A corporation called South Beach Securities filed a petition under Chapter 11 of the Bankruptcy Code and submitted a plan of reorganization. The bankruptcy judge refused to confirm the plan and dismissed the bankruptcy proceeding.
In re South Beach Securities, Inc.,
Led by Leon A. Greenblatt III — a “character” if ever there was one, see Gary Washburn & Kim Barker, “Randolph Tower Running Up a Tab: City Says Owner Faces a Hefty Bill,”
Chicago Tribune,
Mar. 20, 2001, p. 1; Greg Bums, “Scattered’s Chief Buoyed by SEC Victory: Greenblatt Pursues Suit Against Chicago Exchange,”
Chicago Tribune,
No 15, 1998, p. 1; Burns, “The ‘Bad Boys’ of Chicago Arbitrage,”
Business Week Archives,
Aug. 5, 1996, www.businessweek.com/1996/32/b 34876.htm (visited Feb. 19, 2010) — Scattered achieved notoriety some years ago by selling short more shares of LTV than existed. We held that this tactic did
not
violate the securities laws.
Sullivan & Long, Inc. v. Scattered Corp.,
South Beach, the debtor in the bankruptcy proceeding, also is controlled by Greenblatt. It is not participating actively in this appeal (it has merely, as we said, adopted Scattered’s brief), but the U.S. Trustee — a Department of Justice official whose role is to be a watchdog in bankruptcy proceedings, 28 U.S.C. § 586(a)(3) — is. He opposed the confirmation of the plan of reorganization in the bankruptcy court and the district court and defends their rulings in this court. He argues that the only purpose of South Beach’s declaration of bankruptcy, and of the plan of reorganization, is to avoid taxes, and a plan of reorganization cannot be confirmed “if the principal purpose of the plan is the avoidance of taxes.” 11 U.S.C. § 1129(d). The U.S. Trustee’s role was especially important in this case because the bankruptcy was nonadversarial, and, indeed, as we shall see, phony. Were it not for his participation, Scattered would have no opponent in this court.
Scattered argues that the U.S. Trustee is not authorized to object to a plan of reorganization on the ground that the plan’s primary purpose is to avoid taxes. And indeed it is not obvious that his writ runs to policing against tax evasion — one might think the proper watchdog would be the Internal Revenue Service, which could have objected to confirmation of the plan at the outset, or could step in later by invoking section 269 of the tax code (discussed below) when and if a party to the bankruptcy proceeding claimed a tax benefit. 26 C.F.R. § 1.269-3(e). And there are objections based on the text of the Bankruptcy Code to the U.S. Trustee’s playing the role of tax watchdog in bankruptcy proceedings, though not compelling objections.
The Code permits only a “party in interest that is a governmental unit” to oppose a plan of reorganization on the ground that the plan’s primary purpose is to beat taxes. 11 U.S.C. § 1129(d);
In re Trans Max Technologies, Inc.,
But elsewhere in the Code “party in interest” and “United States trustee” are treated disjunctively. See, e.g., 11 U.S.C. § 707(b)(1) (“after notice and a hearing, the court, on its own motion or on a motion by the United States trustee, trustee ... or any party in interest ...”);
id,.,
§ 1104 (“on request of a party in interest or the United States trustee”). Yet when we turn to section 307 of the Code we discover that “the United States trustee may raise and may appear and be heard on any issue in any case or proceeding under this title.” This language, exactly parallel to the authority granted parties in interest by section 1109(b) (“a party in interest ... may raise and may appear and be heard on any issue in a case under this chapter”), suggests that the U.S. Trustee can object to a plan of reorganization after all, in his role as guardian of the public interest in bankruptcy proceedings. See, e.g.
In re United Artists Theatre Co.,
The statute is a mishmash but the view that the U.S. Trustee can be a party in interest makes better sense, as this case illustrates; we’ll see that the case really needed a watchdog, and we cannot see what would be gained if everyone had to wait for the Internal Revenue Service to take action against Greenblatt’s tax shenanigans. The IRS did receive a copy of the plan and didn’t object to it, but may have thought that since it could always disallow the deductions later if the plan got confirmed and since it isn’t in the business of preventing abuse of bankruptcy per se, there was no need for it to intervene in the bankruptcy.
