The Care and Feeding of State Regulators in Chapter 11 Cases

The Care and Feeding of State Regulators in Chapter 11 Cases

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A valuable ally or your worst nightmare, state regulators2 can have a dramatic (occasionally outcome-determinative) impact in a chapter 11 case—and yet, the debtor's relationship with its state regulators is quite often overlooked. Regulatory agencies can of course be creditors, but more significantly, they almost always play an important role in seeing that the debtor's business is conducted lawfully. With that in mind, this article will not only briefly explain why debtors and their counsel should devote attention to the "care and feeding" of regulators, but also offer practical suggestions on how to do so.


Why Should a Debtor Care About the Regulators?

Regulators deserve special attention for a variety of reasons. Not only do they typically exert significantly greater influence over the debtor's business than other parties, but they are also less restricted than most other parties in their ability to exercise their power in a chapter 11 filing. Federal law requires that the debtor (or trustee) continue to comply with all applicable state laws, and the automatic stay does not prevent the government from exercising police and regulatory power against the debtor. In addition, states are protected by the 11th Amendment to the U.S. Constitution from suit in federal court without their consent or waiver, thus a debtor's remedies against state regulators in bankruptcy court are limited in certain circumstances. Another reason for keeping the regulators in mind is that a few appeals courts have found that post-petition state law fines and penalties for a debtor's failure to comply with the law were entitled to administrative expense treatment; sizable post-petition fines or penalties can thus directly impact the feasibility of a reorganization. 28 USC §959(b): Post-petition Operations. This statute specifically requires a debtor or trustee to "manage and operate the property in his possession as such trustee...according to the requirements of the valid laws of the state in which such property is situated, in the same manner that the owner or possessor thereof would be bound to do if in possession thereof." Courts have interpreted this to mean that a debtor must comply with applicable state law just as though there were no bankruptcy proceeding.3

11 U.S.C. §362(b)(4): Police Power Exception to the Automatic Stay. While the automatic stay ordinarily affords the debtor much-needed breathing room, the exception found in 11 U.S.C. §362(b)(4) offers no such relief from enforcement of applicable state law. This so-called "police power exception" specifically empowers regulators to continue to exercise their police and regulatory power against the debtor (including, incidentally, fixing the amount of fines or penalties owed to the government).4 Courts have widely recognized the police power exception to the automatic stay in a variety of contexts.5

11 U.S.C. §503(b): Post-petition Fines as Administrative Expenses. Post-petition fines and penalties levied on a debtor for post-petition violations have been held to be administrative expenses burdening the estate.6 For instance, the First Circuit found that a fine for a debtor's post-petition failure to meet a technical requirement of Florida environmental protection laws was a cost "ordinarily incident to operation of a business" and thus entitled to administrative expense priority.7

Eleventh Amendment Immunity from Suit. A debtor will often be unable to obtain relief against a state agency in bankruptcy court if the state has not yet filed a claim or otherwise submitted to the bankruptcy court's jurisdiction. The 11th Amendment provides that "the judicial power of the United States shall not be construed to extend to any suit in law or equity, commenced or prosecuted against one of the United States by citizens of another state, or by citizens or subjects of any foreign state" and thus offers states protection from being subjected to suit in bankruptcy court as well as other federal courts.8 The 11th Amendment ostensibly applies to any suit against a state, regardless of the relief sought.

