When can a Federal Court employ a federal common law rule to make its decision in the case?  Justice Gorsuch answer this in Rodriguez v. Fed. Deposit Ins. Corp., U.S., No. 18-1269, 2/25/20.[1]  The answer . . . less often than you might think.

Leave it to a bankruptcy case to stir up Supreme Court worthy controversy over who exactly reaps the benefit of a whopping $35,351,690 operating loss.  In this instance, that controversy resolved a circuit split and gives us clear guidance on when federal common law can be employed and when a court should stick to state law.

The controversy arose between Simon Rodriguez (Trustee), the court appointed Chapter 7 Trustee for United Western Bancorp, Inc. (UWBI), which was a bank holding company, and the Federal Deposit Insurance Corporation (FDIC), the receiver for United Western Bank (the subsidiary Bank) over a $4,846,625 tax refund.[2]  The saga began in 2010 when the Bank posted a $35 million loss leading the Office of Thrift Supervision (OTS) to close the Bank and appoint the FDIC as receiver on January 21, 2011.  Because the Bank was UWBI’s principal, if not sole, source of income, the Bank’s receivership resulted in UWBI’s bankruptcy on March 2, 2012.  Before UWBI’s bankruptcy, UWBI filed on behalf of a group of its affiliates a tax refund request for the $4.8 million, based primarily on the Bank’s losses in 2010.[3]  UWBI was authorized to file the refund request for its affiliate the Bank, because Section 1504(a) of the Internal Revenue Code (IRC) of 1986 and the Parties’ Tax Allocation Agreement (the Agreement), both provided that UWBI, as a parent corporation, could file tax returns on behalf of its affiliates.[4]

While IRC Section 1504(a) may have authorized UWBI to file the request, it did little to answer who was entitled to the actual refund dollars from the return.  Was the FDIC entitled to the refund because the Bank’s loss had generated the refund?  Or was it the Trustee’s refund because UWBI held equitable title to the Tax Refund per the plain language of the Agreement?[5]

To answer that question the Tenth Circuit turned quickly to the federal common law rule it had created in in Barnes v. Harris, 783 F.3d 1185, 1195 (10th Cir. 2015), finding that “a tax refund due from a joint return generally belongs to the company responsible for the losses that form the basis of the refund.”  The Barnes principal was adopted from the Ninth Circuit’s decision in In re Bob Richards Chrysler-Plymouth Corp., Inc., 473 F.2d 262, 265 (9th Cir. 1973), commonly referred to the as the Bob Richards rule.

Stepping back a bit, a casual observer might figure that federal common law should apply.  After all, the controversy at hand involves numerous federal players (the FDIC, a bankruptcy trustee, and OTS).  Moreover, the case originated in federal bankruptcy court and implicates both the Bankruptcy Code and the Federal Tax Code.  According to Justice Gorsuch, such an observation would be flat wrong.

In a unanimous opinion on behalf of the Court, overturning precedent in both the Ninth and Tenth Circuits, Justice Gorsuch wrote:

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.[6]

In its decision, the Court followed the Sixth Circuit, noting that “federal common law constitutes an unusual exercise of lawmaking which should be indulged  . . . only when there is a significant conflict between some federal policy or interest and the use of state law.”[7]  The decision goes on to state that “before federal judges may claim a new area of common lawmaking, strict conditions must be satisfied.”[8]  Despite the federal ties to the Tax Code and Bankruptcy Code in this case, the Court found that no such conditions existed here.

Notably, the Supreme Court did not ultimately decide who gets the refund.  Instead, it simply held that the lower courts went about it wrong.  Thus, the case was remanded to the Tenth Circuit to determinewhether the tax refund belonged to the FDIC under applicable state law absent the Bob Richards rule.

The Court’s ruling is likely to have implications well beyond that of a bankruptcy trustee’s ability to collect a debtor’s tax return.  The Court’s unanimous rejection of the Bob Richards rule and the strong language of the opinion cautioning judges that federal common law requires “strict conditions” and implies “significant federal interests” should serve as a warning against reliance on federal common law.  Parties to a federal lawsuit, outside of admiralty jurisdiction, should evaluate their case under state law unless there is a clear federal interest that justifies the application of federal common law.

[1] https://www.supremecourt.gov/opinions/19pdf/18-1269_h3dj.pdf

[2] In re United W. Bancorp, Inc., 914 F.3d 1262, 1266 (10th Cir.), cert. granted sub nom. Rodriguez v. F.D.I.C., 139 S. Ct. 2778, 204 L.Ed.2d 1157 (2019), and vacated and remanded sub nom. Rodriguez v. Fed. Deposit Ins. Corp., No. 18-1269, 2020 WL 889191 (U.S. Feb. 25, 2020).

[3] Id.

[4] See 26 U.S.C. § 1504(a).

[5] In re United W. Bancorp, Inc., 914 F.3d at 1268 (citing Czyzewski v. Jevic Holding Corp., ––– U.S. ––––, 137 S.Ct. 973, 978, 197 L.Ed.2d 398 (2017), citing 11 U.S.C. § 541(a)(1) , and concluding that for the tax refund to be considered part of UWBI’s estate, UWBI must hold both legal and equitable title to the tax refund.

[6] Rodriguez v. Fed. Deposit Ins. Corp., U.S., No. 18-1269, 2/25/20.

[7] Id. at 3 citing FDIC v. AmFin Financial Corp., 757 F.3d 530, 535(2014).

[8] Id. at 4.

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