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Order in the Court: Limits on the Court's Preservation of Debtor Assets

By Jerome M. Schwartzman and Steven J. Joffe
August 31, 2004

Telecom companies invest substantial amounts to acquire their assets, such as underground cables or fiber optic networks. As a consequence of building or acquiring this capital-intensive infrastructure, telecom companies often pay millions of dollars in annual property tax assessments. When telecom asset values drop (as has most recently been the case), telecom companies generally focus on keeping their businesses afloat, rather than on their property taxes.

A Case in Point

Take the case of Metromedia Fiber Network (MFN), which recently emerged from Chapter 11 under the name AboveNet, Inc. As part of the reorganization of its business, Metromedia realized that it had been assessed millions of dollars in property taxes over the prior several years (and would continue to be assessed property taxes), based on assessed asset values that clearly did not reflect the assets' current fair market value. In a clever move, MFN initiated an adversary proceeding in the bankruptcy court seeking a determination of the value of its assets for property tax purposes that would be binding on the state and local taxing jurisdictions. The proceeding included many of MFN's state and local property tax jurisdictions (more than 1000 taxing jurisdictions in which MFN had assets). Metromedia Fiber Network, Inc. v. Various State and Local Taxing Authorities, 299 B.R. 251 (S.D.N. Y. July 15, 2003) (the MFN Case).

This was a clever move for two reasons. First and foremost, had MFN been successful, it would have substantially reduced the amount of cash it would have been required to pay in the property taxes (and possibly set the stage for property tax refunds, which could have brought desperately needed cash into the estate). Second, a successful adjudication of its case would have extended the bankruptcy court “tax activism” displayed in the Prudential Lines case into new territory. Under the Prudential Lines case, shareholders and debtholders could be restrained from taking actions that would adversely impact the tax assets of the debtor, such as net operating losses (NOLs). For example, under the Prudential Lines authority, majority shareholders could be prevented from taking worthless stock deductions (which would destroy the value of the debtor's NOLs) and historical creditors could be prevented from selling their debtholdings (which could prevent the debtor from taking advantage of a favorable tax rule allowing it to avoid a limitation on the use of its NOLs post-emergence).

MFN initiated its case under Section 505 of the Bankruptcy Code, which allows a bankruptcy court to determine the amount or legality of any tax. The state and local taxing jurisdictions, however, argued that the case was not properly before the court (ie, that there was no “jurisdiction”) because, as governmental entities, they could not be sued under the doctrine of “sovereign immunity.” Generally, a governmental entity cannot be sued under this doctrine unless it has waived such immunity or has agreed to the suit.

The Ruling

The court reviewed the long and far-from-clear history of sovereign immunity, starting with Alexander Hamilton and the Federalist Papers. After its lengthy review, the court ultimately held that the state and local taxing jurisdictions were protected by sovereign immunity and therefore MFN could not seek review of the value of its property for property tax purposes in bankruptcy court. Although the U.S. Constitution (Article I, Section 8, Clause 4) says that Congress can provide for uniform bankruptcy laws, thereby (potentially) pre-empting the states' sovereign immunity regarding bankruptcy matters, the court held that that Constitutional provision only applies to substantive bankruptcy matters, which does not include state tax matters. In effect, while the bankruptcy court acknowledged that MFN might be damaged by state property tax assessments out of proportion to current values, it did not believe that this was damage that could be redressed by the bankruptcy court. Thus, the court effectively refused to invoke the Prudential Lines authority to prevent or remedy the “injury” in such a case.

Had the bankruptcy court been willing to determine the value of MFN's property for property tax purposes, it would have pushed the limits of the Prudential Lines authority, which has been used to prevent shareholder and creditor actions that derogate the value of the debtor's assets, such as NOLs. If the court had concluded that it had the authority to establish the value of MFN's assets, it would have expanded the Prudential Lines authority from shareholder and creditor actions to actions taken by state and local tax authorities, and would have expanded such authority from preventing actions, to affirmatively determining values. Although the holding in the MFN case may be viewed as contrary to the Supreme Court's recent holding in Hood, MFN requested the court to determine the value of its property, rather than to determine its property tax liabilities under Bankruptcy Code Section 505(a). Thus, Hood may be inapposite, but raises the interesting question of whether the MFN Case would have been decided differently if MFN had requested the court to determine its property tax liability, rather than the value of its property. Tennessee Student Assistance Corp v. Hood, 124 S. Ct. 1905 (2004) (Court held that a bankruptcy court's exercise of its in rem jurisdiction was not an affront to [Tennessee's] state sovereignty).

What We Can Learn

The lessons to be learned from the MFN Case are: 1) pay attention to asset values – if asset values decline, take affirmative actions to ensure that assessed values are reduced for property tax purposes; 2) if asset values have declined over time, perhaps there is an opportunity to obtain property tax refunds; 3) the bankruptcy court may not be a forum in which to seek asset value determinations for property tax purposes (as was the case in the MFN case in the Southern District of New York); and 4) although we still don't know how far the Prudential Lines case will be expanded, it would appear that it will not be expanded to allowing debtors to prevent taxing authorities from assessing and collecting taxes out of proportion to current values.



