Supreme Court Addresses Bankruptcy Cases
Thus far this term, the United States Supreme Court has issued two decisions addressing bankruptcy issues. In Federal Communications Commission v. NextWave Communications, Inc., 123 S.Ct. 832 (2003), the Supreme Court, in an 8-1 decision, determined that the Federal Communications Commission’s long-running endeavors to take back spectrum licenses awarded to NextWave Personal Communications, Inc. and NextWave Power Partners, Inc. (collectively, “NextWave”) were prohibited under the Bankruptcy Code. In Archer v. Warner, 123 S.Ct. 1462 (2003), the Supreme Court, in a 7-2 decision, should resolve a split in the Circuits with respect to the effect that a pre-bankruptcy settlement has on the dischargeability of a debt.
Federal Communications Commission v. NextWave Communications, Inc.
In 1993, Congress amended the Communications Act of 1934 to authorize the Federal Communications Commission (FCC) to award spectrum licenses “through a system of competitive bidding.” In 1997, NextWave participated in two of the six FCC auction blocks. As a result of the bidding on one of the auction blocks, NextWave was awarded 63 C-Block licenses on winning bids totaling approximately $4.74 billion. On the second FCC auction block, NextWave was awarded 27 F-Block licenses on winning bids totaling $123 million. In accordance with FCC regulations, NextWave made a downpayment on the purchase prices, signed promissory notes for the balances due and executed security agreements in favor of the FCC, which gave the FCC a first lien on all of NextWave’s rights under the spectrum licenses. The FCC properly perfected its security interests in the licenses.
Subsequently, various successful bidders at the FCC auctions, including NextWave, had difficulty funding operations and formally requested that the FCC restructure their installment payments under the promissory notes for the purchase of their licenses. Instead, the FCC suspended the installment payments and presented C-Block licensees, such as NextWave, with various options, which would allow the C-Block licensees to surrender some or all of their licenses for partial or full forgiveness of their debt. On the date established by the FCC for selecting the restructuring option, NextWave filed Chapter 11.
After filing bankruptcy, NextWave filed an adversary proceeding against the FCC, claiming that its $4.74 billion indebtedness to the FCC for the C-Block licenses could be voided as a fraudulent conveyance under the Bankruptcy Code, and alleged that by the time the FCC conveyed the C-Block licenses to NextWave their value had declined from approximately $4.74 billion to less than $1 billion. The Bankruptcy Court agreed with NextWave, ruling that NextWave could keep the C-Block licenses for the reduced price of $1.02 billion. The District Court affirmed the Bankruptcy Court’s decision, but the U.S. Court of Appeals for the Second Circuit reversed, holding, among other things, that the Bankruptcy Court could not change the conditions attached by the FCC to NextWave’s licenses. Following the Second Circuit’s decision, NextWave proposed a plan of reorganization that provided for a lump-sum payment to the FCC to satisfy the $4.3 billion obligation for payment of the C-Block licenses. The FCC objected to the plan, claiming that NextWave’s licenses had been cancelled automatically when NextWave missed its first payment deadline. The FCC also announced that NextWave’s licenses were available for auction under the automatic cancellation provisions of the FCC’s regulations.
NextWave sought emergency relief from the Bankruptcy Court, which declared that the FCC’s cancellation of NextWave’s licenses was void as a violation of various provisions of the Bankruptcy Code. Granting the FCC’s petition for a writ of mandamus, the Second Circuit reversed, declaring that, because exclusive jurisdiction to review the FCC’s regulatory action lay with the courts of appeal and because the FCC’s decision to auction NextWave’s licenses was regulatory, the Bankruptcy Court’s ruling with respect to the FCC action was outside of the Court’s jurisdiction. NextWave then filed a petition with the FCC seeking reconsideration of the FCC’s decision to cancel the licenses, which was denied. Upon NextWave’s appeal of the FCC’s denial of NextWave’s petition, the U.S. Circuit Court of Appeals for the District of Columbia determined that the FCC’s cancellation of NextWave’s licenses violated section 525 of the Bankruptcy Code, stating “[a]pplying the fundamental principle that federal agencies must obey all federal laws, not just those they administer, we conclude that the [FCC] violated the provisions of the Bankruptcy Code that prohibits governmental entities from revoking debtors’ licenses solely for failure to pay debts dischargeable in bankruptcy.” The Supreme Court granted certiorari in 2002.
The FCC made three arguments in support of its position before the Supreme Court. The FCC argued that it had a valid regulatory motive for canceling NextWave’s licenses so that the FCC did not act “solely because” of nonpayment as prohibited under section 525(a) of the Bankruptcy Code. The FCC also argued that regulatory conditions such as full and timely payment are not properly classified as “debts” under section 525. Finally, the FCC argued that interpreting section 525 as prohibiting the termination of the licenses creates a conflict with the Communications Act by obstructing the functioning of the auction provisions of that act.
