Last month's "Toxins-Are-Us" column included a relatively brief discussion of Pennsylvania Dept. of Environmental Resources v. Tri-State Clinical Laboratories Inc., 178 F.3d 685 (3rd Cir. 1999), but it is a case worth revisiting from a government perspective. The decision involved a chapter 11 debtor charged, post-petition, with illegally disposing of infectious medical wastes in a general dumpster rather than by the proper (read, more expensive) method. This activity came to light when the municipal workers loading the garbage truck were sprayed with blood spurting from test tubes left in the waste. Criminal charges were filed while the debtor was in chapter 11, but by the time it was convicted and fined $20,000, the case had been converted to chapter 7. The trustee successfully argued to the courts that the state's claim for the penalty costs should be treated as a simple unsecured claim.

In reaching that decision, the Third Circuit began with an analysis of §503(b)(1)(A), which grants administrative status to expenses "necessary" to "preserve" the estate—i.e., normally those needed to allow the debtor to operate. However, as the court recognized, the Supreme Court held 30 years ago in Reading Co. v. Brown, 391 U.S. 471, 483 (1968), that this test must, for policy reasons, cover all "costs ordinarily incident to the operation of a business, and not be limited to costs without which rehabilitation would be impossible." In Reading, the negligence of a receiver resulted in a fire that damaged a neighboring building; the court held that the tort damages were entitled to priority, even though they could not be said to "benefit" the estate. Rather, the court held, the claims of those who had harm thrust upon them by the post-petition operations of the debtor had precedence over those of pre-petition creditors who could hope to gain from those operations.

Many courts, including the Eleventh Circuit in N.P. Mining Co. v. Alabama Surface Mining Commission, 963 F.2d 1449 (11th Cir. 1992), and the First Circuit in Cumberland Farms Inc. v. Florida Dept. of Environmental Protection, 116 F.3d 16 (1997),¹ have since applied Reading to civil penalties imposed on a debtor for post-petition violations. These too, they hold, are costs incurred during the operation of the business and the state should be no more obliged to subordinate the costs of enforcement mechanisms that protect its citizenry to pre-petition creditors than should post-petition tort claimants.

These decisions are consistent with the frequently articulated view that the petition date is a boundary: Debts incurred before that date may or may not be paid, but costs incurred thereafter must be paid or the debtor should not be able to remain in bankruptcy. This requirement, with respect to statutory obligations, is set forth explicitly in 28 U.S.C. §959(b), which provides that "a trustee...including a debtor-in-possession, shall manage and operate the property in his possession...according to the requirements of the valid laws of the state...in the same manner that the owner or possessor thereof would be bound to do if in possession thereof."

Even without that language, this would be common sense—if the debtor cannot operate lawfully while it is in the hothouse atmosphere of the bankruptcy arena, how can it hope to do so after it emerges? At some point the debtor must either obey the law or shut down; the petition date is the logical starting point for that simple requirement. A debtor that receives the benefits of federal bankruptcy relief should, at the least, comply with the same law as its competitors.

However, the Third Circuit brushed away the logic of Reading and its progeny by stating that allowing the administrative claim for penalties would unfairly result in the exclusion of resources that would otherwise be available to compensate other claimants. Standing alone, that argument proves nothing, since giving non-traditional administrative claimants priority will always deprive others of payment. However, the court viewed the facts in Reading as less problematic because the issue there involved a compensatory claim, unlike non-compensatory criminal penalties. Thus, the court argued virtuously, it was only acting to ensure that "real" creditors were compensated, and were not punished for the debtor's misdeeds.

In reaching that conclusion, the court took a decidedly high-minded view of the expenses that a "legitimate" business would incur during a case. The state argued the obvious—that compliance with the law can be expensive and that there is always a temptation for a struggling business to ignore those requirements. If it had been as cheap and easy to dispose of hazardous wastes properly as to simply ship them off to the municipal dump, there was no reason the debtor would not have done so. Thus, if it did violate the law, one must assume that it was playing the odds against getting caught—and the availability of significant sanctions is meant to change the cost-benefit calculations of those odds.

