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Title Burden

Date 1990

Subject Other\Concurring & Dissenting

Contents

Page 1

64 of 64 DOCUMENTS

In Re BURDEN, WILFRED, H., a/k/a BURDEN, WILFRED, H., JR., t/a BURDEN'S JANITORIAL SERVICE & SUPPLY COMPANY v. The United States of America, Appellant

No. 90-1147

UNITED STATES COURT OF APPEALS FOR THE THIRD CIRCUIT

917 F.2d 115; 1990 U.S. App. LEXIS 18889; 90-2 U.S. Tax Cas. (CCH) P50,598; 66

A.F.T.R.2d (RIA) 5792; 24 Collier Bankr. Cas. 2d (MB) 187; 20 Bankr. Ct. Dec. 1937

July 31, 1990, Argued

October 26, 1990, Filed

PRIOR HISTORY: **1 On Appeal from the United States District Court for the Eastern District of Pennsylvania; (D.C. Civil Action No. 89-06550).

CASE SUMMARY:

PROCEDURAL POSTURE: The Internal Revenue Service appealed from the judgment of the District Court for the Eastern District of Pennsylvania, affirming the Bankruptcy Court's ruling that a claim for nonpecuniary loss tax penalties may be subordinated under 11 U.S.C.S.

§ 510(c).

OVERVIEW: Appellee debtor was assessed taxes, penal- ties, and interest for various tax periods, which he failed to pay. The Internal Revenue Service (IRS) filed four sep- arate notices of a tax lien. Appellee filed for Chapter

13 bankruptcy and the bankruptcy court subordinated the pre-petition penalties portion of the IRS' claims to the claims of other general non-subordinated unsecured claims. The IRS filed an appeal contending that equitable subordination and 11 U.S.C.S. § 510(c) did not permit the automatic subordination of nonpecuniary loss tax penal- ties, and equitable subordination required a showing of misconduct. While the court agreed that the legislative history allowed courts flexibility in applying the prin- ciple of equitable subordination, it found no indication that Congress contemplated that nonpecuniary loss tax penalties would be subordinated automatically. While 11

U.S.C.S. § 510(c) permitted equitable subordination of nonpecuniary loss tax penalties, in determining whether to subordinate courts must balance the equities of the vari- ous claims, and creditor misconduct was not a prerequisite for equitable subordination. Therefore, the judgment was reversed and remanded.

OUTCOME: Although nonpecuniary loss tax penal-

ties were subject to equitable subordination and creditor misconduct was not a prerequisite, because the district court automatically subordinated the tax penalties without weighing the equities of the various claims, the judgment was reversed and remanded.

LexisNexis(R) Headnotes

Bankruptcy Law > Practice & Proceedings > Appeals Civil Procedure > Appeals > Standards of Review > De Novo Review

HN1 Appellate review of a district court's order affirm- ing a bankruptcy court's order is plenary.

Bankruptcy Law > Creditor Claims & Objections > Types of Claims > Unsecured Claims

Bankruptcy Law > Practice & Proceedings > Adversary

Proceedings

HN2 The United States Supreme Court has recog- nized that in the exercise of its equitable jurisdiction the bankruptcy court has the power to sift the circumstances surrounding any claim to see that injustice or unfairness is not done in administration of the bankrupt estate. Bankruptcy Law > Creditor Claims & Objections > Types of Claims > Unsecured Claims

Bankruptcy Law > Creditor Claims & Objections > Allowances & Objections

HN3 The Ninth Circuit has held that the essential pur- pose of subordination is to undo or to offset any inequality in the claim position of a creditor that will produce in- justice or unfairness to other creditors in terms of the bankruptcy results.

Bankruptcy Law > Creditor Claims & Objections > Types of Claims > Unsecured Claims

HN4 11 U.S.C.S. § 510(c)(1) explicitly allows bankruptcy courts to reorder existing priorities among creditors under principles of equitable subordination.

917 F.2d 115, *; 1990 U.S. App. LEXIS 18889, **1;

90-2 U.S. Tax Cas. (CCH) P50,598; 66 A.F.T.R.2d (RIA) 5792

Page 2

Bankruptcy Law > Creditor Claims & Objections > Types of Claims > Unsecured Claims

Governments > Legislation > Interpretation

HN5 11 U.S.C.S. § 510(c)(1) does not explicitly de- fine the phrase "equitable subordination" and therefore it is necessary to draw inferences of congressional intent from legislative history.

Bankruptcy Law > Creditor Claims & Objections > Types of Claims > Unsecured Claims

HN6 See 11 U.S.C.S. § 510(c)(1).

Bankruptcy Law > Creditor Claims & Objections > Types of Claims > Unsecured Claims

HN7 The congressional statements and the legislative history of 11 U.S.C.S. § 510 indicates that Congress in- tended the courts to develop the principles of equitable subordination.

Bankruptcy Law > Creditor Claims & Objections > Governmental Claims > Tax Claims

Bankruptcy Law > Creditor Claims & Objections > Types of Claims > Unsecured Claims

HN8 11 U.S.C.S. § 510(c) permits bankruptcy courts to subordinate nonpecuniary loss tax penalties.

