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Philip Morris Capital Corp. v. KMART Corp.

October 24, 2007


The opinion of the court was delivered by: John F. Grady, United States District Judge


This case is before us on appeal from Bankruptcy Judge Sonderby's Findings of Fact and Conclusions of Law and related orders of February 14, 2007, which resolved certain claims in the bankruptcy reorganization of Kmart Corporation ("Kmart") relating to a leveraged lease transaction involving sixteen Kmart stores. For the reasons explained below, the orders of the bankruptcy court are affirmed.


In May 1995, Kmart entered into a complex form of a structured-finance transaction referred to as a leveraged lease with Philip Morris Capital Corporation and its wholly-owned subsidiary, HNB Investment Corp. (to whom we will refer collectively as "Philip Morris") and various other entities. In general terms, such a transaction involves a series of agreements among several parties through which one party finances property by engaging in a sale and leaseback of the property with an investor whose primary motivation is to obtain the tax benefits associated with the property. In this case, Kmart sold sixteen of its retail properties to a series of "Owner Trusts" for $170 million. Kmart then entered into lease agreements with each of the sixteen Owner Trusts and continued, as lessee, to operate those retail stores. The overarching agreement in the transaction was referred to as the "Participation Agreement," and other agreements included the "Purchase Agreement," the "Tax Indemnification Agreement," and the "Leases."

Before entering into the transaction, Philip Morris ran a sophisticated and complex computer program designed to identify the expected return on its investment. The program generated reports, referred to as the "ABC Pricing Files," upon which the pricing of the properties was based. After considering the reports, Philip Morris, acting as an "Owner Participant," made a $22 million equity investment in the Owner Trusts in partial payment for the properties; the balance of the $170 million purchase price was financed through a public bond offering for which the Bank of New York ("BONY") served as an indenture trustee. The bond offering was secured by mortgages against the sixteen properties in addition to assignments of the sixteen store leases, but was otherwise non-recourse.

Kmart paid rent on the properties to the Owner Trusts. The Owner Trusts, in turn, made payments on the debt service to BONY and for certain other fees. After those payments were made, the remaining "free cash" was transferred by the Owner Trusts to Philip Morris. For income tax purposes, the Owner Trusts were treated as pass-through entities; therefore, Philip Morris could claim tax deductions for periodic depreciation on the properties and for interest on the bond indenture obligations. At the same time, Philip Morris was required to report the full amount of the rental payments from Kmart as its taxable income.

About seven years after the parties entered into the leveraged lease transaction, on January 22, 2002, Kmart and numerous affiliates filed voluntary petitions for reorganization pursuant to Chapter 11 of the United States Bankruptcy Code. Because the bankruptcy filings constituted an event of default under the bond indentures, all principal and unaccrued interest amounts were accelerated and became due. BONY, as indenture trustee, exercised its right to to recover the rents due under the leases, including noticing foreclosures on some of the properties.

Within the bankruptcy proceedings, Kmart elected to assume six of the leases upon the subject properties and to reject the remaining ten leases. The Owner Trusts eventually executed deeds- in-lieu of foreclosure in favor of BONY in satisfaction of the underlying non-recourse mortgage debt against those ten properties. The deeds-in-lieu caused Philip Morris to realize debt forgiveness income and to become liable for the tax on that income.

Philip Morris's realization of income and its consequent tax liability as a result of the deeds-in-lieu of foreclosure is at the heart of this appeal due to a Tax Indemnification Agreement ("TIA") that the parties entered into as part of the leveraged lease transaction. Essentially, the TIA required Kmart to indemnify Philip Morris for lost tax benefits in the event that the transaction ended prematurely. The TIA provides, in pertinent part:

Section 3. Indemnified Losses. (a) Consistent with subsection (b), (i) if as a result of: . . .

(VII) any pursuit of remedies (whether by the Owner Participant or Indenture Trustee or otherwise) following an Event of Default . . . the Owner Participant . . . (B) shall be required to include in gross income for Federal, state or local income tax purposes any amount not described in any of clauses (i) through (vi) of paragraph

(i) of Schedule B hereto (an "Income Inclusion"): (any of the foregoing events in clauses (A) or (B) above so resulting being referred to hereinafter as a "Loss"), Kmart will pay to the Owner Participant an indemnity, determined pursuant to either clause (y) or (z) below.

(R. 2 at 3-4.) The parties agreed that the amount of the tax indemnity was to be determined using clause (z), which is discussed infra.