And even if the U.S. Trustee was not a party in interest, the bankruptcy or district court, since it can hardly be thought
required
to approve an unlawful plan of reorganization, need not turn a deaf ear when the U.S. Trustee, or anyone else for that matter, argues the plan’s unlawfulness. If in doing so the U.S. Trustee is acting
ultra vires,
as we very much doubt, his superiors in the Justice Department can rein him in; but even if he should be thought an officious intermeddler, this
And given the breadth of the statutory definition of “party in interest,” how can the U.S. Trustee have standing to make motions and be heard in bankruptcy cases (as he is expressly authorized to do, 11 U.S.C. §§ 307, 707(b)(1)) if he has no “interest” in such cases? We conclude that he is a party in interest, and come at last to the merits of the appeal.
South Beach was once a registered securities broker/dealer, but by the time it declared bankruptcy it had become a shell. It had no employees or business activities, and its only “assets” were net operating losses. These are better described as
potential
assets, because they can sometimes, but by no means always, as we’re about to see, be set off against taxable income and thus reduce a company’s taxes. 26 U.S.C. § 172;
United Dominion Industries, Inc. v. United States,
South Beach is wholly owned by NOLA, LLC, which has no business operations either; its sole asset is the stock of South Beach. NOLA, a limited liability company, has three members. One is Green-blatt’s father; the others are the fathers of Scattered’s other two officers and directors. NOLA is managed by a company named Teletech whose president and sole employee at the relevant time was Green-blatt and whose sole function is to manage NOLA. Through Teletech, and thus through NOLA, Greenblatt controls South Beach.
In 2001 Greenblatt directed another corporation that he controls, Loop Corporation, to lend South Beach $2.2 million for five years at an annual interest rate of 12 percent. He then had South Beach lend NOLA $3.2 million. The purpose of the loan to NOLA was to enable it to purchase the stock of a company called Health Risk Management, Inc (HRM). We do not know where South Beach obtained $1 million to make up the difference between the $2.2 million that it received from Loop and the $3.2 million that it lent to NOLA. It may have had assets left over from its time
Loop then sold to Scattered, for $100,000, the $2.2 million loan that it had made to South Beach. This made Scattered a creditor of South Beach, because South Beach was Loop’s debtor and now Scattered had stepped into Loop’s shoes. Scattered claims to be owed $3.3 million by South Beach, though it has not explained why the $2.2 million loan that it bought from Loop should give it a $3.3 million claim against South Beach, the debtor on that loan; conceivably the explanation is the high interest rate.
Greenblatt is an officer and director of Scattered, along with the sons of NOLA’s other owners, and it appears that he negotiated all the transactions relating to this case both with and on behalf of South Beach. He also signed South Beach’s Chapter 11 petition. All the companies that we have mentioned except HRM have the same office address. It is apparent that Greenblatt caused Scattered to become South Beach’s creditor and caused South Beach to declare bankruptcy.
South Beach’s bankruptcy filings list, as its sole asset, the stock in HRM, and assign to that stock a value of zero. How South Beach ended up with HRM’s stock, which it had lent NOLA the money to buy, is unexplained, but it confirms the obvious: all these companies are controlled by Greenblatt.
NOLA, having used the money it borrowed from South Beach to buy stock in HRM that became worthless, and having no other assets, went broke too, just like South Beach. Its bankruptcy proceeding began at the same time as South Beach’s, but is not before us.