Bankruptcy Law > Creditor Claims & Objections > Governmental Claims > Tax Claims

Governments > Legislation > Interpretation

HN9 Congress did not intend such a radical alteration in the equitable subordination doctrine as to permit au- tomatic subordination simply because the claim is for nonpecuniary loss tax penalties. Such a major revision in the bankruptcy law would certainly warrant explicit direc- tion from Congress. Since the legislation is silent on this issue, courts must reject the contention that bankruptcy courts may automatically impose a harsh result without consideration of the equities of the claims.

Bankruptcy Law > Creditor Claims & Objections > Proofs of Claim > Time & Necessity of Filing

HN10 The language of 11 U.S.C.S. § 510(c)(1) clearly permits subordination after notice and hearing. Governments > Legislation > Interpretation

HN11 Where the language of the statute is plain and precise, it is conclusive of the statute's meaning absent

clear evidence that reading the language literally would thwart the obvious purposes of the enactment. Bankruptcy Law > Creditor Claims & Objections > Types of Claims > Unsecured Claims

HN12 Creditor misconduct is not a prerequisite for eq- uitable subordination.

Bankruptcy Law > Creditor Claims & Objections > Governmental Claims > Tax Claims

Bankruptcy Law > Creditor Claims & Objections > Types of Claims > Unsecured Claims

HN13 In considering whether to subordinate nonpecu- niary loss tax penalties, the district court must weigh the equities on a case-by--case basis without requiring in ev- ery instance inequitable conduct on the part of the creditor claiming parity among other unsecured general creditors.

COUNSEL:

Robert W. Metzler, Esq., Argued, Shirley D. Peterson, Esq., Gary R. Allen, Esq., Gary D. Gray, Esq., Tax Division, Department of Justice, Washington, District of Columbia, Attorneys for Appellant.

James L. Davis, Esq., Argued, Paul R. Ober

& Associates, Reading, Pennsylvania, Attorneys for

Appellee.

JUDGES:

Higginbotham, Jr., Chief Judge, Scirica and Alito, Circuit Judges. Alito, Circuit Judge, concurring in part and dissenting in part.

OPINIONBY:

HIGGINBOTHAM, JR.

OPINION:

*115 OPINION OF THE COURT HIGGINBOTHAM, JR., Chief Judge

This is a Chapter 13 bankruptcy case. The Internal Revenue Service ("IRS") appeals from the judgment of the District Court for the Eastern District of Pennsylvania, which affirmed the Bankruptcy

917 F.2d 115, *116; 1990 U.S. App. LEXIS 18889, **1;

90-2 U.S. Tax Cas. (CCH) P50,598; 66 A.F.T.R.2d (RIA) 5792

Page 3

*116 Court's ruling that a claim for nonpecuniary loss tax penalties may be subordinated to the claims of other general unsecured creditors, absent a showing of miscon- duct by the government. n1 109 Bankr. 107 (1989).

$1,384.67 in penalties and $3,510.19 in taxes. The is- sue before us on appeal concerns the penalty **3 por- tion (secured and unsecured) of the total liabilities, which amounts to $12,040.31. n3

**2

n1 Nonpecuniary loss tax penalty claims are, in this case, claims by the IRS to collect additions to tax from the debtor for failure to make a reason- able attempt to pay taxes or delinquent payment of taxes. See 26 U.S.C. § 6653 (West 1989), for a description of tax penalties due to negligence and fraud.

The district court's opinion states that "the bankruptcy judge . . . subordinated the pre-petition penalties portion of the IRS's claim to a status of general non-subordinated unsecured claims." 109

Bankr. at 108, Dist. Ct. Op. at 1. This is a variation from the language of the bankruptcy court's order which states that "the penalty portion is hereby sub- ordinated to the claims of other general unsecured creditors pursuant to 11 U.S.C. § 510." Bankruptcy Court Order, Appendix at 23.

n3 The taxes and interest portions of the IRS claim are not at issue in this case. Before this Court, the IRS challenges only the District Court's dispo- sition of its claim for pre-petition penalties.

On March 30, 1989, the debtor filed a timely objection to the IRS' proof of claim. The parties were able to re- solve all of the issues in contention raised by the debtor's objection except one, namely, that in its proof of claim, the IRS failed to subordinate the pre-petition penalties

(totalling $12,040.31) to the claims of other general unse- cured creditors. The parties did agree that only $52,000 in assets were available to compensate the secured creditors, some having interests prior to those of the IRS.

In response to the debtor's objection, on August 1,

1989, the bankruptcy court entered an order that modi- fied the IRS' proof of claim. Pursuant to § 510(c) of the Bankruptcy Code, the court subordinated the pre-petition penalties **4 portion to the claims of other general non-

Because the district court automatically subordinated the tax penalties without weighing the equities of the var- ious claims, we will reverse and remand.

Wilfred H. Burden, debtor and appellee, was assessed federal income and employment taxes, related penalties, and interest for various tax periods from 1980 to 1985. When the debtor failed to pay all of the amounts assessed against him, the IRS filed four separate notices of tax lien. n2

n2 The notices of tax lien were filed on August

31, 1983, May 10, 1984, July 15, 1985 and August

1, 1985.