Supreme Court’s Analysis
NextWave argued, and the U.S. Court of Appeals for the District of Columbia Circuit held, that the FCC’s revocation of its licenses was in violation of section 525 of the Bankruptcy Code. Except as specifically provided in the section, section 525 prohibits a “governmental unit” from, among other things, revoking a license granted to a debtor solely because the debtor has failed to pay a dischargeable debt. There was no dispute that the FCC was a “governmental unit,” that NextWave was a “debtor” under the Bankruptcy Code or that the FCC had revoked licenses granted to NextWave. The FCC did deny, however, that the proximate cause for its cancellation of the licenses was NextWave’s failure to make payments due to the FCC, contending instead, that section 525 did not apply because the FCC had a valid regulatory motive for the cancellation. The Supreme Court gave short shrift to this argument, stating that the FCC’s motive was “irrelevant.” The Supreme Court did not believe that the statute’s reference to a failure to pay a debt as the sole cause of cancellation of a license could be reasonably interpreted to include the governmental unit’s motive in effecting the cancellation. “Section 525 means nothing more or less than that the failure to pay a dischargeable debt must alone be the proximate cause of the cancellation — the act or event that triggers the agency’s decision to cancel, whatever the agency’s ultimate motive in pulling the trigger may be.” 123 S.Ct. at 838-39. The Supreme Court also noted that the Bankruptcy Code contains regulatory exceptions to its provisions and that reading section 525 as the FCC proposed would render superfluous the regulatory exceptions specifically included by Congress.
The FCC contended that NextWave’s license obligations to the Commission are not “debt[s] that [are] dischargeable” in bankruptcy. First, the FCC argued that regulatory requirements, such as the full and timely payment condition, are not properly classified as “debts” under the Bankruptcy Code. In the view of the FCC, the financial nature of a condition on a license did not convert that condition to a debt. The Supreme Court characterized this argument as nothing more than a retooling of the FCC’s argument that “regulatory conditions” should be exempt from section 525. The Court again dismissed this argument using the tautologous statement that “a debt is a debt” even when the payment obligation is a regulatory requirement. Id. at 839. The FCC also argued that NextWave’s obligations were not “dischargeable” in bankruptcy because bankruptcy courts did not have the jurisdictional authority to alter regulatory obligations. Noting that dischargeability is not tied to the existence of such authority, the Court stated that a pre-confirmation debt is dischargeable unless it falls within one of the exceptions to dischargeability contained in the Bankruptcy Code.
Addressing the FCC’s final argument that the Court’s interpretation creates a conflict with the Communications Act, the Court determined that its interpretation does not obstruct the functioning of the auction provisions of the Communications Act because nothing in those auction provisions required that cancellation of the licenses be the sanction for failing to pay the installment payments. Instead, what the FCC described as a conflict was nothing more than a policy preference on the part of the FCC for selling licenses on credit (which was also not required under the auction provisions of the Communications Act) and canceling licenses rather than asserting security interests in the licenses when there was a payment default. “Such administrative preferences cannot be the basis for denying [NextWave’s] rights provided by the plain terms of [the Bankruptcy Code]. Id. at 840. Because there is no inherent conflict between section 525 of the Bankruptcy Code and the Communications Act, both statutes were effective and since section 525 circumscribes the FCC’s permissible action, “the revocation of NextWave’s licenses is not in accordance with law.” Id.
Notwithstanding the plain meaning of section 525, the FCC’s reliance on its regulatory authority in revoking NextWave’s licenses and the procedural history of the parties’ dispute created a great deal of uncertainty for NextWave and other telecommunication companies in bankruptcy, which must rely on the continuation of their licenses as the basis for their reorganization efforts. The NextWave decision has resolved that uncertainty and reinforces the proscriptions contained in section 525. In rendering its decision, the Supreme Court also instructs that governmental agencies are charged with complying with all law and not just with the laws that agencies are charged with administering. If the governmental agencies fail to do so, their actions must be set aside.