In April 2003, the bankruptcy court began its hearing on the confirmation of Kmart's Plan of reorganization. About 165 objections to confirmation of the Plan were filed, many by Kmart's landlords. BONY filed such an objection, raising several issues. On April 22, 2003, Kmart, BONY, and other lessors entered into a stipulation "resolving certain lessor objections to confirmation and establishing agreed claims resolution procedures." BONY agreed to withdraw its objection to confirmation of the Plan, and Kmart agreed to an expedited claims resolution procedure. On April 23, 2003, the bankruptcy court entered an order confirming the Plan.

Approximately one month later, Kmart objected to BONY's claims. After an evidentiary hearing date was set, BONY and Kmart resolved their disputes and submitted a proposed order to the bankruptcy court. The court entered the BONY Order, and Kmart was directed to serve copies of the order on counsel for Philip Morris, which then had ten days to file any objections. Philip Morris received the BONY Order and asked Kmart and BONY for a clarification. Kmart, BONY, and Philip Morris agreed to amend the BONY Order to accommodate this request for clarification. On November 3, 2003, the bankruptcy court entered an amended agreed order resolving BONY's claims.

Between July 31, 2002 and June 5, 2003, Philip Morris filed the claims involved in this appeal, which totaled $30,374,127. The claims were allocated as follows: $21,080,373 under the TIA and the remainder under the general indemnity of the Participation Agreement. Only the claims asserted under the TIA are at issue on appeal. Kmart objected to Philip Morris's claims, and the bankruptcy court held an evidentiary hearing that lasted several days. Kmart argued that the claims were precluded entirely by the Agreed Order or alternatively subject to the cap on damages set out in § 502(b)(6) of the Bankruptcy Code. Putting aside these arguments, Kmart acknowledged that Philip Morris was entitled to its claims under the TIA, but contended that three categories of deductions to the claims were appropriate based on "tax savings" that Philip Morris would enjoy due to the early termination of the transaction. Philip Morris, on the other hand, argued that the Agreed Order precluded Kmart from raising the the § 502(b)(6) issue; that Kmart was estopped from raising the issue; that the cap did not apply in any event; and that the full amount of its claims should be awarded because Kmart's proposed deductions were not allowed under the TIA and because the calculations of Kmart's expert witness had no evidentiary value.

In a detailed written opinion titled "Findings of Fact and Conclusions of Law," In re Kmart Corp., 362 B.R. 361 (Bankr. N.D. Ill. 2007) (Docket No. 30688), Bankruptcy Judge Sonderby held that neither party had proved its claim preclusion argument, but that the doctrine of issue preclusion prevented Kmart from arguing that the § 502(b)(6) cap applied to the claims. The bankruptcy court further held that even if Kmart was not precluded from raising the issue, the cap would not apply to the claims. As for determining the amount of the claims, the bankruptcy court found that Philip Morris's tax indemnity claims had to be reduced by $16,771,747 for "Tax Savings" and thus that the allowable portion of the claims based on the Tax Indemnity Agreement was $4,308,626 ($21,080,373 -$16,771,747).

On February 14, 2007, Bankruptcy Judge Sonderby entered an "Order Allowing Claim No. 50863 and Disallowing Claim Nos. 50110, 50111, 50112 and 50113." The order provides in pertinent part:

IT IS HEREBY ORDERED for the reasons stated in this court's Findings of Fact and Conclusions of Law entered on this date, the amount of claim number 50863 is determined to be $4,737,624 and the same is allowed in that amount as an unsecured nonpriority claim, which is entitled to treatment under Class 5 of the First Amended Joint Plan of Reorganization of Kmart Corporation and its Affiliated Debtors-in-Possession.

IT IS FURTHER ORDERED that claim numbers 50110, 50111, 50112, and 50113 are disallowed. (Docket No. 30689).)*fn1 The same day, Judge Sonderby also issued orders denying Philip Morris's motion in limine to exclude evidence or argument regarding tax savings deductions (Docket No. 30687) and denying Philip Morris's motion for judgment pursuant to Fed. R. Bankr. P. 7052 and Fed. R. Civ. P. 52(c)(Docket No. 30685).

Philip Morris now appeals from Judge Sonderby's orders*fn2 and Findings of Fact and Conclusions of Law (Docket No. 30688), and Kmart has filed a cross-appeal from the above-quoted order (Docket No. 30689) and the Findings of Fact and Conclusions of Law. Philip Morris has requested oral argument. The request is denied because after reviewing the briefs, which are very ...

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