On June 30, 1987, the debtor filed for protection un- der Chapter 13 of the Bankruptcy Code. In response, on July 28, 1987, the IRS timely filed a proof of claim in the amount of $57,930.17, of which $51,903.32 was sub- sequently secured. Of the secured amount $10,655.64 was assessed for penalties and $18,862.68 for interest. The remaining unsecured portion of the claim includes

subordinated unsecured claims. The IRS filed a timely appeal to the bankruptcy court's order. The district court affirmed the bankruptcy court's final order.

The IRS filed a timely appeal before this court con- tending that 1) equitable subordination does not permit the automatic subordination of nonpecuniary loss tax penal- ties; 2) § 510(c) on its face precludes class subordination;

3) the invocation of equitable subordination requires a showing of inequitable conduct; 4) § 510(c) requires a no- tice and fair hearing for all claims; and 5) the automatic subordination of nonpecuniary loss tax penalties would diminish the purpose and effect of such IRS penalties.

HN1 Our review of the district court's order affirm- ing the bankruptcy court's order is plenary. See Universal Minerals, Inc. v. C.A. Hughes & Co., 669 F.2d 98, 101-

03 (3d Cir. 1981).

II.

The issues raised in this appeal require us to address the following concerns: 1) whether § 510(c) permits eq- uitable subordination of penalties; 2) whether automatic subordination of penalties is proper; and 3)

917 F.2d 115, *117; 1990 U.S. App. LEXIS 18889, **4;

90-2 U.S. Tax Cas. (CCH) P50,598; 66 A.F.T.R.2d (RIA) 5792

Page 4

*117 whether creditor misconduct is a necessary pre- requisite for subordination. HN2 The Supreme Court

**5 has recognized that "in the exercise of its equi- table jurisdiction the bankruptcy court has the power to sift the circumstances surrounding any claim to see that injustice or unfairness is not done in administration of the bankrupt estate." Pepper v. Litton, 308 U.S. 295, 307-08,

84 L. Ed. 281, 60 S. Ct. 238 (1939). n4 HN3 The Ninth Circuit has held that the essential purpose of subordina- tion "is to undo or to offset any inequality in the claim position of a creditor that will produce injustice or unfair- ness to other creditors in terms of the bankruptcy results." In re Westgate-California Corporation, 642 F.2d 1174,

1177 (9th Cir. 1981) (quoting In re Kansas City Journal- Post Co., 144 F.2d 791, 800 (8th Cir. 1944)); see In re Lockwood, 14 Bankr. 374, 381 (E.D.N.Y. 1981).

n4 In Pepper v. Litton, the Court held that the bankruptcy court has equitable power to subordi- nate a claim against a fraudulent fiduciary, "other- wise . . . exploitation would become a substitute for justice." 308 U.S. at 312.

Prior to the enactment of the Bankruptcy **6 Act of 1978, subordination of tax penalty claims did not oc- cur because noncompensatory penalty claims owed to the government were specifically disallowed. See Simonson v. Granquist, 369 U.S. 38, 40, 7 L. Ed. 2d 557, 82 S. Ct. 537 (1962) (a congressional purpose of section 57(j)

n5 is to bar all claims against a bankrupt except those based on "pecuniary" loss); In re Kline, 403 F. Supp.

974, 977 (D. Md. 1975) ("claims for 'penalties' shall not be allowed against the bankrupt estate"), aff'd, 547 F.2d

823 (4th Cir. 1977); 30 Stat. 561, amended by 11 U.S.C.

§ 93(j), amended by 11 U.S.C. § 724(a) (West Supp.

1990). Section 510(c)(1) of the Bankruptcy Act of 1978

HN4 explicitly allows bankruptcy courts to reorder ex- isting priorities among creditors "under principles of eq- uitable subordination." See In re Virtual Network Services Corp., 902 F.2d 1246 (7th Cir. 1990); In re Merwede, 84

Bankr. 11 (D. Conn. 1988). n6 However, whether section

510(c)(1) allows bankruptcy courts to subordinate non- pecuniary loss tax penalties is an issue of first impression in this circuit. n7 HN5 The Bankruptcy Act does not explicitly define the phrase "equitable subordination" and therefore it is necessary to draw inferences **7 of con- gressional intent from the legislative history of the Act. Although numerous bankruptcy courts have considered this issue, only recently have Courts of Appeals consid- ered whether § 510(c)(1) permits equitable subordination of nonpecuniary loss tax penalties. See Schultz Broadway Inn v. United States of America, 912 F.2d 230 (8th Cir.

1990); Virtual Network Services Corp., 902 F.2d at 1250. In Virtual Network Services Corp., the Seventh Circuit held that § 510(c) empowers the bankruptcy court to eq- uitably subordinate the IRS claim for nonpecuniary loss tax penalties to claims of other creditors in a Chapter 11 liquidation proceeding. n8 In reviewing the

917 F.2d 115, *118; 1990 U.S. App. LEXIS 18889, **7;

90-2 U.S. Tax Cas. (CCH) P50,598; 66 A.F.T.R.2d (RIA) 5792

Page 5

*118 legislative history to determine Congressional in- tent, the Seventh Circuit concluded that "the committee reports are necessarily inconclusive as to the meaning of 'equitable subordination' as enacted in § 510(c)(1)." Id. at 1248. However, the court considered statements of Representative Edwards and Senator DiConcini, sponsor and co-sponsor of the House and Senate bills, respec- tively, n9 in conjunction with the Second Circuit's holding in In re Stirling Homex Corp., 579 F.2d 206 (2d Cir. 1978) cert. denied, **8 439 U.S. 1074, 99 S. Ct. 847, 59 L. Ed.

