Government Claims in Bankruptcy Professor Jaime Dodge University of Georgia School of Law Phone: (415) ;

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1 Government Claims in Bankruptcy Professor Jaime Dodge University of Georgia School of Law Phone: (415) ; Prepared by: Justin Bargeron & Jill Jenkins My comments during the session will focus primarily on the increasing conflict between forfeiture statutes and the Bankruptcy Code. The presentation will focus upon substantive law conflicts (both real and imagined), as well as the procedural and jurisdictional conflict that has emerged in the wake of Stern v. Marshall. I will also touch upon the strategic conflicts and the residual dysfunction the existing scheme creates and the current reform efforts underway. The materials below summarize the broader landscape of government claims, with an eye toward providing a basic reference for those new to the practice. Overview: I. Applicability of the Automatic Stay Provisions to Government Claims... 1 II. Sovereign Immunity... 1 A. Scope of Waiver... 1 B. Jurisdiction Over Tax Claims... 2 III. Whether the Government Is Exercising Its Police and Regulatory Power or Acting to Further Its Pecuniary Interest... 4 A. Is the actor a governmental unit?... 4 B. Is the governmental unit acting within its police or regulatory powers?... 5 C. What are the limitations on the enforcement of a money judgment?... 7 IV. What May the Government Collect?... 8 A. Statutorily Secured Claims Under s B. Limitations on the Government s Enforcement of Civil Penalties... 8 V. Special Issue: Propriety of a Creditor s Pressing for Government Prosecution of a Bad Check Charge or Other Criminal Actions to Collect Debt VI. Priority & Discharge VII. Conflict Between Bankruptcy and Forfeiture Law... 13

2 I. Applicability of the Automatic Stay Provisions to Government Claims The automatic stay, 11 U.S.C. 362(a), is one of the fundamental debtor protections provided by the bankruptcy laws. Midlantic Nat. Bank v. New Jersey Dep t. of Envtl. Prot., 474 U.S. 494, 503 (1986). It forbids the taking of certain actions against a debtor in bankruptcy and is applicable to all entities. 11 U.S.C. 362(a). By the language of the statute, therefore, the automatic stay applies to governmental entities just as it does to all other types of creditors. However, despite the importance of the automatic stay, Congress has enacted several exemptions codified in section 362(b) in order to prevent the bankruptcy court from becoming a haven for wrongdoers. Berg v. Good Samaritan Hosp. (In re Berg), 230 F.3d 1165, 1167 (9 th Cir. 2000). Several of these exceptions are important in the governmental context. Section 362(b)(1) exempts from the automatic stay provision the commencement or continuation of a criminal action or proceeding against the debtor. 11 U.S.C. 362(b)(1). Section 362(b)(4) exempts the commencement or continuation of an action or proceeding by a governmental unit enforcing its police and regulatory power, including the enforcement of a judgment other than a money judgment from certain actions covered by the automatic stay provision. 11 U.S.C. 362(b)(4). Lastly, section 362(b)(9) permits a governmental unit to audit a debtor to determine tax liability, to issue the debtor a notice of tax delinquency, to demand the debtor s tax returns, or to make a tax assessment. 11 U.S.C. 362(b)(9). However, the government must obtain relief from the automatic stay to actually collect the tax. Although there are other exemptions allowed in section 362(b), the three aforementioned exemptions apply most specifically in the governmental context. II. Sovereign Immunity A. Scope of Waiver A natural conflict exists between sovereign immunity (and the 11 th Amendment analog for states) and the underlying structure of bankruptcy. This conflict has been reconciled by a line of cases establishing a doctrine that the waiver of immunity by a state that files a proof of claim against the debtor is limited to adjudication of that claim such that the debtor or third-parties cannot piggyback off the state's waiver where the debtor

