No. 95-323 IN THE SUPREME COURT OF THE UNITED STATES OCTOBER TERM, 1995 UNITED STATES OF AMERICA, PETITIONER v. THOMAS R. NOLAND, TRUSTEE FOR DEBTOR FIRST TRUCK LINES, INC. PETITION FOR A WRIT OF CERTIORARI TO THE UNITED STATES COURT OF APPEALS FOR THE SIXTH CIRCUIT DREW S. DAYS, III Solicitor General Department of Justice Washington, D.C. 20530 (202) 514-2217 ---------------------------------------- Page Break ---------------------------------------- TABLE OF AUTHORITIES Cases: Page Boteler v. Ingels, 308 U.S. 57 (1939) . . . . 5 Columbia Ribbon Co., In re, 117 F.2d 999(3d Cir. 1941) . . . . 4 Comstock v. Group of Institutional Investors, 335 U.S. 211 (1948) . . . . 2, 3 Nicholas v. United States, 384 U. S. 678 (1966) . . . . 5 Norwest Bank Worthington v. Ahlers, 485 U.S. 197 (1988) . . . . 2 Simonson v. Grandquist, 369 U.S. 38 (1962) . . . . 5 Stebbins v. Crocker Citizens National Bank, 516 F.2d 784 (9th Cir.), cert. denied, 423 U.S. 913 (1975) . . . . 2, 7 United States v. Killoren, 119 F.2d 364(8th Cir.), cert. denied, 314 U. S. 640(1941) . . . . 3-4 United States v. Sotelo, 436 U.S. 268(1978) . . . . 6 Statutes: Bankruptcy Act, 11 U.S.C. 101 et seq.: 11 U.S.C. 93(j) ( 57(j)) (1976 ) . . . . 5 11 U.S.C. 364(c) . . . . 8 11 U.S.C. 364(c)(1) . . . . 7 11 U.S.C. 503(b)(1) . . . . 4 11 U.S.C. 503(b)(1)(C) . . . .1 11 U.S.C. 507(a)(1) . . . .1,4 11 U.S.C. 510(c)(1) . . . .2 11 U.S.C. 726(a)(4) . . . .4 (I) ---------------------------------------- Page Break ---------------------------------------- In the Supreme Court of the United States OCTOBER TERM, 1995 No. 95-323 UNITED STATES OF AMERICA, PETITIONER v. THOMAS R. NOLAND, TRUSTEE FOR DEBTOR FIRST TRUCK LINES, INC. ON WRIT OF CERTIORARI TO THE UNITED STATES COURT OF APPEALS FOR THE SIXTH CIRCUIT REPLY BRIEF FOR THE UNITED STATES The court of appeals recognized that Congress- writing with precision and detail-expressly provided post-petition tax penalty claims of the type involved in this case with a statutory "[f]irst" priority in the distribution of the assets of the debtor's estate (Pet. App. 3a). See 11 U.S.C. 503(b)(1)(C), 507(a)(1). The court stated, however, that it did "not see the fairness or the justice" of that legislative determination (Pet, App. 19a): We do not see the fairness or justice in permitt- ing the * * * claim for tax penalties * * * to enjoy an equal or higher priority with claims based on the extension of value to the debtor* * *. (1) ---------------------------------------- Page Break ---------------------------------------- 2 Believing that "fairness" and "justice" support the view (which Congress evidently did not share) that "claims based on extension of value to the debtor" should be paid before post-petition tax penalty claims, the court annulled and reversed the statutory priori- ties that Congress provided. The court did so quite emphatically and directly, by changing the priority for the tax penalty claims in this case from "[f]irst" to "last." For the reasons detailed in our opening brief, the "principles of equitable subordination" that are codi- fied in Section 510(c)(1) of the Bankruptcy Code (11 U.S.C. 510(c)(1)) do not support this judicial reinven- tion of the priority provisions of the Code. By allow- ing the court's own view of what is "fair" or "unfair" to override the express congressional determination of the priority to be afforded to these competing claims, the court of appeals violated the fundamental principle that a bankruptcy court's equitable powers "must and can only be exercised within the confines of the Bankruptcy Code" (Norwest Bank Worthing - ton v. Ahlers, 485 U.S. 197, 206 (1988)). Principles of equitable subordination do not permit a court "to contradict statutory or common law when [it] feels a fairer result may be obtained by application of a different rule." Stebbins v. Crocker Citizens Na- tional Bank, 516 F.2d 784, 787 (9th Cir), cert. denied, 423 U.S. 913 (1975). They do not permit a court to say, "in effect * * * , `No, the distribution scheme pro- vided by [Congress] is a mistake.'" 516 F.2d at 788. As this Court summarized in Comstock v. Group of Institutional Investors, 335 U.S. 211 (1948), the doc- trine of equitable subordination has the quite different and narrower function of punishing credi- tors who engage in inequitable misconduct, by ---------------------------------------- Page Break ---------------------------------------- 3 "depriv[ing] the wrongdoer of the fruits of his wrong." Id. at 229. See also Pet. Br. 10-16. It is un- disputed that the United States did not engage in any inequitable conduct in this ease. The doctrine of equitable subordination therefore simply does not apply. Respondent advances several arguments in support of the decision below. None of respondent's con- tentions substantiates the untenable proposition that, by codifying the preexisting "principles of equitable subordination," Congress authorized the courts to an- nul and disregard the hierarchy of detailed statutory priorities that Congress enacted to govern the rights of innocent claimants in bankruptcy cases. All but two of respondent's contentions are addressed in our opening brief. We reply here to the two contentions not previously addressed. 1. Respondent claims that there is a "bankruptcy policy of favoring pecuniary loss claims over nonpecuniary loss claims" and that "nonpecuniary loss tax penalties * * * have traditionally been disfavored" in bankruptcy (Resp. Br. 9, 20-21). These assertions are neither relevant nor factually correct. Even if one could identify a source (other than the provisions of the Code) to determine what is "bank- ruptcy policy" and what is not, such "policy" has no lawful force if it has not been enacted as positive law. A court's perception of "policy" (as well as its perception of "fairness" and "justice") can not justify countermanding the statutory priorities that Con- gress has enacted. E.g., United States v. Killoren, 119 F.2d 364,366 (8th Cir.) ("[t]he plain mandate of the law cannot be set aside because of considerations which may appeal to referee or judge as falling within general principles of equity jurisprudence"), cert. ---------------------------------------- Page Break ---------------------------------------- 4 denied, 314 U.S. 640 (1941); In re Columbia Ribbon Co., 117 F.2d 999, 1002 (3d Cir. 1941) (a "court may not by granting a priority which it deems equitable set aside the clear congressional mandate that no such priority shall be accorded"). Moreover, respondent's broad contention that bankruptcy policy" disfavors nonpecuniary loss penalties is demonstrably incorrect. One need look no further than to Sections 503(b)(1) and 507(a)(1) of the Bankruptcy Code, which provide "[f]irst" priority for post-petition tax penalty claims, to see that "bank- ruptcy policy" is far more complex and articulated than respondent contends.1 As this Court has ex- plained, by providing a statutory priority for post- petition tax penalties, Congress sought to advance the legislative policy of ensuring compliance with the ___________________(footnotes) 1 The only category of tax penalties that is "disfavored" in bankruptcy is prepetition nonpecuniary loss penalties in Chapter 7 eases. See 11 U.S.C. 726(a)(4) (subordinating such prepetition penalties to general unsecured claims). BY con- trast, as the court of appeals acknowledged, in providing a "[f]irst" priority for postpetition tax penalty claims, Congress did "not distinguish between tax penalties that are compensatory in nature and those that are not" (Pet. App. 15a). As we discuss in our opening brief (Pet. Br. 19 n.6), Congress has made detailed distinctions in the priorities provided to tax penalty claims in various differing contexts under the Bankruptcy Code. See Pet. App. 14a-15a ("In Chapter 7 cases, Congress assigned differing priorities to pre- and postpetition penalties. 11 U.S.C. 726(a)(l) and 726(a)(4). * * * Section 726(a)(1) gives administrative expense priority to postpetition tax penalty claims."). The careful distinctions that Congress made in providing differing bankruptcy priorities for different types of tax penalty claims would be rendered meaningless if courts were permitted to apply "principles of equitable subordination" to disregard and annul the statutory priorities. See Pet. Br. 20-21. ---------------------------------------- Page Break ---------------------------------------- 5 tax laws by debtors in bankruptcy and thereby ensur- ing that such debtors abide by the same rules of law that apply to every other business (including those with whom they compete). Nicholas v. United States, 384 U.S. 678,694 (1966); Boteler v. Ingels, 308 U.S. 57, 61 (1939).2 Although the court of appeals evidently disagreed with the policy judgment that Congress thus made in providing a "[f]irst" priority for post-petition tax pen- alty claims, the court was nonetheless bound by that legislative determination. As this Court emphasized ___________________(footnotes) 2 Respondent errs in seeking to rely on Simonson v. Grandquist, 369 U.S. 38 (1962), as support for the proposition that penalty claims are disfavored in bankruptcy (Resp. Br. 21). Prior to 1978, prepetition penalty claims had been dis- allowed by statute under Section 57(j) of the Bankruptcy Act, 11 U.S.C. 93(j) (1976). See Simon. son v. Granquist, 369 U.S. at 40. Although the Court stated in Simonson "that the language of 57(j) broadly prohibits the allowance of penalty claims in bankruptcy" (369 U.S. at 39), that statement was necessarily limited to the prepetition tax penalties involved in that case. In Boteler v. Ingels, which was decided two decades before Simonson, a unanimous Court had held that Section 57(j) did not bar a claim for postpetition penalties incurred by the trustee. 308 U.S. at 61. And, four years after Simonson, the Court reaffirmed that holding in Nicholas v. United States, in concluding that the government's claim for a postpetition tax penalty was allowable and entitled to first priority in distribution. 384 U.S. at 694 ("the United States is entitled to exact the penalties here in question as a legitimate means to enforce the prompt filing of the tax returns"). As noted in our opening brief (Pet. Br. 21 n.8), the majority and concurring opinions in the court of appeals overlooked Nicholas and Boteler and thereby erred in stating, without qualification, that "prior to 1978, nonpecuniary loss tax penalty claims against the estate of the bankrupt were not allowed by law" (Pet. App. 12a; see id. at 22a). ---------------------------------------- Page Break ---------------------------------------- 6 in United States v. Sotelo, 436 U.S. 268, 279 (1978), [h]owever persuasive [alternative policy] considera- tions might be in a legislative forum, we as judges cannot override the specific policy judgments made by Congress in enacting the statutory provisions with which we are here concerned." See also Pet. Br. 14-16 & n.2. 2. Respondent contends that, even though Con- gress conferred a "[f]irst" priority on postpetition tax penalty claims as a matter of law, such claims should be subordinated as a matter of "equity" (even "with- out a finding of inequitable conduct" (Resp. Br. 24)) in order to avoid a perceived inconsistency with other provisions of the Bankruptcy Code.3 Respondent grounds this contention on the theory that the statutory priority for postpetition tax penalty claims is "misguided" and should not be enforced (id. at 25). But that assertion is nothing more than a contention that courts should disregard the priorities ___________________(footnotes) 3 Respondent suggests that equitable subordination of tax penalty claims is "not automatic" under the analysis of the court of appeals but is instead to "be determined on a case by case basis" (Resp. Br. 14). That description of the decision below is not correct. The court of appeals held that tax penalty claims are to be subordinated solely because it would be more "fair" for creditors "with claims based on the extension of value to the debtor" to be paid first (Pet. App. 19a). That rationale, if valid, would apply in every bankruptcy case involving an estate without sufficient assets to pay the claims of all creditors. In the rare case in which the estate has sufficient assets to satisfy all claims, there would be no need to invoke the doctrine of equitable subordination-for all claims would then be paid. Moreover, even on "a case by case basis", courts are not permitted to disregard statutory priorities solely on the theory that a different priority scheme might be more "'fair" in a particular case. See Pet. Br. 9-16. ---------------------------------------- Page Break ---------------------------------------- 7 enacted by Congress if they conclude that "the distri- bution scheme provided by the [Bankruptcy Code] is a mistake" (Stebbins v. Crocker Citizens National Bank, 516 F.2d at 788). It is unquestionably not the function of a court of equity, however, to "contradict statutory or common law" merely because the chan- cellor "feels a fairer result may be obtained by appli- cation of a different rule." Id. at 787. See Pet. Br. 11- 17. Moreover, there is nothing "misguided" about the detailed and complex set of priorities that Congress established in the Bankruptcy Code. Respon- dent complains that a "[f]irst" priority for tax penalty claims would require "any party doing business or extending credit postpetition to a trustee or debtor in possession" to demand "superpriority status be- fore providing goods or services" (Resp. Br. 24). The "superpriority" provisions of the Bankruptcy Code permit a party who extends credit to the debtor after the petition is filed to obtain a priority "over any or all administrative expenses" but only if, inter alia, the trustee is otherwise unable "to obtain unsecured credit" (11 U.S.C. 364(c)(1)). Respondent suggests that the "delays" inherent in obtaining authorization for "superpriority" status from the bankruptcy court "could be fatal" to a debtor, and would therefore be "contrary to the strong bankruptcy policy in favor of rehabilitating or reorganizing debtors" (Resp. Br. 24). Respondent thus seems to contend that the prior- ity that Congress established for postpetition tax penalty claims will frustrate the entire object of the Bankruptcy Code. It could as easily be contended that, if Congress had determined not to provide a first priority for post- petition taxes and tax penalties, that determination ---------------------------------------- Page Break ---------------------------------------- 8 would have frustrated the entire object of the Internal Revenue Code.4 The balancing of competing policy objectives is an inherently legislative function. Con- gress has performed that policy function by enacting the complex and detailed scheme of priorities set forth in the Bankruptcy Code. It is not the proper task of the bankruptcy courts to nullify the choices that Congress made based upon the court's differing perception of "fairness" and "justice" (Pet. App. 19a).5 ___________________(footnotes) 4 In enacting the priority scheme of the Bankruptcy Code, Congress obviously gave a high priority to ensuring tax law compliance. It seems hardly necessary to point out that the dilemma that respondent poses-the threatened frustration and collapse of the entire bankruptcy scheme of reorganization-is most unrealistic. Respondent's stated concerns are obviously entirely irrelevant to a debtor that complies with its lawful duties under the Internal Revenue Code and thereby avoids the accrual of priority postpetition tax penalties. Moreover, the conditions precedent to the allowance of "superpriority" status have nothing to do with the risk of tax penalties-they are related to whether the credit status of the debtor is such that unsecured credit is not available. See 11 U.S.C. 364(c). 5 Respondent's extended discussion (Resp. Br. 21-22 n. 14) concerning the priority to be afforded to prepetition penalty claims in a case under Chapter 11 is irrelevant to this case, which involves the priority to be afforded to a postpetition first priority claim in a case under Chapter 7. ---------------------------------------- Page Break ---------------------------------------- 9 For the foregoing reasons and those set forth in our opening brief, the judgment of the court of appeals should be reversed. Respectfully submitted. DREW S. DAYS, III Solicitor General MARCH 1996 ---------------------------------------- Page Break ---------------------------------------- No. 95-323 IN THE SUPREME COURT OF THE UNITED STATES OCTOBER TERM, 1995 UNITED STATES OF AMERICA, PETITIONER v. THOMAS R. NOLAND, TRUSTEE FOR DEBTOR FIRST TRUCK LINES, INC. ON WRIT OF OF CERTIORARI TO THE UNITED STATES COURT OF APPEALS FOR THE SIXTH CIRCUIT DREW S. DAYS, III Solicitor General LORETTA C. ARGRETT Assistant Attorney General LAWRENCE G. WALLACE Deputy Solicitor General KENT L. JONES Assistant to the Solicitor General GARY D. GRAY EDWARD T. PERELMUTER Attorneys Department of Justice Washington, D.C. 20530 (202) 514-2217 ---------------------------------------- Page Break ---------------------------------------- QUESTION PRESENTED Taxes and tax penalties that arise after the date of a bankruptcy filing are "administrative expenses" of the bankruptcy estate. 11 U.S.C. 503(b)(1)(B) and (C). As "administrative expenses," such taxes and tax penalties are entitled to first priority in the distri- bution of the estate. 11 U.S.C. 507(a)(1). This case presents the following question: Whether the statutory priority that Congress conferred on the government's claim for postpetition tax penalties may-under the "principles of equitable subordination" codified in Section 510(c)(1) of the Bankruptcy Code, 11 U.S.C. 510(c)(1)-be subordi- nated to the claims of general unsecured creditors solely because a court determines that it would enhance "fairness" and "justice" to pay the general creditors first. (I) ---------------------------------------- Page Break ---------------------------------------- TABLE OF CONTENTS Opinions below . . . . 1 Jurisdiction . . . . 2 Statutory provisions involved . . . . 2 Statement . . . .2 Introduction and summary of argument . . . .8 Argument: The "principles of equitable subordination" codi- fied in Section 510(c) of the Bankruptcy Code do not, in the absence of inequitable misconduct by the government, authorize the subordination of governmental claims for postpetition tax penalties . . . . 9 A. The doctrine of equitable subordination does not permit a court to disregard the statutory priorities that Congress has enacted merely because the court concludes that a different set of priorities would be more equitable, fair or just . . . . 9 B. The court of appeals misapplied the doctrine of equitable subordination in subordinating a claim in the absence of inequitable conduct by the claimant . . . . 18 Conclusion . . . . 30 TABLE OF AUTHORITIES Cases: Benjamin v. Diamond, 563 F.2d 692(5th Cir. 1977) . . . . 15 Boteler v. Ingels, 308 U. S. 57(1939) . . . . 10,20, 21,24 Burden v. United States, 917 F.2d 115 (3d Cir. 1990) . . . . 6,15,21,22,24 Carpenter v. Wabash Ry., 309 U. S. 23(1940) . . . . 13,14 Columbia Ribbon Co., In re, 117 F.2d 999(3d Cir. 1941) . . . . 10-11, 14, 15 (III) ---------------------------------------- Page Break ---------------------------------------- Iv Cases-Continued: Page Comstock v. Group of Institutional Investors, 335 U.S. 211 (1948) . . . . 5, 11, 12 Credit Industrial Corp., In re, 366 F.2d 402 (2d Cir. 1966) . . . . 16, 18 Louisville Trust Co. v. Louisville, N.A. &C. Ry., 174 U.S. 674 (1899) . . . . 28 Mansfield Tire & Rubber Co., In re, 942 F.2d 1055 (6th Cir. 1991), cert. denied, 502 U.S. 1092 (1992) ,. . . . 5 New Jersey v. Anderson, 203 U.S. 483 (1906) . . . . 14,21 Newton National Bank v. Newbegin, 74 F. 135 (8th Cir. 1896) . . . . 26 Nicholas v. United States, 384 U.S. 678 (1966) . . . . 10,20,21,23,24 Norwest Bank Worthington v. Ahlers, 485 U.S. 197 (1988) . . . . 13 Pepper v. Litton, 308 U.S. 295 (1939) . . . . 5, 11, 12, 25 Samuel Chapman, Inc., In re, 394 F.2d 340 (2d Cir.), cert. denied, 393 U.S. 923 (1968) . . . . 21 Schultz Broadway Inn v. United States, 912 F.2d 230 (8th Cir. 1990) . . . . 6,24 Simonson v. Granquist, 369 U.S. 38 (1962) . . . . 21 Stebbins v. Crocker Citizens National Bank, 516 F.2d 784 (9th Cir.), cert. denied, 423 U.S. 913 (1975) . . . . 8, 9, 11, 13, 14, 15, 19 Stirling Homex Corp., In re, 579 F.2d 206 (2d Cir. 1978), cert. denied, 439 U.S. 1074 (1979) . . . . 26,28 Taylor v. Standard Gas & Electric Co., 306 U.S. 307 (1939) . . . . 5,11 United States v. Killoren, 119 F.2d 364 (8th Cir.), cert. denied, 314 U.S. 640 (1941) . . . . 16 United States v. Reorganized CF&I Fabricators of Utah, Inc., 53 F.3d 1155 (10th Cir. 1995), cert. granted, No. 95-325 (Dec. 1, 1995) . . . . 24,25, 27 United States v. Sotelo, 436 U.S. 268 (1978) . . . . 20 ---------------------------------------- Page Break ---------------------------------------- v Cases-Continued: Page United States Department of Intenrior v. Elliott, 761 F.2d 168 (4th Cir. 1985) . . . . 24 Virtual Network Services Corp., In re, 902 F.2d 1246 (7th Cir. 1990) . . . . 6,24,25,27 Statutes: Bankruptcy Act, 57(j), 11 U.S.C. 93(j) (1976) . . . . 21 Bankruptcy Code, 11 U.S.C. 101 et seq.: 11 U.S.C. 103(b) . . . . 20 11 U.S.C. 503(b)(l)(B) . . . . 2, 18 11 U.S.C. 503(b) (l)(C) . . . . 2,4,8, 10, 18, 19,20,22 11 U.S.C. 507 . . . . 10,29 11 U.S.C. 507(a)(l) . . . . 2,3,8, 10, 18, 19,20 11 U.S.C. 507(a)(7) . . . . 5 11 U.S.C. 510 . . . . 10 11 U.S.C. 510(a) . . . . 10 11 U.S.C. 510(b) . . . . 10,28 11 U.S.C. 510(c) . . . . 2, 3, 5, 6, 8,9, 16, 17, 18,29 11 U.S.C. 510(c)(1) . . . . 3,4,10,16,22 11 U.S.C. 726 . . . . 10, 19, 20,23, 29 11 U.S.C. 726(a) . . . . 2, 10 11 U.S.C. 726(a)(1) . . . . 10, 18, 19 11 U.S.C. 726(a)(4) . . . . 19 11 U.S.C. 726(a)(6) . . . . 28 Bankruptcy Reform Act of 1978, Pub. L. No. 95-598, 92 Stat. 2549 . . . . 6 26 U.S.C. 6651 . . . . 18 Miscellaneous: 2 Collier Bankruptcy Manual (3d ed. 1995) . . . . 11 3 Collier on Bankruptcy (15th ed. 1995) . . . . 18 124 Cong. Rec. (1978): p. 32,398 . . . . 3, 6, 16,25 p. 32,416 . . . . 17,22 p. 33,998 . . . . 3 p. 34,016 . . . . 17,22 H.R. 8200, 95th Cong., 1st Sess. (1977) . . . . 17 H.R. Rep. No. 595, 95th Cong., 1st Sess. (1977) . . . . 17 ---------------------------------------- Page Break ---------------------------------------- VI Miscellaneous-Continued: Page A. Herzog & J. Zweibel, The Equitable Subordination of Claims in Bankruptcy, 15 Vand. L. Rev. 83 (1961) . . . . 11,21 Note, No Fault Equitable Subordination: Reassuring Investors That Only Government Penalty Claims Are At Risk, 34 Wm. & Mary L. Rev. 487 (1993) . . . . 29 Report of the Commission on the Bankruptcy Laws of the United States, H.R. Dec. No. 137, 93d Cong., 1st Sess. Pt. II (1973) . . . . 20 S. Rep. No. 989, 95th Cong., 2d Sess. (1978) . . . . 17,22 ---------------------------------------- Page Break ---------------------------------------- In the Supreme Court of the United States OCTOBER TERM, 1995 No. 95-323 UNITED STATES OF AMERICA, PETITIONER v. THOMAS R. NOLAND, TRUSTEE FOR DEBTOR FIRST TRUCK LINES, INC. ON WRIT OF CERTIORARI TO THE UNITED STATES COURT OF APPEALS FOR THE SIXTH CIRCUIT BRIEF FOR THE UNITED STATES OPINIONS BELOW The opinion of the court of appeals (Pet. App. 1a- 20a) is reported at 48 F.3d 210. The opinion of the district court (Pet. App. 26a-33a) is unreported. The opinion of the bankruptcy court (Pet. App. 34a-55a) is reported at 141 B.R. 621. JURISDICTION The judgment of the court of appeals (Pet. App. 23a) was entered on March 2, 1995. A petition for re- hearing was denied on June 16, 1995 (Pet. App. 24a). The petition for a writ of certiorari was filed on August 25, 1995, and was granted on December 1, (1) ---------------------------------------- Page Break ---------------------------------------- 2 1995. The jurisdiction of this Court rests upon 28 U.S.C. 1254(1). STATUTORY PROVISIONS INVOLVED Sections 503(b)(1)(B) and (C), 507(a)(1), 510(c) and 726(a) of the Bankruptcy Code, 11 U.S.C. 503(b)(1)(B) and (C), 507(a)(1), 510(c) and 726(a), are reproduced at Pet. App. 56a-58a. STATEMENT 1. In 1986, First Truck Lines, Inc., filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code and continued to operate its business as debtor-in-possession. During the follow- ing two years, the debtor failed to pay the social security and unemployment taxes accruing from its operations. After efforts to reorganize the debtor proved unsuccessful, the bankruptcy case was con- verted to a Chapter 7 liquidation in 1988. Respondent was appointed trustee at that time (Pet. App. 2a). The `Internal Revenue Service filed a request for payment of the taxes, interest and tax penalties that accrued after the filing of the bankruptcy peti- tion. Respondent stipulated that, under Section 503(b)(1)(B) of the Bankruptcy Code, 11 U.S.C. 503(b)(1)(B), the unpaid postpetition taxes and interest are "administrative expenses" that are entitled to first priority in distribution of the assets of the estate under Section 507(a)(1) of the Code, 11 U.S.C. 507(a)(1). Respondent asserted, however, that postpetition tax penalties are not entitled to priority in distribution. The parties applied to the bankruptcy court for resolution of that dispute (Pet. App. 2a-3a). 2. The bankruptcy court acknowledged (Pet. App. 40a) that Section 503(b)(1)(C) of the Bankruptcy Code ---------------------------------------- Page Break ---------------------------------------- 3 expressly defines postpetition tax penalties to be "administrative expenses" (11 U.S.C. 507(a)(1)). The court observed, however, that Section 510(c)(1) of the Bankruptcy Code, 11 U.S.C. 510(c)(1), provides that a court may (ibid.), under principles of equitable subordination, subor- dinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim *** Because Section 510(c)(1) "does not expressly define the phrase `equitable subordination,'" the court stated that it would "resort to an examination of the legislative history" (Pet. App. 42a-43a). At the time the Bankruptcy Code was enacted in 1978, the floor statement of the House sponsor stated (Pet. App. 43a, quoting 124 Cong. Rec. 32,398 (1978) (Rep. Edwards), and citing 124 Cong. Rec. 33,998 (1978) (Sen. DeConcini) (emphasis added by court)): It is intended that the term "principles of equitable subordination" follow existing case law and leave to the courts development of this principle. To date, under existing law, a claim is generally subordinated only if [the] holder of such claim is guilty of inequitable conduct, or the claim 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. The bankruptcy court concluded that this legislative history evidences that Congress intended that a tax "penalty''-like any other "penalty''-would be "susceptible to subordination" under the "principles of equitable subordination" codified in Section 510(c) of the Code (Pet. App. 43a). The court deemed it ---------------------------------------- Page Break ---------------------------------------- 4 irrelevant that in 1978 Congress provided a specific statutory priority for postpetition tax "penalties" (11 U.S.C. 503(b)(1)(C)). The court also found it irrele- vant that the United States had not been "guilty of inequitable conduct" in asserting its claim. The court concluded that the government's claim for tax penalties is subject to equitable subordination simply because it is designed to enforce a "penalty" (Pet. App. 44a). In applying the "principles of equitable subor- dination" codified in Section 510(c)(1) of the Bank- ruptcy Code, the court stated that its task is to "weigh the equities of the various claims on a case- by-case basis" to determine whether subordination is appropriate (Pet. App. 44a). The court began its "weighing" or "balancing" of "the equities" by distin- guishing between the pecuniary losses incurred by general commercial creditors and the nonpecuniary loss represented by statutory tax penalties. Finding that the Bankruptcy Code contains a "preference for compensating actual loss claims," the court held "that the equities tilt in favor of subordinating the postpetition non-pecuniary loss tax penalties sought by the IRS" to the claims of general unsecured creditors of the debtor (id. at 49a-50a). Otherwise, the court noted, the assets available for payment of the general unsecured creditors would be reduced by the amount of the tax penalties that, by statute, were given first priority in distribution as administrative expenses of the estate (ibid.). 