On February 25, 2020, the U. S. Supreme Court addressed the time honored judicial concept of “federal common law” in Rodriguez, Trustee for the Bankruptcy Estate of United Western Bancorp, Inc. v. Federal Deposit Insurance Corporation, as Receiver for United Western Bank,[1] on writ of certiorari from the Tenth Circuit Court of Appeals. Justice Gorsuch couched the import of the decision in the opening paragraph of the Court’s unanimous opinion:

But the question we face isn’t who gets the money, only how to decide the dispute. Should federal courts rely on state law, together with any applicable federal rules, or should they devise their own federal common law test? To ask the question is nearly to answer it. The cases in which federal courts may engage in common lawmaking are few and far between. This is one of the cases that lie between.

Background

An affiliated group of corporations may elect to file a consolidated federal corporate income tax return. It is common, but not mandatory, for the members of the group to enter into a tax allocation or sharing agreement to determine how the group members will share the tax liabilities or refunds for each tax year. If the consolidated return reflects a tax refund due, the IRS issues the refund as a single payment to the group’s designated agent. 

If a dispute arises and the members have no tax sharing agreement in place, or if there is an issue with respect to the interpretation of a tax sharing agreement, the federal courts normally turn to state law to resolve the distribution question.  However, several circuit courts have crafted a federal common law rule, known as the Bob Richards rule,[2] which initially provided that, in the absence of a tax sharing agreement, a refund belongs to the group member responsible for the losses that generated the refund. The Bob Richards rule has since evolved, in some jurisdictions, into a general rule that is always fol­lowed unless an agreement unambiguously specifies a different result.

Soon after United Western Bank suffered losses, it was taken over by the FDIC and its parent, United Western Bancorp, Inc., was forced into bankruptcy. When the IRS issued the group a $4 million tax refund, the FDIC and the parent corporation’s bankruptcy trustee, petitioner Simon Rodriguez, each sought to claim it. The dispute wound its way through a bankruptcy court and a federal district court before the Tenth Circuit examined the parties’ tax allocation agreement, applied an expansive version of Bob Richards, and ruled for the FDIC. 

The Supreme Court granted certiorari in the Rodriguez case.  In its petition for certiorari, the petitioner contended that there is an underlying split in the circuits, over who is entitled to the tax refund as between the parent holding company and the subsidiary that sustained the losses giving rise to the tax refund. The divide in the circuits pertains to the recognition of the Bob Richards rule, which provides a default rule that the refund received by the parent of a consolidated group is held in trust for the subsidiary that generated the refund, absent a tax sharing agreement that unambiguously departs from the rule. The other approach would be to look exclusively at applicable state law in determining who gets the refund. In its amicus brief in support of the petition for certiorari, while not taking a position on the merits, the American College of Tax Counsel noted that the sheer number of companies that file consolidated returns supports the argument that the Court should resolve the split in the circuits.

The Court’s Opinion

The Court resolved the split among the circuits. In the unanimous opinion of the Court written by Justice Gorsuch, the Court held that the Bob Richards rule is not a legitimate exercise of federal common lawmaking, noting that “only limited areas exist in which federal judges may appropriately craft the rule of decision.” According to the Court, federal common lawmaking must be “necessary to protect uniquely federal interests,” which do not exist in this case. The Court found that state law is well-equipped to settle disputes of corporate property rights and remanded the case for consideration without application of the Bob Richards rule.

The Court recognized in the opinion that “judicial lawmaking in the form of federal common law plays a necessarily modest role under a Constitution that vests the federal government’s ‘legislative powers’ in Congress and reserves most other regulatory authority to the States. (citations omitted). As this Court has put it, there is ‘no federal general common law.’[3] Instead, only limited areas exist in which federal judges may appropriately craft the rule of decision.”[4] The Court further noted that these areas have included admiralty disputes and certain controversies between states, where federal common law often plays an important role. On the other hand, strict conditions must be satisfied before federal judges may claim a new area for common lawmaking. Quoting the Sixth Circuit: “In the absence of congressional authorization, common lawmaking must be ‘necessary to protect uniquely federal interests.’”

Noting that “nothing like that exists here,” the Court acknowledged that the federal government may have an interest in regulating how it receives taxes from corporate groups, in regulating the delivery of any tax refund due a corporate group, and ensuring that others in the group have no recourse against federal government once it pays the group’s designated agent, but the federal government has no unique interest in determining how the members of a consolidated group distribute the tax refund among its members. The Court stated that “state law is well equipped to handle disputes involving corporate property rights,” and the fact that this case involves federal bankruptcy and tax issues makes little difference.

The Court vacated the judgment of the Tenth Circuit Court of Appeals and remanded the case for further proceedings. “Whether this case might yield the same or a different result without Bob Richards is a matter the court of appeals may consider on remand.” 

The Court made one thing clear — the Bob Richards rule is dead.

Implications of Rodriguez Decision

While net operating loss carrybacks were eliminated prospectively by the Tax Cuts and Jobs Act of 2017, while providing indefinite net operating loss carryforwards limited to 80% of taxable income, the Court’s clarification of the role of federal common law in federal jurisprudence may have application in many other contexts and temper the decisions of federal judges for years to come.

If you have any questions or comments about the foregoing summary of the Supreme Court’s decision in Rodriguez, please contact Wells Hall, or any member of the Nelson Mullins Tax Practice.