3 seeks to pursue a claim against the government that is not compulsory or necessary to the adjudication of the government s claim. See In re Friendship Medical Center, 710 F.2d 1297 (7 th Cir. 1983). Of course, this begs the question of what a compulsory counterclaim is under section 106 of the Bankruptcy Code a continued area of litigation. Most courts are settling on a three-part test for waiver: (1) the estate and governmental unit must each have claims against each other; (2) the claim against the government must be part of the estate; and (3) if these requirements are both satisfied, then the court applies the same transaction or occurrence test, which is utilized in civil procedure more broadly. (For this reason, you can draw upon broader precedent applying this test to construct a stronger argument in briefing your position you should not feel limited to bankruptcy precedent, although this will obviously be helpful in buttressing your argument.) Two final notes: First, be careful in selecting precedent, given that in some cases the results for a claim by or against the federal government will differ from those involving claims by or against a state governmental unit, in light of section 106(a) s treatment of preference claims. Second, note that where the government files against an entity and a second debtor s case is later substantively consolidated, the waiver of sovereign immunity is limited to the first debtor. While this may result in some strategic behavior or aberrant results in particular cases, this result follows from the general principles of knowledgeable waiver. B. Jurisdiction Over Tax Claims Section 505 of the Bankruptcy Code grants broad powers to the bankruptcy court to resolve disputes with tax authorities, stating: the court may determine the amount or legality of any tax, any fine or penalty relating to a tax, or any addition to tax, whether or not previously assessed, whether or not paid, and whether or not contested before and adjudicated by a judicial or administrative tribunal of competent jurisdiction. 11 U.S.C. 505 (a)(1). However, section 505(a)(2) limits this broad power. Importantly, section 505(a)(2)(A) does not allow a bankruptcy court to determine the amount or legality of a tax if such amount or legality was contested before and adjudicated by a - 2 -

4 judicial or administrative tribunal of competent jurisdiction. 505(a)(2)(A). Thus, in In re Harker, 357 F.3d 846 (8th Cir. 2004), the Eighth Circuit stated that the bankruptcy court did not have jurisdiction to determine the debtor s liabilities when those liabilities had been previously established in a Tax Court decision. Id. at 849. While section 505 clearly permits a determination by the bankruptcy court of any unpaid tax liability of the debtor, there is considerable debate whether this code section precludes the bankruptcy court from determining the tax liability of a non-debtor. Some courts have held that section 505 denies the bankruptcy court jurisdiction over nondebtors. E.g., Am. Principals Leasing Corp. v. U.S., 904 F.2d 477, 481 (9 th Cir. 1990); U.S. v. Huckabee Auto Co., 783 F.2d 1546, 1549 (11 th Cir. 1986). To allow bankruptcy courts to have jurisdiction over tax claims of non-debtors would have the absurd result of turning the bankruptcy courts into a second tax court system. Am. Principals 904 F.2d at 481. However, the Eleventh Circuit recognized in In re T.H. Orlando Ltd., 391 F.3d 1287 (11 th Cir. 2004), that the adjudication of substantive entitlements created by bankruptcy law falls squarely within the core jurisdiction of the bankruptcy courts. In re T.H. Orlando, 391 F.3d at In that case, the court held that the bankruptcy court had jurisdiction to determine whether a non-debtor is entitled to an exemption from state intangible and stamp taxes under section 1146(c) of the Bankruptcy Code. The court noted that, otherwise, the state could circumvent the exemption by shifting the tax burden to third parties, even in transactions involving the debtor. Id. In contrast, a minority of courts have held that section 505 neither grants nor denies the bankruptcy court jurisdiction to determine the tax liability of non-debtors. Rather, it only denies bankruptcy court jurisdiction where, prior to bankruptcy, a tax claim has been contested and adjudicated by a judicial or administrative tribunal of competent jurisdiction. E.g., Michigan Employment Sec. Comm'n. v. Wolverine Radio Co., Inc. (In re Wolverine Radio Co., Inc.), 930 F.2d 1132, 1140 (6 th Cir 1991); Quattrone Accountants, Inc. v. I.R.S., 895 F.2d 921, 925 (3 d Cir. 1990). These courts analyze the bankruptcy court s ability to determine the liability of a non-debtor based on the propriety of the bankruptcy court s exercise of jurisdiction under 28 U.S.C Quattrone, 895 F.2d at 926. For further reference as to section 1334, please see id. at