3. The district court affirmed (Pet. App. 26a-33a). The court stated that all types of priority claims- including first priority claims for administrative expenses-may be subordinated under the "principles of equitable subordination" that Congress codified in ---------------------------------------- Page Break ---------------------------------------- 5 Section 510(c) of the Bankruptcy Code (Pet. App. 29a). The court agreed with the bankruptcy court that the "principles of equitable subordination" are not re- stricted to remedying inequitable misconduct by creditors. The court held, instead, that the "prin- ciples of equitable subordination" permit a tax "penalty" to be subordinated solely in order to pro- mote the claims of other creditors who suffered pecuniary losses from their dealings with the estate (id. at 32a-33a). The district court emphasized that "other creditors * * * provided value to [the debtor] and will not receive that for which they bargained if the IRS is to be given priority for sums which do not represent out of pocket losses to it" (Pet. App. 33a). For this reason, the court concluded that "the equities tip in favor of subordinating the IRS's claim for tax penal- ties in this case" (ibid.). 4. a. The court of appeals affirmed (Pet. App. 1a- 20a). The court noted that this Court has applied "principles of equitable subordination" in bankruptcy cases only in situations involving "creditor mis- conduct" (id. at 5a, citing Comstock v. Group of Institutional Investors, 335 U.S. 211 (1948); Pepper v. Litton, 308 U.S. 295 (1939); Taylor v. Standard Gas & Electric Co., 306 U.S. 307 (1939)). The court also noted that, in In re Mansfield Tire & Rubber Co., 942 F.2d 1055 (1991), cert. denied, 502 U.S. 1092 (1992), another panel of that circuit held that the govern- ment's claim for prepetition excise tax liabilities- which have seventh priority in distribution under Section 507(a)(7) of the Bankruptcy Code-is not subject to equitable subordination solely in order to improve the "fairness" of the distribution to other creditors (Pet. App. 5a-6a). The court held, however, ---------------------------------------- Page Break ---------------------------------------- 6 that none of those decisions is controlling in the context of this case, which concerns the application of "principles of equitable subordination" to a tax "penalty" (id. at 6a). The court of appeals followed the analysis of the bankruptcy court in concluding that the legislative history of Section 510(c) indicates that a statutory "penalty" is properly subject to equitable subor- dination. The court noted that the floor statement of the House sponsor of the 1978 Bankruptcy Reform Act reflected that Congress intended to "follow existing case law and leave to the courts development of this principle" (Pet. App. 11a, quoting 124 Cong. Rec. 32,398 (1978) (Rep. Edwards)). The court ac- knowledged that there was no "existing case law" as of 1978 that supported the equitable subordination of tax penalty claims. The court ascribed this, however, to the fact that, "prior to 1978, nonpecuniary loss tax penalty claims against the estate of the bankrupt were not allowed by law" (Pet. App. 12a). The court noted that three more recent decisions have held that claims for prepetition, nonpriority tax penalties may be equitably subordinated even though no govern- mental misconduct occurred (id. at 14a, citing Burden, v. United States, 917 F.2d 115, 119-120 (3d Cir. 1990); In re Virtual Network Services Corp., 902 F.2d 1246, 1248-1250 (7th Cir. 1990); and Schultz Broadway Inn v. United States, 912 F.2d 230,232-234 (8th Cir. 1990)). The court stated that the reasoning of those decisions applied directly to this case (Pet. App. 19a): We do not see the fairness or the justice in permitting the Commissioner's claim for tax penalties, which are not being assessed because of ---------------------------------------- Page Break ---------------------------------------- 7 pecuniary losses to the Internal Revenue Service, to enjoy an equal or higher priority with claims based on the extension of value to the debtor, whether secured or not. Further, assessing tax penalties against the estate of a debtor no longer in existence serves no punitive purpose. Because of the nature of postpetition, nonpecuniary loss tax penalty claims in a Chapter 7 ease, we believe such claims are susceptible to subordination. To hold otherwise would be to allow creditors who have supported the business during its attempt to reorganize to be penalized once that effort has failed and there is not enough to go around. Furthermore, to hold otherwise could result in rewarding the debtor-in-possession, the party who failed to pay the taxes on time, to the detriment of the creditors. The debtor-in-possession remains liable individually for the postpetition tax penal- ties. However, if the bankruptcy court cannot subordinate these penalties in the appropri- ate case, the creditors, and not the debtor-in- possession, will have borne the burden of paying the penalties. b. Judge Batchelder filed a concurring opinion (Pet. App, 21a-22a). She stated that the court had correctly determined that the "principles of equitable subordination" permit subordination of priority tax claims. In her view, the plain language of the statute mandates that conclusion and "nothing requires us to delve into the legislative history" (id. at 22a): Section 726(a) [see note 1, infra] explicitly, clearly, and unambiguously makes the distribution of the property of the estate subject to the provisions of 510. Postpetition nonpecuniary ---------------------------------------- Page Break ---------------------------------------- 8 loss tax penalties are therefore subject to equitable subordination. End of story. INTRODUCTION AND SUMMARY OF ARGUMENT The court of appeals held in this case that postpetition tax penalties are not to be given the first priority that Congress expressly provided for such claims in Sections 503(b)(1)(C) and 507(a)(1) of the Bankruptcy Code. ._ The court held that claims for such penalties are instead to be denied any priority and are to be subordinated even to general unsecured claims against the debtor. The court stated that its conclusion results from application of the judge-made "principles of equitable subordination" that Congress codified in Section 510(c) of the Bankruptcy Code. The court reasoned that, because tax penalty claims do not compensate a specific, economic loss incurred by the government, such claims should-as a matter of "fairness" and "justice''-be equitably subor- dinated to the claims of "creditors who suffered actual losses" (Pet. App. 19a, 20a). By holding that a tax "penalty" is to be subor- dinated to all other claims against the debtor's estate, the decision in this case annuls and reverses the precisely opposite set of statutory priorities that Congress enacted. The decision thereby conflicts with the established rule that equitable subordination in bankruptcy does not permit a court "to contradict statutory or common law when [it] feels a fairer result may be obtained by application of a different rule" (Stebbims v. Crocker Citizens National Bank, 516 F.2d 784, 787 (9th Cir.), cert. denied, 423 U.S. 913 (1975)). The doctrine of equitable subordination does not confer a power of statutory nullification on the ---------------------------------------- Page Break ---------------------------------------- 9 bankruptcy courts. Instead, the doctrine has the appropriate and narrow role of deterring "conduct either in acquiring or asserting the claim which is itself inequitable" (id. at 788). That traditional ra- tionale obviously would not justify subordination of the tax penalty claims in this case. By assuming a broad authority to realign statutory priorities based upon a "weighing" or "balancing" of the "equities," the court of appeals has fundamentally transformed and misapplied the judge-made doctrine of "equitable subordination" and unloosed that doctrine from its proper moorings. If courts were permitted to determine, by "balancing" the "equi- ties," whose claims are to be paid first and whose are to be paid last, the carefully constructed scheme of priorities in the Bankruptcy Code would be made superfluous. ARGUMENT "PRINCIPLES OF EQUITABLE SUBOR- DINATION" CODIFIED IN SECTION 510(c) OF THE BANKRUPTCY CODE DO NOT, IN THE ABSENCE OF INEQUITABLE MISCONDUCT BY THE GOVERNMENT, AUTHORIZE THE SUBOR- DINATION OF GOVERNMENTAL CLAIMS FOR POSTPETITION TAX PENALTIES A. The Doctrine Of Equitable Subordination Does Not Permit A Court To Disregard The Statutory Priorities That Congress Has Enacted Merely Because The Court Concludes That A Different Set Of Priorities Would Be More Equitable, Fair Or Just 1. A postpetition tax penalty is defined by statute to be an administrative expense of the bankruptcy ---------------------------------------- Page Break ---------------------------------------- 10 estate. 11 U.S.C. 503(b)(1)(C). As an "administrative expense," such a penalty has "[f]irst" priority in the distribution of the assets of the estate. 11 U.S.C. 507(a)(1). See also 11 U.S.C. 726(a) (1).1 As this Court has emphasized, the priority for postpetition tax penalties was enacted by Congress precisely because the enforcement of such penalties is an important and necessary measure for ensuring tax compliance in bankruptcy cases. See Nicholas v. United States, 384 U.S. 678, 694 (1966); Boteler v. Ingels, 308 U.S. 57, 61 (1939). The priorities that Congress has established in the Bankruptcy Code for competing classes of claims apply "[e]xcept as provided in section 510" of the Code. 11 U.S.C. 726(a). Section 510 authorizes only three specific exceptions to the statutory ordering of priorities. First, any claim may be subordinated by agreement. 11 U.S.C. 510(a). Second, claims seeking rescission or damages from sales of the debtor's securities may be subordinated. 11 U.S.C. 510(b). Third, any claim may be subordinated to any other claim "under principles of equitable subordination." 11 U.S.C. 510(c)(1). The question presented in this case is thus not whether "principles of equitable subordination" may be applied to priority claims; instead, it is what those principles are and how they are to be applied to priority claims. 2. The judge-made doctrine of equitable subor- dination has a clear origin and a limited scope (In re ___________________(footnotes) 1 This case involves a liquidation of the debtor's assets under Chapter 7 of the Bankruptcy Code (Pet. App. 2a). The priorities established in Section 507 are made applicable to bankruptcy cases under Chapter 7 by Section 726 of the Bank- ruptcy Code. See 11 U.S.C. 726(a)(1). ---------------------------------------- Page Break ---------------------------------------- 11 Columbia Ribbon Co., 117 F.2d 999, 1002 (3d Cir. 1941) (emphasis added)): [A] court of bankruptcy under its equitable powers may disallow or subordinate a particular claim in bankruptcy which, because of the fraudulent nature of the claim or the bad faith or improper conduct of the claimant, ought not in equity and good conscience to be allowed or paid on a parity with other claims. See also Stebbins v. Crocker Citizens National Bank, 516 F.2d 784, 788 (9th Cir.), cert. denied, 423 U.S. 913 (1975). The issue that is to be resolved "under principles of equitable subordination" is whether (2 Collier Bankruptcy Manual Par. 510.01[1], at 510-2 (3d ed. 1995)): harmful conduct [of the claimant] was directed at other creditors. If it was, the claim which is otherwise provable and allowable should be postponed until the claims of the creditors, who were harmed, have been satisfied. See Comstock v. Group of Institutional Investors, 335 U.S. 211, 229 (1948); Pepper v. Litton, 308 U.S. 295, 311 (1939); A. Herzog & J. Zweibel, The Equitable Subordination of Claims in Bankruptcy, 15 Vand. L. Rev. 83,85 (1961). The limited scope of the doctrine of equitable subordination is reflected in the decisions of this Court. In Taylor v. Standard Gas & Electric Co., 306 U.S. 307, 323-324 (1939), the Court held that the claim of a parent corporation against its subsidiary could be subordinated to the claims of preferred stockholders in the subsidiary "based on the equities of the case- the history of spoliation, mismanagement, and faith- ---------------------------------------- Page Break ---------------------------------------- 12 less stewardship of the affairs of the subsidiary by [the parent] to the detriment of the public investors." Pepper v. Litton, 308 U.S. at 308. In Pepper v. Litton, the Court held that the claim of a dominant shareholder of a bankrupt corporation could be subor- dinated to the claims of other creditors where the shareholder- had breached his fiduciary duties and engaged in a "'planned and fraudulent scheme" that damaged other creditors. Id. at 303-306. And, in Comstock v. Group of Institutional Investors, 335 U.S. 211 (1948), the Court reviewed those decisions and confirmed that "principles of equitable subor- dination" require the presence of creditor mis- conduct. The issue in Comstock was whether the claim of a dominant shareholder against the bankrupt could be equitably subordinated even though there was no evidence of misconduct. The Court held that equit- able subordination could not apply in those circum- stances (335 U.S. at 229): It is not mere existence of an opportunity to do wrong that brings the rule into play, it is the unconscionable use of the opportunity afforded by the domination to advantage itself at the injury of the subsidiary that deprives the wrongdoer of the fruits of his wrong. On the findings in this case, the claim of [the parent] was the outgrowth of complicated but legitimate good faith business transactions, neither in design or effect producing injury to the petitioner or the interests for which he speaks. The doctrine of equitable subordination thus provides a means to redress harmful misconduct of an individual claimant. The premise of any application of ---------------------------------------- Page Break ---------------------------------------- 13 the doctrine of "equitable subordination" to "creditor misconduct" is that Congress has measured the equities of competing classes of claims but has not measured the conduct of the individual creditors who assert those claims. See Carpenter v. Wabash Ry., 309 U.S. 23,28 (1940). Because Congress did not (and indeed cannot) take the conduct of individual creditors into account in enacting a bankruptcy distribution scheme, subordination of a particular claim based upon the inequitable conduct of a specific creditor does not contravene the legislative judgment that Congress has made concerning the relative priorities to be afforded to specified categories of claims. See Stebbins v. Crocker Citizens National Bank, 516 F.2d at 787. The doctrine of equitable subordination does not, however, authorize a court to disregard statutory priorities merely because the court concludes that a different ordering of priorities would enhance "fairness" or "justice" (Pet. App. 19a). "[W]hatever equitable powers remain in the bankruptcy courts must and can only be exercised within the confines of the Bankruptcy Code." Norwest Bank Worthington v. Ahlers, 485 U.S. 197, 206 (1988). As the Ninth Circuit explained in Stebbins v. Crocker Citizens National Bank, 516 F.2d at 787, it is important to keep in mind that the chancellor never did, and does not now, exercise unrestricted power to contradict statutory or common law when he feels a fairer result may be obtained by application of a different rule. Courts of equity have long applied standards of conscience to conduct on an individual basis to prevent formally proper but unconscionable applications of legal ---------------------------------------- Page Break ---------------------------------------- 14 rules; they have not engaged in the practice of making abstract legislative judgments about the fairness of a result contemplated by the leg- islature's statutory scheme if it has otherwise been followed in good faith and without overreaching. See also In re Columbia Ribbon Co., 117 F.2d at 1002.2 This Court has noted that, in enacting the statutory priority scheme, Congress itself made a "reasonable classification of claims as entitled to priority because of superior equities." Carpenter v. Wabash Ry., 309 U.S. at 28. The categorical balanc- ing of equities that Congress made in adopting the Code's priority provisions may not categorically be displaced by the courts under the guise of "equitable subordination." As the Ninth Circuit stated in Stebbins v. Crocker Citizens National Bank, 516 F.2d at 788, the doctrine of equitable subordination does not permit a court to say, "in effect * * * , `No, the distribution scheme provided by the [Bankruptcy] Act is a mistake.'" ___________________(footnotes) 2 Similarly, in New Jersey v. Anderson, 203 U.S. 483 (1906), the Court rejected the assertion that a statutory priority for state taxes should not be recognized because it created an "injustice" for other creditors and gave the State an undue "advantage" (id. at 490): [C]onsiderations of this character, however properly ad- dressed to the legislative branch of the government, can have no place in influencing judicial determination It is the province of the court to enforce. not to make the laws, and if the law works inequality the redress, if any, must be had from Congress. ---------------------------------------- Page Break ---------------------------------------- 15 Courts therefore traditionally and consistently held that "[decisions about the treatment of cate- gories of claims in bankruptcy proceedings * * * are not dictated or illuminated by principles of equity and do not fall within the judicial power of equitable subordination." Burden v. United States, 917 F.2d 115, 122 (3d Cir. 1990) (Alito, J., concurring in part and dissenting in part; emphasis added).3 See also Ben- jamin v. Diamond, 563 F.2d 692, 700 (5th Cir. 1977) (equitable subordination requires that "[t]he claimant must have engaged in some type of inequitable conduct"); Stebbins v. Crocker Citizens National Bank, 516 F.2d at 788 ("there must be conduct either ___________________(footnotes) 3 The Third Circuit has placed itself on both sides of this issue. In 1941, the court explained that the doctrine of equitable subordination does not authorize a court to adopt a priority scheme different from the statutory scheme based simply upon the court's "theory of equity." In re Columbia Ribbon Co., 117 F.2d at 1002. Instead, the court explained, equitable subordination may be applied to "disallow or subor- dinate a particular claim in bankruptcy which, because of the fraudulent nature of the claim or the bad faith or improper conduct of the claimant, ought not in equity and good conscience to be allowed or paid on a parity with other claims. " Ibid. In 1990, the Third Circuit acknowledged that, "prior to the enactment of the Bankruptcy [Code] of 1978," the doctrine of equitable subordination had applied "only when there has been a showing of bad faith on the part of the creditor." Burden v. United States, 917 F.2d at 119. The court identified nothing in the text or history of the 1978 legislation to justify a departure from that historical understanding of equitable subordination. The court stated, nevertheless, that it was persuaded by several recent decisions holding that "creditor misconduct is not a prerequisite for equitable subordination." Id. at 120-121. See pages 24-28, infra. AS described in the text, Judge Alito dissented from that part of the court's opinion. ---------------------------------------- Page Break ---------------------------------------- 16 in acquiring or asserting the claim which is itself inequitable in order to subordinate a claim"); In re Credit Industrial Corp., 366 F.2d 402, 408 (2d Cir. 1966). As the Eighth Circuit stated in United States v. Killoren, 119 F.2d 364, 366, cert. denied, 314 U.S. 640 (1941), in reversing a decision that had applied "equitable subordination" to a claim for taxes, "[t]he plain mandate of the law cannot be set aside because of considerations which may appeal to referee or judge as falling within general principles of equity juris- prudence." 3. In" 1978, Congress codified the judge-made doctrine of equitable subordination as Section 510(c) of the Bankruptcy Code. That provision states that bankruptcy courts may, `tinder principles of equitable subordination, subordinate for purposes of distri- bution all or part of an allowed claim to all or part of another allowed claim." 11 U.S.C. 510(c)(1). By codifying the doctrine of equitable subor- dination, the statute did not enlarge the equitable authority that courts had previously exercised. The express' language of the statute-which refers to "principles of equitable subordination''-indicates that Congress intended courts to exercise the limited equitable powers that had then been established in decisions of this Court and the courts of appeals. The floor statement accompanying Section 510(c)(1) confirms that Congress "intended that the term `principles of equitable subordination' follow exist- ing case law and leave to the courts development of this principle." 124 Cong. `Rec. 32,398 (1978) (Rep. Edwards). The text and history of Section 510(c) reflect a deliberate policy determination of Congress that "existing case law" was to be followed in applying ---------------------------------------- Page Break ---------------------------------------- 17 "principles of equitable subordination." In enacting the Bankruptcy Code in 1978, Congress considered and rejected statutory language that would have granted bankruptcy courts authority to subordinate claims on much broader grounds. The bill that first passed the House of Representatives contained a version of Section 510(c) that would have allowed any claim to be subordinated simply "on equitable grounds." H.R. 8200, 95th Cong., 1st Sess., 510 (1977). The report accompanying the House bill em- phasized that this language differed from the existing doctrine of equitable subordination, for it would permit the courts to order "subordination on any equitable grounds." H.R. Rep. No. 595, 95th Cong., 1st Sess. 359 (1977). The broad language of the House bill was deleted, however, from the final legislation. The phrase "under principles of equitable subordi- nation" was substituted in its place. See S. Rep. No. 989, 95th Cong., 2d Sess. 74 (1978); 124 Cong. Rec. 32,416 (1978) (Rep. Edwards); id. at 34,016 (Sen. DeConcini).4 ___________________(footnotes) 4 The Senate Report on the provision enacted as Section 510(c) states (S. Rep. No. 989, supra, at 74) (emphasis added): [A]ny subordination ordered under this provision must be based on principles of equitable subordination. 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. As originally introduced, the bill provided specifically that a tax claim may not be subordinated on equitable grounds. The bill deletes this express exception, but the effect under the amendment should be much the same in most situations since, under the judicial doctrine of equitable subordination, a tax claim would rarely be subordinated. ---------------------------------------- Page Break ---------------------------------------- 18 The history of Section 510(c) thus confirms that Congress consciously elected to adopt only the "existing" principles of equitable subordination and rejected a broader equitable authority for the bankruptcy courts. That existing authority rejected application of equitable subordination to displace the categorical priorities enacted by Congress in the absence of particularized misconduct by a specific creditor. See pages 10-16, supra. See also In re Credit Industrial Corp., 366 F.2d at 408; 3 Collier on Bankruptcy Par. 510.01 (15th ed. 1995) ("The law in this area is of long standing, having been judicially created."). B. The Court Of Appeals Misapplied The Doctrine Of Equitable Subordination In Subordinating A Claim In The Absence Of Inequitable Conduct By The Claimant 1. In the present case, the court of appeals acknowledged that the tax penalty claim was not derived from any "misconduct" of the government (Pet. App. 4a).5 The court also recognized that Congress expressly provided first priority in the distribution of the assets of the estate for such tax penalty claims (ibid., citing 11 U.S.C. 503(b)(1)(B) and (C), 507(a)(1), and 726(a)(1)). The court concluded, however, that Congress acted "unfairly" and "un- justly" in awarding first priority to the government's claims for postpetition tax penalties under Section ___________________(footnotes) 5 Indeed, the claim in this case was derived from the debtor's failure to file a timely return (26 U.S.C. 6651), which represents "misconduct" by the debtor, not the creditor (the United States). Hence, the doctrine of equitable subordination, which applies only to creditor misconduct, has no application here. ---------------------------------------- Page Break ---------------------------------------- 19 503(b)(1)(C) and Section 507(a)(1). The court of appeals "in effect said, `No, the distribution scheme provided by the Act is a mistake'" (Stebbins V. Crocker Citizens National Bank, 516 F.2d at 788). The court stated that it did not "see the fairness or the justice in permitting the Commissioner's claim for tax penalties * * * to enjoy an equal or higher priority with claims based on the extension of value to the debtor, whether secured or not" (Pet. App. 19a). For that reason, the court held that the tax penalty claim should not be given the "[f]irst" priority that Congress specified for that claim. The court held, instead, that the government's claim should be "equitably" subordinated even to the claims of unse- cured general creditors (ibid.). The court of appeals erred in applying the doctrine of equitable subordination to annul the statutory priorities established by Congress simply because the court believed that "fairness" and "justice" could be enhanced by a different distribution scheme. Con- gress directed that postpetition tax penalties are to be given "[f]irst" priority in distribution. 11 U.S.C. 507(a)(1); see 11 U.S.C. 503(b)(1)(C).6 Even if there ___________________(footnotes) 6 While Section 726(a)(1) preserves first priority in distri- bution for postpetition tax penalties in Chapter 7 cases (see note 1, supra), Section 726(a)(4) expressly subordinates prepetition tax penalties to general unsecured claims. Compare 11 U.S.C. 726(a)(1) with 11 U.S.C. 726(a)(4). The reasoning adopted by the court of appeals in this case is thus invalid for the additional reason that it conflicts with the carefully crafted distinctions that Congress made in enacting Section 726. By requiring subordination of postpetition tax penalties, the decision in this case relegated those penalties to the same status that Congress elected to apply only to prepetition tax penalties in Section 726. ---------------------------------------- Page Break ---------------------------------------- 20 were a basis to believe that it might be more "fair" to pay other creditors before postpetition tax penalties are paid, any dispute about the relative merits of alternative priority schemes is simply irrelevant to the task that the court of appeals properly had before it.7 Congress authoritatively resolved that policy issue when it expressly provided a first priority for postpetition tax penalty claims in Section 503(b)(1)(C) and Section 507(a)(1). Moreover, as this Court explained in enforcing the priority for postpetition tax penalties in Nicholas v. United States, 384 U.S. at 694, Congress adopted that first priority for postpetiton tax penalty claims precisely because such penalties serve to enforce compliance with the tax laws in bankruptcy cases. See also Boteler v. Ingels, 308 U.S. at 61. That legislative judgment is obviously binding on the courts and may not be displaced by a court's differing perception of "equity" or "fairness" (Pet. App. 19a). See, e.g., United States v. Sotelo, 436 U.S. 268,279 (1978) ("we as judges cannot override the specific policy judgments made by Congress i n enacting the statutory provisions with which we are ___________________(footnotes) Section 726 sets forth the order of distribution in cases under Chapter 7. See 11 U.S.C. 103(b); note 1, supra. In cases outside of Chapter 7, prepetition tax penalties are paid on a parity with general unsecured claims. Congress rejected pro- posals that would have required subordination of prepetition tax penalty claims in cases under all chapters. See Report of the Commission on the Bankruptcy Laws of the United States, H.R. Dec. No. 137, 93d Cong., 1st Sess. Pt. II, at 115, 4-406(a)(3) (1973). 