2d 40 (1979). In Stirling Homex Corp., which was decided prior to the enactment of the Bankruptcy Act of 1978, the Second Circuit explicitly adopted subordination of claims of defrauded shareholders who had acted wrongfully. 902

F.2d at 212-15. The stockholders in Stirling Homex were allegedly defrauded by the corporation when they pur- chased their stock certificates. However, the court did not decide whether the stockholders were creditors within the meaning of the Bankruptcy Act. Id. at 212. The court ex- plicitly noted that it was proceeding on "the more narrow question whether it was inequitable for the bankruptcy court to subordinate the claims by the stockholders to those made by ordinary creditors" and it concluded that it was not. Id. n10

n5 In the Bankruptcy Act of 1898, § 57(j) pro- vided that a claim for a nonpecuniary loss penalty could not be allowed. See 30 Stat. 561, amended by

11 U.S.C. § 93(j), amended by 11 U.S.C. § 724(a)

(West Supp. 1990); In re Schultz Broadway Inn, Ltd., 89 Bankr. 43, 44 (W.D. Mo. 1988), aff'd, 1989

U.S. Dist. LEXIS 6465 (W.D. Mo. Apr. 26, 1989).

**9

n6 11 U.S.C. § 510(c)(1) HN6 provides in pertinent part:

(1) under principles of equitable subordination, subordinate for pur- poses of distribution all or part of an allowed claim to all or part of another allowed claim or part of an allowed in- terest to all or part of another allowed interest. . . .

n7 In a case that did not involve tax penalties, a bankruptcy court in this circuit has interpreted §

510(c) to permit subordination. See In re Americana

Apparel, Inc., 55 Bankr. 160 (E.D. Pa. 1985) (court subordinated a claim owed an insider for consulting fees).

n8 Virtual Network Services (VNS), a long- distance telephone service company, filed Chapter

11 bankruptcy petition. As the debtor in posses- sion, VNS sold most of its operating assets and filed an amended reorganization plan to liquidate the company.

The IRS filed a proof of claim for employment and withholding taxes and pre-petition tax penal- ties. The IRS identified the tax penalties as a gen- eral unsecured claim. VNS objected, contending that the IRS' non-pecuniary tax penalty should be subordinated to the other general unsecured credi- tors based on principles of equitable subordination. The bankruptcy court ruled in favor of the IRS but the district court reversed. The Seventh Circuit af- firmed the district court. 902 F.2d at 1250.

**10

n9 As the sponsor and co-sponsor of the Bankruptcy Reform Act of 1978, Representative Edwards and Senator DiConcini were recorded as legislative leaders on the matter. Their statements were intended to inform members of Congress of the eight years of revisions leading up to the first substantial reform of the bankruptcy laws in forty years. See Bankruptcy Reform Act of 1978, Pub. L. No. 95-598, reprinted in 1978 U.S. Code Cong.

& Admin. News 5787, 6436, 6505.

n10 The court did not resolve whether subor- dination would be proper without creditor miscon- duct.

Based on its review, the court in Virtual Services Network Corp. rejected the government's position that nonpecuniary loss tax penalty claims are not subject to eq- uitable subordination under § 510(c). Id. at 1248-49. The district court's reasoning in the case at bar is consistent with the Seventh Circuit's reasoning. However, the district court interpreted the legislative history of § 726(a)(4), as opposed to § 510(c)(1), to conclude that subordination of tax penalties has long been considered appropriate by Congress. n11 Section **11 726(a)(4), which applies to Chapter 7 actions, explicitly subordinates nonpecuniary loss tax penalties. The district court concluded that the legislative history allows courts flexibility in applying the principles of equitable subordination in Chapter 13 cases

917 F.2d 115, *118; 1990 U.S. App. LEXIS 18889, **11;

90-2 U.S. Tax Cas. (CCH) P50,598; 66 A.F.T.R.2d (RIA) 5792

Page 6

as well as in Chapter 7 cases.

n11 Section 726(a)(4) specifically provides for automatic subordination in Chapter 7 cases:

(a) Except as provided in section 510 of this title, property of the estate shall be distributed --

. . . .

(4) fourth, in payment of any allowed claim, whether secured or unsecured, for any fine, penalty, or forfeiture, or for multiple, exemplary, or punitive damages, arising before the earlier of the order for relief or the appointment of a trustee, to the extent that such fine, penalty, forfeiture, or damages are not compensation for actual pecuniary loss suffered by the holder of such claim. .

. .

11 U.S.C. § 726(a)(4) (West 1979).

The IRS contends in this case that there is no spe- cific provision, such as 11 U.S.C. § 726, allowing **12 subordination of nonpecuniary loss tax penalties under Chapter 13, and that, in any event, Congress did not in- tend such a result in Chapter 13 cases. The debtor asserts that Congress intended the bankruptcy courts to develop the concept of equitable subordination and thereby to ex- pand the traditional doctrine of subordination. Therefore, according to the debtor, the court has the power to sub- ordinate nonpecuniary loss tax penalties in Chapter 13 cases.