5 In addition to section 505(a)(2)(A), section 505(a)(2)(B) deprives the bankruptcy court of jurisdiction to determine the bankruptcy estate s rights to a tax refund before the earlier of the governmental unit determining the estate s eligibility for the refund or 120 days after the trustee requests the refund. 11 U.S.C. 505(a)(2)(B). Lastly, section 505 prevents the bankruptcy court from determining the amount or legality of any tax liability due to ad valorem taxes on the estate s real or personal property if the period for contesting such liability has expired under non-bankruptcy law. 11 U.S.C. 505(a)(2)(C). However, even where the bankruptcy court has jurisdiction to hear a tax issue, there are circumstances where the court may choose to abstain. The six factors the courts look to in making the determination of whether to abstain include: the complexity of the tax issue, the need to orderly and efficiently administer the bankruptcy case, the burden on the bankruptcy court's docket, the length of time required for the issue to be adjudicated, the debtor s asset and liability structure, and the prejudice to the debtor and potential prejudice to the governmental unit. In re A.N.C. Rental Co., 316 B.R. 153, 159 (Bankr. D. Del. 2004). For additional information, see Collier on Bankruptcy 505 (16 th ed. 2012), Norton Bankruptcy Law and Practice 51 (3 rd ed ) III. Whether the Government Is Exercising Its Police and Regulatory Power or Acting to Further Its Pecuniary Interest A. Is the actor a governmental unit? Section 364(b)(4), also known as the police power exemption to the automatic stay, allows government actors to remain unfettered by the bankruptcy code in the exercise of their regulatory powers. In re Commerce Oil Co., 847 F.2d 291, 295 (6 th Cir. 1988). In order for the exemption to apply, the actor in question must be a governmental unit. 11 U.S.C. 362(b)(4). The legislative history of section 362 shows that Congress intended the term governmental unit to be construed broadly. In re Arsi, 354 B.R. 770, 773 (Bankr. D.S.C. 2006). The key is to determine whether the department, agency, or instrumentality carries out a governmental function. Id. For example, the exemption to the automatic stay has applied to state bar disciplinary proceedings, employment discrimination actions labor law enforcement proceedings, rent regulation enforcement, the enforcement of minimum wage laws, - 4 -

6 enforcement of water quality control standards and many other actions. Id. In In re Arsi, one of the debtor-spouses was a former member of the South Carolina bar. He had been disbarred after absconding with fees to which he was not entitled and incurred a penalty of approximately $353,000. The court held that regulation of the conduct of officers of the court could not be more clearly within the police and regulatory exception because it extends to the regulation of the practice of law and protects the public. Id. It is important to determine whether the creditor is, in fact, a governmental unit because governmental units need not seek to have the automatic stay lifted where an exemption applies. N.L.R.B. v. Edward Cooper Painting, Inc., 804 F.2d 934, 939 (6 th Cir. 1986). Because section 362(b) lists exemptions, the stay simply does not apply to those actions. However, the section 362(b)(4) exemption only applies where the governmental unit is acting to enforce its police or regulatory powers. Therefore, the next important issue is whether a governmental unit is acting within its police or regulatory powers. B. Is the governmental unit acting within its police or regulatory powers? Though the definition of governmental unit is to be construed broadly, whether the governmental unit is acting within its police or regulatory powers should be construed narrowly. In re Nortel Networks Corp., 426 B.R. 84, 91 (Bankr. D. Del. 2010). The courts have developed two tests to determine whether an action by a governmental entity is exempted from the automatic stay provision as an exercise of the entity s police power: the pecuniary purpose test and the public policy test. In re Commerce Oil Co., 847 F.2d at 296. Under the pecuniary purpose test, the courts focus on whether the action relates primarily to the protection of the government's pecuniary interest in the debtor s property, and not to matters of public safety. Id. Those proceedings relating to matters of public safety are exempted from the automatic stay. Under the public policy test, the courts must distinguish between actions adjudicating private rights and those effectuating public policy. The latter are exempted. Id. at 295. The Supreme Court explained in Midland Nat. Bank that the automatic stay does not apply where a governmental unit is suing a debtor to prevent or stop violation of fraud, environmental protection, consumer protection, safety, or similar police or regulatory laws, or attempting to fix damages for violation of such a law. Midland Nat. Bank, 474 U.S. at 501 (emphasis omitted)