7 In assessing the "fairness" of the statutory distribution scheme, the court of appeals wholly failed to consider the enforcement function served by tax penalties during the administration of the estate. ---------------------------------------- Page Break ---------------------------------------- 21 here concerned"); New Jersey v. Anderson, 203 U.S. at 490; note 2, supra. 2. In its decision in this case, the court of appeals sought to rely on the 1978 floor statement of Representative Edwards that "existing case law" permits subordination of "a claim * * * of a status susceptible to subordination, such as a penalty" (Pet. App. 11a). As Judge Alito correctly observed in his separate opinion in Burden v. United States, 917 F.2d at 123, however, that description of "existing case law" by Representative Edwards was simply in- correct. As of 1978, no court had held that tax "penalty" claims, or any other kind of "penalty" claims, were subject to equitable subordination. Prior to 1978, claims for prepetition tax penalties were disallowed by statute (not subordinated through exercise of a court's equitable powers) under Section 57(j) of the Bankruptcy Act, 11 U.S.C. 93(j) (1976). See Simonson v. Granquist, 369 U.S. 38, 40 (1962); Herzog & Zweibel, supra, 15 Vand. L. Rev. at 85-88 (noting the difference between claim disallowance and claim subordination). By contrast, claims for post- petition penalties incurred by the trustee or debtor in possession-the type of penalties involved in this case-were allowable and were given first priority in distribution of the bankruptcy estate. Nicholas v. United States, 384 U.S. at 692-695; Boteler v. Ingels, 308 U.S. at 61; In re Samuel Chapman, Inc., 394 F.2d 340,341-342 (2d Cir.), cert. denied, 393 U.S. 923 (1968).8 ___________________(footnotes) 8 The majority and concurring opinions in this case (Pet. App. 12a-13a, 22a) thus simply erred in stating, without qualifi- cation, that penalty claims were disallowed under the former Bankruptcy Act. ---------------------------------------- Page Break ---------------------------------------- 22 Any misdescription of "existing case law" in the 1978 floor statement of Representative Edwards obviously does not alter the preexisting "principles of equitable subordination" that are to be applied under Section 510(c)(1). See Burden v. United States, 917 F.2d at 123 (Alito, J., concurring in part and dis- senting in part). Moreover, although it is unclear what "penalty" Representative Edwards may have had in mind in asserting that penalty claims were of a status "susceptible to subordination," he obviously was not contemplating that postpetition tax penalty claims would be subordinated under Section 510(c)(1) when Section 503(b)(1)(C) of the same Act provides "[f]irst" priority for such claims. See 11 U.S.C. 503(b)(1)(C). Indeed, Representative Edwards went on to say in the next portion of his remarks (124 Cong. Rec. 32,416 (1978)): Since the House amendment authorizes subor- dination of claims only under principles of equitable subordination, and thus incorporates principles of existing case law, a tax claim would rarely be subordinated under this provision of the bill. See also id. at 34,016 (Sen. DeConcini); S. Rep. No. 989, supra, at 74 (noting that, "under the judicial doctrine of equitable subordination, a tax claim would rarely be subordinated" for "a claim may normally be subordinated only if its holder is guilty of mis- conduct"); note 4, supra. The suggestion that tax penalty claims are categorically of a "status susceptible to subor- dination" is also refuted by the careful distinctions that Congress made in providing disparate treatment for prepetition and postpetition tax penalties. Section ---------------------------------------- Page Break ---------------------------------------- 23 726 provides first priority for claims for postpetition tax penalties but subordinates claims for prepetition penalties to general unsecured claims. See note 6, supra. The precisely formulated legislative judgment that Congress made in Section 726 may not be annulled by a judicial conclusion that "fairness" and "justice" require that some different priority scheme apply. As this Court has noted, Congress has long provided first priority for postpetition tax penalties as a "legitimate means to enforce" compliance with the tax laws in bankruptcy cases. Nicholas v. United States, 384 U.S. at 694. By effectively ensuring that claims for postpetition penalties will not be paid from the assets of bankruptcy estates, the decision in this case would allow debtors-in-possession and trustees to disregard their legal obligations with impunity.9 Allowing violations of the law to go unsanctioned and undeterred is neither "fair," nor "equitable," nor good "policy''-as Congress authoritatively determined by providing first priority for the payment of such claims. As this Court has recognized, the priority for postpetition tax penalties in bankruptcy exists precisely to ensure that debtors abide by the same rules of law that apply to every other business ___________________(footnotes) 9 The court of appeals erred in suggesting (Pet. App. 19a) that the tax penalties involved in this case can be collected by the government even if that claim is subordinated in the liquidation proceedings, The court reasoned that ultimate collection is assured because the "debtor-in-possession remains liable individually for the postpetition tax penalties" (ibid.). In making that statement, however, the court seems to have forgotten that this case involves a liquidation under Chapter 7. After such a liquidation, the debtor will have no assets available to pay any unsatisfied, subordinated tax penalty claim. ---------------------------------------- Page Break ---------------------------------------- 24 (including those with whom they compete). Nicholas v. United States, 384 U.S. at 694; Boteler v. Ingels, 308 U.S. at 61. See also United States Department of Interior V. Elliott, 761 F.2d 168, 171 (4th Cir. 1985).10 3. a. Other courts have also recently held that "principles of equitable subordination" are not con- fined to remedying creditor misconduct and instead permit courts categorically to subordinate "penalty" claims to the claims of other creditors who have incurred an "actual loss" (Pet. App. 20a). See Burden v. United States, 917 F.2d at 119-120, In re Virtual Network Services Corp., 902 F.2d 1246, 1248-1250 (7th Cir. 1990); Schultz Broadway Inn v. United States, 912 F.2d 230,232-234 (8th Cir. 1990); United States v. Reorganized CF&I Fabricators of Utah, Inc., 53 F.3d 1155 (10th Cir. 1995), cert. granted, No. 95-325 (Dec. 1, 1995). In these other cases, as here, the courts reasoned that subordination of a tax penalty claim is appropriate to ensure that payment. of the penalty does not reduce the assets available for other claimants. In so holding, these courts acknowledged that, prior to enactment of the Bankruptcy Code in 1978, the "existing case law" had held that the doctrine of equitable subordination required a showing of creditor misconduct. See, e.g., In re Virtual Network ___________________(footnotes) 10 In United States Department of Interior v. Elliott, the court further explained the rationale for granting statutory priority to claims for postpetition penalties even though such claims may deplete the assets available to other creditors. Creditors may influence the debtor-in-possession or trustee to allow such penalties to accrue and should not be permitted to benefit from the false economies recognized by the estate through its failure to comply with applicable nonbankruptcy law. 761 F.2d at 171. ---------------------------------------- Page Break ---------------------------------------- 25 Services Corp., 902 F.2d at 1248, citing Pepper v. Litton, 308 U.S. at 304-305. The courts also rec- ognized that Congress intended such "existing case law" to apply in any future elaboration of the "principles of equitable subordination" (902 F.2d at 1248; Pet. App. 11a). They reasoned, however, that the history of the 1978 Bankruptcy Code indicates that such older authority is not necessarily binding because "Congress intended courts to continue developing the principles of equitable subordination." United States v. Reorganized CF&I Fabricators of Utah, Inc., 53 F.3d at 1158, citing In re Virtual Network Services Corp., 902 F.2d at 1249-1250. The courts relied for this conclusion on the portion of the floor statement of Representative Edwards which states (124 Cong. Rec. 32,398 (1978)): It is intended that the term "principles of equitable subordination" follow existing case law and leave to the courts development of this principle. Read as a whole, however, this sentence cannot logically be understood to suggest that courts may, in the "development of this principle," establish "principles of equitable subordination" that conflict with the "existing case law" that, as of 1978, had con- cluded that equitable subordination could not be applied to discard the categorical classifications of priorities that Congress enacted in the Code. Such a reading would place one part of that sentence at war with the other part. Instead, this sentence from the floor statement indicates only that equitable subordination is a judicially created remedy that should be applied compatibly with the prior case law. The statement ---------------------------------------- Page Break ---------------------------------------- 26 cannot properly be read-as the court read it in this case (Pet. App. 18a)-as an invitation to depart fundamentally from prior case law by substituting the court's judgment about the comparative equities of classes of claims for the judgment that Congress itself has made. b. The only authority cited by these courts as evidence of the "developing" principles of equitable subordination is the Second Circuit's decision in In re Stirling Homex Corp., 579 F.2d 206 (1978), cert. denied, 439 U.S. 1074 (1979). In that case, the court of appeals held that the claims of shareholders who alleged that they were defrauded in purchasing stock of the debtor should be subordinated to general unsecured claims because "the equities favor the con- ventional general creditors rather than the allegedly defrauded stockholders." Id. at 213. The court noted that the claims of these stockholders for the recovery of their capital contributions are claims asserted in their capacity as shareholders. Ibid. The court held that the claims of shareholders brought in their capacity as shareholders, rather than in the capacity of a trade or business creditor, should not be treated on a parity with the claims of general unsecured creditors. ibid.11 In so holding, the court cited and relied (i bid.) on the authority of Newton National Bank v. Newbegin, 74 F. 135, 140 (1896), where the Eighth Circuit stated that the temptation for stockholders to attempt to "lay aside the garb of a ___________________(footnotes) 11 Stirling Homex involved an attempt by equity share- holders who allegedly were defrauded in the purchase of the debtor's securities to elevate their priority in the corporate bankruptcy from last priority (as equity holders) to that of unsecured creditors (as tort claimants). 579 F.2d at 211-213. ---------------------------------------- Page Break ---------------------------------------- 27 stockholder, on one pretense or another, and to assume the role of a creditor, is very strong, and all attempts of that kind should be viewed with suspicion." Other courts have suggested that Stirling Homex is an example of a "developing" principle of equitable subordination under which courts should make a "case-by-case" evaluation of the equities and should not require actual proof of creditor misconduct. In United States v. Reorganized CF&I Fabricators of Utah, Inc., 53 F.3d at 1159, quoting In Re Virtual Network Services Corp., 902 F.2d at 1250, the court broadly stated: [Section] 510(c)(1) authorizes courts to equit- ably subordinate claims to other claims 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. But nothing in Stirling Homex provides support for the proposition that courts may apply "equitable subordination" categorically to alter the distribution scheme that Congress enacted. The Second Cir- cuit did not mention, much less question, the well- established case law holding that courts may not disregard the statutory priority scheme based on their contrary view of what is "fair" or "just ." Instead, the decision in Stirling Homex was based upon the necessity of determining whether the claims of the shareholders were for the recovery of capital- and therefore to be paid only after general unsecured claims-or were instead business and trade claims properly to be treated on a parity with the general unsecured claims brought by strangers to the ---------------------------------------- Page Break ---------------------------------------- 28 corporation. The Second Circuit concluded in Stirling Homex that the claims of shareholders that stem from their status as shareholders are capital in nature and are therefore subordinated, under ordinary priority principles, to creditor claims. 579 F.2d at 213. See, e.g., Louisville Trust Co. v. Louisville, N.A. & C. Ry., 174 U.S. 674, 684 (1899) (noting the "familiar rule that the stockholder's interest in the property is subordinate to the rights of creditors"). Stirling Homex is thus a particular application of, not a negation or nullification of, the statutory priority classification scheme that Congress has enacted.12 Under that scheme, the interests of shareholders in the capital of the corporation is comp- ensated only after the claims of general unsecured creditors are paid. See 11 U.S.C. 726(a)(6). 4. The doctrine of equitable subordination does not permit courts to act as committees of legislative review to promulgate priority schemes that are more closely aligned with their view of "fairness or * * * justice" (Pet. App. 19a). The categorical judicial re- evaluation of the "equities" of competing classes of claims authorized by the decision of the court of appeals in this case would create harmful un- certainties for private, as well as public, creditors. An unfettered "equitable" authority to adjust statutory priorities to enhance "fairness" would threaten "the financial community [by calling] into ___________________(footnotes) 12 The rule articulated in Stirling Homex was codified in Section 510(b) of the Bankruptcy Code (11 U.S.C. 510(b)) and was described in the 1978 floor statement of Representative Edwards as an example of "existing case law." See Pet. App. ha. ---------------------------------------- Page Break ---------------------------------------- 29 question the future of bankruptcy priority." Note, No Fault Equitable Subordination: Reassuring In- vestors That Only Government Penalty Claims Are At Risk, 34 Wm. & Mary L. Rev. 487, 488 (1993). Under the theory applied by the court of appeals in this case, it could be questioned whether, for example, claims for punitive damages would be regarded as subject to subordination because "inequitable" (in the sense of not involving "actual losses" (Pet. App. 19a)) or, instead, entitled to preferential treatment because "equitable" (in the sense of being designed to promote the public purpose of deterring malicious behavior). Similarly, postpetition governmental "penalty" claims designed to deter violations of health and safety regulations would plausibly be subject to subordination on the theory adopted by the court of appeals in this case-because they do not compensate the government for "pecuniary loss" and may reduce the recovery of other claimants (ibid.). The establishment of categorical priorities among competing, innocent claimants has never been the function of the judiciary in bankruptcy cases. In the Bankruptcy Code itself, Congress specified the priorities that innocent claimants are to receive. See 11 U.S.C. 507, 726. By ignoring those statutory priorities-and, indeed, adopting a precisely opposite set of priorities in this case-the decision of the court of appeals represents a marked departure both from the common understanding of "equitable" authority and from the specific understanding of the doctrine of "equitable subordination" that Congress codified in 1978 in Section 51O(c) of the Bankruptcy Code.13 ___________________(footnotes) 13 This case will be argued in tandem with United States v. Reorganized CF&I Fabricators of Utah, Inc., No. 95-425, ---------------------------------------- Page Break ---------------------------------------- 30 CONCLUSION The judgment of the court of appeals should be reversed. Respectfully submitted. DREW S. DAYS, III Solicitor General LORETTA C. ARGRETT Assistant Attorney General LAWRENCE G. WALLACE Deputy Solicitor General KENT L. JONES Assistant to the Solicitor General GARY D. GRAY EDWARD T. PERELMUTER Attorneys JANUARY 1996 which presents a closely analogous question concerning the proper scope of the "principles of equitable subordination" in bankruptcy cases. We have furnished a copy of the brief for the United States in Reorganized CF&I Fabricators to counsel for the respondents in this case. We have also furnished a copy of the brief for the United States in this case to counsel for the respondents in Reorganized CF&I Fabricators. ---------------------------------------- Page Break ---------------------------------------- No. 95-323 IN THE SUPREME COURT OF THE UNITED STATES OCTOBER TERM, 1995 UNITED STATES OF AMERICA, PETITIONER v. THOMAS R. NOLAND, TRUSTEE FOR THE DEBTOR FIRST TRUCK LINES, INC. PETITION FOR A WRIT OF CERTIORARI TO THE UNITED STATES COURT OF APPEALS FOR THE SIXTH CIRCUIT DREW S. DAYS, III Solicitor General LORETTE C. ARGRETT Assistant Attorney General LAWRENCE G. WALLACE Deputy Solicitor General KENT L. JONES Assistant to the Solicitor General GARY D. GRAY EDWARD T. PERELMUTER Attorneys Department of Justice Washington, D.C. 20530 (202) 514-2217 ---------------------------------------- Page Break ---------------------------------------- QUESTION PRESENTED Taxes and tax penalties that arise after the date of a bankruptcy filing are "administrative expenses" of the bankruptcy estate. 11 U.S.C. 503(b)(1)(B) and (C). As "administrative expenses," such taxes and tax penalties are entitled to first priority in the distribution of the estate. 11 U.S.C. 507(a)(1). This case presents the following question: Whether the statutory priority that Congress con- ferred on the government's claim for post-petition tax penalties may-under the "principles of equitable subordination" codified in Section 510(c)(1) of the Bankruptcy Code, 11 U.S.C. 510(c)(1)-be subor- dinated to the claims of general unsecured creditors solely because a court determines that it would en- hance "fairness" and "justice" to pay the general creditors frost. (I) ---------------------------------------- Page Break ---------------------------------------- TABLE OF CONTENTS Opinions below . . . . 1 Jurisdiction . . . . 2 Statutory provisions involved . . . . 2 Statement . . . . 2 Reasons for granting the petition . . . . 8 Conclusion . . . . 25 Appendix A . . . . 1a Appendix B . . . . 23a Appendix C . . . . 24a Appendix D . . . . 26a Appendix E . . . . 34a Appendix F . . . . 56a TABLE OF AUTHORITIES Cases: Benjamin V. Diamond, 563 F.2d 693 (5th Cir. 1977) . . . . 16-17, 18 Boteler V. Ingels, 308 U.S. 57 (1939) . . . . 14, 15 Burden V. United States, 917 F.2d 115 (3d Cir. 1990) . . . . 6,15,16,17,19 Carpenter V. Wabash Ry., 309 U.S. 23 (1940) . . . . 12,13 Colin, In re, 44 B.R. 806 (Bankr. S.D.N.Y. 1984). . . . 23 Columbia Ribbon Co., In re, 117 F.2d 999 (3d Cir. 1941) . . . . 11,13,16 Comstock v. Group of Institutional Investors, 335 U.S. 211 (1948) . . . . 5,11 Credit Industrial Corp., In re, 366 F.2d 402 (2d Cir. 1966) . . . . l7, 18,21 New Jersey V. Anderson, 203 U.S. 483 (1906 ). . . . 13 Nicholas V. United States, 384 U.S. 678 (1966) . . . . 9,14, 15, 24 (III) ---------------------------------------- Page Break ---------------------------------------- IV Cases-Continued: Page Norwest Bank Worthington VAhlers, 485 U.S. 197 (1988) . . . . 12 Pepper V. Litton, 308 U.S. 295 (1939) . . . . 5,21 Shultz Broadway Inn v. United States, 912 F.2d 230 (8th Cir. 1990) . . . . 7,19 Simonson V. Granquist, 362 U.S. 38 (1962) . . . . 15 Stebbins V. Crocker Citizens National Bank, 516 F.2d 784 (9th Cir.), cert. denied, 423 U.S. 913 (1975) . . . . 8,9,11,12,13,18,22 Stirling Homex Corp., In re, 579 F.2d 206 (2d Cir. 1978) . . . . 20,21 Taylor v. Standard Gas & Electric Co., 306 U.S. 307 (1939) . . . . 5,11 United States Dep't of Interior V. Elliott, 761 F.2d 168 (4th Cir. 1985) . . . . 24 United States V. Killoren, 119 F.2d 364 (8th Cir. 1941) . . . . 17 United States V. Mansfield Tire& Rubber Co., 942 F.2d 1055 (6th Cir. 1991), cert. denied, 502 U.S. 1092 (1992) . . . . 5-6 United States V. New York Creditmen's Adjust- ment Bureau, Inc., 394 F.2d 340 (2d Cir. 1968). . . . 15 United States V. Reorganized CF&I Fabricators of Utah, Inc., 53 F.3d 1155 (10th Cir. 1995) . . . . 10,19 20, 21 Virtual Network Semites Corp., In re, 902 F.2d 1246 (7th Cir. 1990) . . . . 7,19,20,22 Statutes: Bankruptcy Act 57j, 11 U.S.C. 93(j) (1976) . . . . 15 Bankruptcy Code, 11 U.S.C. et seq.: 11 U.S.C. 503 (b) (1) (B) . . . . 2, 56a 11 U.S.C. 503 (b) (1) (C) . . . . 2, 3, 4, 8, 10, 14, 15, 56a 11 U.S.C. 507 (a) (1) . . . . 2, 3, 14, 56a 11 U.S.C. 507 (a) (7) . . . . 6, 8, 10 11 U.S.C. 510 . . . . 10 11 U.S.C. 510 (a) . . . . 10 11 U.S.C. 510 (b) . . . . 11, 21 11 U.S.C. 510 (c) . . . . 2, 4, 5, 6, 8, 11, 18 ---------------------------------------- Page Break ---------------------------------------- v Statutes-Continued: Page 11 U.S.C. 510 (c) (1) . . . . 3, 4, 15, 16, 17, 57a 11 U.S.C. 726 . . . . 14, 57a 11 U.S.C. 726 (a) . . . . 2, 10 11 U.S.C. 726 (a) (1) . . . . 10, 14, 57a 11 U.S.C. 726 (a) (4) . . . . 14, 19, 58a Miscellaneous: 2 Collier Bankruptcy Manual (3d ed. 1995) . . . . 11 3 Collier on Bankruptcy (15th ed. 1995) . . . . 19-20 124 Cong. Rec. (1978): p. 32,398 . . . . 3,6,17 p. 32,416 . . . . 15,18 p. 33,992 . . . . 3 p. 33,998 . . . . 3,15 p. 34,016 . . . .15,18 H.R. 8200, 95th Cong., 1st Sess. (1977) . . . . 18 H.R. Rep. No. 595, 95th Cong., 1st Sess. (1977) . . . . 18 Herzog & Zweibel, The Equitable Subordination of Claims in Bankruptcy, 15 Vand L. Rev. 83 (1961) . . . . 12 Note, No Fault Equitable Subordination: Reassur- ing Investors That Only Government Penalty Claims Are At Risk, 34 Wm. & Mary L. Rev. 487 (1993) . . . . 23 Report of the Commission on the Bankruptcy Laws of the United States, H.R.. Doe. No. 137, 93d Cong., 1st Sess. Pt. 11 (1973) . . . . 19 S. Rep. No. 989, 95th Cong., 2d Sess. (1978) . . . . 18 ---------------------------------------- Page Break ---------------------------------------- In the Supreme Court of the United States OCTOBER TERM, 1995 No. UNITED STATES OF AMERICA, PETITIONER v. THOMAS R. NOLAND, TRUSTEE FOR DEBTOR FIRST TRUCK LINES, INC. PETITION FOR A WRIT OF CERTIORARI TO THE UNITED STATES COURT OF APPEALS FOR THE SIXTH CIRCUIT The Solicitor General, on behalf of the United States of America, petitions for a writ of certiorari to review the judgment of the United States Court of Appeals for the Sixth Circuit in this case. OPINIONS BELOW The opinion of the court of appeals (App., infra, 1a-20a) is reported at 48 F.3d 210. The opinion of the district court (App., infra, 26a-33a) is unreported. The opinion of the bankruptcy court (App., infra, 34a-55a) is reported at 148 B.R. 332. (1) ---------------------------------------- Page Break ---------------------------------------- 2 JURISDICTION The judgment of the court of appeals was filed on March 2, 1995 (App., infra, 23a). A petition for rehearing was denied on June 16, 1995 (App., infra, 24a). The jurisdiction of this Court is invoked under 28 U.S.C. 1254(1) . STATUTORY PROVISIONS INVOLVED Sections 503(b)(1)(B) and (C), 507(a)(1), 510(c) and 726 (a) of the Bankruptcy Code, 11 U.S.C. 503(b)(1)(B) and (C), 507(a)(1), 510(c) and 726 (a), are reproduced in the Appendix, infra, at 56a-58a. STATEMENT 1. In 1986, First Truck Lines, Inc., filed a volun- tary petition for relief under Chapter 11 of the Bank- ruptcy Code and continued to operate its business as debtor-in-possession. During the following two years, the debtor failed to pay the social security and unem- ployment taxes accruing from its operations. After efforts to reorganize the debtor proved unsuccessful, the bankruptcy case was converted to a Chapter 7 liquidation in 1988, Respondent was appointed trustee at that time (App., infra, 2a). The Internal Revenue Service filed a request for payment of the taxes, interest and tax penalties that accrued after the filing of the bankruptcy petition. Respondent stipulated that the unpaid postpetition taxes and interest are "administrative expenses" that are entitled to first priority in the distribution of the assets of the estate under Section 507(a)(1) of the Bankruptcy Code, 11 U.S.C. 507(a)(1). Respondent asserted, however, that postpetition tax penalties are ---------------------------------------- Page Break ---------------------------------------- 3 not entitled to priority in distribution. The parties applied to the bankruptcy court for resolution of that dispute (App., infra, 2a-3a). 2. The bankruptcy court acknowledged (App., infra, 40a) that Section 503 (b) (1) (C) of the Bank- ruptcy Code expressly defines postpetition tax penal- ties to be "administrative expenses" (11 U.S.C. 507 (a) (1) ). The court observed, however, that Sec- tion 510 (c) (1) of the Bankruptcy Code, 11 U.S.C. 510(c) (1), provides that a court may (ibid.), under principles of equitable subordination, sub- ordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim * * *. Because Section 510 (c) (1) "does not expressly define the phrase `equitable subordination,' " the court stated that it would "resort to an examination of the legislative history" (App., infra, 42a-43a). At the time the Bankruptcy Code was enacted in 1978, the floor statement of the House sponsor stated (App., infra, 43a, quoting 124 Cong. Rec. 32,398 (1978) (Rep. Edwards), and citing 124 Cong. Rec. 33,992, 33,998 (1978) ( Sen. DeConcini) (emphasis added by court)) : It is intended that the term "principles of equi- table subordination" follow existing case law and leave to the courts development of this prin- ciple. To date, under existing law, a claim is generally subordinated only if [the] holder of such claim is guilty of inequitable conduct, or the claim is of a status susceptible to subordina- tion, such as a penalty or a claim for damages arising from the purchase or sale of a security of the debtor. ---------------------------------------- Page Break ---------------------------------------- 4 The bankruptcy court concluded that this legislative history evidences that Congress intended that a tax "penalty''-like any other "penalty''-would be "sus- ceptible to subordination" under the "principles of equitable subordination" codified in Section 510(c) of the Code (App., infra, 43a). The court deemed it irrelevant that in 1978 Congress provided a specific statutory priority for postpetition tax "penalties" (11 U.S.C. 503(b)(1)(C)). The court also found it irrel- evant that the United States had not been "guilty of inequitable conduct" in asserting its claim. The court concluded that the government's claim for tax penal- ties is subject to equitable subordination simply be- cause it is designed to enforce a "penalty" (App., infra, 44a). In applying the "principles of equitable subordina- tion" codified in Section 510 (c) (1) of the Bank- ruptcy Code, the court stated that its task is to "weigh the equities. of the various claims on a case- by-case basis" to determine whether subordination is appropriate (App., infra, 44a). The court began its "weighing" or "balancing" of "the equities" by dis- tinguishing between the pecuniary losses incurred by general commercial creditors and the nonpecuniary loss represented by statutory tax penalties. Finding that the Bankruptcy Code contains a "preference for compensating actual loss claims," the court held "that the equities tilt in favor of subordinating the post- petition nonpecuniary loss tax penalties sought by the IRS" to "the claims of general unsecured creditors of the debtor" (id. at 49a-50a). Otherwise, the court noted, the assets available for payment of the general unsecured creditors would be reduced by the amount of the tax penalties that, by statute, were given first ---------------------------------------- Page Break ---------------------------------------- 5 priority in distribution as administrative expenses of the estate (ibid.). 