We are persuaded by the Seventh Circuit's reasoning that HN7 the congressional statements and the legisla- tive history of § 510 indicates that Congress intended the courts to develop the principles of equitable subordina- tion. Virtual Network Services Corp., 902 F.2d at 1249-

50. Given this

917 F.2d 115, *119; 1990 U.S. App. LEXIS 18889, **12;

90-2 U.S. Tax Cas. (CCH) P50,598; 66 A.F.T.R.2d (RIA) 5792

Page 7

*119 authority, we conclude that § 510(c) HN8 per- mits bankruptcy courts to subordinate nonpecuniary loss tax penalties and therefore uphold the district court's de- termination that subordination is permitted pursuant to this section of the Act.

While we agree with the district court and the debtor that equitable subordination of nonpecuniary loss tax penalties is permissible, we also believe that HN9 Congress did not intend such a radical alteration in the equitable **13 subordination doctrine as to permit au- tomatic subordination simply because the claim is for nonpecuniary loss tax penalties. Such a major revision in the bankruptcy law would certainly warrant explicit di- rection from Congress. Since the legislation is silent on this issue, we must reject the contention that bankruptcy courts may automatically impose a harsh result without consideration of the equities of the claims.

In addition, HN10 the language of § 510(c)(1)

clearly permits subordination after notice and hearing.

HN11 Where, as here, the language of the statute is plain and precise, it is conclusive of the statute's meaning absent "clear evidence that reading the language literally would thwart the obvious purposes of the Act." Mansell v. Mansell, 490 U.S. 581, 109 S. Ct. 2023, 2030, 104 L. Ed. 2d 675 (1989). Accord Burlington No. R. Co. v. Okla. Tax Comm'n, 481 U.S. 454, 461, 95 L. Ed. 2d 404, 107

S. Ct. 1855 (1987); Amp Inc. v. U.S., 820 F.2d 612, 615

(3d Cir. 1987). Therefore, we conclude that the district court erred as a matter of law by subordinating the IRS penalties without considering the equities involved in the various claims.

Our final concern is whether in determining the equi- ties of the claims, a court can subordinate only when there

**14 has been a showing of bad faith on the part of the creditor -- as was required prior to the enactment of the Bankruptcy Act of 1978. See In re Mobile Steel, 563 F.2d

692 (5th Cir. 1977) (abuse of discretion to subordinate when conduct was not shown to be unfair to the bankrupt or its creditors). n12

n12 But see In re Stirling Homex Corp., 579

F.2d 206 (prior to the Bankruptcy Act of 1978, a broad class of claims of allegedly defrauded stockholders was automatically subordinated to the claims of general unsecured creditors).

The IRS argued before the district court that there was a requirement of misconduct for equitable subordination. It argued that the Bankruptcy Act merely codified ex- isting caselaw which prohibited subordination without a showing of inequitable conduct. Id. See also Comstock v. Group Investors, 335 U.S. 211, 229, 92 L. Ed. 1911, 68 S.

Ct. 1454 (1948); Spach v. Bryant, 309 F.2d 886, 889 (5th Cir. 1962). However, at oral argument, the IRS conceded that subordination pursuant to § 510(c) would be proper without creditor **15 misconduct, when there has been an ad hoc inquiry to determine the relative equities of the competing claims. n13

n13 The tape of the oral argument discloses that the following colloquy ensued between the court and counsel for the IRS:

THE COURT: So what you are talking about is that the government now takes the position that Virtual is correct -- that you can have a subordi- nation of a nonpecuniary loss penalties involving tax penalties in an IRS claim but you can't have an automatic one? Is that the government's position? COUNSEL: That is the government's position

. . . At one time the government had argued in the courts below that it was a prerequisite of miscon- duct on the part of the government before you could have subordination.

THE COURT: So that's the only position -- so you in effect before us withdraw the broader based argument you've made and you are now saying that the only thing which you want us to consider is whether you can have subordination of a nonpecu- niary loss tax penalty of an IRS claim, would be whether it can be automatic or whether it has to be looked at on an ad hoc basis?

COUNSEL: Essentially your honor, yes.

THE COURT: And if it's looked at at an ad hoc basis, then that is permissible within the breadth of the statute.

COUNSEL: Yes, your honor.

THE COURT: So therefore the most that you would be entitled to in this case would be a remand for an inquiry as to whether there should be at an ad hoc subordination rather than the automatic. COUNSEL: Your honor, I would essentially agree with your analysis if one thing had been dif- ferent in this case, and this is why it is unusual. Here, the debtor, not any creditor, came in and said we want the claim subordinated. So at the point in time no creditor has come in and shown the equities of this claim. So essentially we see at this point in

time, we see a need for reversal.

