Downey Financial Trumps FDIC In $374M Tax Refund Tussle

October 9, 2013 | By Jamie Santo | Law360

Downey Financial Corp.'s Chapter 7 trustee notched a victory over the Federal Deposit Insurance Corp. Tuesday as a Delaware bankruptcy judge ruled that a nearly $374 million tax refund belongs to the failed home lender's estate, not the FDIC.

In a 56-page opinion, U.S. Bankruptcy Judge Christopher S. Sontchi determined that under the tax sharing agreement between Downey Financial and subsidiary Downey Savings and Loan Association FA, the refund is an asset of the parent's bankruptcy estate.

"At its core, this is a case of contract interpretation," Judge Sontchi wrote. "Under the plain, unambiguous language of the TSA, the court finds, as a matter of law, that the TSA creates a debtor-creditor relationship and, as a result, the tax refund is property of the debtor's estate."

With the decision, the $378.8 million refund becomes an asset that can be divvied up on a pro rata basis between Downey Financial's various creditors, which include Wilmington Trust - indenture trustee for $200 million in notes - and the FDIC, according to court documents.

In November 2008, the U.S. Office of Thrift Supervision ordered Downey Saving's operations seized, appointing the FDIC as receiver. The bank was burdened by an increasing amount of bad loans, including real estate-related loans.

The FDIC promptly sold all of the failed bank's assets to U.S. Bank NA, and Downey Financial filed for Chapter 7 days later.

Downey Financial's Chapter 7 trustee launched an adversary proceeding in October 2010 staking claim to the tax refund as an estate asset, and Judge Sontchi subsequently allowed Wilmington Trust to intercede as a plaintiff in the suit.

According to the opinion, the parties concede that the refund arises from the carryback of Downey Saving's net operating losses in 2008 to the taxable income reported by Downey Financial and its affiliates for the tax years 2003 through 2007.

Downey Financial filed returns, paid taxes and received refunds under the TSA prior to entering Chapter 7, according to the opinion, and the question for summary judgment hinged on whether the agreement created a debtor-creditor relationship or - as the FDIC asserted - an agency or trust relationship.

The TSA clearly established a creditor-debtor relationship, Judge Sontchi ruled, since it met the three factors laid out in the IndyMac Bancorp Inc. case: It created fungible payment obligations among the parties; there were no escrow or segregation obligations, or use restrictions; and the tax filer was given sole discretion regarding tax matters.

Morever, the judge said, nothing beyond the four corners of the agreement created a different relationship between Downey Financial and its affiliates.

The FDIC "did not meet its burden in showing that a resulting trust was intended by the parties, nor that the parties's course of performance indicates a trust or agency relationship," Judge Sontchi said.

"We think it's a very well-reasoned opinion," William H. Stassen, counsel for the Chapter 7 trustee, told Law360.

Stassen, who has been tracking similar cases in various courts, said "Judge Sontchi did one of the most thorough jobs of analyzing the issue."

The FDIC does not comment on active litigation, an agency spokesman told Law 360.

In June, Judge Sontchi blessed a settlement between the parties and the federal government that resolved litigation brought by the trustee in the U.S. Court of Federal Claims. The deal fixed the amount of the refund at $373.8 million plus interest but did not resolve the issue of who owned the funds.

The U.S. Department of Justice still needs to sign off on the settlement, Stassen said.

Original Chapter 7 trustee Montague S. Claybrook resigned from the case in July, and has been succeeded on an interim basis by Alfred T. Giuliano, according to court documents.

The Chapter 7 trustee is represented by Michael G. Menkowitz, William H. Stassen, Raymond M. Patella and L. John Bird of Fox Rothschild LLP.

Wilmington Trust is represented by Alan R. Glickman, Brian D. Pfeiffer, Adam C. Harris, and William H. Gussman Jr. of Schulte Roth & Zabel LLP and Michael D. DeBaeke and Victoria Guilfoyle of Blank Rome LLP.

The FDIC is represented by Melanie L. Cyganowski and Peter Feldman of Otterbourg Steindler Houston & Rosen PC and William F. Taylor Jr. and Kate R. Buck of McCarter & English LLP.

The case is In re: Downey Financial Corp., case number 08-13041, in the U.S. Bankruptcy Court for District of Delaware.

- Additional reporting by Kurt Orzeck and Lance Duroni. Editing by Stephen Berg

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