Report of the American Bar Association Tax Section Task Force on the Tax Recommendations of the National Bankruptcy Review Commission

DISCLOSURE STATEMENTS

(COMMISSION TRACK NUMBER 701)

Present Law

Bankruptcy Code Section 1125(b) generally requires a debtor or other plan proponent to furnish creditors and equity security holders with a written disclosure statement before an acceptance or rejection of the plan can be solicited. The disclosure statement must be approved by the court before it can be distributed to such parties.

In order to approve the disclosure statement, a bankruptcy court must find that it contains "adequate information." "Adequate information" generally is defined as information of a kind, and in sufficient detail, that would enable a hypothetical reasonable investor typical of holders of claims or interests of the relevant class to make an informed judgment about the plan.

The extent to which tax-related information must be discussed in a disclosure statement in order to satisfy the "adequate information" requirement of Bankruptcy Code Section 1125 currently is unclear. The actual practice of bankruptcy and tax attorneys appears to vary widely, with some disclosure statements providing a full and complete discussion of all or nearly all material tax matters while others providing only the most cursory discussion of tax matters. Occasionally, creditors are told nothing more than, in effect, "go see your own tax advisor."

The failure to analyze and discuss the tax aspects of a plan of reorganization sometimes results in serious consequences. In Smith v. Bank of New York (fn. 233), a creditor proposed a plan of reorganization providing for the establishment of a liquidating trust, the funding of such trust with all of the debtor's assets and a sale of certain real property (valued at $255.3 million) to the creditor-proponent. The creditor-proponent's disclosure statement "failed to include any analysis of the state and federal tax consequences of consummation of the plan" (fn. 234). In particular, the disclosure statement failed to address whether the liquidating trust would owe any taxes and, if so, the amount by which distributions to creditors would be reduced because of such tax payments.

The creditor-proponent's plan was confirmed and became effective. The trustee of the liquidating trust subsequently was found liable to pay federal income taxes and consequently was unable to pay creditors the full amount they expected to be paid under the plan (fn. 235). The trustee brought suit against the creditor-proponent for negligent misrepresentation regarding the liquidating trustee's tax obligations under the plan. The bankruptcy court found the creditor-proponent liable to the trustee on this claim (fn. 236).

Proposals Before the Commission

Commission Track Number 701. This proposal.

Task Force Position

Amend Bankruptcy Code Section 1125(b) to provide that the bankruptcy court shall not approve a disclosure statement unless it contains (1) a discussion of the material federal and state tax consequences of the plan to the debtor and any entity created pursuant to the plan, and (2) with respect to each class of claims and interests, a discussion of the material federal tax consequences of the plan to a hypothetical investor typical of the holders of claims or interests of the relevant class.

Reasons for Position

As the Bank of New York case indicates, a failure to discuss the plan of reorganization's tax consequences in the disclosure statement can result in seriously misleading creditor constituencies and other parties in interest about the plan's economic effects.

There is no justification for allowing a plan proponent to ignore a plan's tax consequences in the disclosure statement. A plan's tax consequences represent an important aspect of the plan and should be fully discussed to the extent they are material.

A chapter 11 debtor or other plan proponent who possesses the financial resources to propose a plan of reorganization and draft a disclosure statement is likely to possess the necessary resources to analyze the plan's tax effects.

>From a bankruptcy court's standpoint, the feasibility of a plan of reorganization cannot be properly evaluated unless the plan's material tax consequences to the debtor have been identified. An understanding of the plan's tax consequences will aid the bankruptcy court in making the feasibility determination required for plan confirmation by Bankruptcy Code Section 1129(a)(11).

>From a creditor's standpoint, information regarding the plan's tax effects has twofold importance. First, information concerning the plan's tax effect on the debtor aids the creditor in making its own determination whether the debtor can successfully reorganize. Naturally, this will influence the creditor's decision to accept or reject the plan. Second, information concerning the tax effect of the plan on a hypothetical creditor in such creditor's own class will aid the creditor in determining its own tax consequences under the plan.

>From a debtor's standpoint, a requirement that the disclosure statement address material tax matters affecting the debtor is in a debtor's enlightened self-interest. It will reduce the likelihood of unpleasant tax surprises in the post-effective date period.

Smith v. Bank of New York shows what can occur when a disclosure statement fails to address the material tax issues inherent in a plan of reorganization. The amendment of section 1125 as proposed by the Task Force will preclude a recurrence of this type of case.

The Task Force's proposal adopts a middle position between the extremes of no tax disclosure at all and burdensome tax disclosure. The actual tax effect of a plan on creditors may vary from creditor to creditor based upon a creditor's accounting period and method and the tax basis in its claim. Likewise, the effect of a plan on a creditor under state tax law may vary from state to state. A debtor or other plan proponent cannot be expected to provide each creditor with individually tailored tax information; it would be impractical and unreasonably expensive. On the other hand, addressing the material federal tax matters affecting a hypothetical creditor or equity security holder in each class created under the plan is not burdensome, and a plan proponent fairly can be required to supply such information in its disclosure statement.

**************************FOOTNOTES*********************************

fn. 233: 161 B.R. 302 (Bankr. S.D. Fla. 1993).

fn. 234: 161 B.R. at 304.

fn. 235: 161 B.R. at 305-06.

fn. 236: 161 B.R. at 307.

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