3. The district court affirmed (App., infra, 26a- 33a). The court stated that all types of priority claims-including first priority claims for adminis- trative expenses-may be subordinated under the "principles of equitable subordination" that Congress codified in Section 510 [c) of the Bankruptcy Code (App., infra, 29a). The court agreed with the bank- ruptcy court that the "principles of equitable subor- dination" are not restricted to remedying inequitable misconduct by creditors. The court held, instead, that the "principles of equitable subordination" permit a tax "penalty" to be subordinated solely in order to promote the priority of the claims of other creditors who suffered pecuniary losses from their dealings with the estate (id. at 32a-33a). The district court emphasized that "other credi- tors * * * provided value to [the debtor] and will not receive that for which they bargained if the IRS is to be given priority for sums which do not represent out of pocket losses to it" (App., infra, 33a). For this reason, the court concluded that "the equities tip in favor of subordinating the IRS's claim for tax penalties in this case" (ibid.). 4. a. The court of appeals affirmed (App., infra, 1a-20a). The court noted that this Court has applied "principles of equitable subordination" in bank- ruptcy cases only in situations involving "creditor misconduct" (App., infra, 5a, citing Comstock v. Group of Institutional Investors, 335 U.S. 211 (1948) ; Pepper v. Litton, 308 U.S. 295 (1939); Tay- lor v. Standard Gas & Electric Co., 306 U.S. 307 (1939) ). The court also noted that, in United States ---------------------------------------- Page Break ---------------------------------------- 6 v. Mansfield Tire & Rubber Co., 942 F.2d 1055 (1991), cert. denied, 502 U.S. 1092 (1992), another panel of that circuit held that the government's claim for prepetition excise tax liabilities-which have seventh priority in distribution under Section 507 (a) (7) of the Bankruptcy Code-is not subject to equitable subordination solely in order to improve the "fairness" of the distribution to other creditors (App., infra, 5a-6a). The court held, however, that none of these decisions is controlling in the context of this case, which concerns the application of "prin- ciples of equitable subordination" to a tax "penalty" (id. at 6a). The court of appeals followed the analysis of the bankruptcy court in concluding that the legislative history of Section 510(c) indicates that a statutory "penalty" is properly subject to equitable subordina- tion. The court noted that the floor statement of the House sponsor of the 1978 Bankruptcy Reform Act reflected that Congress intended to "follow existing case law and leave to the courts development of this principle" (App., infra, 11a, quoting 124 Cong. Rec. at 32,398 (Rep. Edwards)). The court acknowl- edged that there was no "existing case law" as of 1978 that supported the equitable subordination of priority tax penalty claims. The court ascribed this, however, to the fact that, "prior to 1978, nonpecuni- ary loss tax penalty claims against the estate of the bankrupt were not allowed by law" (App., infra, 12a). The court noted that three more recent deci- sions have held that claims for prepetition nonpriority tax penalties may be equitably subordinated even though no governmental misconduct occurred (id. at 14a, citing Burden v. United States, 917 F.2d 115, 119-120 (3d Cir. 1990), In re Virtual Network Serv- ---------------------------------------- Page Break ---------------------------------------- 7 ices Corp.,902 F.2d 1246, 1248-1250 (7th Cir. 1990), and Schultz Broadway Inn v. United States, 912 F.2d 230, 232-234 (8th Cir. 1990)). The court stated that the reasoning of those decisions applied directly, to this case (App., infra, 19a) : We do not see the fairness or the justice in per- mitting the Commissioner's claim for tax penal- ties, which are not being assessed because of pecuniary losses to the Internal Revenue Service, to enjoy an equal or higher priority with claims based on the extension of value to the debtor, whether secured or not. Further, assessing tax penalties against the estate of a debtor no longer in existence serves no punitive purpose. Because of the nature of postpetition, nonpecuniary loss tax penalty claims in a Chapter 7 case, we be- lieve such claims are susceptible to subordina- tion. To hold otherwise would be to allow credi- tors who have supported the business during its attempt to reorganize to be penalized once that effort has failed and there is not enough to go around. Furthermore, to hold otherwise could result in rewarding the debtor-in-possession, the party who failed to pay the taxes on time, to the detriment of the creditors. The debtor-in- possession remains liable individually for the postpetition tax penalties. However, if the bank- ruptcy court cannot subordinate these penalties in the appropriate case, the creditors, and not the debtor-in-possession, will have borne the bur- den of paying the penalties. b. Judge Batchelder filed a concurring opinion (App., infra, 21a-22a). She stated that the court had correctly determined that the "principles of equitable subordination" permit subordination of pri- ority tax claims. In her view, the plain language ---------------------------------------- Page Break ---------------------------------------- 8 of the statute mandates that conclusion and "noth- ing requires us to delve into the legislative history" (id. at 22a): Section 726 (a) explicitly, clearly, and unam- biguously makes the distribution of the property of the estate subject to the provisions of 510. Postpetition nonpecuniary loss tax penalties are therefore subject to equitable subordination. End of story. REASONS FOR GRANTING THE PETITION The court of appeals held in this case that post- petition tax penalties are not to be given the firsf priority that Congress expressly provided for such claims in Sections 503(b)(1)(C) and 507 (a) (7) of the Bankruptcy Code. The court held that claims for such penalties are instead to be denied any priority and are to be subordinated to general unsecured claims against the debtor. The court stated that its conclusion results from application of the judge-made "principles of equitable subordination" that Congress codified in Section 510(c) of the Bankruptcy Code. By holding that a tax "penalty" is to be subordi- nated to all other claims, the decision in this case annuls and reverses the precisely opposite set of stat- utory priorities that Congress enacted. The decision thereby conflicts with the established rule that equi- table subordination in bankruptcy does not permit a court "to contradict statutory or common law when [it] feels a fairer result maybe obtained by applica- tion of a different rule" (Stebbins v. Crocker Citizens National Bank, 516 F.2d 784, 787 (9th Cir. ), cert. denied, 423 U.S. 913 (1975) ). The doctrine of equi- table subordination does not confer a power of statu- tory nullification on the bankruptcy courts. Instead, ---------------------------------------- Page Break ---------------------------------------- 9 as this Court's decisions reflect, the doctrine has a far narrower and more appropriate role. Its func- tion is to deter "conduct either in acquiring or as- serting the claim which is itself inequitable" (ibid.). That traditional rationale obviously would not justify subordination of the tax penalty claims in this case. By assuming a broad authority to realign statu- tory priorities based upon a "weighing" or "balanc- ing" of the "equities," the court of appeals has seriously misapplied the judge-made doctrine of "equitable subordination" and unloosened that doc- trine from its proper moorings. If courts are per- mitted to determine, on a case-by-case analysis of the "balance of the equities," whose claims are to be paid first and whose are to be paid last, the carefully constructed scheme of priorities established in the Bankruptcy Code would be made superfluous. The decision in this case has broad recurring sig- nificance. The conclusion that a prescribed tax pen- alty is to be subordinated to all other claims against the debtor has obvious significance for tax enforce- ment. Indeed, as this Court recognized in Nicholas v. United States, 384 U.S. 678, 694 (1966), Congress enacted the priority for postpetition tax penalties precisely because such penalties are an important and necessary measure for ensuring tax compliance in bankruptcy cases. The court's rationale that, because tax penalty claims do not compensate for pecuniary loss, they should be equitably subordinated to the claims of "creditors who suffered actual losses," as a matter of "fairness" (App., infra, 19a), places in question not merely the priority of tax penalties. It will spawn litigation over whether claims for other types ---------------------------------------- Page Break ---------------------------------------- 10 of governmental penalties, punitive damages, liqui- dated damage: and other non-compensatory damages may be "equitably" subordinated simply because those claims do not involve an outlay of funds that extended "value to the debtor" (ibid.). Because the courts of appeals are in conflict in their understanding and application of the judge- made doctrine of Equitable subordination," and be- cause of the importance of the issue presented, re- view by this Court of the decision in this case is warranted.1 1. a. A postpetition tax penalty is defined by stat- ute to be an "administrative expense" of the bank- ruptcy estate. 11 U.S.C. 503(b)(1)(C). As an "ad- ministrative expense," such a penalty has "[f]irst" -priority in the distribution of the assets of the estate. 11 U.S.C. 507(a)(1). See also 11 U.S.C. 726(a)(1). The priorities that Congress established in the Bankruptcy Code apply "[e]xcept as provided in sec- tion 510" of the Code. 11 U.S.C. 726(a). Section 510 authorizes only three specific exceptions to the statu- tory ordering of priorities. First, any claim may be subordinated by agreement. 11 U.S.C. 510(a). Sec- ___________________(footnotes) 1 The United States is concurrently filing a petition for a writ of certiorari to review the decision of the Tenth Circuit in United States V. Reorganized CF&I Fabricators of Utah, Inc., 53 F.3d 1155 (1995), which presents issues closely related to those of the present case. If, as we urge, both petitions are granted, we suggest that the two cases be set for argument in tandem. We have furnished a copy of the petition in United States V. Reorganized CF&I Fabricators of Utah, Inc. to counsel for respondents in this case. We have also furnished a copy of the petition in this case to counsel for respondents in United States v. Reorganized CF&I Fabricators of Utah, Inc. ---------------------------------------- Page Break ---------------------------------------- 11 end, claims seeking rescission or damages from sales of the debtor's securities may be subordinated. 11 U.S.C. 510 (b). Third, any claim may" be subordi- nated to any other claim "under principles of equi- table subordination * * *." 11 U. S. Cl. 510(c). The question presented in this case is thus not whether "principles of equitable subordination" may be ap- plied to priority claims; instead, it is what those principles are and how they are to be applied to priority claims. b. The judge-made doctrine of equitable subordi- nation has a clear origin and a limited scope (In re Columbia Ribbon Co., 117 F.2d 999, 1002 (3d Cir. 1941)): [A] court of bankruptcy under its equitable powers may disallow or subordinate a particular claim in bankruptcy which, because of the fraud- ulent nature of the claim or the bad faith or im- proper conduct of the claimant, ought not in equity and good conscience to be allowed or paid on a parity with other claims. See also Stebbins v. Crocker Citizens National Bank, 516 F.2d 784, 788 (9th Cir.), cert. denied, 423 U.S. 913 (1975 ). The issue that is to be resolved "under principles of equitable subordination" is whether (2 Collier Bankruptcy Manual Par. 510.01 [1], at 510-2 (3d ed. 1995) ) : harmful conduct [of the claimant] was directed at other creditors. If it was, the claim which is otherwise provable and allowable should be postponed until the claims of the creditors, who were harmed, have been satisfied. See Comstock v. Group of Institutional Investors, 335 U.S. 211, 229 (1948); Pepper v. Litton, 308 U.S. 295, 311 (1939) ; Taylor v. Standard Gas & Electric ---------------------------------------- Page Break ---------------------------------------- 12 Co., 306 U.S. 307, 323 (1939) ; Herzog & Zweibel, The Equitable Subordination of Claims in Bank- ruptcy, 15 Vand. L. Rev. 83, 85 (1961). The doctrine of equitable subordination thus pro- vides a means to redress harmful misconduct of an individual claimant.2 The doctrine does not, however, authorize a court to disregard statutory priorities merely because the court concludes that it would be more "fair''-or would somehow be better policy- to adopt a different distribution scheme. "[W]hat- ever equitable powers remain in the bankruptcy courts must and can only be exercised within the confines of the Bankruptcy Code." Norwest Bank Worthington v. Ahlers, 485 U.S. 197, 206 (1988). As the Ninth Circuit explained in Stebbins v. Crocker Citizens National Bank, 516 F.2d at 787: [1] t is important to keep in mind that the chan- cellor never did, and does not now, exercise un- restricted power to contradict statutory or com- mon law when he feels a fairer result may be obtained by application of a different rule. Courts of equity have long applied standards of conscience to conduct on an individual basis to ___________________(footnotes) 2 The underlying premise of any application of the doctrine of "equitable subordination" to "creditor misconduct" is that Congress has measured the equities of competing classes of claims but has not measured the conduct of the individual creditors who assert those claims. See Carpenter V. Wabash Ry., 309 U.S. 23, 28 (1940). Because Congress did not (and indeed cannot) take the conduct of individual creditors into account in enacting a bankruptcy distribution scheme, sub- ordination of a particular claim based upon the inequitable conduct of the specific creditor does not contravene the legis- lative judgment concerning the relative equities of the various classes of claims in general. See Stebbins V. Crocker (Citizens National Bank, 516 F.2d at 787. ---------------------------------------- Page Break ---------------------------------------- 13 prevent formally proper but unconscionable ap- plications of legal rules; they have not engaged in the practice of making abstract legislative judgments about the fairness of a result contem- plated by the legislature's statutory scheme if it has otherwise been followed in good faith and without overreaching. See also, In re Columbia Ribbon Co., 117 F.2d at 1002.3 In enacting the statutory priority scheme, Congress itself made a "reasonable classification of claims as entitled to priority because of superior equities" (Car- penter v. Wabash Ry., 309 U.S. 23, 28 (1940)). The categorical balancing of equities that Con- gress made in adopting the Code's priority pro- visions may not categorically be displaced by the courts under the guise of "equitable subordination." As the Ninth Circuit stated in Stebbins v. Crocker Citizens National Bank, 516 F.2d at 788, the doctrine of equitable subordination does not permit a court to say, "in effect * * *, `No, the distribution scheme provided by the [Bankruptcy] Act is a mistake * * *.' " ___________________(footnotes) 3 Similarly, in New Jersey V. Anderson, 203 U.S. 483 (1906), the Court rejected the assertion that a statutory priority for state taxes should not be recognized because it created an "injustice" for other creditors and gave the State an undue "advantage" (id. at 490) : [C]onsiderations of this character, however properly addressed to the legislative branch of the government, can have no place in influencing judicial determination. It is the province of the court to enforce, not to make the laws, and if the law works inequality the redress, if any, must be had from Congress. ---------------------------------------- Page Break ---------------------------------------- 14 The decision in the present case ultimately reflects an implicit policy judgment by the courts below that Congress somehow erred or acted "unfairly" in awarding first priority to the governments claims for postpetition tax penalties under Section 503 (b) (1) (C) and Section 507(a)(1).4 Even if there were a basis to believe that it might be more "fair" to pay other creditors before postpetition tax penalties are paid, any dispute about the relative merits of alternative priority schemes is simply irrelevant to the task that the court of appeals properly had be- fore it. Congress authoritatively resolved that policy issue when it expressly provided a first priority for postpetition tax penalty claims in 11 U.S.C. 503 (b) (1) (C). As this Court explained in enforcing the priority for postpetition tax penalties in Nicholas v. United States, 384 U.S. at 694, Congress adopted that priority precisely because penalties are an im- portant and "legitimate means to enforce" compli- ance with the tax laws in bankruptcy cases. See also Boteler v. Ingels, 308 U.S. 57, 61 (1939 ).5 By in- ___________________(footnotes) 4 While Section 726 (a) (1) preserves first priority in dis- tribution for postpetition tax penalties, Section 726 (a) (4) expressly subordinates prepetition tax penalties to general unsecured claims. Compare 11 U.S.C. 726 (a) (1) with 11 U.S.C. 726(a) (4). The reasoning adopted by the courts below is thus invalid for the additional reason that it deprives the carefully crafted distinctions made by Congress in enacting Section 726 of any force. 5 The court of appeals erred in relying on the suggestion of Representative Edwards that "existing case law" permits subordination of "a claim * * * of a status susceptible to subordination, such as a penalty * * *" (App., infra, 11a). Whatever "penalty" Representative Edwards may have had in mind in making that assertion, he obviously was not ---------------------------------------- Page Break --------------------------------------- 15 voking "equitable subordination" as authority for annulling the categorical priorities that Congress en- acted, the decision in this case conflicts with the deci- ___________________(footnotes) contemplating that postpetition tax penalty claims would be subordinated under Section 510 (c) (1) when Section 503 (b) (1) (C) of the same Act provides " [f]irst" priority for such claims. See 11 U.S.C. 503 (b) (1) (C). Indeed, Rep- resentative Edwards went on to say in the next portion of hiS remarks (124 Cong. Rec. at 32,416c): Since the House amendment authorizes subordination of claims only under principles of equitable subordination, and thus incorporates principles of existing case law, a tax claim would rarely be subordinated under this provi- sion of the bill. See also 124 Cong. Rec. 33,998, 34,016 (1978) (Sen. DeConcini). It is also apparent that, in suggesting that "penalty" claims are subject to subordination, the floor statement of Repre- sentative Edwards did not accurately describe "existing case law." Neither prepetition nor postpetition governmental penalties were subordinated under "existing case law" in 1978. Claims for prepetition penalties were disallowed (not subordinated) under Bankruptcy Act 57j, 11 U.S.C. 93(j) (1976). See Simonson V. Granquist, 369 U.S. 38, 40 (1962). Claims for postpetition penalties incurred by the trustee or debtor-in-possession were allowable, however, and were en- titled to first priority in distribution "of the bankruptcy estate. Nicholas V. United States, 384 U.S. 678, 692-695 (1966); Boteler v. Ingels, 308 U.S. 57, 61 (1939); United States V. New York Creditmen's Adjustment Bureau, Inc., 394 F.2d 340, 341-342 (2d Cir. 1968). The majority and concurring opinions in this case (App., infra, 12a-13a, 22a) thus erred in stating, without qualifica- tion, that penalty claims were disallowed under the former Bankruptcy Act. There also was no "existing case law" sub- ordinating or disallowing postpetition penalty claims based upon their "status." See Burden V. United States, 917 F.2d 115, 123 (3d Cir. 1990) (Alito, J., concurring in part and ---------------------------------------- Page Break ---------------------------------------- 16 sion of the Ninth Circuit in Stebbins and with the long line of cases holding that " [decisions about the treatment of categories of claims in bankruptcy pro- ceedings * * * are not dictated or illuminated by principles of equity and do not fall within the judicial power of equitable subordination * * *." Burden V. United States, 917 F.2d at 122 (Alito, J., concurring in part and dissenting in part; emphasis added ).6 See, e.g., Benjamin v. Diamond, 563 F.2d 693, 700 ___________________(footnotes) dissenting in part). Any misdescription of "existing case law" contained in the 1978 floor statement of Representative Edwards obviously could not alter the "principles of equitable subordination" that the courts had developed and that are to be applied under Section 510 (c) (1). 6 The Third Circuit has placed itself on both sides of this issue. In 1941, the court explained that the doctrine of equitable subordination does not authorize a court to adopt a priority scheme different from the statutory scheme based simply upon the court's "theory of equity." In re Columbia Ribbon Co., 117 F.2d at 1002. Instead, the court explained, equitable subordination may be applied to "disallow or sub- ordinate a particular claim in bankruptcy which, because of the fraudulent nature of the claim or the bad faith or im- proper conduct of the claimant, ought not in equity and good conscience to be allowed or paid on a parity with other claims." Ibid. In 1990, the Third Circuit acknowledged that "prior to the enactment of the Bankruptcy Act of 1978," the doctrine of equitable subordination had applied "only when there has been a showing of bad faith on the part of the creditor." Burden V. United States, 917 F.2d at 119. The court identified noth- ing in the text or history of the 1978 legislation to justify a departure from that historical understanding of equitable subordination. The court stated, however, that it was "per- suaded" by several recent decisions holding that "creditor misconduct is not a prerequisite for equitable subordination." ---------------------------------------- Page Break ---------------------------------------- 17 (5th Cir. 1977) (equitable subordination requires that "[t]he claimant must have engaged in some type of inequitable conduct") ; In re Credit Indus- trial Corp., 366 F.2d 402, 408 (2d Cir. 1966); United States v. Killoren, 119 F.2d 364, 366 (8th Cir. 1941) (reversing "equitable subordination" of a claim for taxes, for "[t]he plain mandate of the law cannot be set. aside because of considerations which may appeal to referee or judge as falling within general principles of equity jurisprudence"). c. In 1978, Congress codified the judge-made doc- trine of equitable subordination as Section 510(c)(1) of the Bankruptcy Code. That provision states that bankruptcy courts may, "under principles of equita- ble subordination, subordinate for purposes of dis- tribution all or part of an allowed claim to all or part of another allowed claim * * *." 11 U.S.C. 510(c)(1). That statute did not enlarge the authority that courts had previously exercised. As the 1978 floor statement quoted by the court of appeals emphasizes, Congress "intended that the term `principles of equi- table subordination' follow existing case law and leave to the courts development of this principle" (App., infra, ha, quoting 124 Cong. Rec. 32,398 (Rep. Edwards) ). The emphasis in the 1978 floor statement that "existing case law" is to be followed in applying "principles of equitable subordination" reflects a de- liberate policy determination that Congress made at that time. In enacting the 1978 Act, Congress con- ___________________(footnotes) Id. at 120-121. As described in the text, Judge Alito dis- sented from that part of the court's opinion. ---------------------------------------- Page Break ---------------------------------------- 18 sidered and rejected statutory language that would have granted bankruptcy courts authority to subor- dinate claims on much broader grounds. The bill that first passed the House of Representatives contained a version of Section 510(c) that would have allowed any claim to be subordinated simply "on equitable grounds." H.R. 8200, 95th Cong., 1st Sess., 510 (1977). The report accompanying the House bill emphasized that this language differed from the ex- isting doctrine of equitable subordination, for it would permit the courts to order "subordination on any equitable grounds." H.R. Rep. No. 595, 95th Cong., 1st Sess. 359 (1977). The broad language of the House bill was deleted, however, from the final legislation. The phrase "under principles of equitable subordination" was substituted in its place. See S. Rep, No. 989, 95th Cong., 2d Sess. 74 (1978); 124 Cong. Rec. 32,416 (1978) (Rep. Edwards); 124 Cong. Rec. 34,016 (1978) (Sen DeConcini). The history of Section 510(c) thus reflects that Congress consciously elected to adopt only the "exist- ing" principles of equitable subordination and re- jected a broader equitable authority for the bank- ruptcy courts. In the present case, however, the court of appeals declined to follow the "existing case law" that had squarely held that "equitable subordination" may not be applied categorically to reorder statutory priorities. By refusing to apply that "existing case law," the court of appeals placed itself in conflict with the decisions of the Fifth and Ninth Circuits in Benjamin v. Diamond and Stebbins v. Crocker citi- zens National Bank. See also In re Credit Industrial Corp., 366 F.2d at 408; 3 Collier on Bankruptcy ---------------------------------------- Page Break ---------------------------------------- 19 Par. 510.01 (15th ed. 1995) ("The law in this area is of long standing, having been judicially created"). d. The conflict among the courts of appeals con- cerning the proper scope of the doctrine of equitable subordination has recently become pronounced. In conflict with the decisions of the Fifth Circuit in Benjamin and the Ninth Circuit in Stebbins-as well as the earlier decisions of the Third Circuit in In re Columbia Ribbon Co. and the Eighth Circuit in Kil- loren-the Third, Seventh, Eighth and Tenth Circuits have joined the Sixth Circuit in holding that "prin- ciples of equitable subordination" are not confined to remedying creditor misconduct and instead permit courts categorically to subordinate "penalty" claims to the claims of other creditors who have incurred an "actual loss" (App., infra, 20a). See Burden v. United States, 917 F.2d 115, 119-120 (3d Cir. 1990); In re Virtual Network Services Corp., 902 F.2d 1246, 1248-1250 (7th Cir. 1990) ; Schultz Broadway Inn v. United States, 912 F.2d 230,232-234 (8th Cir. 1990); United States v. Reorganized CF&I Fabricators of Utah, Inc., 53 F.3d 1155, 1158 (10th Cir. 1995).7 ___________________(footnotes) 7 These cases from the Third, Seventh, Eighth and Tenth Circuits all involve the subordination of nonpriority tax pen- alty claims in cases under Chapters 11 and 13, rather than Chapter 7, of the Bankruptcy Code. As we have noted (note 4, supra), in Chapter 7 cases, Congress expressly provided priority for postpetition tax penalty claims and subordinated only prepetition tax penalty claims. Compare 11 U.S.C. 726 (a) (4). No similar provision subordinates prepetition penalty claims in cases under other chapters. Indeed, Con- gress rejected proposals that would have required subordina- tion of prepetition tax penalty claims in cases under all chap- ters. See Report of the Commission on the Bankruptcy Laws of the United States, H.R. Dec. No. 137, 93d Cong., 1st Sess. Pt.. II, at 115, 4-406(a) (3) (1973). ---------------------------------------- Page Break ---------------------------------------- 20 These courts, like the Sixth Circuit in this case, con- cluded that equitable subordination of a tax penalty claim is appropriate to ensure that payment of the penalty does not reduce the assets available for other claims. In so holding, these courts acknowledged that, prior to enactment of the Bankruptcy Code in 1978, the "existing case law" had held that the doctrine of equitable subordination requires a showing of cred- itor misconduct. See, e.g., In re Virtual Network Services Corp., 902 F.2d at 1248, citing Pepper v. Litton, 308 U.S. at 304-305. The courts also recog- nized that Congress intended such "existing case law" to apply in any future elaboration of the "principles of equitable subordination" (902 F.2d at 1248; App., infra, 11a). They reasoned, however, that the history of the 1978 Act indicates that such older authority is not necessarily binding because "Congress intended courts to continue developing the principles of equi- table subordination." United States v. Reorganized CF&I Fabricators of Utah, Inc., 53 F.3d at 1158, citing In re Virtual Network Services Corp., 902 F.2d at 1249-1250. As evidence of the "developing" principles of equi- table subordination, the courts noted that in In re Stirling Homex Corp., 579 F.2d 206 (1978), the Sec- ond Circuit held that the claims of shareholders who alleged that they were defrauded in purchasing stock of the debtor should be equitably subordinated-even in the absence of any creditor misconduct.8 The courts ___________________(footnotes) 8 In re Stirling Homex Corp. involved an attempt by equity shareholders who allegedly were defrauded in the purchase of the debtor's securities to elevate their priority in the cor- porate bankruptcy from last priority (as equity holders) to ---------------------------------------- Page Break ---------------------------------------- 21 concluded that, under this "developing" principle (but see note 8, supra), equitable subordination should be based on a "case-by-case" evaluation of the equi- ties and should no longer require proof of creditor misconduct (United States v. Reorganized CF&I Fabricators of Utah, Inc., 53 F.3d at 1159, quoting ___________________(footnotes) that of unsecured creditors (as tort claimants). The court subordinated the shareholders' claims to the claims of general unsecured creditors because "the equities favor the conven- tional general unsecured creditors rather than the allegedly defrauded stockholders." 