7 The determination of whether a particular action is exempted from the automatic stay will likely be fact-intensive. For example, in In re Commerce Oil Co., the debtor was found to be in violation of the Tennessee Water Quality Control Act and damages were assessed in the amount of $16, In re Commerce Oil Co., 847 F.2d at 292. The court stated that damages for civil liability may be assessed for a violation of federal and state laws without violating the stay. Id. at 295. The court explained that the rationale and policies behind the Act were to punish wrongdoers, deter illegal activity, recover remedial costs of damage to the environment, provide for the costs of administration. Id. at 296. These policies are not pecuniary in nature, nor do they deal only with the state s concern with its property interests. However, if the governmental unit simply seeks monetary damages as compensation for reclamation already performed, the exemption under 362(b)(4) would not apply. Id. at 295. Although the assessment of damages is exempted under section 362(b)(4), the collection of the penalties is not. N.L.R.B., 804 F.2d at 943. The court in In re Geeslin, 296 B.R. 70 (Bankr. M.D. Ga. 2003), rev d on other grounds, 303 B.R. 533 (Bankr. M.D. Ga. 2004), refused to exempt a district attorney s attempt to collect a bail bond forfeiture from a professional bail bondsman who declared bankruptcy. The court stressed that the matter was civil in nature and the bail bondsmen acted in a professional capacity. Id. at Measures employed to deter criminal or fraudulent conduct are commonly exempted from the automatic stay. See In re WinPar Hospitality Chattanooga, LLC., 401 B.R. 289, (Bankr. E.D. Tenn. 2009). As a professional, the bondsman in Geeslin would not have been deterred from criminal or fraudulent conduct by the district attorney s actions, like he would be if he were the criminal defendant. In contrast, courts have exempted: state bar disciplinary proceedings, employment discrimination actions, labor law enforcement proceedings, rent regulation enforcement, the enforcement of minimum wage laws, enforcement of water quality control standards, enforcement of actions by the Federal Trade Commission to enjoin illegal lending, by the Securities Exchange Commission, including actions seeking disgorgement of illicit profits, and the enforcement of a prepetition award of sanctions against the debtor in enforcing a court order

