Clarity Of Drafting And Reliance On A Spouse For Bankruptcy Protection - A Cautionary Tale
The importance of clarity in drafting agreements can never be understated. And while there are strategies available to spouses of business owners to help protect a family in bankruptcy, it is imperative to properly plan and draft to receive such protection from the Courts. In re Somerset Regional Water Resources, LLC, _____________ F.3d ________________ (3rd Cir. 2020) (“Somerset”), recently decided by the Third Circuit Court of Appeals, offers a prime example of both cautionary concepts.
Desperate for cash, Somerset Regional Water Resources, LLC (“Debtor”), a debtor in a Chapter 11 case, obtained a $1 million loan from Somerset Trust Company (“Trust”), already the Debtor’s largest creditor on account of a prior loan of $3 million. The prior loan was secured by a lien on all of the Debtor’s assets and backed by a personal guarantee from the Debtor’s principal, Larry Mostoller. Before it would make the new loan, the Trust required Mostoller to pledge a forthcoming personal tax refund as collateral.
In the new loan agreement, Mostoller pledged as collateral “any rights or interest in the 2015 Federal tax refund due to him individually, but attributable to the operating losses of the Debtor.” However, the agreement left open the details about executing the tax filings needed to trigger the expected refund. Notwithstanding that omission, the bankruptcy Court approved the agreement and entered it on its docket as a consent order (“Loan Order”).
Shortly after receiving the new loan, the Debtor defaulted. Because it did not have access to additional financing, the Debtor converted its case to a Chapter 7 liquidation. After initially refusing to file his 2015 tax return and amend the 2013 and 2014 returns, which steps were necessary to generate the refund collateral, Mostoller subsequently made the necessary filings and reached an agreement with the Trust to receive half of the refund, less any taxes due, with the other half going to Mostoller’s wife.
When the refund arrived, however, Mostoller took the position that he was entitled to keep all of it. He offered two justifications for this position. First, he claimed that he pledged as collateral only his refund on taxes paid for 2015, and not any refund attributable to the 2013 and 2014 tax years. Second, he argued that because he and his wife owned the refund as tenants by the entirety under Pennsylvania law, and because his wife had not signed the Loan Order, the Trust could not seize any of the refund. The United States District Court for the Western District of Pennsylvania affirmed the bankruptcy court’s decision that Mostoller’s argument contravened the express language of the loan documents underlying the transaction and ruled in favor of the Trust. The Third Circuit affirmed the District Court’s ruling.
In holding in favor of the Trust with respect to Mostoller’s first argument, the Circuit Court found that the description of the collateral (i.e., the tax refund) in the Loan Order was ambiguous, and thus permitted the use of extrinsic evidence to clarify the parties’ intentions. A ruling in favor of the Trust was necessary, according to the Court, because the Trust would never have made such a risky loan without an assurance that the loan’s security was adequate to protect it in the event of a default.
On the alternative argument, the Court found that Pennsylvania law did not entirely control the question of ownership of the tax refund proceeds, because federal tax law determines who owns a portion of a federal tax refund. According to the Court, “federal tax law provides that spouses ownership of a refund depends on how they owned the income that generated that refund under state property law.” The Court held that, under Pennsylvania law, the Mostollers' held separate interests in the Debtor’s income because Mostoller was the sole owner of the Debtor. Moreover, the Internal Revenue Code does not automatically treat refunds from joint marital returns as jointly owned, but rather that each spouse owns a portion of the refund separately according to his or her share of the overpayment. In short, “If the income is separate going in, then the refund is separate coming out. Merely filing a joint tax return does not change that.” Accordingly, the Court held that Mostoller owned almost the entire refund separately from his wife because, under Pennsylvania law, he separately owned most of the spouse’s income since he separately owned the Debtor. As such, Mostoller’s contention that his pledge was unenforceable without his wife’s consent was meritless.
 The Debtor had overpaid its taxes for several years while filing as an S Corporation, thus passing through its taxable income and losses through to Mostoller, its sole owner. Mostoller filed his taxes jointly with his wife during 2013-2015. The Debtor, which was in the oil and gas servicing industry, had substantial income in 2013-2014, but significant losses in 2015 following the sharp plunge in worldwide oil and gas prices, which could offset the gains in 2013 and 2014. Accordingly, the parties to the new loan transaction had an expectation that Mostoller’s tax refund would be roughly equal to the principal amount of the new loan.
 Id. at _________________.