In re Somerset Regional Water Resources LLC

The bankruptcy court had ‘core’ jurisdiction over a dispute between two nondebtor third parties because the litigation involved the interpretation of a financing order.

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Case Type:
Case Status:
19-1874 (3rd Circuit, Feb 11,2020) Published
Where the sole owner of a bankruptcy company pledged his "2015 Federal tax refund" as collateral for a debtor-in-possession loan in a Chapter 11 case, the Third Circuit affirmed the bankruptcy court's ruling that the language of the contract was ambiguous and, based on testimony of the negotiations, the pledge included refunds generated by amended 2013 and 2014 tax returns generated from company losses in 2015. The Third Circuit also affirmed the bankruptcy court's exercise of jurisdiction under 28 U.S.C. §157(b)(2)(D) and its holding that the tax refund was not held by the entireties.
Procedural context:
The bankruptcy court ruled for appellee, Somerset Trust Company, after an evidentiary hearing and supplemental briefing on the following three issues: (i) the bankruptcy court had proper jurisdiction of the dispute as a core matter respecting obtaining of credit under 28 U.S.C. §157(b)(2)(D); (ii) the contract was ambiguous and, with the benefit of parole evidence, it was clear that the parties intended that the pledge include all federal tax refunds owed to Mr. Mostoller as a result of the debtor's losses in 2015, including refunds from amended tax returns for 2013 and 2014; and (iii) the right to a tax refund was not held by the entireties under Pennsylvania law as applied to the facts of the case and, therefore, the wife's consent to the pledge was unnecessary at least as to half of the refund.. On appeal, the District Court of the Western District of Pennsylvania affirmed the bankruptcy court's ruling in all respects. The appellants further appealed to the Third Circuit, and the Third Circuit also upheld the bankruptcy court's ruling in all respects.
Mr. Mostoller, a married man, was the sole owner of Somerset Regional Water Resources, LLC ("Debtor"), which was taxed as a pass-through entity. The Debtor was profitable until mid to late 2014, at which time it began experiencing significant losses. In late 2015, the Debtor filed a voluntary Chapter 11 bankruptcy case. To continue operations, the Debtor required an emergency loan. The Debtor's primary secured lender, Somerset Trust Company (the "Trust") was willing to provide an emergency loan, but only if additional collateral was pledged. To secure the loan, Mr. Mostoller pledged as collateral for the loan “any rights or interest in the 2015 Federal tax refund due to him individually, but attributable to the operating losses of the Debtor.” The parties anticipated, based on a preliminary accountant's estimate, that Mr. Mostoller would be entitled to a refund of approximately $1 million due to the Debtor's 2015 losses. Mr. Mostoller subsequently amended his 2013 and 2014 tax returns to claim a refund based on carryback losses due to the company's large losses in 2015. The Debtor subsequently defaulted under the emergency loan and the Trust sought to exercise its rights against Mr. Mostoller's tax refund. Mr. Mostoller argued that (i) the Trust was entitled only to his refund for the 2015 tax return, which was minimal, and that the Trust had no interest in his refunds based on his amended 2013 and 2014 returns; (ii) the refunds were all held by the entireties with his wife and could not be alienated without his wife's consent; and (iii) the bankruptcy court had no jurisdiction because the Debtor was not a party to the dispute. The bankruptcy court ruled against Mr. Mostoller and in favor of the Trust on all three issues.

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