Regular readers of the "Toxins-Are-Us" column over the past eight years have seen one issue revisited on a number of occasions: whether environmental claims could be considered an administrative expense under 11 U.S.C. §503(b). This article deals with a recent Third Circuit Court of Appeals decision on the subject.

On June 2, 1999, in Pennsylvania Dept. of Environmental Resources v. Tri-State Clinical Laboratories Inc., 178 F.3d 685 (3rd Cir. 1999) (Tri-State), the Third Circuit considered whether a criminal fine is entitled to priority as an administrative claim under §503(b) in a chapter 7 bankruptcy proceeding. In a detailed opinion, the court held that punitive criminal fines arising from post-petition conduct are not administrative expenses.

Facts and Procedural History

On Aug. 14, 1990, Tri-State Clinical Laboratories Inc. filed a chapter 11 that was later converted to chapter 7. Id. at 687. After the petition was filed, two municipal workers were sprayed with blood while emptying a dumpster outside a Tri-State facility. The blood was from test tubes that Tri-State had illegally placed in the dumpster.

On Jan. 21, 1992, the Pennsylvania Attorney General filed a two-count criminal complaint charging Tri-State with violating Pennsylvania's Solid Waste Management Act. Id. The first count charged Tri-State with unlawful conduct pre-petition, and the second count involved unlawful post-petition conduct.

On July 28, 1994, while the chapter 7 proceedings were still pending, Tri-State was convicted on both counts of the criminal complaint. Id. Two fines were imposed: $10,000 for pre-petition conduct and $20,000 for post-petition conduct. The fines were purely punitive and did not include actual costs or expenses incurred by the Department of Environmental Resources (DER) for cleaning up Tri-State's mess.

Thereafter, the DER filed a proof of claim, asserting a subordinated claim for the $10,000 fine resulting from Tri-State's pre-petition conduct and a priority claim for the $20,000 fine for post-petition conduct, asserting that the $20,000 was an administrative expense pursuant to §503(b). Id. There was no objection to the $10,000 subordinated claim, but the trustee objected to treating the $20,000 post-petition fine as an administrative expense.

The bankruptcy court determined that the $20,000 fine for post-petition criminal conduct was not an administrative expense under §503(b), and instead classified the fine as an unsecured claim. Id. The district court affirmed, and the DER appealed.

The Arguments

On appeal to the Third Circuit, the DER argued that the $20,000 fine should be given priority as an administrative expense for three reasons: (1) the list of administrative expenses in §503(b) is non-exclusive; (2) other courts have found that tort damages, post-petition civil penalties and civil environmental fines enjoy priority as administrative expenses; and (3) policy reasons, i.e., if criminal fines are not given priority, debtors-in-possession (DIPs) will be encouraged to break the law without fear of economic consequences. Id. at 688.

The trustee argued that there is a distinction between compensatory damages, which were given priority as administrative expenses in a prior Third Circuit case, and non-compensatory fines, which do not reimburse creditors for actual expenses incurred. Id. Further, the trustee asserted that because Congress specifically referred to non-compensatory criminal fines elsewhere in the Bankruptcy Code, those fines would have been expressly included in §503(b) if Congress had intended them to be treated as administrative expenses. Finally, the trustee argued that non-compensatory criminal fines survive bankruptcy and can be assessed against the corporation or its officers, so there is no incentive for a corporation to break the law while its bankruptcy is pending.

The Court's Analysis

Statutory Interpretation. The court began with an analysis of §503(b)(1)(A), which provides, in part, that "there shall be allowed, administrative expenses...including...the actual, necessary costs and expenses of preserving the estate, including wages, salaries or commissions for services rendered after the commencement of the case..." Id. The court interpreted the language to mean that to enjoy priority as an administrative expense, a claim "must be (1) a 'cost' or 'expense' that is (2) 'actual' and 'necessary' to (3) 'preserving the estate.'" Id. at 689.

The Supreme Court has determined that the phrase "preserving the estate" includes the "larger objective...of operating the debtor's business with a view to rehabilitating it." Id. Further, the definition of "necessary costs" under the Code is broader than the Webster's Dictionary definition because the term should include "costs ordinarily incident to operation of a business, and not be limited to costs without which rehabilitation would be impossible."