579 F.2d at 213. The decision in Stirling Homex did not constitute a startling departure from the "existing case law," as some of the courts of appeals have assumed. Instead, that decision appears to represent an application of a settled rule described in the prior decision of the Second Circuit in In re Credit Industrial Corp., 366 F.2d at 408-409 (emphasis added): Equitable subordination, which is founded upon estoppel, is the doctrine invoked by courts to deny equal treatment to creditors based on some inequitable or unconscionable conduct in which they have engaged, or a special position which they occupy vis-a-vis the bankrupt that justifies subordination of their claims. That particular application of the principles of equitable sub- ordination can be traced to this Court's decision in Pepper V. Litton, 308 U.S. 295 (1939). See In re Credit Industrial Corp., 366 F.2d at 409. Nothing in Stirling Homex provides support for the propo- sition that courts may apply "equitable subordination" cate- gorically to annul the priority classification schemes that Congress enacted. Indeed, the rule that the Second Circuit applied to shareholder claims in Stirling Homex was codified in 1978 as subsection Section 510 (b) of the Bankruptcy Code (11 U.S.C. 510 (b)), which the 1978 floor statement of Repre- sentative Edwards described as an example of "existing case law." See App., infra, 11a. ---------------------------------------- Page Break ---------------------------------------- 22 In re Virtual Network Services Corp., 902 F.2d at. 1250) : [Section] 510 (c) (1) authorizes courts to equi- tably subordinate claims to other claims 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. In the absence of creditor misconduct, however, the doctrine of equitable subordination does not au- thorize the "case-by-case" balancing of equities that these courts have upheld. In particular, equitable subordination does not authorize judicial disregard of the categorical priorities that Congress has enacted; nor does it authorize judicial nullification of the statutory priority scheme. By reaching the opposite conclusion in this case, the decision of the court of appeals has enlarged the developing conflict and has ignored the inherent limitations of any court sitting in "equity." See Stebbins v. Crocker Citizens Na- tional Bank, 516 F.2d at 787: ( [T] he chancellor never did, and does not now, exercise unrestricted power to contradict statutory or common law when he feels a fairer result may be obtained by applica- tion of a different rule.). 3. The proper scope of the doctrine of equitable subordination is a matter of. substantial recurring importance. The decision in this case has significance not only for the enforcement of federal, state and local tax laws but also for the enforcement of many other types of governmental programs. For example, under the rationale applied by the court of appeals ---------------------------------------- Page Break ---------------------------------------- 23 in this case, penalties designed to enforce federal and state health and safety regulations presumably would also be subject to "equitable subordination" to the claims of the general unsecured creditors who in- curred an "actual loss" in their dealings with the estate ( App., infra, 20a). Commentators have further noted that the "case- by-case" evaluation of the "equities" of each claimant that these decisions authorize creates harmful uncer- tainties for private creditors as well. The unfettered equitable authority assumed in these decisions has threatened "the financial community [by calling] into question the future of bankruptcy priority." See Note, No Fault Equitable Subordination: Reassur- ing Investors That Only Government Penalty Claims Are At Risk, 34 Wm. & Mary L. Rev. 487, 488 (1993).9 By effectively ensuring that claims for postpetition penalties will not be paid from the assets of bank- ruptcy estates, the decision in this case would allow debtors-in-possession to disregard their legal obliga- tions with impunity.10 Allowing violations of the law ___________________(footnotes) 9 Under a case-by-case evacuation of the "equities" of each competing, innocent claim, it is not possible to be certain whether, for example, claims for punitive damages would be regarded as "inequitable" (because not involving "actual losses") or "equitable" (because designed to promote the public purpose of deterring malicious behavior). See In re Colin, 44 B.R. 806, 810 (Bankr. S.D.N.Y. 1984). 10 The court of appeals erred in suggesting (APP., infra, 19a) that the tax penalties involved in this case can be col- lected by the government even if that claim is subordinated in the liquidation proceedings. The court reasoned that ulti- mate collection is assured because the "debtor in possession remains liable individually for the postpetition tax penalties" ---------------------------------------- Page Break ---------------------------------------- 24 to go unsanctioned-and undeterred-is neither "fair," nor "equitable," nor good "policy." As this Court recognized in Boteler v. Ingels, 308 U.S. 57, 61 (1939), and Nicholas v. United States, 384 U.S. 678, 694 (1966), the priority for postpetition penalties in bankruptcy exists for the very purposes of ensuring that debtors abide by the same rules of law that apply to every other business. See also United States Depart- ment of Interior v. Elliott, 761 F.2d 168, 171 (4th Cir. 1985).11 In any event, as we have noted and as other circuits have held, the doctrine of equitable sub- ordination does not authorize a "reweighing" of the balance of equities that Congress itself struck in pro- viding the statutory priority for postpetition tax penalty claims. ___________________(footnotes) (ibid.). In making that statement, however, the court seems to have forgotten that this case involves a liquidation under Chapter 7. After such a liquidation, the debtor will have no assets available to pay any unsatisfied, subordinated tax pen- alty claim. 11 In United States Dep't of Interior V. Elliott, the court ex- plained why priority is granted to claims for postpetition pen- alties even though such claims may deplete the assets available to other creditors. Creditors may influence the debtor in pos- session or trustee to prevent the accrual of such penalties and should not be permitted to benefit from the false economies recognized by the estate through its failure to comply with applicable nonbankruptcy law. 761 F.2d at 171. ---------------------------------------- Page Break ---------------------------------------- 25 CONCLUSION The petition for a writ of certiorari should be granted. Respectfully submitted. DREW S. DAYS, III Solicitor General LORETTA C. ARGRETT Assistant Attorney General LAWRENCE G. WALLACE Deputy Solicitor General KENT L. JONES Assistant to the Solicitor General GARY D. GRAY EDWARD T. PERELMUTER Attorneys AUGUST 1995 ---------------------------------------- Page Break ---------------------------------------- APPENDIX A UNITED STATES COURT OF APPEALS FOR THE SIXTH CIRCUIT No. 93-4311 IN RE: FIRST TRUCK Lines, INC., DEBTOR UNITED STATES OF AMERICA, APPELLANT v. THOMAS R. NOLAND, Trustee, APPELLEE On Appeal from the United States District Court for the Southern District of Ohio Decided and Filed March 2, 1995 Before: MARTIN and BATCHELDER, Circuit Judges: and ENSLEN, District Judge. * MARTIN, J., delivered the opinion of the court, in which ENSLEN, D. J., joined. BATCHELDER, J. (pp. 18-19), delivered a separate concurring opinion. ___________________(footnotes) * The Honorable Richard A. Enslen, United States District Judge for the Western District of Michigan, sitting by designation. (la) ---------------------------------------- Page Break ---------------------------------------- 2a BOYCE F. MARTIN, JR., Circuit Judge. We have before us an appeal of the bankruptcy court's decision to equitably subordinate the Commissioner of Inter- nal Revenue Service's claim for postpetition, non- pecuniary loss tax penalties to the claims of general unsecured creditors. For the following reasons we affirm the decision of the district court. The debtor in this case, First Truck Lines, Inc., voluntarily filed for relief under Chapter 11 of the Bankruptcy Code on April 10, 1986. During the postpetition operation of its business, the debtor-in- possession did not pay to the Internal Revenue Serv- ice accrued Federal Insurance Contributions Act and Federal Unemployment Tax Act taxes. In June 1988, the debtor moved to convert the case to a Chapter 7 bankruptcy, and the bankruptcy court ordered con- version on August 1, 1988. Thomas R. Noland was appointed the Trustee. The debtor ceased operations thereafter, and liquidation of the estate assets did not produce sufficient funds to pay all creditors in full. The bar date for filing claims under Chapter 7 was December 1, 1988. On November 22, 1988, the Internal Revenue Serv- ice. filed a "Request for Payment of Administrative Expenses" claim ("Claim 102" ). Claim 102 was comprised of accrued postpetition, preconversion taxes, interest, and penalties. On April 20, 1989, the Internal Revenue Service filed an additional "Request for Payment of Administrative Expenses" claim ("Claim 107"), amending Claim 102. The bank- ruptcy court permitted Claim 107 to partially amend Claim 102, adding a penalty for postpetition, unpaid Federal Unemployment Tax Act taxes. Once litigation commenced, the Commissioner and the Trustee stipulated that the tax and interest por- ---------------------------------------- Page Break ---------------------------------------- 3a tion of Claim 102, but not the tax penalty portion, were administrative expenses with priority under 11 U.S.C. 726(a)(1), 507 (a)(1), and 503(b)(1) (1988). We take this stipulation to mean that all taxes and interest were in fact given a priority in the bankruptcy estate. The issue before the bankruptcy court, then, was whether administrative expense priority should be accorded to the postpetition tax penalties. The bankruptcy court held that, although postpetition tax, interest, and penalties were "ad- ministrative expenses" pursuant to 11 U.S.C. 503 (b), the tax penalties were subject to the court's equitable subordination powers under 11 U.S.C. 510(c) (1988). The court then interpreted and applied its powers of equitable subordination to in- clude the ability to subordinate a claim, not only in the case of creditor misconduct, but also in the case of postpetition, nonpecuniary loss tax penalties. In bal- ancing the equities, the bankruptcy court reasoned that the Bankruptcy Code exhibited a preference for compensating actual losses, especially in a liquidation proceeding. Furthermore, the bankruptcy court rea- soned that, unlike business creditors who had sur- rendered a valuable asset to the debtor, the United States had not suffered an actual pecuniary loss with regard to the penalties. The bankruptcy court con- cluded that the equities of the case required subordi- nation of the Commissioner's tax penalty claim to the claims of general unsecured creditors. The district court agreed. The central issue in this appeal is whether a bank- ruptcy court may, in a Chapter 7 case, equitably sub- ordinate postpetition, nonpecuniary loss tax penalties to any other claim, including the claims of general unsecured creditors, in the absence of creditor mis- ---------------------------------------- Page Break ---------------------------------------- 4a conduct: here, in the absence of misconduct by the commissioner. No other Circuit has addressed this precise issue, although three other Circuits have de- termined that prepetition, nonpecuniary loss tax penalty claims could be equitably subordinated even in the absence of creditor misconduct. Burden v. United States, 917 F.2d 115 (3d Cir. 1990) (Chapter 13 case); Schultz Broadway Inn v. United States, 912 F.2d 230 (8th Cir. 1990) (liquidating Chapter 11 ease) ; In re Virtual Network Servs. Corp., 902 F.2d 1246 (7th Cir. 1990) (liquidating Chapter 11 case). Should we decide that postpetition, nonpecu- niary loss tax penalty claims are also subject to equitable subordination in a Chapter 7 case even in the absence of creditor misconduct, we must also decide whether the bankruptcy court properly sub- ordinated the tax penalty claim in this ease. The Commissioner argues that the bankruptcy court does not have the power to equitably subor- dinate the postpetition tax penalties in Claim 102 to the claims of general unsecured creditors. The Com- missioner's primary assertion is that Congress has already balanced the equities with regard to posh petition tax penalty claims in a Chapter 7 case and has expressly awarded administrative expense prior- ity to claims for postpetition taxes, interest and penalties under 11 U.S.C. 726(a)(1), 507(a)(1), and 503 (b) (1) (B) and (C). The Commissioner con- tends that Congress was well aware that tax penal- ties, by their nature, are not related to the giving of value to #e debtor. Thus, knowing that the only colorable argument that can be made for equitably subordinating postpetition, nonpecuniary loss tax penalty claims is that it is unfair and unjust to award the government higher priority for a claim ---------------------------------------- Page Break ---------------------------------------- 5a not based on the extension of value to the debtor, Congress still gave tax penalties administrative ex- pense priority. The argument continues that a bank- ruptcy court may not, based on the same equitable ground, disregard the will of Congress and grant equitable relief to general unsecured creditors by sub- ordinating the tax penalty claim. The Commissioner concludes that the principles of equitable subordina- tion enable a bankruptcy court to subordinate a post- petition tax penalty claim only in the presence of mis- conduct. In support of this position, the Commissioner relies on our decision in In re Mansfield Tire & Rubber Co., 942 F.2d 1055 (6th Cir. 1991), cert. denied, 112 S. Ct. 1165 (1992 ), and on pre-1978 Supreme Court cases permitting equitable subordination of claims because of creditor misconduct. See Comstock v. Group of Institutional Investors, 335 U.S. 211 (1948); Pepper v. Litton, 308 U.S. 295 (1939); Taylor v. Standard Gas & Elec. Co., 306 U.S. 307 (1939). The Commis- sioner argues that our decision in Mansfield Tire re- quires us to reverse the district court. The Commis- sioner construes Mansfield Tire as expressly rejecting the proposition that bankruptcy courts may employ equitable subordination to override Congress's prior- ity scheme based on the court's own view of equity. Id. at 1062. The view of the Commissioner, while partially correct, constitutes an incomplete under- standing of Mansfield Tire. This Court also said in Mansfield Tire that, while a bankruptcy court may not impose its own view of equity where Congress has set priorities, Section 510 (c) expressly permits a bankruptcy court. to apply the "principles of equitable subordination" to subordinate a claim "otherwise susceptible to subordination, such as a penalty." ---------------------------------------- Page Break ---------------------------------------- 6a Mansfield Tire, 942 F.2d at 1062 (citing 1978 U.S.C.C.A.N. 5787, 6452 (statement of Rep. Ed- wards); 1978 U. S. C. C.A.N. 6505, 6521 (statement, of Sen. DeConcini) ). In Mansfield Tire, we decided only whether a claim for an excise tax was the type of claim susceptible to subordination, and not whether a tax penalty claim was susceptible to subordination. As to the Supreme Court cases cited above, these do not address the precise question this Court must an- swer and do not preclude our holding that equitable subordination may be proper even in the absence of creditor misconduct. The Trustee and the Commissioner agree that Con- gress has given postpetition tax penalties first prior- ity as administrative expenses in a Chapter 7 case. 11 U.S.C. 726(a)(1), 507(a)(1), 503(b)(1)(C). This Court, in the case of In re Flo-Lizer, Inc., 916 F.2d 363, 366 (6th Cir. 1990), reached the same con- clusion, but we did not discuss the relationship between Section 510 (c) and Section 503 (b). Although the parties agree as to the priority of postpetition, non- pecuniary loss tax penalty claims, the parties disagree as to the effect of Section 510 (c) on the tax penalty claim. The Trustee argues that the statutory treat- ment of a postpetition tax penalty as an administra- tive expense does not necessarily mean that the claim cannot be equitably subordinated under Section 510 (c). The trustee contends that 11 U.S.C. 726 (a) (1) provides that all Chapter 7 distributions are subject to Section 510(c), and that Section 510 (c), in turn, permits equitable subordination in the appropriate case. The- Trustee then relies on our opinion in Mansfield Tire for the proposition that tax penalties are subject to equitable subordination. Mansfield Tire, 942 F.2d at 1062 (distinguishing tax ---------------------------------------- Page Break ---------------------------------------- 7a claims, which are not ordinarily subject to equitable subordination, from penalties, which are ). In his brief, the Trustee sums up his position as follows: [T]he IRS's argument that equitable subordina- tion ignores Congressional mandates for priority in reality ignores the Congressional mandate un- der 11 U.S.C. 726(a) that these priorities are explicitly subject to 11 U.S.C. 510(c). Equita- ble subordination of these penalties is not incon- sistent with the Bankruptcy Code if the Code itself specifically authorizes it. Here, we review the decision of the district court deciding questions of statutory interpretation de novo. United States v. Hans, 921 F.2d 81, 82 (6th Cir. 1990). It is clear that the starting point for our in- quiry into the meaning of the statutes at issue is the language used by Congress. Estate of Floyd Cowart v. Nicklos Drilling Co., 112 S. Ct. 2589, 2594 (1992) (citing Demurest v. Manspeaker, 498 U.S. 184, 190 (1991) ). "[W]hen a statute speaks with clarity to an issue [,] judicial inquiry into the statute's meaning, in all but the most extraordinary circumstances, is finished." Id.; see also United States v. Ron Pair Enters., Inc., 489 U.S. 235, 242 (1989) (observing that "[T] he plain meaning of legislation should be conclusive, except in `rare cases [in which] the literal application of a statute will produce a result demon- strably at odds with the intention of the drafters.'") (citation omitted). However, when there is an am- biguous term in a statute, or when a term is un- defined or its meaning unclear from the context of the statute, it is our duty to examine the legislative history in order to render an interpretation that gives ---------------------------------------- Page Break ---------------------------------------- 8a effect to Congress's intent. In re Vause, 886 F.2d `794, 801 (6th Cir. 1989). In this case, the interpretation of the phrase "principles of equitable subordination," found in Section 510(c), is crucial to the outcome of this case and is not defined by statute. Therefore, we must look to legislative history or case law to inter- pret this phrase. First, we note, as did the bankruptcy court, that the tax penalty claims here were properly charac- terized as postpetition administrative expenses pur- suant to 11 U.S.C. 348(d). Section 348(d) states that a claim against the estate or the debtor that arises after the order for relief but before conversion in a case that is converted under section 113,2, 1307, or 1208 of this title, other than a claim specified in section 503(b) of this title [adminis - trative expenses], shall be treated for all pur- poses as if such claim had arisen immediately before the date of the filing of the petition. (emphasis added). Therefore, the tax penalty claim in this case is a postpetition claim-a claim against the estate of the bankrupt-and retains its priority under Section 726 (a) (1). In Chapter 7 cases, Congress gave first priority to postpetition claims for taxes and related penalty claims, as administrative expenses. However, the pri- ority of the tax and penalty claims is specifically subject to Section 510 (c) under the terms of Section 726 (a). Section 726 (a) (1) reads in full: (a) Except as provided in section 510 of this title, property of the estate shall be distributed- ---------------------------------------- Page Break ---------------------------------------- 9a (1) first, in payment of claims of the kind specified in, and in the order specified in, section 507 of this title; (emphasis added). Section 507 (a) (1) specifies that certain claims and expenses have priority as adminis- trative expenses. Section 507 (a) (1) states: (a) The following expenses and claims have pri- ority in the following order: (1) First, administrative expenses allowed under section 503 (b) of this title. . . . Section 503 (b) gives the following expenses and claims first priority status as administrative expenses: (b) After notice and a hearing, there shall be allowed, administrative expenses . . . including- (1) (A) the actual, necessary costs and ex- penses of preserving the estate, including wages, salaries, or commissions for services rendered after the commencement of the case; (B) any tax- (i) incurred by the estate. . . . (C) any fine, penalty, or reduction in credit relating to a tax of a kind specified in subparagraph (B) of this paragraph; Thus, a tax penalty relating to a tax incurred by the estate has first priority. However, Section 726 (a) (1) makes the priority subject to Section 510. Subsec- tion 510 (c) permits equitable subordination and it reads: ---------------------------------------- Page Break ---------------------------------------- 10a (c) Notwithstanding subsections (a) and (b) of this section, after notice and a hearing, the court may- (1) under principles of equitable subordina- tion, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim or all or part of an allowed interest to all or part of another allowed interest; 11 U.S.C. 510(c)(1). Given "a normal commonsense reading" of the stat- utes to this point, United States v. X-citement Video, Inc., 63 U.S.L.W. 4019, 4023 (U. S., Nov. 29, 1994) (Stevens, J., concurring), the language used by Con- gress gives tax penalty claims administrative expense priority subject to the bankruptcy court's equity powers. However, as Section 510(c) provides, the court's power may not be exercised arbitrarily, but only pursuant to the principles of equitable subordina- tion. The phrase "principles of equitable subordina- tion" is not, however, defined by the Bankruptcy Code. Thus, in order to comprehend the scope of the bank- ruptcy court's equitable subordination powers, we look to any relevant case law and at the legislative history to determine what Congress meant by the phrase "principles of equitable subordination." Both the district court, and the Seventh Circuit in Virtual Network Services, examined in detail the legislative history of Section 510(c), as well as the meaning properly accorded that history. We agree with the Seventh Circuit's view that the statements of Representative Edwards and Senator DeConcini pro- vide the most reliable indicia of the legislative intent as to the meaning of the phrase "principles of equita- ble subordination." We recite here the oft-quoted ---------------------------------------- Page Break ---------------------------------------- 11a passage from identical statements made by Represent- ative Edwards and Senator DeConcini to their respec- tive houses of Congress regarding Section 510(c): It is intended that the term "principles of equita- ble subordination" follow existing case law and leave to the courts development of this principle. To date, under existing 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. . . . Virtual Network Services, 902 F.2d at 1248; 11 U.S.C.A. 510(c) note (1993) (Legislative State- ments ) (emphasis added) ; 124 Cong. Rec. H11,095 (Sept. 28, 1978) (statement of Rep. Edwards); 124 Cong. Rec. S17,412 (Oct. 6, 1978) (statement of Sen. DeConcini). What did Representative Edwards and Senator DeConcini mean by stating that a "penalty" is the type of claim susceptible to subordination? In the context of the distribution scheme of Section 726(a), perhaps they meant that penalties, other than tax penalties, are subject to the court's equitable subordi- nation powers. Or they may have intended that only tax penalties that are punitive in nature, i.e. non- pecuniary loss penalties, be subject to equitable sub- ordination. Despite the lack of clarity as to what Congress meant by claims that are "of a status suscep- tible to subordination, " we must attempt to determine what claims are subject to equitable subordination. In any event, the legislative history indicates that pen- alty claims are susceptible to equitable subordination. Because Congress intended the "principles of equita- ble subordination" to follow existing case law, we turn ---------------------------------------- Page Break ---------------------------------------- 12a now to such case law as it existed in 1978 when the Bankruptcy Reform Act became effective. We will also examine further legislative history addressing what Congress may have meant when it specified a "penalty" claim as the type of claim susceptible to subordination. At the time of. the enactment of the Bankruptcy Code (Nov. 6, 1978), the case law on the principles of equitable subordination included three Supreme Court cases subordinating certain claims due to creditor mis- conduct and one appellate case subordinating the claims of defrauded shareholders, despite the absence of misconduct. Comstock, 335 U.S. 211; Pepper, 308 U.S. 295; Taylor, 306 U.S. 307; In re Stirling Homex Corp., 579 F.2d 206, 211 (2d Cir. 1978) (affirming equitable subordination of the claims of allegedly de- frauded stockholders to the claims of general un- secured creditors; stockholders were not guilty of mis- conduct), cert. denied, 439 U.S. 1074 (1979). The Commissioner argues that the principles of equitable subordination should not be expanded beyond cases of creditor misconduct, and certainly may not include the power to subordinate a postpetition tax penalty. To support this position, the Commissioner primarily relies on the absence of case law permitting the equita- ble subordination of tax penalty claims. This absence of case law equitably subordinating tax penalty claims is explained by the fact that prior to 1978, nonpecuniary loss tax penalty claims against the estate of the bankrupt were not allowed by law. Under the Bankruptcy Act of 1898, and the ensuring reenactment of this provision in 1952, non pecuniary loss tax penalty claims against the bankrupt's estate were simply not allowed as claims. "Debts owing to ---------------------------------------- Page Break ---------------------------------------- 13a the United States . . . as a penalty . . . shall not be allowed, except for the amount of the pecuniary loss sustained. . . ." Bankruptcy Act of 1898, ch. 541, 57(j), 30 Stat. 561; 11 U.S.C. 93(j), 66 Stat. 424 (1952). In 1961, the Supreme Court interpreted Sec- tion 93(j) broadly to disallow both secured and un- secured claims for tax penalties against the estate of the bankrupt. Simonson v. Granquist, 369 U.S. 38 (1962). [T]his section [57(j)/93(j)], which has been part of the Bankruptcy Act since its enactment in 1898, is in keeping with the broad aim of the Act to provide for the conservation of the estates of insolvents to the end that there may be as equitable a distribution of assets as is consistent with the type of claims involved. Moreover, the prohibition of all tax penalties in bankruptcy is wholly consistent with the policy of the penalty provisions themselves. Tax penalties are imposed at least in part as punitive measures against per- sons who have been guilty of some default or wrong. Enforcement of penalties against the estates of bankrupts, however, would serve not to punish the delinquent taxpayers, but rather their entirely innocent creditors. Id. at 40-41 (emphasis added); see also United States v. Coleman, 344 F.2d 903, 909 (6th Cir. 1965) (not- ing that "[57(j)/93(j)] plainly manifests a congres- sional purpose to bar all claims of any kind against a bankrupt except those based on a `pecuniary' loss"). Moreover, a few Circuits have recently developed the principles of equitable subordination to recognize the power of the bankruptcy court to subordinate a ---------------------------------------- Page Break ---------------------------------------- 14a prepetition, nonpecuniary loss tax penalty claim. The Third, Eighth, and Seventh Circuits have held that prepetition, nonpecuniary loss tax penalties are sub- ject to equitable subordination in the appropriate case without a showing of government misconduct. Bur- den 917 F.2d at 115 (holding that prepetition, non- pecuniary loss tax penalties may be subordinated in a Chapter 13 case; bankruptcy court must balance equi- ties; creditor misconduct not required) ; Schulz Broad- way Inn, 912 F.2d at 230 (holding that equitable sub- ordination provision applies to prepetition tax penalty claims of governmental units; misconduct not re- quired; general unsecured creditors suffering actual losses should receive preference over Government's claim for prepetition, nonpecuniary loss penalty in liquidating Chapter 11 case) ; Virtual Network Serv- ices, 902 F.2d at 1246 (holding that bankruptcy court may equitably subordinate claim of IRS for prepeti- tion, nonpecuniary loss tax penalties in liquidating Chapter 11 case; inequitable conduct not required). While these eases all concerned, prepetition penalties, the reasoning of these Circuits is equally applicable to postpetition penalties because the priority of both pre- and postpetition penalties is governed by 11 U.S.C. 726(a), and this entire provision is subject to Section 510(c). Further, the legislative history of the sections we address indicates that Congress in- tended nonpecuniary loss tax penalties to be subject to the bankruptcy court's power to ensure that the dis- tribution of the estate in a Chapter 7 case is equitable. In Chapter 7 cases, Congress assigned differing priorities to pre- and postpetition penalties. 