8 In re Arsi, 354 B.R. at 773. The key determination will be the nature and purpose of the challenged action. Further, the actions exempted cannot have the primary purpose of reimbursing third parties for damages. However, the fact that private parties may benefit from the imposition of sanctions does not prevent those monetary sanctions from being exempted from the automatic stay. For example, where attorney s fees have been imposed as a sanction for improper conduct in litigation, the collection of those fees is not subject to the automatic stay. 1 In re Berg, 230 F.3d at Although an individual may benefit privately from these sanctions, the government imposes the sanctions for the deterrent effect they have. The governmental unit s interest is to keep the stream of federal litigation free from unnecessary and abusive legal obstructions. O Brien v. Fischel, 74 B.R. 546, 549 (Bankr. D. Hawai i 1987). Therefore, these sanctions help to effectuate public policy, not to protect the private rights of an individual, and are exempted from the automatic stay. C. What are the limitations on the enforcement of a money judgment? Unlike the terms governmental units and police and regulatory powers, Congress did not clearly define enforcement of a money judgment. Penn Terra Ltd. v. Dep t of Envtl. Res., Pennsylvania, 733 F.2d 267, 274 (3 d Cir. 1984). Therefore, the courts must look to the common understanding of the term, which is an order entered by the court or by the clerk, after a verdict has been rendered for plaintiff, which adjudges that the defendant shall pay a sum of money to the plaintiff. Id. at 275. However, the mere entry of a money judgment in favor of a governmental unit is not a violation of the automatic stay, so long as the governmental unit sought the money judgment pursuant to its police and regulatory powers. Id. It is the enforcement of the money judgment that may violate the automatic stay. However, there is a fear that governmental units will bring suit under the guise of entering a judgment when their actual purpose is the enforcement of a money judgment. Id. Therefore, the courts must look beyond the face of the governmental unit s suit to determine the unit s purpose for bringing suit. Id. For example, the court in Jaffee v. 1 The only contrary authority is Brandt v. Schal Assocs., 131 F.R.D. 512, 514 (N.D. Ill. 1990), aff d on other grounds, 960 F.2d 640 (7 th Cir. 1992)

9 United States, 592 F.2d 712 (3 d Cir. 1979), determined that, though the suit was only seeking an injunction, the underlying purpose was to enforce a money judgment. Enforcement of the injunction would have required payment for medical services. Therefore, the suit, while facially seeking an equitable remedy, was actually a suit for money damages. The court s reasoning reflects that of the court in Penn Terra that the proper inquiry focuses on the nature of the injuries which the challenged remedy is intended to redress - including whether plaintiff seeks compensation for past damages or prevention of future harm - in order to reach the ultimate conclusion as to whether these injuries are traditionally rectified by a money judgment and its enforcement. Penn Terra, 733 F.2d at 278. IV. What May the Government Collect? A. Statutorily Secured Claims Under Section 506 Post-petition interest may be collected by the government as an over-secured creditor, just as any other over-secured creditor. In U.S. v. Ron Pair Enters., Inc., 489 U.S. 235 (1989), the Supreme Court held that section 506(b) requires a written agreement to support the collection of fees, costs, or charges but that there was no need for such a writing with respect to interest. In that case, the government was able to argue that its tax claim was secured by a statutory lien, and thus it was entitled to post-petition interest. (This ruling has been criticized; for a discussion see Collier on Bankruptcy [2] (16 th ed. 2012), Norton Bankruptcy Law and Practice 52:9 (3 rd ed ) As with non-governmental claims, interest in Chapter 11, 12, and 13 cases is accrued on the unpaid principal, but not the unpaid pre-petition interest. B. Limitations on the Government s Enforcement of Civil Penalties In a Chapter 7 case, a penalty is paid only after allowed claims under 11 U.S.C. 726(a)(1)-(3), unless the penalty is compensation for actual pecuniary loss. Since the assets of the debtor will generally be insufficient to cover the allowed claims under section 726(a)(1)-(3), fitting into the exception for actual pecuniary losses is critical. This may be difficult since generally the penalties and the interest thereon are not in compensation for pecuniary loss and are not entitled to priority. In re Bates, 974 F.2d - 8 -

