By Arvind Ravichandran (Cravath, Swaine & Moore LLP)
[Editor’s Note: The following summary is a duplicate of the article’s introduction.]
How should a federal bankruptcy court decide which of a federally regulated thrift or an FDIC controlled bank gets a federal tax refund? The Supreme Court of the United States’ answer in Rodriguez: Look to state law. So unremarkable was this holding that it required approximately six pages of text and attracted no dissent or concurrence.
As the Supreme Court said, the decision was not really about tax refunds, but was instead an opportunity to instruct lower courts on making federal common law. Indeed, the Tenth Circuit on remand reaffirmed its earlier decision almost entirely by citing to its earlier opinion. But the Court’s instructions and analysis cast serious doubt on the validity of a long-standing and critical aspect of many bankruptcy proceedings-the first day net operating loss trading order. It also requires re-evaluation of authorities related to preserving the non-taxpaying status of the debtor; a somewhat less common but related issue.
These authorities have generally analyzed the question of whether net operating losses or the tax status of a bankrupt entity is entitled to protection under the Bankruptcy Code by examining applicable provisions of the Internal Revenue Code (“I.R.C.”) and relying on their own sense of fairness. The result is federal common law, in all but name, that largely protects net operating losses but not tax status. Examining these authorities reveals the precise concern Rodriguez identifies with the improper creation of federal common law – a body of law that is inconsistent and poorly grounded. Following Rodriguez, courts faced with these questions should more comprehensively analyze applicable state law in determining the treatment of net operating losses or the tax status in a bankruptcy proceeding. Moreover, relying on appropriate state law doctrines will allow private parties to rely on contract law to set forth their desired outcomes in bankruptcy. Ideally, this will all result in a firmer approach to these issues in bankruptcy.
That is what this Article is about. First, it discusses the specific issue in Rodriguez and its history-the allocation of tax refunds in bankruptcy and the Bob Richards rule. Second, it discusses the legal history of first day trading orders to preserve net operating losses. Third, it re-examines these authorities in light of Rodriguez. Finally, it concludes by discussing the issues regarding the tax status of the debtor.
The full article is available here.