The court, though, refused to engage in such a pragmatic view of what businesses really do. Instead, it simply stated, "We refuse to adopt an analysis of administrative expenses that is based upon the assumption that legitimate businesses engage in a 'cost-benefit' analysis to determine if they will comply with criminal laws that protect the very public that the owners and operators of those legitimate businesses are part of."²

Thus, the court concluded that only "legitimate" expenses will be treated as administrative; if the debtor shouldn't have incurred the fine, then creditors shouldn't have to pay for it.

While this might be a praiseworthy view of how businesses should operate, it plainly fails the reality test. Punitive sanctions are imposed to dissuade regulated parties from making a bet on not getting caught in violation of the law. By blinding themselves to the possibility that businesses make such trade-offs, the court missed the point of the state's argument—namely, that because the debtor would undoubtedly have had to incur extra costs to dispose of the wastes properly, there is no unfairness to other creditors. If the debtor had obeyed the law, those added compliance costs would have been an administrative expense and would have served, just as with a fine, to diminish the amounts available for other creditors. Whether the amounts are exactly equivalent in a given case is irrelevant; the point is that sanctions and compliance costs are simply opposite sides of the same administrative expense coin. The Fifth Circuit made this point in In the Matter of H.L.S. Energy Co. Inc. (Texas v. Lowe), 151 F.3d 434 (5th Cir. 1998), in dealing with a claim by Texas for the cost it paid (on behalf of the debtor) to comply with the statutory requirement that non-operating wells be plugged. The court granted the state administrative status for its claim, noting that, "The unplugged unproductive wells operated as a legal liability on the estate, a liability capable of generating losses in the nature of substantial fines every day the wells remained unplugged." (emphasis added). The court saw the two costs as a simple trade-off—the debtor could either comply with the law or would be required to pay a penalty for failing to do so. This was true even if plugging the wells provided no benefit to the estate; debtors may not ignore the law merely to save the compliance costs for payment to their other creditors.

The rest of the Third Circuit's opinion consists of a series of non sequiturs. The court began by extensively reviewing the treatment of penalties under the Bankruptcy Act and in the proposals that led to the Code, but failed to mention until the very end that all of the discussions dealt with pre-petition penalties. In doing so, the court used the same fallacious reasoning as the Sixth Circuit had in In re First Truck Lines Inc. (U.S. v. Noland), 48 F.3d. 210, rvs'd, U.S. v. Noland, 517 U.S. 535 (1996), where the lower court had been so taken by policy arguments for subordinating pre-petition tax penalties that it had ignored explicit Code language giving post-petition tax penalties administrative status. The conflict with the language of the Code is less stark here, but the need to protect the effectiveness of sanctions relating to police and regulatory issues is even more crucial than for the purely monetary issues involved with tax penalties.³

Inexplicably, the Third Circuit court failed to note or distinguish the case of United States Dept. of Interior v. Elliott, 761 F.2d 168, 171-172 (4th Cir. 1985). That case did deal with post-petition penalties under the Bankruptcy Act and noted that the Supreme Court had already twice held that the language relied upon by the Third Circuit in this case (§57(j) of the Act) was not applicable to post-petition tax penalties. Elliott concluded that the same logic applied to non-tax penalties as well and granted them administrative status. Thus, upon even cursory examination, the historical support on which the Third Circuit built its opinion simply crumbles away.

Next, the court pointed to the distinction in §523(a)(7) between compensatory and punitive fines and suggested that this showed that Congress, as a general principle, distinguishes between the two. The reasoning, however, is difficult to follow. To begin with, §523(a)(7) is not even applicable to a corporate debtor. However, the Third Circuit apparently believed that the state should not have sanctioned the company, but should instead have sought criminal penalties against "responsible individuals." Even aside from the difficulties in trying to prove who gave the orders to dump the waste, this approval ignores the fact that it was the debtor's operations that benefited from violating the law, and that creditors could hope to receive more from those operations if the reduced costs helped the debtor to reorganize. It is hardly unfair, in this light, to have the impact of the violation fall on those two groups. See, i.e., Elliott; In re Charlesbank Laundry Inc., 755 F.2d 200, 203 (1st Cir. 1985).