South Beach did not list its net operating losses as an asset. But its disclosure statement, consistent with the requirement that material tax consequences be described in it, does state that the purpose of the bankruptcy is to monetize South Beach’s net operating losses. (Amendments made to the Bankruptcy Code in 2005 — which don’t apply to this case, filed in April 2005 — make this disclosure requirement explicit. 11 U.S.C. § 1125(a)(1); 5
Bankruptcy Service, Lawyer’s Edition
§ 44:353 (2010). But the requirement has been held to be implicit in the pre-2005 version of section 1125 applicable to this case. See
Hall v. Vance,
The plan of reorganization proposed by South Beach and turned down by the bankruptcy judge and the district judge would have given Scattered all the stock of South Beach. A court can’t confirm a plan of reorganization, however, unless the owners of at least one class of “impaired claims” (a term broadly defined to encompass claims altered by the plan, 11 U.S.C. § 1124;
In re Wabash Valley Power Ass’n, Inc.,
Had the plan been confirmed, Scattered, as sole creditor of the debtor, would have ended up owning South Beach’s net operating losses. South Beach could not have offset those losses against its own income since it has no income or assets (aside from the potential assets consisting of the losses themselves) and no prospects of obtaining any; it is not engaged in any business or investment activities and in fact is defunct, though it remains a corporation in good standing. Consistent with the law of Mississippi (where it is incorporated) for maintaining its corporate status in the absence of an agreement by the shareholders to eliminate the board of directors, South Beach has a single director. Miss.Code Ann. §§ 79-4-8.01(a), -8.03(b). He is unpaid and inactive, since he does nothing. But he does have, Greenblatt testified, “a beating heart,” and no more is required.
Outside of bankruptcy, South Beach’s net operating losses could be used to obtain a tax benefit only if the company received a capital infusion that enabled it to obtain income against which to offset the losses, or if its assets (other than the net operating losses) were acquired by a company that had income or assets. For the general rule is that taxpayers may not transfer net operating losses to other taxpayers.
In re Luster,
Consistent with the general rule that we just mentioned, both the Internal Revenue Code and the judge-made tax doctrine of “substance over form” (on which see, e.g.,
Gregory v. Helvering,
But the statute treats family members (spouses, children, grandchildren, parents) as a single owner, corporations as being owned by their shareholders, and trusts as being owned by their beneficiaries, 26 U.S.C. §§ 318(a)(1), (a)(2)(B), 382(i )(3)(A); 26 C.F.R. §§ 1.382-2T(h)(2), (6), 2 Bittker
Corporations in Chapter 11 bankruptcy, moreover, are allowed to match net operating losses against income beyond what is permitted by section 382(a) if immediately after the reorganization the debtor’s shareholders and its “qualified creditors” (which include creditors, like Scattered, who have held debt for at least 18 months prior to the filing of the bankruptcy proceeding) own at least half the stock by virtue of their prior status. 26 U.S.C. § 382(Z)(5); 2 Bittker & Eustice, supra, ¶ 14.44[6], pp. 14-102 to 14-106. The thinking behind section 382(i)(5) is that in bankruptcy the creditors rather than the shareholders are the true owners of the corporation, so there’s no real ownership change when the creditors receive the stock of the corporation. 7 Mertens Law of Federal Income Taxation, § 29:158 (2010). Consistent with this thinking, the statute imposes certain restrictions on the deduction of net operating losses. See 26 U.S.C. § 382(i )(5)(B); 7 Mertens, supra, § 29:158; 2 Bittker & Eustice, supra, ¶ 14.44[6][a], p. 14-103. But we needn’t get into these; we can just assume that Scattered’s plan is not vulnerable under section 382.
Section 269(a)(1) of the Internal Revenue Code, however, which overlaps the doctrine of substance over form and imposes restrictions on obtaining tax benefits from net operating losses beyond the restrictions imposed by section 382, disallows deductions and other tax benefits, including net operating losses, 7 Mertens, supra, § 38:97, when the principal purpose of acquiring corporate control, or of certain other intercorporate transactions, on which the claim of benefits is based is to avoid tax. To preserve the tax benefits of the transaction the taxpayer must demonstrate that business reasons unrelated to tax avoidance were the primary purpose of the transaction.
The attribution rules of 26 U.S.C. § 318 don’t apply to section 269; for section 318 applies only when expressly made applicable to other provisions in subchap-ter C of the tax code, and it hasn’t been made expressly applicable to section 269, which anyway is not in subchapter C. But a beneficial owner of a company is deemed to control it for section 269 purposes; so if he subsequently becomes its legal owner, there is no acquisition of corporate control and so the change in ownership does not trigger the restrictions imposed by the section. See
Ach v. Commissioner,
Greenblatt
may
be the beneficial owner of both Scattered and South Beach, though this is uncertain, since Scattered is owned by two other companies and a trust set up for Greenblatt’s father and children, while South Beach is owned by NOLA, which is owned by Greenblatt’s father and the fathers of the two other directors. But because the attribution rules of section 318 don’t apply to section 269, the ownership of South Beach can’t be ascribed to Scattered even if Greenblatt
is
the beneficial owner of both corporations; and since Scattered therefore is not the beneficial owner of South Beach, its acquisition of South Beach can’t escape the bar of section 269(a)(1).
