 1123, 1128, 1129, 1141, 1142, 1144. The Defendants ask this Court to view the adversary proceeding as an attack upon the 1996 confirmation order. For the reasons set forth earlier in this Opinion, I have already held that § 1144 is not applicable to this adversary proceeding. The Government's claims arise in the 1998 Bankruptcy Case. In 1996, the Court had no knowledge of any misconduct. When a fraudulent scheme comes to light, "the necessity of equitable relief against that fraud becomes insistent." Pepper v. Litton, 308 U.S. 295, 312, 60 S.Ct. 238, 248, 84 L.Ed. 281 (1939). "No matter how technically legal each step in that scheme may have been, once its basic nature was uncovered it was the duty of the bankruptcy court in the exercise of its equity jurisdiction to undo it." Id.
The Defendants urge that this Court recognize the unfairness of applying equitable subordination in this case, since the Series A Holders received their secured claims pursuant to a chapter 11 plan that was disseminated to all interested parties (including the IRS) and approved after a hearing before the Bankruptcy Court. They argue that equitable subordination of such notes will chill investments in financially troubled entities. Equitable subordination is a "drastic" and "unusual" remedy because it means "that a court has chosen to disregard an otherwise legally valid transaction." In re Lifschultz Fast Freight, 132 F.3d 339, 347 (7th Cir. 1997). The Defendants also point out the Seventh Circuit's observation that:
Lifschultz, 132 F.3d at 347. However, equitable subordination of the Series A Junior PIK Notes to the administrative tax claims is not unpredictable. In this case, the parties invented an artifice to gain an unfair advantage over the IRS and saw their opportunity to do so in the 1996 Bankruptcy Case. At the time they improved their position by obtaining a security interest, the Series A Holders were not "investors" because they did not provide value in return for the security interest. The lien secured prior, unsecured, out-of-the-money debt.
Accordingly, I conclude that the Series A Holders engaged in inequitable conduct in obtaining a lien for their prior debt that enabled the Series A Holders to gain an unfair advantage and priority over another creditor. Namely, this misconduct harmed the IRS (and possibly other taxing authorities) designed to prevent them from collecting any capital gains tax. I also conclude that equitable subordination of the Series A Junior PIK Notes to the administrative tax claims is consistent with the distribution provisions of the Bankruptcy Code.
The Government argues that the claims of the Series B Junior PIK Noteholders (the "Series B Holders") also should be equitably subordinated to the administrative tax claims. The Indenture Trustee argues that the Government has not proven that any of the Series B Holders are insiders of Scott Cable or engaged in any misconduct. The Government argues that the facts support equitable subordination of all of the Junior PIK Notes, without regard to the inequitable conduct of individual holders. The Government also argues that facts demonstrate misconduct on behalf of the Series B Holders because the Creditors Committee, consisting mostly of Series B Holders, and their professionals knew about the tax avoidance scheme and negotiated to for "a piece of the action."
I first address whether the claims of the Series B Holders can be equitably subordinated without a showing of inequitable conduct by the Noteholders. The Government claims that the Series B Holders obtained the 15% interest in the Junior PIK Notes as successors-in-interest to the Series A Holders, whose claims should be
To equitably subordinate the Series B Holders' claims without a finding of inequitable conduct on their part would be to accept "no-fault" equitable subordination. In the past, the Third Circuit has held that creditor misconduct is not always a prerequisite for equitable subordination. In re Burden v. United States, 917 F.2d 115, 120 (3d Cir.1990). In that case, the court subordinated a tax penalty in the absence of government misconduct. SubMicron, 432 F.3d at 462 n. 16. In United States v. Noland, 517 U.S. 535, 116 S.Ct. 1524, 134 L.Ed.2d 748 (1996), the Supreme Court held that a subordinating a post-petition tax penalty claim "runs directly counter to Congress's policy judgment that a postpetition tax penalty should receive the priority of an administrative expense." Id., 517 U.S. at 541, 116 S.Ct. at 1528. The Nolan Court, however, expressly reserved ruling on whether a bankruptcy court must always find creditor misconduct before a claim may be equitably subordinated. Id., 517 U.S. at 543, 116 S.Ct. at 1528. More recent Third Circuit cases adopt the 3-prong test for equitable subordination, which requires inequitable conduct. Winstar, 554 F.3d at 411. See also Moll Indus., 454 B.R. at 585 (reading Winstar as adopting inequitable conduct as a formal requirement for equitable subordination). Based on the foregoing, I conclude that if no fault equitable subordination can still be pursued in this Circuit, the circumstances allowing it would be extremely limited. I decline to adopt no fault equitable subordination in this case.
The Government further argues that the Series B Noteholders waived defenses by failing to intervene, constituting an attempt to reverse the burden of proof in this matter. As the moving party, the Government has the burden of coming forward with evidence to rebut the prima facie validity of the claim and, once the movant comes forward with material evidence of misconduct, the burden shifts to the claimant to demonstrate the fairness of his conduct. Mid-American Waste, 284 B.R. at 69. Accordingly, I will review whether the Government has come forward with evidence of misconduct of the Series B Holders.
The Government has not proven that the Series B Holders are "insiders" of Scott Cable. When equitable subordination claims are leveled against noninsider, non-fiduciary claimants, the level of pleading and proof and even higher. ABF Capital Mgmt v. Kidder Peabody & Co. (In re Granite Partners, L.P.), 210 B.R. 508, 515 (Bankr.S.D.N.Y.1997). While equitable subordination can apply to an ordinary creditor, the circumstances supporting such a claim are few and far between. Id. Generally, a creditor may improve its position vis-à-vis another creditor provided he does not receive a preference or fraudulent transfer. Granite Partners, 210 B.R. at 515. Courts have described the type of inequitable conduct needed to equitably subordinate a non-insider creditor as "gross and egregious," "tantamount to fraud, misrepresentation, overreaching or spoliation," or "involving moral turpitude." Id.; Sentinel Mgmt., 728 F.3d at 670.
I cannot impute any misconduct of individual Creditors Committee members to all of the Series B Holders. A leading commentator has noted that committees cannot bind their constituents, writing:
7 COLLIER ON BANKRUPTCY ¶ 1103.05[1][d][i] (Alan N. Resnick & Henry J. Sommer, eds., 16th ed. rev.2014). Here, the Creditors Committee represented all unsecured creditors, not just the Public Debenture Holders. Their actions did not bind all unsecured creditors—or even individual Public Debenture Holders. Moreover, the parties concede that after the 1996 Bankruptcy Case, many of the Series B Junior PIK Notes were traded on the open market. The Government has not provided evidence of egregious misconduct by the individual Series B Holders. "[A]lthough it is a court of equity, [the Bankruptcy Court] is not free to adjust the legally valid claim of an innocent party who asserts the claim in good faith merely because the court perceives that the result is inequitable." Noland, 517 U.S. at 539, 116 S.Ct. at 1526. The record before me does not reveal whether the holders of the Series B Junior PIK Notes at the time of confirmation of the 1996 Plan are the same as the Series B Holders in the 1998 Bankruptcy Case. I conclude that the Government has not met its burden of proving gross and egregious misconduct by the Series B Holders.
For the reasons set forth above, I conclude that (i) the Government's recharacterization claim is denied; and (ii) the Government's equitable subordination is granted with respect to the Series A Junior PIK Noteholders, and denied with respect to the Series B Junior PIK Noteholders.
An appropriate Order follows.