11 U.S.C. 726(a)(1) and 726(a)(4). As discussed ---------------------------------------- Page Break ---------------------------------------- 15a above, Section 726 (a) (1) gives administrative ex- pense priority to postpetition tax penalty claims. However, unlike Section 726 (a) (4), Section 726 (a) (1) and its related statutes (Sections 507 (a) (1) and 503 (b) ) do not distinguish between tax penalties that are compensatory in nature and those that are not. Section 726 (a) (4), however, makes such a dis- tinction and gives fourth priority to claims, "for any . . . penalty . . . arising before the earlier of the order for relief or the appointment of a trustee, to the extent that such . . . penalty . . . [is] not com- pensation for actual pecuniary loss suffered by the holder of such claim." In other words, prepetition, as well as pre-appointment of trustee claims (whether pre- or postpetition), for nonpecuniary loss tax pen- alties are relegated to fourth priority. What priority Congress intended to give prepetition pecuniary loss tax penalty claims is unclear. Nevertheless, the lan- guage of Section 726(a) (4) indicates that in the col- lective mind of Congress a distinction exists between nonpecuniary loss ("punitive") penalties and pecu- niary loss ("compensatory" ) penalties, at least so far as prepetition tax penalties are concerned. This distinction surfaces elsewhere in the Bank- ruptcy Code. In Section 505, for example, the bank- ruptcy court is empowered to determine "the amount or legality of any tax . . . or penalty relating to tax." Prior to the approval of the final version of S. 2266, Senator DeConcini explained the House amendment to the Senate amendment to Section 505: The House Amendment authorizes the bank- ruptcy court to rule on the merits of any tax claim involving an unpaid tax, fine, or penalty relating to a tax, or any addition to a tax, of the ---------------------------------------- Page Break ---------------------------------------- 16a debtor or the estate. This authority applies, in general, whether or not the tax, penalty, fine, or addition, to tax had been previously assessed or paid. . . . The House amendment also adopts the substance of the Senate bill rule permitting the bankruptcy court to determine the amount of any penalty, whether punitive or pecuniary in nature, over which it has jurisdiction. 124 Cong. Rec. S17,426-27 (Oct. 6, 1978) (state- ment of Sen. DeConcini) ; 124 Cong. Rec. H11,110 (Sept. 28, 1978) (statement of Rep. Edwards) (em- phasis added). The distinction between punitive and pecuniary loss tax penalties also appears in Senator DeConcini's statements regarding Section 502 [Al- lowance of Claims] and regarding the priority scheme in Section 507. As to Section 502, Senator DeCon- cini stated: The Senate amendment allowed this reduction [tax claim resulting from reduction in FUTA tax credit], but would have subordinated it to other claims in the distribution of the estate's assets by treating it as a punitive (nonpecuniary loss) penalty. 124 Cong. Rec. S17,426 (Oct. 6, 1978). The distinc- tion between pecuniary loss and nonpecuniary loss penalties is continued in Senator DeConcini's state- ment regarding Section 507 (to which Section 726 (a) (1) refers). This statement implies that pecuni- ary loss tax penalties have first priority: The House amendment also adopts the provi- sions of the Senate amendment which include in the definition of administrative expenses un- der section 503 any fine, penalty (including "ad- ---------------------------------------- Page Break ---------------------------------------- 17a ditions to tax" under applicable tax laws) or re- duction in credit imposed on the estate. . . . For -purposes of the above [Section 507] priority rules, the House amendment adopts the provision of the Senate bill that any tax liability which, under otherwise applicable tax law, is collectible in the form of a "penalty," is to be treated in the same manner as a tax liability. In bank- ruptcy terminology, such tax liabilities are re- ferred to as pecuniary loss penalties. Thus, any tax liability which under the Internal Revenue Code or State or local tax law is payable as a "penalty," . . . will be entitled to the priority which the liability would receive if it were ex- pressly labeled as a "tax" under the applicable tax law. However, a tax penalty which is puni- tive in nature is given subordinated treatment under section 726(a) (4). 124 Cong. Rec. S17,428-30 (Oct. 6, 1978) (statement of Sen. DeConcini); 124 Cong. Rec. H11,113 (Sept. 28, 1978) (statement of Rep. Edwards) (emphasis added). The foregoing paragraph is evidence of Congress's desire to give first priority to something it calls "pecuniary loss penalties," if such things exist, and to give fourth priority to tax penalties that are truly penalties-i. e., that are punitive in nature. In light of this legislative history, including the distinction Congress has made between pecuniary loss and non- pecuniary loss tax penalties, we believe that Congress intended nonpecuniary loss, punitive penalties to be subject to the bankruptcy court's equitable subordina- tion powers under Section 510 (c). As mentioned above, both Section 726 (a) (1) and 726 (a) (4) are ---------------------------------------- Page Break ---------------------------------------- 18a subject to the courts' equitable subordination power under Section 51 O(C). This results is in accord with the Third, Seventh and Eighth Circuits' decisions in- terpreting the principles of equiable subordination to include the power to subordinate nonpecuniary loss tax penalties in bankruptcy cases under other chapters of the Bankruptcy Code. In drafting Section 726(a) (1) and making it sub- ject to Section 510(c), Congress made postpetition, nonpecuniary loss tax penalties, traditionally dis- allowed in bankruptcy, subject to the bankruptcy courts' equitable subordination power. A review of the sketchy Legislative history of Section 510(c) re- veals a statement by both of the leading legislators on this issue referring to penalties as a type of claim susceptible to subordination. The legislative history also reveals that Congress intended the courts to con- tinue to develop the principles of equitable subordina- tion. Therefore, we do not believe that Congress in- tended to arrest the development of the principles of equitable subordination as of 1978. Neither do we be- lieve that the development of this area of law is restricted to cases of creditor misconduct. Compelling reasons of justice and equity, as well as our interpre- tation of the plain language of the statutes, and the legislative history regarding the purposely undefined phrase "principles of equitable subordination," move this Court to agree with the other Circuits that non- pecuniary loss tax penalty claims are one type of claim subject to equitable subordination. The essence of bankruptcy is equity. While Con- gress has over the years re-codified traditional notions of equity, the current Code vests in the bankruptcy court significant discretion and equitable powers. ---------------------------------------- Page Break ---------------------------------------- 19a However, the bankruptcy court's equitable subordina- tion powers must be exercised within the confines of the Bankruptcy Code. In re Granger Garage, Inc., 921 F.2d 74, 77 (6th Cir. 1990). An examination of the Code reveals that the bankruptcy courts have the power to subordinate any claim to any other claim under the principles of equitable subordination; Con- gress has left the development of these principles to the courts. The wisdom of such a course is obvious, given the many ways in which parties to a bankruptcy seek advantage in recouping losses. We do not see the fairness or the justice in permitting the Commission- er's claim for tax penalties, which are not being assessed because of pecuniary losses to the Internal Revenue Service, to enjoy an equal or higher priority with claims based on the extension of value to the debtor, whether secured or not. Further, assessing tax penalties against the estate of a debtor no longer in existence serves no punitive purpose. Because of the nature of postpetition, nonpecuniary loss tax pen- alty claims in a Chapter 7 case, we believe such claims are susceptible to subordination. To hold otherwise would be to allow creditors who have supported the business during its attempt to reorganize to be penal- ized once that effort has failed and there is not enough to go around, Furthermore, to hold otherwise could result in rewarding the debtor-in-possession, the party who failed to pay the taxes on time, to the detriment of the creditors. The debtor-in-possession remains liable individually for the postpetition tax penalties. However, if the bankruptcy court cannot subordinate these penalties in the appropriate case, the creditors, and not the debtor-in-possession, will have borne the burden of paying the penalties. ---------------------------------------- Page Break ---------------------------------------- 20a Our decision today does not mean that every tax penalty assessed by the Commissioner will be equita- bly subordinated. Section 726 (a) (1) does not require automatic subordination, and, as we have observed, there may be cases where "penalties" are not actually punitive in nature but represent compensation for some actual loss. Section 505 leaves this determina- tion to the bankruptcy court. As with every claim for equitable subordination under Section 510(c), the bankruptcy court must weigh the equities involved. We turn, then, to whether the bankruptcy court prop- erly subordinated the tax penalty in this case. The bankruptcy court determined that a post- petition tax penalty claim could be equitably subordi- nated if the equities so required. The court went on to find that the equities balanced in favor of general unsecured creditors who suffered actual losses, as opposed to the Commissioner whose actual losses, the tax and interest claims, retained their first priority status. Because the parties agreed that the tax pen- alty claim was for nonpecuniary loss, the bankruptcy court did not have to decide that issue in balancing the equities of the case. Therefore, because the bank- ruptcy court did not clearly err in making its findings of fact, or err in its application of the law, we believe that the district court properly affirmed the decision of the bankruptcy court equitably subordinating the Commissioner's postpetition tax penalty claim to the claims of general unsecured creditors. We therefore AFFIRM the judgment of the district court. ---------------------------------------- Page Break ---------------------------------------- 21a ALICE M. BATCHELDER, Circuit Judge, concurring. I write separately only to express my view that 11 U.S.C. 726 (a) is clear and unambiguous and therefore we have no reason to speculate about the intent of particular legislators or of the Congress as to what was intended by that section. As the majority opinion points out, the Supreme Court has made it clear that we are to look to the language of the statute to determine the statute's meaning. When the statute speaks with clarity to the issue we address, our in- quiry is, "in all but the most extraordinary circum- stances," over. Estate of Floyd Coward v. Nicklos Drilling Co., 112 S. Ct. 2589, 2594 (1991) (citation omitted ), cert. denied sub nom. Burger v. Petroleum Helicopters, Inc., 112 S. Ct. 3026 (1992). There are no such extraordinary circumstances present here. Section 726 (a) says that except as provided in 11 U.S.C. 510, property of the estate is to be distrib- uted first to pay claims of the kind and in the order specified in 11 U.S.C. 507. Section 510 permits equitable subordination of claims. Section 507 gov- erns priorities and gives first priority to administra- tive expenses allowed under 503. Title 11 U.S.C. 503 governs allowance of administrative expenses and allows as an administrative expense any tax in- curred by the estate and any penalty relating to a tax incurred by the estate. By definition, penalties on taxes incurred by the estate are postpetition penalties. Section 503 does not set any priorities among admin- istrative expenses; it simply identifies what those ex- penses are. Read together, 3$726, 507, and 503 re- quire that when property is distributed in a Chapter 7 proceeding, it goes first to pay administrative ex- penses, which include taxes incurred by the estate and penalties relating to those taxes, and that this entire ---------------------------------------- Page Break ---------------------------------------- 22a distribution scheme is subject to the equitable sub- ordination power of the court as set out in 510. I have no quarrel with the majority's exploration of the legislative history behind 510(c) in order to determine what the Congress intended by the term "principles of equitable subordination," which is no- where defined in the statute. Noting the absence of case law equitably subordinating tax penalty claims at the time the Bankruptcy Code was adopted, the majority rightly concludes that this absence of case law is explained by the fact that before the Code was enacted, nonpecuniary loss tax penalty claims against the estate were simply not allowed at all. Further, the majority looks to subsequent case law, noting that that body of law permits equitable subordination to prepetition nonpecuniary loss tax penalty claims. So far, so good. Having determined the meaning of "principles of equitable subordination," however, nothing requires us to delve into the legislative history of 726. Spe- cifically, nothing in 726 itself permits, much less re- quires, a review of the legislative history of that sec- tion as part of our analysis of whether postpetition nonpecuniary loss tax penalties are subject to equita- ble subordination. Section 726(a) explicitly, clearly, and unambiguously makes the distribution of the property of the estate subject to the provisions of 510. Postpetition nonpecuniary loss tax penalties are therefore subject to equitable subordination. End of story. Because the unambiguous language of 726 per- mits the equitable subordination of postpetition tax penalties, it is not necessary for us to undertake any further analysis. Indeed, it is necessary that we not do SO. ---------------------------------------- Page Break ---------------------------------------- 23a APPENDIX B [Filed Mar. 2, 1995] UNITED STATES COURT OF APPEALS FOR THE SIXTH CIRCUIT No. : 93-4311 IN RE: FIRST TRUCK LINES, INC., DEBTOR UNITED STATES OF America, APPELLANT v. THOMAS R. NOLAND, Trustee, APPELLEE Before: MARTIN, and BATCHELDER, Circuit Judges; and ENSLEN, District Judge JUDGMENT ON APPEAL from the United States District Court for the Southern District of Ohio at Dayton. THIS CAUSE was heard on the record from the district court and was argued by counsel. ON CONSIDERATION WHEREOF, it is OR- DERED that the judgment of the district court is AFFIRMED. ENTERED BY ORDER OF THE COURT /s/ Leonard Green LEONARD GREEN Clerk Issued as Mandated: March 24, 1995 ---------------------------------------- Page Break ---------------------------------------- 24a APPENDIX C [Filed Jun. 16, 1995] UNITED STATES COURT OF APPEALS FOR THE SIXTH CIRCUIT No. 93-4311 IN RE: FIRST TRUCK LINES, DEBTOR UNITED STATES OF AMERICA, IRS, PLAINTIFF-APPELLANT v. THOMAS R. NOLAND, TRUSTEE, DEFENDANT-APPELLEE ORDER Before: MARTIN, and BATCHELDER, Circuit Judges; and ENSLEN, * District Judge. The court having_ received a petition for rehearing en bane, and the petition having been circulated not only to the original panel members but also to all other active judges of this court, and no judge of this court having requested a vote on the suggestion for rehearing en bane, the petition for rehearing has been referred to the original hearing panel. ___________________(footnotes) * Hon. Richard A. Enslen, Chief Judge United States Dis- trict Court for the Western District of Michigan, sitting by designation. ---------------------------------------- Page Break ---------------------------------------- 25a The panel has further reviewed the petition for re- hearing and concludes that the issues raised in the petition were fully considered upon the original sub- mission and decision of the case. Accordingly, the petition is denied. ENTERED BY ORDER OF THE COURT /s/ Leonard Green LEONARD GREEN Clerk ---------------------------------------- Page Break ---------------------------------------- 26a APPENDIX D [Filed Sep. 21, 1993] IN THE UNITED STATES DISTRICT COURT FOR THE SOUTHERN DISTRICT OF OHIO WESTERN DIVISION Case No. C-3-92-304 JUDGE WALTER HERBERT RICE INTERNAL REVENUE SERVICE, APPELLANT vs. THOMAS R. NOLAND, TRUSTEE, APPELLEE DECISION AND ENTRY AFFIRMING THE DECISION OF THE BANKRUPTCY COURT; JUDGMENT TO BE ENTERED IN FAVOR OF APPELLEE AND AGAINST APPELLANT; TERMINATION ENTRY This is an appeal by the Internal Revenue Service ("IRS") from a decision by the United States Bank- ruptcy Court, subordinating the IRS's claim of tax penalties to the priority of the claims of general, un- secured creditors. This appeal arises out of a bank- ruptcy petition under Chapter 11 of the Bankruptcy Code, which First Truck Lines ("FTL") filed on April 10, 1986. After filing the petition, FTL con- tinued its business operations as a debtor in posses- sion. However, during its postpetition operations, FTL did not pay to the IRS the FICA and FUTA ---------------------------------------- Page Break ---------------------------------------- 27a taxes which accrued. FTL discontinued business operations, and, on August 1, 1988, the Bankruptcy Court converted the Chapter 11 proceedings to a Chapter 7 liquidation. After this case was converted to a Chapter 7 pro- ceeding, the Bankruptcy Court was called upon to distribute, among the various parties filing claims, the property of FTL's estate. The IRS had filed a claim for the unpaid FICA and FUTA taxes, inter- est on those taxes, as well as penalties on those taxes ("tax penalties").1 The IRS further sought to have the Bankruptcy Court hold that all three components of its claim were entitled to priority as administra- tive expenses. The Bankruptcy Court agreed with the IRS that the three components of the IRS's claim were administrative expenses; however, pursuant to 510 (c) of the Bankruptcy Code, 11 U.S.C. 510(c), that court held that IRS's claim for tax penalties should be equitably subordinated to the status of the claims of general unsecured creditors.2 Thus, the IRS's claim was given priority for the unpaid taxes and for the interest on those taxes; however, its claim for tax penalties was not given such priority. The Bankruptcy Court subordinated the IRS's claim for tax penalties because, unlike business creditors, the IRS had not suffered an actual pecuniary loss with ___________________(footnotes) 1 The IRS filed a claim and an amended claim for taxes, interest and tax penalties, seeking the sum of $128,756.64. The trustee argued before the Bankruptcy Court that the amended claim was not a proper claim; however, that court concluded that it was a proper claim. Accordingly, that ques- tion is not before this Court, and the Court will treat the two claims (original and amended) as one. 2 The Bankruptcy Court's decision is reported. In re First Truck Lines, Inc., 141 B.R. 621 (Bkrtcy.S.D.Ohio 1992). ---------------------------------------- Page Break ---------------------------------------- 28a regard to the penalties. In other words, the IRS's claim for tax penalties, unlike those of all business creditors, did not arise after the surrendering of a valuable asset to the debtor. Before this Court, the IRS presents two arguments, to wit: 1) that administrative expenses can never be equitably subordinated; and 2) that, if such ex- penses can be subordinated, the Bankruptcy Court improperly subordinated the tax penalties in this case. As an initial matter, the Court will set forth the familiar standard against which it must review the Bankruptcy Court's decision in this litigation. This Court reviews the Bankruptcy Court's findings of fact under a clearly erroneous standard and con- ducts a de novo review of that court's conclusions of law. In re Caldwell, 851 F.2d 852, 857 (6th Cir. 1988), See also, Bankruptcy Rule 8013. First, the IRS argues that the tax penalties are administrative expenses and that such expenses are never subject to equitable subordination, because they are given such a high priority in 507 of the Bank- ruptcy Code, 11 U.S.C. 507. Although the tax pen- alties were administrative expenses,3 this Court does not agree with the IRS that such expenses are never subject to equitable subordination. This argument presents a simple question of statutory construction. This question, like every question of statutory con- struction, compels this Court to determine the intent of Congress. The starting point of that analysis is, ___________________(footnotes) 3 Section 507(a) (1) provides that expenses allowed under 503 (b) are administrative expenses. Section 503 (b) pro- vides that certain taxes and related penalties, including those herein, are administrative expenses. The Appellee concedes that the tax penalties are administrative penalties. See Doc. #6at2. ---------------------------------------- Page Break ---------------------------------------- 29a of course, the language of the statute. United States v. Ron Pair Enterprises, Inc., 489 U.S. 235, 241 (1989). When construing the Bankruptcy Code (and other statutes ), the Supreme Court has cautioned that that inquiry must end "when the statute's lan- guage is plain." Id. The provision which this Court must construe is 726(a) of the Bankruptcy Code, 11 U.S.C. 726 (a), which governs the distribution of the property in a Chapter 7 debtor's estate. Sec- tion 726 (a) provides, in pertinent part: Except as provided in section 510 of this title, property of the estate shall be distributed- (1) first, in payment of claims of the kind specified in, and in the order specified in, section 507 of this title. Section 507 is the provision by which administrative expenses are given priority. Section 510 (c) of the Bankruptcy Code plainly confers upon the court the power to equitably subordinate claims.4 Given the plain and clear language of 726(a), it is simply not possible to conclude that administrative expenses are not subject to equitable subordination. Moreover, other courts have concluded that administrative ex- penses are subject to equitable subordination. For instance, in In re Import & Mini Car Parts, Ltd., Inc., ___________________(footnotes) 4 Section 510 (c) provides, in pertinent part: Notwithstanding subsections (a) and (b) of this section, after notice and a hearing, the court may- (1) under principles of equitable subordination, sub- ordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim or all or part of an allowed inter- est to all or part of another allowed interest. ---------------------------------------- Page Break ---------------------------------------- 30a 136 B.R. 178, 181 (Bkrtcy.N.D.Ind. 1991), the court rejected the proposition that administrative expenses cannot be equitably subordinated, stating: [T]he IRS first argues that section 510(c) does not authorize the subordination of adminis- trative expenses. Based upon the plain language of section 726(a) this argument cannot prevail. The distributive scheme established by 726 is expressly subject to the power of subordination pursuant to 510. Accord In re F.A. Potts& Co., 114 B.R. 92 (Bkrtcy. E.D.Pa. 1990). Accordingly, this Court must decline the IRS's invitation to rewrite the plain language of 726(a) and concludes that administrative expenses (in this case tax penalties) are subject to equitable subordination. Second, having determined that administrative ex- penses can be equitably subordinated, the question re- mains as to whether the Bankruptcy Court correctly concluded that the administrative expenses (the tax penalties) in this litigation should be so subordinated. Section 510 (c) does not expressly state when a claim may be equitably subordinated; rather, that section provides that claims may be subordinated "under principles of equitable subordination." The legislative history to 510(c) explains: It is intended that the term "principles of equita- ble subordination" follow existing case law and leave to the courts the development of this princi- ple. To date, under existing law, a claim is gen- erally subordinated only if the holder of such claim is guilty of inequitable conduct, or if the ---------------------------------------- Page Break ---------------------------------------- 31a claim itself is of a status susceptible to subordina- tion, such as a penalty . . . 