Therefore, the court determined that the language of §503(b) suggests a situation where the estate incurs a debt in exchange for "some consideration necessary to the operation or rehabilitation of the estate." Id. at 689-90. Priority is given to these expenses to compensate the providers of "necessary goods, services or labor." Id. at 690.

The court found justification for its interpretation of §503(b) in the legislative history of the Code. Id. To achieve the purpose of rehabilitation, the debtor must continue its business and incur additional expenses, and Congress recognized the need to provide an incentive to creditors who continue to provide services to a failing business. Therefore, the "actual, necessary costs and expenses of preserving the estate" enjoy priority under the Code. Without the priority afforded to these expenses, a debtor could not maintain its business while it attempted to reorganize.

Prior Cases. In reaching its conclusion, the Tri-State court addressed three cases that dealt with similar circumstances: Reading Co. v. Brown,² Pennsylvania Dept. of Env. Resources v. Conroy³ and N.P. Mining Co. v. Alabama Surface Mining Commission.⁴

The U.S. Supreme Court's 1968 decision in Reading held for the first time that a claim for a post-petition tort was entitled to priority as an administrative claim as one of the "actual, necessary costs" under Chapter XI of the former Bankruptcy Code. Tri-State, 178 F.3d at 690-91. The Supreme Court reasoned, that even though the tort claim was not a cost of "preserving the estate," fairness dictated that those injured by the operation of a business by a receiver acting within the scope of his authority in a Chapter XI bankruptcy case should be compensated for their injuries. In doing so, the Supreme Court acknowledged that the allowed administrative claim would come ahead of the pre-petition creditors, for whose benefit the Chapter XI case was instituted. Id. at 690-92.

However, the Tri-State court distinguished the facts of Reading. In Tri-State, allowing the $20,000 post-petition fine to be treated as an administrative expense would require the fine to be "paid to the exclusion of, and out of the resources otherwise available for, claims of other creditors." Id. at 692. This would result in Tri-State's criminal fines effectively being paid for out of its creditors' pockets, which the Tri-State court found unfair and impractical.

The court also distinguished Tri-State from Pennsylvania Dept. of Env. Resources v. Conroy. Id. at 693. In Conroy, the DER filed a claim for reimbursement after it cleaned up hazardous chemicals at a site the debtor tried to abandon. The Conroy court gave those costs priority as an administrative expense because if the DER had not cleaned up the site, the debtor would have been required to do so. If the debtor had arranged the clean-up itself, the associated costs would have been an administrative expense. Therefore, the Conroy court found that when the DER cleaned up the site, it provided a service that the debtor itself would have had to perform during the course of normal operations, so the DER should be compensated for that service.

The court distinguished the Conroy situation from that of Tri-State because the purpose of Tri-State's criminal fine was "deterrence, retribution and punishment," as opposed to compensation for services or proper business operations. Id. Although the DER argued that the cost of complying with criminal laws is a necessary cost of doing business, the court disagreed.

Finally, the Tri-State court recognized a tension between its analysis and that of N.P. Mining Co., where the court held that civil fines imposed solely as punishment for violation of environmental regulations were afforded priority as administrative claims. Id. at 697. The N.P. Mining holding relied on §969(b), which requires that the trustee or DIP manage and operate the property in compliance with state law.

The Tri-State court was not persuaded by this analysis, because to do so would require it to infer that Tri-State's disposal of infectious human waste, which endangered public health and violated the law, was part of the ordinary and necessary operations of a business. Id. at 698. Further, the court noted that, unlike Tri-State, the violation in N.P. Mining did not involve safety. Id. at 10-11.

Conclusion

In summary, Tri-State is a significant decision in the area of environmental bankruptcy law. The rejection of criminal fines as an administrative expense may affect the outcome of many cases. In fact, Tri-State already has been cited by another court in In re Miloszar, 1999 WL 545370 (D. N.J. 1999). Because the Tri-State decision is only a few months old, the full impact of the decision remains to be seen.

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Footnotes

¹ Ms. Thomas is a third-year student at Salmon P. Chase College of Law and is a partxtime law clerk at Greenebaum Doll & McDonald PLLC. Return to article

² 391 U.S. 471 (1968). Return to article

³ 24 F.3d 568 (3d Cir. 1994). Return to article

⁴ 963 F.2d 1449 (11th Cir. 1992). Return to article

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