Archer v. Warner
In late 1991, Leonard and Arlene Warner bought the Warner Manufacturing Company for $250,000. Approximately six months later, the Warners sold the company to the Archers for $610,000. A few months after, the Archers sued the Warners in North Carolina state court for (among other things) fraud. In May 1995, the parties settled the lawsuit through the execution of a settlement agreement. The settlement agreement provided that the Warners would pay the Archers $300,000 and the Archers would execute releases to all claims against the Warners, except as to the amounts to be paid pursuant to the settlement. The Warners paid the Archers $200,000 and executed a promissory note for the balance of the settlement amount and the parties executed the releases. The releases provided that there was no admission of any liability or wrongdoing and there was no determination as to whether the Warners had committed fraud prior to the dismissal with prejudice of the state court lawsuit pursuant to the settlement. In November 1995, the Warners failed to make the first payment due under the promissory note. The Archers sued for payment in state court and the Warners filed for bankruptcy. In the Warners’ Chapter 7 case, the Archers filed an adversary proceeding for a determination that the Warners’ debt of $100,000 was nondischargeable under section 523(a)(2)(A) as a debt for money obtained by fraud. Leonard Warner agreed to a consent order holding that the debt was nondischargeable. Arlene Warner contested the nondischargeability of the debt.
The Bankruptcy Court ruled against the Archers, finding that the debt was dischargeable. Both the U.S. District Court and the U.S. Court of Appeals for the Fourth Circuit affirmed. The Fourth Circuit determined that the settlement agreement, releases and promissory note had worked a kind of “novation.” The Fourth Circuit reasoned that this novation replaced the original potential debt to the Archers for money obtained by fraud with a new debt for money promised in a settlement contract. The Fourth Circuit’s decision was consistent with that of the Ninth Circuit, see Key Bar Invs., Inc. v. Fischer (In re Fischer), 116 F.3d 388 (9th Cir. 1997)(per curiam), and that of the Seventh Circuit, see In re West, 22 F.3d 775 (7th Cir. 1994), but differed from the approach taken by the D.C. Circuit, see United States v. Spicer, 57 F.3d 1152 (D.C. Cir.), cert. denied, 516 U.S. 1043 (1996), and by the Eleventh Circuit, see Greenberg v. Schools, 711 F.2d 152 (11th Cir. 1983)(per curiam). The countervailing view focuses on the substance of the claim rather than on the form of the claim and argues that the congressional policy of affording relief only to an “honest but unfortunate debtor” prevents a fraudulent debtor from escaping a determination of nondischargeability merely by altering the form of the debt through a settlement agreement.
Supreme Court’s Analysis
The Supreme Court agreed with the Fourth Circuit Court of Appeals that the settlement agreement, the promissory note and the releases completely addressed and released all of the state law claims, leaving only one relevant debt — a debt for money under the settlement agreement. The Court did not believe, however, that that conclusion ended the inquiry. Instead, the Court determined that it must also decide whether the remaining contractual debt could also amount to a debt for money obtained by fraud within the terms of section 523(a)(2)(A) of the Bankruptcy Code.
In addressing that issue, the Court concluded that its decision in Brown v. Felsen, 442 U.S. 127, 99 S.Ct. 2205 (1979), governed the outcome in this case. As described by the Supreme Court, the facts in Brown were very similar to the facts in Warner, except that in Brown the debt was embodied in a stipulation and a consent judgment and not in a settlement agreement. In Brown, the Court determined that the existence of the stipulation and consent order did not bar the Bankruptcy Court from looking behind the judgment to determine if the debt was nondischarge-able. The Court continued by stating that as a matter of logic, Brown’s holding means that the Fourth Circuit’s novation theory could not be right. If reducing a fraud claim to a settlement changed the nature of the debt for dischargeability purposes, the nature of the debt in Brown would have changed similarly, rendering the debt dischargeable. Yet in Brown, the Court held that the Bankruptcy Court should look behind the stipulation to determine whether the debt at issue was a debt for money obtained by fraud. Based on the Brown decision, the Court concluded that the Archers’ settlement agreement and releases may have worked a kind of novation, but that fact does not bar the Archers from showing that the settlement debt arose out of fraud and, consequently, is dischargeable. Because Arlene Warner had raised alternative grounds for determining that the debt was not excepted from discharge, which the Fourth Circuit did not address, the Supreme Court, in reversing and remanding to the Fourth Circuit, noted that the Fourth Circuit was free on remand to determine whether the alternative arguments were properly raised or preserved and, if so, to decide them.
The majority opinion of the Supreme Court only focused on the narrow question of whether Brown controlled. In rendering its decision, however, the Supreme Court noted that there had been no showing that with the use of the settlement agreement the parties had intended to resolve the issue of whether the debt would be dischargeable in a subsequent bankruptcy. This notation seems to leave open the door that a pre-bankruptcy settlement agreement can affect the discharge-ability of a debt if the obligor can prove “what has not been established here … that the parties meant to resolve the issue of fraud or, more narrowly, to resolve the issue for purposes of a later claim of nondischargeability in bankruptcy.” Warner, 123 S.Ct. at 1467. Because the Warner case involved a general release, the decision should not be read to address one way or the other the validity of either a specific waiver and release of nondischargeability or the preservation of nondischargeability if the parties have specifically addressed the dischargeability issue in the negotiated resolution of their