The potential breadth of the court's opinion is disconcerting. At times, the Third Circuit seemed to limit its views to criminal fines or chapter 7 cases. Elsewhere, though, it treated the two chapters alike and its repeated references to "non-compensatory" penalties could apply equally to civil and criminal fines. Thus, the opinion could be read to rule out any ability of the government to give teeth to post-petition sanctions, leaving a gaping hole in the state's enforcement authority. Indeed, in the worst case, a debtor that was financially troubled because of the costs of obeying the law could file bankruptcy, stop complying and start saving money, then rest securely, knowing that penalties imposed during the case would be thrown into the general distribution pool when—and if—it ever confirmed a plan. Worst of all, this is true, no matter how egregious the debtor's conduct—the Third Circuit actually asserted that because these violations involved safety issues, that was more reason to find they weren't administrative (because, of course, no "legitimate" business would do anything so reckless). Alice-in-Wonderland logic, indeed! The court even suggested that the Eleventh Circuit might have agreed with it in N.P. Mining had the violations there involved safety issues—although it is clear from N.P. that the Eleventh Circuit only struggled with the case because the violations did not create safety issues.

The Third Circuit was right, though, about one thing: The language in §507(a)(1)(A) doesn't really do the trick with non-traditional costs. The problem is bad enough with tort claims; it is even more difficult with respect to statutory compliance costs. Those costs often may not provide any direct benefit to the estate. Employees must be paid something, for instance—but is it really necessary to pay them the minimum wage if they can be induced to work for less? Does it "benefit" the estate to install expensive safety equipment just because the law says so? If my employees are careful, isn't this cost unnecessary? Obviously, applying the traditional "benefit" tests to legally required costs doesn't make much sense. 28 U.S.C. §959(b) says debtors must obey the law—whether or not doing so helps them reorganize and whether or not it costs money. Put another way, a business that cannot obey the law and still operate profitably cannot and should not continue. Congress makes that economic decision when it passes legislation that imposes costs on businesses; bankruptcy does not give debtors immunity from those policy choices.

Pennsylvania is seeking certiorari on Tri-State, and the states hope that the clear circuit split will catch the court's interest and result in a reversal of the decision. Regardless of the outcome of that petition, though, the most helpful change would be for Congress to amend the definition of administrative expenses as part of the pending revisions to the Code. The issue doesn't have the high profile of the consumer bankruptcy issues that have dominated the debate over the last two years, but it is of far more importance in ensuring that bankruptcy does not become the haven for the lawlessness that Congress has long decried.

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Footnotes

¹ The Ninth Circuit can probably also be added. In Oregon v. Witcosky (In re Allen Care Centers Inc.), 96 F.3d. 1328 (9th Cir. 1994), it refused to grant administrative status to the state's costs for closing a failing nursing home pursuant to a state law that allowed a financially troubled operator to transfer facilities to the state. The court held that the costs were not administrative expenses because the debtor did not violate the law. Under its analysis, Reading only applied to situations where the debtor's conduct involved wrongful, tort-like conduct. While I find that view of Reading overly restrictive, at a minimum it should mean that if the debtor does violate the law, then the costs arising out of that violation would receive administrative status. Return to article

² It is difficult to fathom the court's point about laws being meant to protect the public that the operators are part of. If this was meant to imply that those persons would not violate the law because doing so could expose themselves to harm, it ignores the reality that the harm caused will probably not affect the wrongdoers. They are not the municipal workers who will be sprayed with blood, nor will they, in all likelihood, live near the municipal landfill contaminated with infectious wastes. Rather, the burden of the debtor's actions falls on those unable to protect themselves—those whom state law seeks to protect and who are left defenseless by this ruling. Return to article

³ The court noted that tax penalties were explicitly mentioned in §507 and argued that this implied that other penalties should not receive such status. However, this distinction could equally have been made because Congress thought the language in §959 and the need to protect police and regulatory sanctions made those issues easy, but that it might be a harder sell to convince courts to protect the state's purely pecuniary interest in tax penalties, so specific language was needed. Return to article