10 1234, 1236 (10 th Cir. 1992). The court s unwillingness to allow recovery of nonpecuniary penalties extends to cases arising under other bankruptcy chapters since allowing recovery would unduly punish creditors who are innocent of the wrongdoing. In re Hillsborough Holdings Corp., 146 B.R. 1015, 1022 (M.D. Fla. 1992) (refusing to apply section 726 in a Chapter 11 case, but disapproving of punitive damages as punishing the entire body of creditors ). Whether a particular claim is for an actual pecuniary loss or a penalty may be fact-dependent and, thus, beyond the scope of this presentation. V. Special Issue: Propriety of a Creditor s Pressing for Government Prosecution of a Bad Check Charge or Other Criminal Actions to Collect Debt Typically, a federal court cannot enjoin a state proceeding. However, the Bankruptcy Code is an expressly authorized exception to this rule. Matter of Davis, 691 F.2d 176 (3 d Cir. 1982). The courts have split on the appropriate test to apply when determining whether a state criminal prosecution to collect a debt from a debtor in bankruptcy violates the automatic stay. The Supreme Court has stated that criminal actions should be enjoined only under extraordinary circumstances. Fenner v. Boykin, 271 U.S. 240, 243 (1926). Extraordinary circumstances means that great, immediate and irreparable harm will occur without federal interference and that the threat to a federally protected right must be a threat that cannot be eliminated through a defense in the state proceeding. Matter of Tenpins Bowling, Ltd., 32 B.R. 474, 478 (Bankr. M.D. Ga. 1983). Once again, the courts were concerned with the use of bankruptcy as a safe haven for criminals seeking to escape restitution and penalty payments. The purpose of the bankruptcy courts is to protect those in financial, not moral, difficulty. Id. at 479. Therefore, the interest of the public in pursuing criminal prosecutions overrides any interest the bankruptcy court may have in protecting the financial interest of debtors. Id. However, there is a counter-concern that the prosecution of a criminal act may simply be a subversion of the criminal process in order to collect the debt. Unfortunately, courts do not all use the same method to determine whether prosecution is simply a guise for collection efforts. Courts have generally applied one of two tests: the principal motivation test and the bad faith test. The 11 th Circuit Court of Appeals adheres to the - 9 -

11 bad faith test. Under this test, the debtor must first show that the criminal prosecution was brought in bad faith. Matter of Tenpins Bowling, Ltd., 32 B.R. at 480. Second, the court must refuse to enjoin the proceeding if the debtor could adequately raise the debt collection defense in the criminal proceeding. Barnette v. Evans, 673 F.2d 1250, 1252 (11 th Cir. 1982). In order to raise such a defense, however, the debtor must show specific evidence that the prosecutor acted improperly or was bringing charges in bad faith. Matter of Tenpins Bowling, Ltd., 32 B.R. at 481. The hope for repayment is not enough. Id. As long as the government brings the prosecution to protect a valid state interest, and not simply the furtherance of the creditor s financial interest, it is within the sound discretion of the prosecutor whether to bring criminal charges. Id. Other parties alternate motives do not alter the state s interest in prosecuting criminals. Id. Consequently, courts applying the bad faith test often expressly reject the principal motivation test as it would require a prosecutor to conduct a searching inquiry into the public spirit of the victim of a crime before proceeding with what appears to be an otherwise valid criminal prosecution. Davis v. Sheldon, 691 F.2d 176, 179 (3 d Cir. 1982). Since the intentions of complaining witnesses are not controlling, it would seem entirely proper for creditors to press the government to bring bad check and other criminal charges. Other courts have adopted the principal motivation test. The court in In re Taylor, 16 B.R. 323 (Bankr. D. Md. 1981), stated that: [t]he nature of the moving force behind the institution of the criminal proceeding is the determinative factor. Prosecutions instituted primarily to vindicate the public welfare by punishing criminal conduct of the Debtor and to discourage similar conduct of others are not usually interfered with by Bankruptcy Courts. When it is clear that the principal motivation is neither punishment nor a sense of public duty, but rather to obtain payment of a dischargeable debt either by an order of restitution or by compromise of the criminal charge upon payment of the civil obligation, the Bankruptcy Court may properly enjoin the criminal proceeding