**16

917 F.2d 115, *120; 1990 U.S. App. LEXIS 18889, **16;

90-2 U.S. Tax Cas. (CCH) P50,598; 66 A.F.T.R.2d (RIA) 5792

Page 8

*120 The debtor contends that subsequent to the passage of the Act, the overwhelming majority of the bankruptcy courts which have analyzed subordination of tax penalties pursuant to § 510(c)(1) have "provided for equitable subordination without making creditor miscon- duct a necessary prerequisite for its application." Virtual Network Services Corp., 902 F.2d at 1249. Accord In re Airlift, Intern., Inc., 97 Bankr. 664, 670 (S.D. Fla. 1989)

(because of their nature, claims for tax penalties may be subordinated); In re Merwede, 84 Bankr. 11, 13 (D. Conn. 1988) (wrongful misconduct is no longer the ex- clusive basis for equitable subordination). See also In re Schultz Broadway Inn, Ltd., 89 Bankr. 43 (W.D. Mo. 1988)

(creditor misconduct was not an issue where the court sub- ordinated negligence penalties assessed by the IRS in a Chapter 11 case); In re Standard Johnson Co., Inc., 90

Bankr. 41 (E.D.N.Y. 1988) (no creditor misconduct where the court upheld debtor's objection to IRS proof of claim conferring priority status to pre-petition penalties); In re Patco Photo Corp., 82 Bankr. 192 (E.D.N.Y. 1988) (court granted debtor's motion to reclassify penalty and fines related pre-petition **17 tax claims as general unse- cured claims because they were punitive in nature); In re Mansfield Tire and Rubber Co., 80 Bankr. 395 (N.D. Ohio 1987) (excise taxes determined to be penalties and subordinated in Chapter 11 case) (quoting In re Colin,

44 Bankr. 806, 810 (S.D.N.Y. 1984) (inequitable conduct is not the exclusive basis for subordination under section

510(c)). The court in Virtual Network Services Corp., also held that creditor misconduct is not a prerequisite for equitable subordination. We are persuaded by this over- whelming consistency in judgments rendered by the fed- eral courts and conclude that HN12 creditor misconduct is not a prerequisite for equitable subordination.

HN13 In considering whether to subordinate non- pecuniary loss tax penalties, the district court must weigh

the equities "on a case-by--case basis without requiring in every instance inequitable conduct on the part of the creditor claiming parity among other unsecured general creditors." Virtual Network Services Corp., 902 F.2d at

1250. See also Schultz Broadway Inn v. United States of America, 912 F.2d 230, 232-34 (creditor misconduct is not a prerequisite to equitable subordination but sub- ordination **18 must be considered on case-by--case basis).

Our holding today does not subject the government to any requirement that is not also a requirement for other creditors seeking a non-subordinated status. The penal- ties sought by the IRS or by any other creditor may be subordinated, in the proper case, by the exercise of the court's equitable jurisdiction. If, as the district court sug- gests, the courts were free to subordinate a class of claims as a matter of law, then the notice and hearing require- ment of § 510(c) would be nullified in any instance where the claimholder does not dispute that its claim is of a particular type. We believe that the notice and hearing requirement calls on courts to explore the particular facts and circumstances presented in each case before deter- mining whether subordination of a claim is warranted.

III.

While we agree with the district court that the leg- islative history allows courts flexibility in applying the principle of equitable subordination, there is no indica- tion that Congress contemplated that nonpecuniary loss tax penalties would be subordinated automatically. To summarize, we conclude that § 510(c) permits equitable subordination of nonpecuniary loss **19 tax penalties; in determining whether to subordinate courts must bal- ance the equities of the various claims; n14 and creditor misconduct

917 F.2d 115, *121; 1990 U.S. App. LEXIS 18889, **19;

90-2 U.S. Tax Cas. (CCH) P50,598; 66 A.F.T.R.2d (RIA) 5792

Page 9

*121 is not a prerequisite for equitable subordination. Therefore, we will reverse and remand to the district court for further proceedings consistent with this opinion.

n14 Implicitly, the dissent seems to assume that the government is willing to breach its obligation to collect funds due by its "concession at oral argu- ment that nonpecuniary loss tax penalties may be subordinated on a case-by--case basis without in- equitable conduct." Dis. op., at 121 n.1; see supra note 13. The government's concession is adequate for the majority. Furthermore, although obviously unintentionally, the dissent hypothesizes that the

"majority's position seems very likely" to cause

"penalties to be subordinated on a wholesale ba- sis in proceedings under chapters 9, 11, and 13." Id. at 123. We respectfully submit that this hypoth- esized result is a result we do not intend. In fact, our position could not be stated in clearer language than our explicit direction to the bankruptcy and district courts to "explore the particular facts and circum- stances presented in each case before determining whether subordination of a claim is warranted" and that "in determining whether to subordinate courts must balance the equities of the various claims. . .

." Supra at 120. We also respectfully disagree with the dissent in its characterization that this is "a new procedure." Dis. op. at 121 n.1. As we noted above,

§ 510(c) requires notice and hearing prior to the subordination of any class of claims. See supra n.6 and Typescript at pp. 10-11. We also noted that "our holding today does not subject the government to any requirement that is not also a requirement for other creditors seeking non-subordinated status." Id. at 120. Accordingly, we do not think we have prescribed any procedure that is not already "pre- scribed by law." Dis. op. at 121 n.1.