Brick Milling Co. v. Commissioner,
The plan of reorganization also had to be rejected on the closely related ground that it hadn’t been proposed in good faith. 11 U.S.C. § 1129(a)(3). To be in good faith a plan of reorganization must have a true purpose and fact-based hope of either “preserving [a] going concern” or “maximizing property available to satisfy creditors.”
Bank of America National Trust & Savings Ass’n v. 203 North La-Salle Street Partnership,
Scattered contends that there was another motive for the bankruptcy besides the tax motive, and that was to shield South Beach from suits. The argument is bogus. South Beach’s bankruptcy schedule listed no claims other than Scattered’s, and the deliberate omission of creditors from the list submitted by the debtor is unlawful and is grounds for dismissal of the bankruptcy proceeding. 11 U.S.C. §§ 521(a)(1), 1112(e);
In re Seaman,
Greenblatt’s
other
enterprises are targets of a number of suits, see, e.g.,
Wachovia Securities, LLC v. Neuhauser,
No. 04 C 3082,
The bankruptcy judge and the district judge had still another ground for denying confirmation of the proposed plan of reorganization, illustrating what a travesty this bankruptcy proceeding is: South Beach’s sole creditor — Scattered—is an insider of South Beach. Remember that a plan of reorganization can’t be confirmed unless “at least one class of claims that is impaired under the plan has accepted the plan, determined without including any acceptance of the plan by any insider.” 11 U.S.C. § 1129(a)(10). The only claim alleged to be impaired by the plan is Scattered’s claim to the money it is owed by virtue of having bought Loop’s loan to South Beach. Scattered voted to accept the plan but was an insider of the debtor when it did so, because Greenblatt controls South Beach, Loop, and Scattered. And while “insider” includes a “person in control of the debtor,” 11 U.S.C. § 101(31)(B)(iii), it is not limited to such persons; it includes any entity so closely related to the debtor as to “suggest that any transactions were not conducted at arm’s length.”
In re Winstar Communications, Inc.,
We recall that acceptance by a class of claims requires approval by two-thirds (in amount) and more than one-half (in number) of the claimants, excluding insiders. 11 U.S.C. §§ 1126(c), 1129(a)(10). With Scattered excluded because of its insider status, there are no eligible voters.
The exclusion of insiders in deciding whether a plan has been accepted by impaired creditors is intended to prevent conflicts of interest that can arise when a creditor has substantial influence over the debtor beyond what is implicit in being a creditor. See
In re U.S. Medical, Inc., supra,
It is true that at an earlier stage of the bankruptcy proceeding the district court reversed the bankruptcy judge’s ruling that the petition for bankruptcy had been filed in bad faith and should therefore be dismissed. The reversal was not necessarily error, because all the facts were not yet before the bankruptcy court or the district court. Scattered’s argument that the district court’s finding that the petition had not been filed in bad faith is “law of the case” and cannot be reexamined by us is frivolous, because the doctrine of law of the case limits reexamination of a ruling in an earlier stage of a litigation by the same court, not by a higher court.
Lujan v. National Wildlife Federation,
Greenblatt’s evasive and at times incredible testimony, and his orchestration of a scheme aimed at a palpable misuse of bankruptcy, raise serious ethical and perhaps legal concerns. The appeal to the district court and now to our court was frivolous, and we invite the U.S. Trustee to consider applying for sanctions against Scattered and South Beach, Greenblatt, the appellants’ law firms, and the firms’ lawyers who worked on the case, for misconduct in the bankruptcy and district courts. And we order the appellants, and the law firms and lawyers that appeared for them in this court, to show cause why they should not be sanctioned for their conduct here.
AFFIRMED AND SHOW-CAUSE ORDER ISSUED.