12 Id. at The court found in that case that the primary motivation behind the criminal prosecution was to collect a debt. Key factors leading the court to that conclusion were: (1) the promptness with which the creditors sought criminal warrants, (2) that the creditor was the sole impetus for the prosecution, (3) that the authorities failed to uncover the conduct as part of an independent investigation, and most importantly, (4) the creditor offered to drop the charges after the debtor fulfilled the debt. Id. at This suggests that creditors wanting to institute criminal prosecution to collect a debt should attempt to maintain, as much as possible, a hands-off approach to the prosecution. VI. Priority & Discharge The central policy of the Bankruptcy Code is the equal distribution of assets among all of a debtor s creditors. In re Suburban Motor Freight, Inc., 36 F.3d 484 (6 th Cir. 1994). However, section 507(a) establishes a list of priorities - those creditors that, for various reasons, should be paid before other creditors, thereby eliminating the equal distribution of assets. Because priority status grants such special powers, the priorities must be construed narrowly. Thus, creditors must directly tie their priority claims to specific provisions of the Bankruptcy Code. Id. at 487. The two specific priority claims relating to governmental units are sections 507(a)(2) and (a)(8). Section 507(a)(8) awards priority status to a finite list of unsecured claims of governmental units, including some taxes. 11 U.S.C. 507 (a)(8). Section 507(a)(2) awards priority status to administrative expenses, including any tax incurred by the estate not listed in section 507(a)(8). 11 U.S.C. 507(a)(2). The administrative expenses under section 507(a)(2) have greater priority than the claims listed in section 507(a)(8). 11 U.S.C. 507(a). However, the Bankruptcy Code does not define tax, and the definitions must be interpreted under federal law. City of New York v. Feiring, 313 U.S. 283 (1941). In Feiring, the Supreme Court defined taxes as involuntary pecuniary burdens placed upon individuals for the purpose of supporting the government. Id. at 285. However, government fees charged for services rendered are not taxes since they merely restore the cost of providing benefits to individuals. In re Park, 212 B.R. 430, 433 (Bankr. D.Mass

13 1997). Although the Supreme Court has provided a definition of taxes, courts have subsequently refined the definition, albeit not consistently. For example, the Ninth Circuit defined a tax, for bankruptcy purposes, as: a) an involuntary pecuniary burden, regardless of name, laid upon individuals or property; b) imposed by, or under authority of the legislature; c) for public purposes, including the purposes of defraying expenses of government or undertaking authorized by it; d) under the police or taxing power of the state. In re Lorber, 675 F.2d 1062, 1066 (9 th Cir. 1982). The Sixth Circuit in In re Suburban Motor Freight added two more elements to this test: 1) the exaction must be universally applicable to similarly situated entities, and 2) the granting of a priority claim must not disadvantage private creditors with like claims. However, these two definitions are not exhaustive, and practitioners should consult the applicable law in their jurisdictions. Although most debts may be discharged in bankruptcy, those debts falling under section 523(a)(1) are not dischargeable for individual debtors. 11 U.S.C Section 523(a)(1)(A) specifically excludes those claims under section 507(a)(8), which includes certain taxes, from discharge, meaning that many government claims for tax liabilities are non-dischargeable. Therefore, unless either the debtor or the governmental unit elects to litigate the nondischargeability of a debt under 523(a)(1)(C) in the bankruptcy court, the claim survives the bankruptcy, is unaffected by the discharge, and may be brought later in another court. U.S. v. Clayton, 465 B.R. 72 (Bankr. M.D.N.C. 2011). Those tax liabilities allowed under section 507(a)(2) as administrative priorities are not listed as an exemption to dischargeability under section 523. However, section 523(a)(1)(C) disallows discharge of tax liabilities for those debtors who willfully attempt to evade or defeat their tax obligations. U.S. v. Beninati, 438 B.R. 755, 758 (Bankr. D.Mass. 2010). Any tax liability should be carefully evaluated, not only to determine the specific definition used within the practitioner s jurisdiction, but also to determine the possible dischargeability of the tax liability