**20

CONCURBY:

ALITO (In Part)

DISSENTBY:

ALITO (In Part)

DISSENT:

ALITO, Circuit Judge, concurring in part and dissent- ing in part.

I concur in the judgment of the Court that the district court decision automatically subordinating nonpecuniary loss tax penalties must be reversed and that the case must

be remanded for a hearing. I disagree, however, regarding the legal standard that should be applied on remand. The majority holds that the district court on remand may sub- ordinate nonpecuniary loss tax penalties without proof of inequitable conduct by the government if a weighing of competing equities suggests that subordination is appro- priate. This apparently means that a nonpecuniary loss tax penalty not associated with any inequitable government conduct may be subordinated to other unsecured claims provided these claims are not themselves inequitable. In my view, this holding, which treats nonpecuniary loss tax penalties less favorably than other categories of unsecured claims, is incorrect. n1

n1 The majority relies in part upon the gov- ernment's concession at oral argument that nonpe- cuniary loss tax penalties may be subordinated on a case-by--case basis without proof of inequitable conduct (Maj. op., at 119 & n. 13, 120 n. 14.), but the majority does not base its decision on that con- cession alone. I believe this is the proper approach. By adopting the new position advanced at oral ar- gument, the government not only gave up what it had argued in its briefs was a legal right (i.e., the right to be free from equitable subordination absent proof of inequitable conduct), it also asserted that the bankruptcy courts must perform a new proce- dure (i.e., conduct a hearing involving a comparison of the competing equities) whenever equitable sub- ordination is sought. This court should not require the bankruptcy courts to follow this new procedure unless it is prescribed by law. Therefore, despite the government's concession, this court must decide for itself whether this procedure is necessary.

**21

As the majority notes, 11 U.S.C. § 510(c)(1) provides that a bankruptcy court, after notice and a hearing, may subordinate all or part of one claim or interest to all or part of another claim or interest "under principles of equitable subordination." The critical phrase -- "under principles of equitable subordination" -- was clearly meant to codify the principles of equitable subordination worked out in the case law. "The normal rule of statutory construction is that if Congress intends for legislation to change the in- terpretation of a judicially created concept, it makes that intent specific." Midlantic National Bank v. N.J. Dept. of Environmental Protection, 474 U.S. 494, 501, 88 L. Ed.

2d 859, 106 S. Ct. 755 (1986). This rule should be fol- lowed "with particular care in bankruptcy codifications"

(id.).

The legislative history of Section 510 points unmis- takably to the same conclusion. Following the revision

917 F.2d 115, *121; 1990 U.S. App. LEXIS 18889, **21;

90-2 U.S. Tax Cas. (CCH) P50,598; 66 A.F.T.R.2d (RIA) 5792

Page 10

of Section 510 in conference, Representative Edwards, sponsor of the House bill, and Senator DeConcini, co- sponsor of the Senate bill, stated on the floor: "It is in- tended that the term 'principles of equitable subordination' follow existing case law and leave to the courts develop-

ment of this principle." **22 124 Cong. Rec. 32416

(1978) (Rep. Edwards); 124 Cong. Rec. 34016 (1978)

(Sen. DeConcini). Similarly, the report on the Senate bill, from which the phrase "principles of equitable subordi- nation" was taken, stated

917 F.2d 115, *122; 1990 U.S. App. LEXIS 18889, **22;

90-2 U.S. Tax Cas. (CCH) P50,598; 66 A.F.T.R.2d (RIA) 5792

Page 11

*122 that "these principles are defined by case law, and have generally indicated that a claim may normally be subordinated only if its holder is guilty of misconduct." S. Rep. No. 95-989, 95th Cong., 2d Sess. 74, reprinted in 1978 U.S. Code Cong. & Admin. News 5787, 5860. Likewise, the report on the House bill, which permitted subordination "on equitable grounds," explained that this section was intended to codify case law. H.R. Rep. No.

95-595, 95th Cong., 1st Sess. 359, reprinted in 1978 U.S. Code Cong. & Admin. News 5693, 6315.

What, then, did "principles of equitable subordina- tion" mean in the case law when the new bankruptcy code was adopted in 1978? As the Fifth Circuit explained in an authoritative decision surveying the cases on the eve of the adoption of the new code, those principles required, among other things, that "the claimant must have engaged in some type of inequitable conduct." In re Mobile Steel Co., 563 F.2d 692, 700 (5th Cir. 1977). See also, **23 e.g., In re Ahlswede, 516 F.2d 784, 788 (9th Cir. 1975), cert. denied, 423 U.S. 913, 96 S. Ct. 218, 46 L. Ed. 2d 142

(1975); Farmers Bank v. Julian, 383 F.2d 314, 323 (8th

Cir. 1967), cert. denied, 389 U.S. 1021, 19 L. Ed. 2d 662,

88 S. Ct. 593 (1967); In re Credit Industrial Corporation,

366 F.2d 402, 408 (2d Cir. 1966).

The conspicuous paucity of contrary authority in the decisions addressing the subordination of nonpecuniary loss tax penalties is telling. Indeed, these decisions iden- tify only one pre-1978 case that purportedly permitted equitable subordination without proof of inequitable con- duct by the claimant. In that case, In re Stirling Homex Corp., 579 F.2d 206 (2d Cir. 1978), cert. denied, 439 U.S.