124 Cong.Rec. H11089 (Sept. 28, 1978) (statement of Rep. Edwards), reprinted in, 1978 USCC&AN 5787, 6452 (emphasis added); 124 Cong.Rec. S17406 (Oct. 6, 1978) (statement by Sen DeConcini), re- printed in 1978 USCC&AN 6505, 6521 (emphasis added ).5 Herein, there is no hint or allegation that the IRS was guilty of inequitable conduct; therefore, the only question for this Court is whether a claim for a tax penalty is of the status susceptible to sub- ordination. Although the Sixth Circuit has not addressed the questions,6 other circuits have consistently held that claims for tax penalties are subject to equitable sub- ordination, even in the absence of misconduct by the government. See, e.g., Schultz Broadway Inn v. United States, 912 F.2d 230 (8th Cir. 1990); Burden v. United States, 917 F.2d 115 (3rd Cir. 1990) ; Matter ___________________(footnotes) 5 The Supreme Court has treated the statements, by Rep- resentative Edwards and Senator DeConcini, on the Bank- ruptcy Reform Act of 1978, as "persuasive evidence of con- gressional intent." Beiger v. IRS, 496 U.S. 53, 64 n. 5. See also, In re Mansfield Tire & Rubber Co., 942 F.2d 1055, 1058 n. 3 (6th Cir, 1991). 6 In re Mansfield Tire & Rubber Co., 942 F.2d 1055, 1062 (6th Cir. 1991), the Sixth Circuit quoted the statement and held that the excise tax was not subject to equitable subroga- tion because the IRS was not guilty of inequitable conduct and the tax was not a penalty. However, the Mansfield Tire court did not suggest that a tax penalty is not subject to equi- table subordination. Indeed, the Mansfield Tire court recog- nized that equitable subordination is appropriate "if the claim itself is of a status susceptible to subordination." Id. ---------------------------------------- Page Break ---------------------------------------- 32a of Virtual Network Services Corp., 902 F.2d 1246 (7th Cir. 1990). These courts have held that a court must balance the equities before subordinating a tax penalty. For instance, in Virtual Network, the Sev- enth Circuit held that the district court correctly con- cluded that the equities tipped in f aver of subordina- tion because it was unfair to allow the tax penalties to come from the pockets of other creditors. Id. at 1250. In Schultz, the Eighth Circuit upheld the dis- trict court's decision to equitably subordinate tax penalties and commented that the decision "accords with the legislative history of the Bankruptcy Reform Act, which generally prefers claims for actual losses over punitive claims." 912 F.2d at 234. After weighing the equities, the Bankruptcy Court concluded that principles of equitable subordination upheld the subordination of the tax penalties in this case. This Court concludes that the Bankruptcy Court reached the proper balance. The IRS'S claim for tax penalties is unquestionably a penalty,7 an additional ___________________(footnotes) 7 Before the adoption of the Bankruptcy Reform Act of 1978, tax penalties were specifically disallowed as claims against a bankrupt's estate. Burden, 917 F.2d at 117. In Simmonson v. Granquist, 369 U.S. 38, 41 (1962), the Supreme Court explained the rationale behind that disallowance: Tax penalties are imposed at least in part as punitive measures against persona who have been guilty of some wrong. Enforcement of penalties against the estates of bankrupts, however, would serve not to punish the de- linquent taxpayers, but rather their entirely innocent creditors. See also, In re Cassidy, 983 F.2d 161, 164 (10th Cir. 1992) ("The policy of protecting unsecured creditors from the bad conduct of the debtor is beat implemented by avoiding bur- dening the claims of unsecured creditors with penalties im- posed on the debtor."). ---------------------------------------- Page Break ---------------------------------------- 33a assessment., so to speak, for the debtor's having failed to pay the taxes and the interest due on the taxes in a timely manner, sums which, unlike the statutory penalties, represent actual losses (or the loss of the use of money) to the IRS. The IRS has priority to its claims for unpaid taxes and for interest on those taxes; therefore, it will not suffer a pecuniary loss if it does not obtain priority for the tax penalties. The same cannot be said for other creditors; rather, those persons provided value to FTL and will not receive that for which they bargained if the IRS is to be given priority for sums which do not represent out of pocket losses to it. Accordingly, this Court concludes that the equities tip in favor of subordinating the IRS's claim for tax penalties in this case. Based upon the foregoing, this Court affirms the Bankruptcy Court's decision to subordinate the IRS's tax penalties to the priority of the claims of general unsecured creditors. Judgment is to be entered in favor of the Appellee and against the Appellant. The captioned cause is hereby terminated upon the docket records of the United States District Court for the Southern District of Ohio, Western Division, at Dayton. /s/Walter Herbert Rice WALTER HERBERT RICE United States District Judge ---------------------------------------- Page Break ---------------------------------------- 34a APPENDIX E [Entered Jan. 25, 1992] UNITED STATES BANKRUPTCY COURT SOUTHERN DISTRICT OF OHIO WESTERN DIVISION Case No. 3-86-00925 Chapter 7 (Judge Waldron) IN RE: FIRST TRUCK LINES, INC., DEBTOR DECISION ON ORDER ON OBJECTION DATED AT DAYTON, OHIO this 25th day of June, 1992: This proceeding, which arises under 28 U.S.C. 1334(b) in a case referred to this court by the Standing Order of Reference entered in this district on July 30, 1984, is determined to be a core proceed- ing pursuant to 28 U.S.C. 157(b) (2) (B) -allow- ance or disallowance of claims against the estate and estimation of claims. Presently before the court is an objection filed by the trustee to the tax claims filed by the Internal Revenue Service (Doc. 193). A hearing on this ob- jection was held and this proceeding was taken under advisement. BACKGROUND The parties filed a Stipulation Of The Trustee And the United States Of America Relating To Allowance ---------------------------------------- Page Break ---------------------------------------- 35a Or Disallowance Of Claims Of the Internal Revenue Service (Dec. 216). The relevant stipulations are as follows : 1) The parties agree that this court has jurisdic- tion to determine the claims and requests of the In- ternal Revenue Service (the "IRS"). 2) On April 10, 1986, the debtor voluntarily filed for relief under chapter 11 of the Bankruptcy Code. 3) The debtor moved to convert the case to chapter 7 in June, 1988. An order converting this case to chapter 7 was entered on August 1, 1988. 4) The bar date for filing claims in the chapter 7 proceeding was December 1, 1988. 5) On November 22, 1988, the IRS filed a Request for Payment of Administrative Expenses which was numbered 102 by the clerk ("Claim 102"). The amounts listed in Claim 102 involve claims which accrued postpetition and preconversion for taxes, in- terest, and penalties. Claim 102 did not include any claims made in previous claims or requests filed by the IRS in this case. 6) On April 20, 1989, the IRS filed a Request for Payment of Administrative Expenses which was num- bered 107 by the clerk ("Claim 107"). 7) On August 7, 1991, the trustee filed an objec- tion to Claim 102 and Claim 107. 8) In response to this objection, the United States filed the United States Opposition To Trustee's Ob- jection To Allowance Of Claims Of Internal Reve- nue Service (Dec. 196) and a Memorandum Of Law In Support Of The United States' Opposition To Trustee's Objection To Allowance Of Claims of In- ternal Revenue Service (Doc. 210). The Trustee filed a Response Of Trustee To Memorandum Of USA In ---------------------------------------- Page Break ---------------------------------------- 36a Opposition To Objection To Claim (Dec. 198) and a Memorandum Of Trustee Relative To Memorandum Of Law In Support Filed by USA For Allowance Of Claims Of The Internal Revenue Service (Dec. 211). 9) The parties agree that the tax and interest amounts in Claim 102 will be allowed as an adminis- trative expense claim with priority under Sections 503(b), 507(a)(1), and 726(a)(1). However, the parties request that the court determine the priority, if any, of the penalties related to Claim 102. 10) The parties agree that the tax and interest claims made in Claim 107 involving quarters ending December 31, 1986 (WT-FICA) for $964.80 and De- cember 31, 1987 (WT-FICA) for $74,670.39 are claims not raised in previous claims and should be subordinated pursuant to Section 726(a)(3). How- ever, the parties request that the court determine the priority, if any, of the penalties related to Claim 107. 11) The parties agree that, with respect to Claim 107, the quarters ending September 30, 1986 (WT- FICA) for $264.51, September 30, 1987 (WT-FICA) for $28,039.08, March 31, 1988 (WT-FICA) for $24,363.81, June 30,1988 (WT-FICA) for $29,718.50, the FUTA tax for the year 1987 for $3,709.46, and the corporate income tax for the year 1987 for $300.00 are the same amounts sought in previous claims timely filed in these proceedings. 12) The parties agree that, with respect to Claim 107, the amount claimed for FUTA tax for the year 1988 was greater in amount than the amount claimed in Claim 102 for the same year and that Claim 102 delineated the 1988 year as being estimated. The United States maintains that the increased amount for FUTA tax should be allowed as an administrative ---------------------------------------- Page Break ---------------------------------------- 37a expense, but the trustee maintains that the increased amount for FUTA tax should not be allowed. The parties agree that, if Claim 107 is allowed as an amended claim, the court should determine the pri- ority, if any, of the penalties included in Claim 107. ISSUES Based upon the parties' stipulations, this court finds that the following issues are before this court for determination: 1) With respect to Claim 102, what priority will the tax penalties be accorded. 2) With respect to Claim 107, will a) the FUTA tax be allowed as an amendment to Claim 102 and allowed as an administrative expense, b) the penalty related to this FUTA tax be allowed as an amend- ment to Claim 102, and if so, what priority will it be accorded, and c) the penalties related to FICA claims, which have not been previously asserted, be allowed, and if so, what priority will these penalties be ac- corded. DISCUSSION The resolution of the interrelated issues of federal tax priorities, penalties, and subordination requires an examination of the interstices of several seem- ingly contradictory provisions of the Code (11 U.S.C. 348, 503, 507, 510, and 726). The subject of an "appropriate analytical task" and an "agreed upon methodology" in statutory interpretation of the Bank- ruptcy Code has been continually emphasized in re- cent Supreme Court decisions. Patterson v. Shumate, No. 91-913, 1992 U.S. LEXIS 3546, 60 U.S.L.W. 4550 (U.S. June 15, 1992). This methodology may ---------------------------------------- Page Break ---------------------------------------- 38a be described by acknowledging that, although "canons of construction are no more than rules of thumb that help courts determine the meaning of legislation," Connecticut Nat'l Bank v. Germain, - U.S. - 112 S.Ct. 1146, 1149 (1992), the initial examination commences with the language of the statute. Pennsyl- vania Dept. of Public Welfare v. Davenport, 495 U.S. 552, 110 S. Ct. 2126, 2130 (1990) ("the fundamental canon [of] statutory interpretation begins with the language of the statute itself."). " [C]ourts must presume that a legislature says in a statute what it means and means in a statute what it says there." Germain, 112 S. Ct. at 1149. If the statutory language is ambiguous a court must resort to examination of legislative history. See United States v. Ron Pair Enterprises, Inc., 489 U.S. 235, 109 S. Ct. 1026, 1030 (1989). As the Supreme Court stated in Ron Pair, "[t]he plain meaning of legislation should be con- clusive, except in the `rare cases [in which] the literal application of a statute will produce a result demon- strably at odds with the intention of its drafters.'" 109 S. Ct. at 1031. "In such cases, the intention of the drafters, rather than the strict language, controls." 109 S. Ct. at 1031. Further, it is necessary to note that a court should be reluctant to "accept arguments that would interpret the Code, however vague the particular language under consideration might be, to effect a major change in pre-Code practice that is not the subject of at least some discussion in the legisla- tive history." Dewsnup v. Timm, - U.S. -, 112 S. Ct. 773,779 (1992). I. Claim 10 The parties request that this court determine the priority to be accorded the postpetition, preconver- ---------------------------------------- Page Break ---------------------------------------- 39a sion non-pecuniary loss tax penalties asserted in this claim. The IRS asserts that postpetition, preconver- sion tax penalties are administrative expenses en- titled to the priority accorded by 11 U.S.C. 507(a)(1). Section 507(a)(1) provides: (a) The following expenses and claims have priority in the following order: (1) First, administrative expenses al- lowed under section 503 (b) of this title, and any fees and charges assessed against the estate under chapter 123 of title 28. The administrative expenses allowed under 503(b) include the taxes incurred by a bankruptcy estate. Section 503 (b) (1) provides: (b) After notice and a hearing, there shall be allowed administrative expenses, other than claims allowed under section 502 (f), of this title, including- (1) (A) the actual, necessary costs and expenses of preserving the estate, including wages, salaries, or commissions for services rendered after the commencement of the case: (B) any tax- (i) incurred by the estate, ex- cept a tax of a kind specified in section 507 (a) (7) of this title; or (ii) attributable to an excessive allowance of a tentative carryback adjustment that the estate re- ceived, whether the taxable year to which such adjustment relates ---------------------------------------- Page Break ---------------------------------------- 40a ended before or after the com- mencement of the case; and (C) any fine, penalty, or reduction in credit relating to a tax of a kind spe- cified in subparagraph (B) of this paragraph [.] The parties have agreed that the tax and interest sought in Claim 102 will be allowed as an adminis- trative expense under 503(b). Because of the Code's express reference to taxes in 503(b)(1)(B), this court determines that the parties have stipulated that the taxes will be allowed under this subsection. As 503(b)(1)(C) demonstrates, the penalties related to taxes which come within the provisions of 503(b)(1)(B) are administrative expenses. There- fore, having been expressly defined as administrative expenses, the postpetition tax penalties receive first priority under 507(a)(1). The trustee contends, however, that these tax pen- alties should be subordinated. Initially, the trustee asserts that, as a result of the conversion of this case from a ease under chapter 11 to a case under chapter 7, the provisions pertaining to distribution in liquida- tion cases, specifically 726(a)(4), dictate the prior- ity of the tax penalties. Section 726(a)(4) provides: (a) Except as provided in section 510 of this title, property of the estate shall be distrib- uted- (4) fourth, in payment of any allowed claim, whether secured or unsecured, for any fine, penalty, or forfeiture, or for mul- tiple, exemplary, or punitive damages, aris- ing before the earlier of the order for relief ---------------------------------------- Page Break ---------------------------------------- 41a or the appointment of a trustee, to the ex- tent that such fine, penalty, forfeiture, or damages are not compensation for actual pecuniary loss suffered by the holder of such claim[.] At first blush it appears that there is a conflict between 503(b)(1)(C) and 726(a)(4), since both sections contain the same term "penalty" but do not accord it the same priority. Resolution of this conflict is found in the provisions in 11 U.S.C. 348(d). Section 348(d), pertaining to conversion, provides: (d) A claim against the estate or the debtor that arises after the order for relief but before conversion in a case that is converted under sec- tion 1112, 1307, or 1208 of this title, other than a claim specified in section 503(b) of this title, shall be treated for all purposes as if such claim had arisen immediately before the date of the filing of the petition. (Emphasis supplied). Section 348 (d), by expressly omitting claims under 503(b), prevents chapter 11 administrative claims from becoming prepetition claims upon conversion. United States v. Ginley (In re Johnson), 901 F.2d 513, 520 (6th Cir. 1990); In re Bondi's Valu-King, Inc., 102 B.R. 108, 111 (Bankr. N.D. Ohio 1989); aff'd, 126 B.R. 47 (N.D. Ohio 1991) ; 2 Collier On Bankruptcy para. 348.05 at 348-10 (15th ed. 1991). Accordingly, the express statutory language indicates that these penalties retain their status as administra- tive claims under 503(b)(1)(C) and are to be paid in accordance with the distribution provisions set ---------------------------------------- Page Break ---------------------------------------- 42a forth in 726(a)(1)1 and 726(b),2 and not the pro- visions contained in 726(a) (4). The trustee alternatively argues that the postpeti- tion tax penalties sought by the IRS in Claim 102 should be equitably subordinated under 11 U.S.C. 510(c)(1). Section 510(c)(1) provides: (c) Notwithstanding subsections (a) and (b) of this section, after notice and a hearing, the court may- (1) under principles of equitable sub- ordination, subordinate for purposes of dis- tribution all or part of an allowed claim to all or part of another allowed claim or all or part of an allowed interest to all or part of another allowed interest [.] The Bankruptcy Code does not expressly define the phrase "equitable subordination," therefore, it is ___________________(footnotes) 1 (a) Except as provided in section 510 of this title, prop- erty of the estate shall be distributed- (1) First, in payment of claims of the kind specified in, and in the order specified in, section 507 of this title[.] 2 Payment on claims of a kind specified in paragraph (1), (2), (3), (4), (5), (6) or (7) of section 507(a) of this title, or in paragraph (2), (3), (4), or (5) of subsection (a) of this section, shall be made pro rata among claims of the kind specified in each such particular paragraph, execute that in a case that has been converted to this chapter under section 1112, 1208 or 1307 of this title, a claim allowed under section 503 (b) of this title incurred under this chapter after such conversion has priority over a claim allowed under section 503 (b) of this title incurred under any other chapter of this title or under this chapter before such conversion and over any expenses of a custodian superseded under section 543 of this title. ---------------------------------------- Page Break ---------------------------------------- 43a necessary to resort to an examination of the legisla- tive history of the Code.3 Legislative history indi- cates that the meaning of the phrase "equitable sub- ordination" was to be developed by the courts. The Congressional Record states: It is intended that the term "principles of equi- table subordination" follow existing case law and leave to the courts development of this prin- ciple. To date, under existing law, a claim is generally subordinated only if holder of such claim is guilty of inequitable conduct, or the claim itself is of a status susceptible to subor- dination, such as a penalty or a claim for dam- ages arising from the purchase or sale of a security of the debtor. 124 Gong. Rec. H11089, H11095 (1978) (emphasis added) (remarks of Rep. Edwards), printed in 1978 U.S. Code Gong. & Admin. News 6436, 6452; see also 124 Cong. Rec. S17406, S17412 (1978) (remarks of Sen. DeConcini), reprinted in 1978 U.S. Code Cong. & Admin. News 6505, 6521. See also United States v. Mansfield Tire & Rubber Co. (In re Mansfield Tire & Rubber Co.), 942 F.2d 1055, 1062 (6th Cir. 1991) ("We continue to recognize that equitable subordina- tion in bankruptcy may be appropriate if the claim- holder is guilty of inequitable conduct or if the claim itself is of a status susceptible to subordination."). Section 510 (c) (1) has been utilized to subordinate claims for non-pecuniary tax penalties. Burden v. ___________________(footnotes) 3 As the Third Circuit noted in Burden, "[p]rior" to the enactment of the Bankruptcy Act of 1978, subordination of tax penalty claims did not occur because noncompensatory penalty claims owed to the government were specifically dis- allowed. 917 F.2d at 117 (citations omitted). ---------------------------------------- Page Break ---------------------------------------- 44a United States, 917 F.2d 115 (3d Cir. 1990); Schultz Broadway Inn v. United States, 912 F.2d 230 (8th Cir. 1990); In re Virtual Network Services Corp., 902 F.2d 1246 (7th Cir. 1990) ; In re Manchester Lakes Assocs., 117 B.R. 221, 225 (Bankr. E.D. Va. 1990) ; In re Merwede, 84 B.R, 11, 14 (Bankr. D. Corm. 1988). These claims have been subordinated despite the absence of creditor misconduct. Burden, 917 F.2d at 120; Schultz Broadway Inn, 912 F.2d at 233; Virtual Network Services, 902 F.2d at 1250; In re Merwede, 84 B.R. at 14. The determination of whether a penalty should be subordinated requires the court to weigh the equities of the various claims on a case-by-case basis. Burden, 917 F.2d at 120; Schultz Broadway Inn, 912 F.2d at 234; Virtual Net- work Services, 902 F.2d at 1250. Otherwise, subor- dination would automatically occur merely because a claim is a penalty, and a major revision in the bank- ruptcy law such as this would warrant explicit direc- tion from Congress. Burden, 917 F.2d at 119. The IRS acknowledges that courts have subordi- nated tax penalties under 510(c)(1) but contends that these decisions are not applicable to this proceed- ing because they involve prepetition tax penalties, and not postpetition tax penalties. In support of its contention the IRS distinguishes the penalties sought in this proceeding from those in Virtual Network Services. In Virtual Network Services, the Seventh Circuit addressed the issue of whether prepetition non- pecuniary loss tax penalties could be equitably sub- ordinated under 510(c)(1). 902 F.2d at 1247-50. In examining the equities of the case before it, the appeals court concluded that non-pecuniary loss tax penalties could be subordinated under 11 U.S.C. ---------------------------------------- Page Break ---------------------------------------- 45a 510(c)(1). In reaching this determination, the ap- peals court examined the IRS's challenges to the district court's holding that equitable subordination would be applied to the case "because 1) the goal of equitable subordination focuses not on the conduct of the creditor but on a fairness to creditors in a particular case, 2) punishing or deterring VNS's [the debtor's] innocent creditors because of VNS's wrongful conduct serves no purpose, and 3) the IRS's claims in this case are punitive in nature." Virtual Network Services, 902 F.2d at 1250. Specifically, the IRS challenged the district court's holdings on grounds 2 and 3. With respect to the district court's holding in ground 2, the IRS asserted, on appeal, that it was just as innocent as the debtor's general unsecured creditors, thus it was unfair to punish it in relation to those other creditors. In addressing this contention, the appeals court noted that the IRS had been found innocent by the district court, but that the district court also emphasized "that it [the IRS] had waited too long to collect its debt, therefore, making it unfair for the court to shift the burden of the debt to other innocent creditors." Virtual Network Services, 902 F.2d at 1250. With respect to its objection to ground number 3, the appeals court stated that the IRS was challenging the district court's findings that the tax penalty claims were punitive by attempting to re- characterize the nature of its claims as being unlike other non-pecuniary loss penalties because they are designed to not only punish the debtor, but to pro- tect " `the integrity of tax systems and to reimburse the Government for . . . costs incurred as a result of certain taxpayer misconduct.' " Virtual Network Semites, 902 F.2d at 1250. In addressing this con- ---------------------------------------- Page Break ---------------------------------------- 46a tention, the appeals court noted that this argument had not been properly raised to the district court by the IRS; but, nonetheless, stated, "this vague asser- tion is an attempt to diffuse the purpose behind the tax penalties, i.e., to punish those who fail to abide by the taxing structure, and to deter those who might be inclined to avoid tax payment." Id. The court concluded, "allowing the IRS to recover its non- pecuniary loss claims along with others who have actually `invested' in VNS [the debtor] and lost would be unfair on these facts." Id. The appeals court further stated: As for the other grounds that the district court relied on in applying equitable subordina- tion to the IRS's claims, we are persuaded that the district court accurately addressed the equi- ties of this case. The district court correctly considered that it was unfair to allow the IRS's tax penalty `claims to come out of the "pockets" of other general unsecured creditors who had not been paid their pecuniary losses. Moreover, in this case the debtor has sold most of its op- erating assets and filed an amended plan for liquidation. In other words, VNS [the debtor] exists in name only, as an entity out of which remaining funds are distributed, in this case between 15-30% of that due, to its creditors. We agree that the equities in this case favor the subordination of the IRS's claims to those of the other general unsecured creditors. 902 F.2d at 1250. Similarly, the Eighth Circuit, in Schultz Broadway Inn, concluded that the IRS'S tax penalty claims would be subordinated under 510(c)(1). 912 F.2d ---------------------------------------- Page Break ---------------------------------------- 47a at 234. Notably, in Schultz Broadway Inn, the Gov- ernment argued that subordination of non-pecuniary loss penalties is precluded under chapter 11 because Congress, as evidenced by its express subordination of non-pecuniary loss penalty claim in 726(a)(4), intended to restrict subordination of punitive claims to proceedings under chapter 7. 912 F.2d at 233. The Schultz Broadway Inn court rejected the Govern- ment's argument and stated: [I]n proceedings under chapter 7, Congress could be certain that in most cases the debtor would cease operations with assets that were in- sufficient to cover the creditors' claims in full. Therefore, in the chapter 7 context, a uniform rule subordinating penalty claims recognizes that ordinary creditors should receive protection from debtors' punitive obligations. The same rule, however, would be inappropri- ate for proceedings under chapter 11. In chap- ter 11 proceedings, Congress expected that many debtors would continue their operations under a reorganization plan and ultimately return to a viable and profitable economic state. In such cases, the debtor, quite rightly, should bear the burden of its full punitive obligations. Where a chapter 11 debtor opted to liquidate, however, the consequences to creditors could be very simi- lar to a proceeding under chapter 7. 912 F.2d at 233 (citation omitted). The Schultz Broadway Inn court concluded that, in accordance with the "legislative history of the Bankruptcy Re- form Act, which generally prefers claims for actual losses over purely punitive claims," the "general un- secured creditors who suffered actual losses should ---------------------------------------- Page Break ---------------------------------------- 48a receive preference over the Government's claim for a non-pecuniary loss tax penalty in this liquidating chapter 11." 