Jerome M. Schwartzman [email protected] Steven J. Joffe [email protected]

Telecom companies invest substantial amounts to acquire their assets, such as underground cables or fiber optic networks. As a consequence of building or acquiring this capital-intensive infrastructure, telecom companies often pay millions of dollars in annual property tax assessments. When telecom asset values drop (as has most recently been the case), telecom companies generally focus on keeping their businesses afloat, rather than on their property taxes.

A Case in Point

Take the case of Metromedia Fiber Network (MFN), which recently emerged from Chapter 11 under the name AboveNet, Inc. As part of the reorganization of its business, Metromedia realized that it had been assessed millions of dollars in property taxes over the prior several years (and would continue to be assessed property taxes), based on assessed asset values that clearly did not reflect the assets' current fair market value. In a clever move, MFN initiated an adversary proceeding in the bankruptcy court seeking a determination of the value of its assets for property tax purposes that would be binding on the state and local taxing jurisdictions. The proceeding included many of MFN's state and local property tax jurisdictions (more than 1000 taxing jurisdictions in which MFN had assets). Metromedia Fiber Network, Inc. v. Various State and Local Taxing Authorities , 299 B.R. 251 (S.D.N. Y. July 15, 2003) (the MFN Case).

This was a clever move for two reasons. First and foremost, had MFN been successful, it would have substantially reduced the amount of cash it would have been required to pay in the property taxes (and possibly set the stage for property tax refunds, which could have brought desperately needed cash into the estate). Second, a successful adjudication of its case would have extended the bankruptcy court “tax activism” displayed in the Prudential Lines case into new territory. Under the Prudential Lines case, shareholders and debtholders could be restrained from taking actions that would adversely impact the tax assets of the debtor, such as net operating losses (NOLs). For example, under the Prudential Lines authority, majority shareholders could be prevented from taking worthless stock deductions (which would destroy the value of the debtor's NOLs) and historical creditors could be prevented from selling their debtholdings (which could prevent the debtor from taking advantage of a favorable tax rule allowing it to avoid a limitation on the use of its NOLs post-emergence).

MFN initiated its case under Section 505 of the Bankruptcy Code, which allows a bankruptcy court to determine the amount or legality of any tax. The state and local taxing jurisdictions, however, argued that the case was not properly before the court (ie, that there was no “jurisdiction”) because, as governmental entities, they could not be sued under the doctrine of “sovereign immunity.” Generally, a governmental entity cannot be sued under this doctrine unless it has waived such immunity or has agreed to the suit.

The Ruling

The court reviewed the long and far-from-clear history of sovereign immunity, starting with Alexander Hamilton and the Federalist Papers. After its lengthy review, the court ultimately held that the state and local taxing jurisdictions were protected by sovereign immunity and therefore MFN could not seek review of the value of its property for property tax purposes in bankruptcy court. Although the U.S. Constitution (Article I, Section 8, Clause 4) says that Congress can provide for uniform bankruptcy laws, thereby (potentially) pre-empting the states' sovereign immunity regarding bankruptcy matters, the court held that that Constitutional provision only applies to substantive bankruptcy matters, which does not include state tax matters. In effect, while the bankruptcy court acknowledged that MFN might be damaged by state property tax assessments out of proportion to current values, it did not believe that this was damage that could be redressed by the bankruptcy court. Thus, the court effectively refused to invoke the Prudential Lines authority to prevent or remedy the “injury” in such a case.

Had the bankruptcy court been willing to determine the value of MFN's property for property tax purposes, it would have pushed the limits of the Prudential Lines authority, which has been used to prevent shareholder and creditor actions that derogate the value of the debtor's assets, such as NOLs. If the court had concluded that it had the authority to establish the value of MFN's assets, it would have expanded the Prudential Lines authority from shareholder and creditor actions to actions taken by state and local tax authorities, and would have expanded such authority from preventing actions, to affirmatively determining values. Although the holding in the MFN case may be viewed as contrary to the Supreme Court's recent holding in Hood, MFN requested the court to determine the value of its property, rather than to determine its property tax liabilities under Bankruptcy Code Section 505(a). Thus, Hood may be inapposite, but raises the interesting question of whether the MFN Case would have been decided differently if MFN had requested the court to determine its property tax liability, rather than the value of its property. Tennessee Student Assistance Corp v. Hood , 124 S. Ct. 1905 (2004) (Court held that a bankruptcy court's exercise of its in rem jurisdiction was not an affront to [Tennessee's] state sovereignty).

What We Can Learn

The lessons to be learned from the MFN Case are: 1) pay attention to asset values – if asset values decline, take affirmative actions to ensure that assessed values are reduced for property tax purposes; 2) if asset values have declined over time, perhaps there is an opportunity to obtain property tax refunds; 3) the bankruptcy court may not be a forum in which to seek asset value determinations for property tax purposes (as was the case in the MFN case in the Southern District of New York); and 4) although we still don't know how far the Prudential Lines case will be expanded, it would appear that it will not be expanded to allowing debtors to prevent taxing authorities from assessing and collecting taxes out of proportion to current values.



Jerome M. Schwartzman [email protected] FTI Consulting Steven J. Joffe [email protected]

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