1074, 99 S. Ct. 847, 59 L. Ed. 2d 40 (1979), the Second Circuit affirmed the subordination of the claims of al- legedly defrauded stockholders. As stockholders, these claimants would not have been entitled to any of the pro- ceeds resulting from liquidation, but by suing they sought to achieve parity with the general unsecured creditors. Although the Second Circuit did not explicitly label their conduct inequitable, its decision was clearly based on the view that their conduct was designed to achieve an

inequitable result that should not be permitted. **24 Thus, even if In re Stirling Homex Corp. was a departure from prior precedent, it did not abandon the concept that equitable subordination must be based on the conduct of the individual claimant. At most, In re Stirling Homex Co. represented an incremental change in the established doctrine.

By contrast, the holdings of the district court and the majority in the present case represent a sharp break from the established doctrine codified in Section 510(c)(1). The holdings of the district court and the majority do not rest on the claimant's conduct but on the view that one category of unsecured claims (those representing actual pecuniary loss) should be treated more favorably than another cat- egory of unsecured claims (those representing nonpecu- niary loss tax penalties). Decisions about the treatment of categories of claims in bankruptcy proceedings, however, are not dictated or illuminated by principles of equity and do not fall within the judicial power of equitable subordi- nation, as codified in Section 510(c)(1).

The sequence of events leading to the enactment of Section 510 also suggests that Congress did not intend to authorize the subordination of penalty claims under the **25 doctrine of equitable subordination. In the Bankruptcy Commission's proposed statute, Section 4-

406(a)(1) subordinated all penalty claims, while Section

4-406(c) codified the court's power of equitable subor- dination. H.R. Doc. No. 93-137, pt. II, 93d Cong., 1st Sess. 115-117 (1973). Bills containing provisions closely patterned after Section 4-406 of the Commission's recom- mendation were then introduced in the House and Senate. See, e.g., H.R. 10792, 93d Cong., 1st Sess., sec. 4-406

(1973); H.R. 31, 94th Cong., 1st Sess., sec. 4-406 (1975); S. 236, 94th Cong., 1st Sess., sec. 4-406 (1975). After hearings, however, new bills following the different ap- proach to subordination contained in the present code were introduced. Under that approach, although the gen- eral power of equitable subordination was still recognized

(11 U.S.C. § 510(c)(1)), the subordination of

917 F.2d 115, *123; 1990 U.S. App. LEXIS 18889, **25;

90-2 U.S. Tax Cas. (CCH) P50,598; 66 A.F.T.R.2d (RIA) 5792

Page 12

*123 penalties was restricted to proceedings under chapter 7 (11 U.S.C. § 726). This sequence of events strongly suggests that Congress did not want penalties to be subordinated on a wholesale basis in proceedings under chapters 9, 11, and 13. Yet the majority's position seems very likely to bring about precisely that result. Contrary **26 to the interpretation contained in some decisions permitting the equitable subordination of nonpecuniary loss tax penalties (see, e.g., Schultz Broadway Inn v. United States, 912 F.2d 230, 232-33

(8th Cir. 1990); In re Virtual Network Services Corp.,

902 F.2d 1246, 1248 (7th Cir. 1990)), the previously mentioned statements made on the floor of Congress by Representative Edwards and Senator DeConcini do not justify any fundamental departure from established case law. In an identical passage in both statements, Representative Edwards and Senator DeConcini, after stating that section 510(c)(1) was meant to "follow exist- ing case law," added that "development" of the principles of equitable subordination would be " left to the courts." This "development," however, while very likely meant to permit the kind of incremental change effected by In re Stirling Homex, cannot include a fundamental break from

"existing case law" such as that adopted by the district court or the majority in this case.

Nor can the reference to "a penalty" in these same floor statements justify the holding of the district court or the majority. In the passage noted above, Representative

**27 Edwards and Senator DeConcini stated:

To date, under existing case law a claim is

generally subordinated only if the holder of such claim is guilty of inequitable conduct, or the claim itself is of a status susceptible to subordination, such as a penalty or a claim for damages arising from the purchase or sale of a security of the debtor.

124 Cong. Rec. 32416 (1978) (Rep. Edwards); 124 Cong. Rec. 34016 (1978) (Sen. DeConcini) (emphasis added). The meaning of this reference to "a penalty," how- ever, is unclear. Representative Edwards and Senator DeConcini were describing equitable subordination "un- der existing case law," and "under existing case law," as previously noted, penalties were not "susceptible to subordination." Since it is impossible to determine what Representative Edwards and Senator DeConcini meant when they referred to "a penalty," that reference should not control the interpretation of the statute. Moreover, whatever Representative Edwards and Senator DeConcini had in mind, a single, ambiguous reference to "a penalty" in their floor statements could not have alerted the other members of Congress that the new code would funda- mentally change the "principles of **28 equitable sub- ordination" recognized by the courts. A fleeting reference in floor statements -- even authoritative floor statements by sponsors of the proposed legislation -- should not be

given controlling weight.

In conclusion, the claims at issue in the present case should be subordinated on remand only if there is ev- idence of conduct by the government in this particular case that makes subordination equitable.

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