912 F.2d at 234. However, the court noted that, despite the preference for compensating creditors' actual losses first, appropriate circum- stances may exist such that the Government's non- pecuniary loss claims will not be subordinated, but the ''Government bears the burden of directly bring- ing such equitable considerations to the bankruptcy court's attention." Id. As previously stated, in determining whether to subordinate a claim under 510(c)(1), the various equities of the claims must reconsidered, The nature of the claim as arising prepetition or postpetition is only one of several factors to weigh when balancing the equities in a proceeding. In attempting to balance the equities in its favor, the IRS has made several assertions. First, the IRS asserts that it has not waited too long to collect the debt owed it when the debtor has been in bankruptcy. This court agrees, In this proceeding, unlike in Virtual Network Serv- ices, the IRS has not waited too long to collect its debt. Second, the IRS asserts that requiring debtors to pay penalties which are administrative expenses does not punish innocent creditors, but rather insures that chapter 11 debtors obey the law while they are under the protection of the bankruptcy court. This assertion, similar to that made by the IRS in Virtual Network Services, is unpersuasive in this liquidation proceeding. Penalties may punish a debtor who is attempting to reorganize and may insure that the debtor obeys the tax laws; however, in a Chapter 7 liquidation or in a liquidating chapter 11, the parties who are punished are other creditors because payment ---------------------------------------- Page Break ---------------------------------------- 49a of penalties reduces estate assets available for dis- tribution. Third, the IRS asserts that, although the Bankruptcy Code provides for the readjustment of prepetition debts, the Code requires that administra- tive expenses are not to be readjusted but are to be paid in full. The IRS's assertion is correct but not complete since it ignores the equitable principles con- tained in 510(c)(1). Under principles of equity, particularly when such principles are expressly con- tained in statutory enactments, the rigidity of other- wise applicable law is modified to comply more ap- propriately with legislative intention. Lastly, the IRS asserts that it would be inequitable to allow the debtor to subordinate a liability incurred by the debtor while under the protection of the bankruptcy court. Al- though " [t]he inclusion of penalties on postpetition taxes in section 503(b) indicates that Congress was willing to have the bankruptcy estate pay for ex- penses that arise out of the failure of the debtor in possession or the trustee to pay taxes in a timely man- ner," United States v. Flo-Lizer, Inc. (In re Flo-Lizer, Inc.), 916 F.2d 363, 366 (6th Cir. 1990), again, the provisions of 510(c)(1) incorporate the principle of equitable subordination and, accordingly, the court must consider the equities of all claims, not just the priority of the claims of the IRS, Weighing the foregoing against the Code's prefer- ence for compensating actual loss claims, and the fact that, in this liquidation proceeding, it appears the total amount of assets to be distributed will fully compensate only the first priority claim holders and will be distributed on a pro rata basis to the second priority claim holders, the court concludes that the equities tilt in favor of subordinating the postpetition ---------------------------------------- Page Break ---------------------------------------- 50a non-pecuniary loss tax penalties sought by the IRS. See Walker v. Ferguson (In re Import & Mini Car- Parts, Ltd., Inc.), 136 B.R. 178, 182 (Bankr. N.D. Ind. 1991) (court analyzed the decision in Virtual Network, Burden, and Schultz Broadway Inn and concluded that, as a result of the equities existing in the proceedings, the postpetition tax penalties would be subordinated);4 In re F.A. Potts & Co., Inc., 114 B.R. 92, 94 (Bankr. E.D. Pa. 1990) (postpetition tax penalties assessed against debtor were subordinated under 510(c)(1)). II. Claim 107 This court must determine whether Claim 107, filed after the bar date, may be allowed as an amendment. Specifically, this court must determine whether the FUTA tax listed in Claim 107 may be allowed as an amendment to the FUTA tax listed in Claim 102 and as an administrative expense. Additionally, this court must determine the priority of the penalty related to the additional FUTA tax and the priority, if any, of the penalties related to the FICA claims not previously listed in any timely filed claim. The determination of whether to permit an amend- ment to a timely filed proof of claim rests within the discretion of the court. In re Wilson, 136 B.R. 719, 721 (Bankr. S.D. Ohio 1991); In re Parsons, 135 B.R. 283, 284 (Bankr. S.D. Ohio 1991) ; In re Mc- Lean Indus., Inc., 121 B.R. 704,708 (Bankr. S.D.N.Y. ___________________(footnotes) 4 However, unlike the courts in Virtual Network Services and Schultz Broadway Inn, the bankruptcy court, as the trus- tee requested, subordinated the tax penalties to the other unpiad chapter 11 administrative expenses. Id. ---------------------------------------- Page Break ---------------------------------------- 51a 1990); In re Milan Steel Fabricators, Inc., 113 B.R. 364, 368 (Bankr. N.D. Ohio 1990). In making this determination courts have developed a two-part test. Parsons, 135 B.R. at 284; McLean, 121 B.R. at 708; Bishop v. United States (In re Leonard), 112 B.R. 67, 71 (Bankr. D. Corm. 1990). Under the first prong of the test, the court must determine whether the amendment reasonably relates to a timely filed claim or whether it is merely an attempt to file a new claim. United States v. Simon (In re Bondi's Valu-King, Inc.), 126 B.R. 47, 49 (N.D. Ohio 1991); Wilson, 136 B.R. at 721; McLean, 121 B.R. at 708; Milan Steel Fabricators, 113 B.R. at 367. (" [A]mendment to a claim is freely allowed where the purpose is to cure a defect in the claim as originally filed, to describe the claim with greater par- ticularity or to plead a new theory of recovery on the facts set forth in the original claim." Milan Steel Fabricators, 113 B.R. at 368 (quoting United States v. Int'l Horizons, Inc. (In re Int'l Horizons, Inc.), 751 F.2d 1213, 1216 (11th Cir. 1985)). Examples of amendments permitted include a correction in "the amount of tax, penalties or interest claimed in a timely filed claim." In re Unroe, 937 F.2d 346, 349 (7th Cir. 1991). However, if the claim is a new claim, it will be disallowed. Milan Steel Fabricators, 113 B.R. at 367. Under the second prong, the court must perform an equitable analysis. McLean, 121 B.R. at 708; In re Leonard, 112 B.R. at 71. In McLean, the court set forth indicia to consider when balancing the equities, including: 1) whether there is undue prejudice to an oppos- ing party, ---------------------------------------- Page Break ---------------------------------------- 52a 2) whether there is bad faith or dilatory behavior on the part of the claimant, 3) whether other creditors would receive a wind- fall were the amendment not allowed, 4) whether other claimants might be harmed or prejudiced, 5) whether there is justification for the inability to file the amended claim at the time the original claim was filed. 121 B.R. at 708. See also Parsons, 135 B.R. at 285. It is undisputed that Claim 102, the original claim, was timely filed. Claim 102 sets forth the FUTA tax owed by the debtor for two tax periods, December 31, 1987 and December 31, 1988, and states at the bottom of the claim: "Estimated tax claims have been filed because the debtor has failed to file the return(s) for the estimated periods. As soon as the debtor files the return (s) with the I.R.S. as required by law, this claim will be adjusted as necessary." The parties have agreed that the FUTA tax claims in Claim 102 will be allowed as administrative claims. It is undisputed that the FUTA tax for the tax period December, 1987 listed in Claim 107 is iden- tical to that in Claim 102, therefore, it is only the FUTA tax sought for the tax period December, 1988 which the IRS seeks to amend. The FUTA tax listed in Claim 107, the amended claim, is for an identical tax period as the FUTA tax listed in Claim 102. The only difference between the FUTA tax claims is the amount. Further, the FUTA tax in Claim 107, listed as an administrative claim, does not attempt to change the character or nature of the claim. Thus, ---------------------------------------- Page Break ---------------------------------------- 53a the claim for the additional FUTA tax in Claim 107 relates to the timely filed claim sought in Claim 102 and is not a new claim, For identical reasons, this court finds that the penalty related to the FUTA tax in Claim 107 relates to Claim 102, the timely filed claim. Accordingly, with respect to the FUTA tax and the penalty related to this FUTA tax, the first prong of the test has been satisfied. With respect to the penalties which relate to FICA claims not previously listed in a timely filed claim, this court finds that these penalties do not relate to any timely filed claim. Thus, they fail to satisfy the first prong of the test utilized in determining whether to allow an amendment to a timely filed claim. Ac- cordingly, they will be disallowed. Having met the first prong of the test, unless equi- table considerations militate strongly against this amendment, the FUTA tax will be allowed. McLean, 121 B.R. at 709. The trustee asserts that, if this claim is allowed, creditors in the same class will be prejudiced because it will "reduce their dividend." (Dec. 211 at 7). In light of the policy favoring lib- eral amendment, see McLean, 121 B.R. at 710, this type of prejudice by itself, in this proceeding, is in- sufficient. This court finds that there is no undue prejudice to the trustee or any other claimant. Moreover, there is justification for the failure to file a timely claim.5 The IRS stated that Claim 102 was an estimated claim. The IRS has justified the need for the statement that the tax amounts were just an estimate because "the bar date fell before the debtor's 1988 tax return was due," and no evi- ___________________(footnotes) 5 This court recognizes that the IRS's amended claim was not filed until approximately 5 months following the bar date. ---------------------------------------- Page Break ---------------------------------------- 54a dence in the record exists to dispute this assertion. (Dec. 210 at 7). Although such a statement, stand- ing alone, might not provide justification for an un- timely claim, it does provide the trustee and claim- ants with notice that the amounts contained in the IRS's initial claim may not be accurate and may be subsequently amended. The trustee asserts that the proposed amended claim should not be allowed because it does not state on its face that it is an "amendment." As the very party that has strenuously argued, and has there- after benefited from the application of equitable prin- ciples on the subordination issue, it is not particu- larly persuasive far the trustee to attempt to prevent the application of equitable principles on the amend- ment issue. This court finds that Claim 107, the amended claim, though not specifically designated an "amendment," substantively constitutes an amend- ment and is thus determined to be an amended claim. See In re Pyramid Building Co., 87 B.R. 38, 40 (Bankr. N.D. Ohio 1988). "A contrary result would clearly elevate form over substance and violate equi- table considerations controlling amendments." Id. Further, with respect to the penalty related to the FUTA tax, this court finds no equitable considera- tions militating against its allowance; however, in accordance with this court's previous discussion of equitable subordination ( 510 (c) (1) ), this court subordinates this penalty to that of the general un- secured creditors. Accordingly, this court, having initially examined the plain meaning of the applicable Code provisions, and, where appropriate, having consulted Legislative history and having found no evidence of congressional intention to break with the pre-Code practice of ---------------------------------------- Page Break ---------------------------------------- 55a preferring the payment of actual losses prior to the payment of penalties, and having determined that this result is not at odds with the intention of Con- gress, the court concludes: 1) With respect to Claim 102: a) the penalties are equitably subordinated to that of the general unsecured creditors, 2) With respect to Claim 107: a) the FUTA tax is allowed as an amend- ment to the FUTA tax in Claim 102 and is allowed as an administrative expense, b) the penalty related to this FUTA tax is allowed; however, this penalty is equitably subordinated to that of the general unse- cured creditors and c) the penalties which relate to the FICA claims not previously listed in a timely filed claim do not amend claims in Claim 102 and are disallowed. An order in accordance with this decision is simul- taneously entered. SO ORDERED. /s/ Thomas F. Waldron THOMAS F. WALDRON United States Bankruptcy Judge ---------------------------------------- Page Break ---------------------------------------- 56a APPENDIX F L Section 503, 11 U.S.C. (1988), provides in rele- vant part: (b) After notice and a hearing, there shall be allowed administrative expenses, other than claims allowed under section 502 (f) of this title, including- (1) *** (B) any tax- (i) incurred by the estate, except a tax of a kind specified in section 507 (a) (7) of this title; or (ii) attributable to an excessive al- lowance of a tentative carryback ad- justment that the estate received, whether the taxable year to which such adjustment relates ended before or after the commencement of the case; and (C) any fine, penalty, or reduction in credit relating to a tax of a kind specified in subparagraph (B) of this paragraph; * * * * * 2. Section 507, 11 U. S. C., provides in relevant part: (a) The following expenses and claims have priority in the following order: (1) First, administrative expenses allowed under section 503 (b) of this title, and any fees and charges assessed against the estate under chapter 123 of title 28. * * * * * ---------------------------------------- Page Break ---------------------------------------- 57a 3. Section 510, 11 U. S. C., provides in relevant part: (c) Notwithstanding subsections (a) and (b) of this section, after notice and a hearing, the court may- (1) under principles of equitable subordina- tion, subordinate for purposes of distribution all or part of an allowed claim to all or part of an- other allowed claim or all or part of an allowed interest to all or part of another allowed inter- est; or (2) order that any lien securing such a sub- ordinated claim be transferred to the estate. 4. Section 726, 11 U. S. C., provides in relevant part: (a) Except as provided in section 510 of this title, property of the estate shall be distributed- (1) first, in payment of claims of the kind specified in, and in the order specified in, section 507 of this title; (2) second, in payment of any allowed un- secured claim, other than a claim of a kind speci- fied in paragraph (1), (3), or (4) of this sub- section, proof of which is- (A) timely filed under section 501 (a) of this title; (B) timely filed under section 501 (b) or 501 (c) of this title; or (C) tardily filed under section 501 (a) of this title, if- (i) the creditor that holds such claim did not have notice or actual knowledge ---------------------------------------- Page Break ---------------------------------------- 58a of the case in time for timely filing of a proof of such claim under section 501 (a) of this title; and (ii) proof of such claim is filed in time to permit payment of such claim; (3) third, in payment of any allowed unse- cured claim proof of which is tardily filed under section 501 (a) of this title, other than a claim of the kind specified in paragraph (2) (C) of this subsection; (4) fourth, in payment of any allowed claim, whether secured or unsecured, for any fine, pen- alty, 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; (5) fifth, in payment of interest at the legal rate from the date of the filing of the petition, on any claim paid under paragraph (1), (2), (3), or (4) of this subsection; and (6) sixth, to the debtor. * * * * * *U.S. GOVERNMENT PRINTING OFFICE; 1995 387147 20103 ---------------------------------------- Page Break ---------------------------------------- No. 95-323 IN THE SUPREME COURT OF THE UNITED STATES OCTOBER TERM, 1995 UNITED STATES OF AMERICA, PETITIONER v. THOMAS R. NOLAND, TRUSTEE FOR THE DEBTOR FIRST TRUCK LINES, INC. ON PETITION FOR A WRIT OF CERTIORARI TO THE UNITED STATES COURT OF APPEALS FOR THE SIXTH CIRCUIT REPLY BRIEF FOR THE UNITED STATES DREW S. DAYS, III Solicitor General Department of Justice Washington, D.C. 20530 (202) 514-2217 ---------------------------------------- Page Break ---------------------------------------- TABLE OF AUTHORITIES Cases: Page Benjamin v. Diamond, 563 F.2d 692(5th Cir. 1977) . . . . 4 Boteler v. Ingels, 308 U. S. 57(1939) . . . . 2 Columbia Ribbon Co., In re, 117 F.2d 999 (3d Cir. 1941) . . . . 4, 5 Comstock v. Group of Institutional Investors, 335 U.S. 211 (1948) . . . . 4 Nicholas v. United States, 384 U.S. 678 (1966 ). . . . 2, 3, 5 Norwest Bank Worthington v. Alders, 485 U.S. 197 (1988) . . . . 2 Stebbins v. Crocker Citizens National Bank, 516 F.2d 784 (9th Cir.), cert. denied, 423 U.S. 913 (1975) . . . . 2, 4, 5 United States v. Killoren, 119 F.2d 364(8th Cir.), cert. denied, 314 U. S. 640(1941) . . . . 4, 5 United States v. Reorganized CF&I Fabricators of Utah, Inc., 53 F.3d 1155(6th Cir. 1995), petition for cert. pending, No. 95-325 . . . . 7 Statutes: Bankruptcy Code, 11 U.S.C. 101 et seq.: 11 U.S.C. 507(a)(1) . . . . 1, 3 11 U.S.C. 510(c) . . . . 4, 5, 6 11 U.S.C. 726 . . . . 3 11 U.S.C. 726(a) . . . . 3 Internal Revenue Code (26 U.S.C.): 4971(a) . . . . 6 Miscellaneous: Note, No Fault Equitable Subordination: Reassuring Investors That Only Government Penalty Claims Are At Risk, 34 Wm. & Mary L. Rev. 487 (1993) . . . . 6 (I) ---------------------------------------- Page Break ---------------------------------------- IN THE SUPREME COURT OF THE UNITED STATES OCTOBER TERM, 1995 No. 95-323 UNITED STATES OF AMERICA, PETITIONER v. THOMAS R. NOLAND, TRUSTEE FOR DEBTOR FIRST TRUCK LINES, INC. ON PETITION FOR A WRIT OF CERTIORARI TO THE UNITED STATES COURT OF APPEALS FOR THE SIXTH CIRCUIT REPLY BRIEF FOR THE UNITED STATES 1. In this case, the court of appeals applied judge- made "principles of equitable subordination" to nul- lify the determination of Congress that postpetition tax penalties should be given "[f]irst" priority in the distribution of the assets of the debtor's estate (11 U.S.C. 507(a)(1)). The court predicated its decision on the view that payment of the tax penalty claim on a first priority basis would be "unfair" to creditors who had extended value to the debtor because it would reduce the assets available for distribution to them (Pet. App. 19a). By allowing its views of what is "fair" (1) ---------------------------------------- Page Break ---------------------------------------- 2 or "unfair" to override the express congressional de- termination as to the priority to be afforded to these competing claims, the court of appeals violated the fundamental principle that a bankruptcy court's equitable powers "must and can only be exercised within the confines of the Bankruptcy Code" (Nor- west Bank Worthington v. Ahlers, 485 U.S. 197, 206 (1988)). The Sixth Circuit's decision also conflicts with the established rule that equitable subordination in bankruptcy does not permit a court "to contradict statutory or common law when [it] feels a fairer result may be obtained by application of a different rule." Stebbins v. Crocker Citizens National Bank, 516 F.2d 784,787 (9th Cir.), cert. denied, 423 U.S. 913 (1975). The court further compounded its error by ignoring the decisions of this Court that hold that claims for postpetition penalties are to be paid from the assets of the estate in order to ensure compliance with the laws that the penalties are designed to enforce. See Nicholas v. United States, 384 U.S. 678, 694 (1966); Boteler v. Ingels, 308 U.S. 57,61 (1939).1 2. Respondent errs in contending (Br. in Opp. 11) that the decision in this case will not result in the nonpayment of postpetition tax penalty claims in bankruptcy cases. The court of appeals subordinated the government's claim precisely because the estate lacked sufficient assets to satisfy the claims of all creditors (Pet. App. 19a). It is obvious that a similar deficiency in assets exists in virtually all bankruptcy cases. Moreover, in the rare case in which a bank- ruptcy estate has sufficient assets to satisfy all ___________________(footnotes) 1 Respondent. does not dispute that the court of appeals erred in stating (Pet. App. 12a-13a) that all penalty claims were disallowed under the former Bankruptcy Act. ---------------------------------------- Page Break ---------------------------------------- 3 claims, there would be no need to invoke the doctrine of equitable subordination-for all claims would then be paid. The priority scheme of the Bankruptcy Code serves a purpose only when the assets of the bankruptcy estate are not sufficient to satisfy all claims. The approach adopted. by the court of appeals in this case deviates from the priority scheme that Congress enacted by nullifying the express award of first priority to postpetition tax penalties under Section 507(a)(1) of the Bankruptcy code.2 3. Respondent errs in contending (Br. in Opp. 8-9) that the "plain language" of Section 726 supports the decision of the court of appeals. Section 726 merely provides that the priorities Congress established in the Bankruptcy Code apply in Chapter 7 cases "[e]x- cept as provided in section 510" (11 U.S.C. 726(a)). Section 726 does not provide any guidance on the issue that is critical to this case: which is how the ___________________(footnotes) 2 Respondent argues (Br. in Opp. 11 n.7) that equitable subordination is appropriate to punish the IRS for failure to monitor the estate's compliance with the tax laws. That con- tention is in error for several reasons. First. the statutory grant of first priority is not contingent upon IRS monitoring of the debtor. Second, as this Court recognized in Nicholas v. United States, 384 U.S. at 694, the grant of first priority is made precisely to ensure that trustees and debtors-in-possession comply with the tax laws. To argue, as respondent does, that penalty claims should not be paid because the debtor-in- possession did not comply with its obligations turns the statute on its head. Moreover, it is unrealistic to suggest that the IRS is in a position to monitor the internal practices of thousands of bankruptcy estates. Ours is a self-reporting system of taxation, which relies on penalties to assure compliance. ---------------------------------------- Page Break ---------------------------------------- 4 "principles of equitable subordination" codified in Section 510(c) are to be applied.3 The decisions of this Court and of other courts of appeals establish that "principles of equitable subor- dination" require the presence of creditor miscon- duct. See Comstock v. Group of Institutional Inves- tors, 335 U.S. 211, 229 (1948) ("It is not mere exis- tence of an opportunity to do wrong that brings the rule into play; it is the unconscionable use of the opportunity afforded by the domination to advantage itself at the injury of the subsidiary that deprives the wrongdoer of the fruits of his wrong."); In re Colum- bia Ribbon Co., 117 F.2d 999, 1002 (3d Cir. 1941); Benjamin v. Diamond, 563 F.2d 692, 700 (5th Cir. 1977) (equitable subordination requires that "[t]he claimant must have engaged in some type of in- equitable conduct"); United States v. Killoren, 119 F.2d 364, 366 (8th Cir.), cert. denied, 314 U.S. 640 (1941); Stebbins v. Crocker Citizens National Bank, 516 F.2d at 787. Moreover, as the petition notes (Pet. 17-19), in codifying these preexisting "principles of equitable subordination" in Section 510(c) of the Bankruptcy Code, Congress considered and rejected a provision that would have granted bankruptcy courts ___________________(footnotes) 3 Respondent errs in asserting (Br. in Opp. 7-8) that the issue in this case is whether equitable subordination applies to priority claims. We do not dispute that priority claims in Chapter 7 cases maybe subordinated. The question presented by this case involves the circumstances under which sub- ordination may be accomplished under "principles of equitable sub ordination." In our view, those circumstances require creditor misconduct; any subordination based simply upon the nature of the claim itself necessarily undertakes to reweigh the competing equities that Congress itself balanced in formulating the statutory priority scheme. ---------------------------------------- Page Break ---------------------------------------- 5 authority to subordinate claims on the broader grounds asserted by the court of appeals in this case. 4. Respondent does not cite or discuss the de- cisions of the courts of appeals under the former Bankruptcy Act that established the "principles of equitable subordination" that Congress codified in Section 510(c) of the Bankruptcy Code. See, e.g., In re Columbia Ribbon Co., 117 F.2d at 1002; United States v. Killoren, 119 F.2d at 366; Stebbins v. Crocker Citizens National Bank, 516 F.2d at 787. Moreover, respondent does not dispute that the decision of the court of appeals in the present ease conflicts with those preexisting decisions. And, except for the fact that Congress codified the preexisting "principles of equitable subordination" in Section 510(c) of the Code, respondent offers no basis for distinguishing those decisions from the conflicting decision in the present case. In sum, respondent's contention that a conflict does not exist rests solely upon the untenable proposition that Congress changed the preexisting "principles of equitable subordination" under the guise of codifying them. 5. Contrary to respondent's contention (Br. in Opp. 13-14), the decision in the present case has ex- ceptional administrative import ante. Trustees and debtors-in-possession often incur tax penalties dur- ing the administration of a bankruptcy estate. In Nicholas v. United States, 384 U.S. at 699, this Court emphasized the importance of requiring payment of such penalties on a first priority basis, to ensure that debtors and trustees abide by the same rules of law that apply to other businesses. As the petition notes (Pet. 22-23), the decision in this case has recurring importance not only for enforcement of federal, state and local tax laws; it also threatens to undermine ---------------------------------------- Page Break ---------------------------------------- 6 enforcement of a broad variety of governmental reg- ulations, such as health and safety rules that are designed to protect. workers and the public at large. Moreover, as one commentator has noted, by un- hinging the doctrine of equitable subordination from its traditional framework, the rationale applied by the court of appeals in this case affects not only governmental claims; it has also sent a "chill" through the financial community by threatening to "eclipse the structure of bankruptcy prioritiza- tion." Note, No Fault Equitable Subordination: Re- assuring Investors That Only Government Penalty Claims Are At Risk, 34 Wm. & Mary L. Rev. 487, 488 (1993). By ignoring and nullifying the priorities that Congress established, the reasoning applied by the court of appeals in this case poses a serious threat to the integrity of the statutory scheme that Congress enacted. 6. As noted in the petition (Pet. 10 n.1), we suggest that this case be set for argument together with United States v. Reorganized CF&I Fabricators of Utah) Inc., No. 95-325, in the event that certiorari is granted in both cases. The second question presented in the CF&I case is whether a postpetition excise tax claim under Section 4971(a) of the Internal Revenue Code, 26 U.S.C. 4971(a), may be equitably subordi- nated to general unsecured claims in the absence of creditor misconduct. Although respondent suggests (Br. in Opp. 15) that the CF&I case is distinguishable, the controlling question presented in both cases is identical: whether Section 510(c) of the Bankruptcy Code authorizes equitable subordination of claims in the absence of creditor misconduct. The Tenth Cir- cuit recognized the closeness of these two cases by ---------------------------------------- Page Break ---------------------------------------- 7 relying on the Sixth Circuit's decision in this case in its opinion in CF&I. See 53 F.3d 1155, 1158 (1995). ***** For the reasons set forth above and in the petition, the petition for a writ of certiorari should be granted. Respectfully submitted. DREW S, DAYS, III Solicitor General NOVEMBER 1995 ---------------------------------------- Page Break ----------------------------------------