14 VII. Conflict Between Bankruptcy and Forfeiture Law The priority and distribution framework of the Bankruptcy Code often conflicts with those of the federal forfeiture statutes 2 in fraudulent scheme cases. The Bankruptcy Code seeks to compensate all of the debtor s similarly situated creditors equally. In contrast, the forfeiture statutes compensate victims, which is defined by regulations promulgated by the Department of Justice as person[s] who [have] incurred a pecuniary loss as a direct result of the commission of the offense underlying a forfeiture. 28 C.F.R. 9.2(v). This definition often includes investors, a group receiving less favorable treatment than general trade creditors and employees in bankruptcy. See 11 U.S.C. 507 (listing creditors with priority status). This allows victims to recover under the forfeiture statutes before creditors having priority in bankruptcy and reduces the debtor s bankruptcy estate, leaving fewer assets for distribution to those creditors. As a result, the conflict between the Bankruptcy Code and the federal forfeiture statutes frequently creates litigation as the bankruptcy trustee, the government, and individual creditors are left to squabble over who gets what. United States v. Dreier, 682 F. Supp. 2d 417, 417 (S.D.N.Y. 2010). Normally, all interests in property of the debtor at the commencement of the bankruptcy case become property of the bankruptcy estate. In addition, property recovered through the trustee s avoidance powers becomes property of the bankruptcy estate. 11 U.S.C It would appear, therefore, that assets not yet forfeited would enter into the bankruptcy estate, over which the bankruptcy court has exclusive jurisdiction. 3 However, under the relation-back doctrine, the property is forfeited by the debtor at the time of the commission of the crime or fraud. See 18 U.S.C. 981(f); 21 U.S.C. 853(c). Since the property is not property of the debtor at the time of the commencement of the bankruptcy case, the property never enters into the bankruptcy estate. The relation-back doctrine may also extend to property in the hands of third parties. This bars the bankruptcy trustee from attempting to use his avoidance powers to bring that property within the bankruptcy estate. Importantly, the government may commence or continue forfeiture proceedings, notwithstanding the automatic stay 2 18 U.S.C. 983 (civil forfeiture); 21 U.S.C. 853 (criminal forfeiture) U.S.C. 1334(e)

15 imposed by the filing of the bankruptcy petition since forfeiture is considered punishment for a crime and not remuneration to the government. See United States v. Bajakajian, 524 U.S. 321 (1998). Advocates of the forfeiture process make several policy arguments as to why its priority and distribution framework is preferable. First, they note that criminal investigations often proceed for a substantial period of time before the commencement of the bankruptcy proceedings and uncover and preserve substantial assets. Second, they argue that the forfeiture process is faster and less expensive than the bankruptcy process. Advocates of the bankruptcy process respond that it allows for greater judicial review and oversight and incentivizes trustees to pursue their avoidance powers. Coordination between the bankruptcy trustee and the Department of Justice may be the best way to take advantage of the distinct advantages offer by each of these processes. One way to increase coordination is through a coordination agreement. 4 While the negotiation required to reach a coordination agreements takes time, allowing the property to depreciate and leading to considerable administrative expenses, coordination agreements will certainly be in the best interests of the victims and creditors. Such agreements specify the manner of dividing and assigning assets. Coordination between the bankruptcy trustee and the Justice Department may also create a more comprehensive list of victims, allowing for more complete noticing and access to the forfeited property, and prevent double recovery by offsetting recovery under one process when calculating the appropriate recovery under the other process. Indeed, the Department of Justice has already begun to consider measures that would help harmonize forfeiture and bankruptcy proceedings. They include (1) advising prosecutors to investigate whether there is a pending bankruptcy case at the time of forfeiture and, if so, communicate with the bankruptcy trustee to develop a list of all possible victims, (2) amending the list of victims when a bankruptcy is filed after forfeiture and the bankruptcy reveals new victims, and (3) setting up a system to track criminal cases with parallel bankruptcy filings. 4 See for examples of coordination agreements

16 In conclusion, the competition created between victims by the conflict in bankruptcy and forfeiture law harms all of the victims. The easiest way to avoid this is through early and frequent communication and coordination between the Justice Department and the bankruptcy trustee