Arguably, then, a debtor should have difficulty getting injunctive relief against a state agency, given that Bankruptcy Rule 7001 requires an adversary proceeding and such a suit squarely triggers the 11th Amendment.9

Rooker-Feldman Doctrine. Bankruptcy courts may be bound by state court determinations of injunctive relief or the fixing of damages or fines. Under the so-called Rooker-Feldman doctrine, a federal court cannot sit as an appellate court to review a final state court decision. The U.S. Supreme Court recently explained that:

The Rooker-Feldman doctrine merely recognizes that 28 U.S.C. §1331 is a grant of original jurisdiction and does not authorize district courts to exercise appellate jurisdiction over state-court judgments, which Congress has reserved to this court (see 28 U.S.C. §1257 (a)). The doctrine has no application to judicial review of executive action, including determinations made by a state administrative agency.10

Statutory Reservation of Jurisdiction. It is worth noting as well that occasionally federal law "carves out" regulation of particular debtors, explicitly reserving such regulation to the states. This is true even where the debtor itself is not ineligible for bankruptcy protection under 11 U.S.C. §109. For example, the McCarran-Ferguson Act (recently ratified by the Gramm-Leach-Bliley Act) gives states the exclusive jurisdiction to regulate the business of insurance. The recent Conseco Inc. case (the third-largest chapter 11 filing to date) involves an insurance holding company whose most valuable assets are its subsidiary insurance companies. Under most states' laws, both insurance companies domiciled in that state, and to a lesser degree, the companies that "hold" or "control" those insurance companies, are subject to state insurance regulation. In the Conseco case, therefore, formulation of a plan has necessarily involved extensive state regulator involvement and cooperation.11

How Does One Care for and Feed the Regulators?

Now that the debtor appreciates why it should work with the regulators, the issue then becomes how to work with them. Common sense would dictate that one treat the regulators with respect and candor, keeping them informed of the debtor's activities and objectives in the reorganization proceeding. Having said that, a few practical suggestions follow.

First, keep in mind that it is not only possible but likely that the debtor may be heavily regulated (e.g., environmental, telecommunications, etc.), so find out the extent to which the debtor's business is impacted by governmental control or regulation. Next, find out exactly what kind of history your client has had with the regulators.

If the debtor is regulated, decide on a strategy early on (ideally, pre-petition) for dealing with the regulators. Just as the debtor and its bankruptcy counsel always meet with existing and potential lenders, creditors and counsel early in a case, meeting with the regulators as early as possible will foster the trust and confidence that may be a key factor in avoiding regulatory action outside bankruptcy court or regulatory efforts to seek appointment of a chapter 11 trustee or conversion to chapter 7. Reassure the regulators that the debtor will continue to comply with applicable law (i.e., make it clear to the authorities that you're aware of 28 U.S.C. §959(b)) or, if the debtor has had regulatory problems in the past, let the regulators know what the debtor is doing to become a model corporate citizen.

Consider the regulators' perspective when preparing your bankruptcy filings. Of course, the debtor should schedule governmental agencies as creditors if they hold pre-petition claims (or, for notice purposes if for no other reason, listing both local office contacts as well as the agency headquarters address). In addition, recall that the Statement of Financial Affairs (Official Bankruptcy Form 7) was revised several years ago to include a question specifically dealing with environmental obligations; Question Number 17 asks in detail for information concerning environmental conditions, notices given or received about environmental sites, and pending, threatened or concluded litigation or proceedings (including, presumably, regulatory actions).

Be mindful of the interplay between the bankruptcy proceedings themselves, the debtor's business and the regulator's responsibilities. As bankruptcy counsel for regulatory agencies grow more and more sophisticated (and state regulators network to share information and strategies), the first-day motions that "gore the state's ox" set the wrong tone and, understandably, ensure a chapter 11 full of contention and appeals. Provide the regulators with advance copies of portions of the disclosure statement and plan affecting the regulator's ability to enforce the law, as well as treatment of the regulator's claims (if any). For example, when seeking authority to sell real property free and clear under §363, rather than running the risk of drawing an objection from the environmental regulatory authorities, consider including language in the §363 sale order that would eliminate any ambiguity, from the government's perspective, concerning the scope of the "free and clear of liens" relief.12

Bankruptcy Code §525 provides that an agency may not "deny, revoke, suspend or refuse to renew a license, permit, charter, franchise or other similar grant" solely due to the debtor's insolvency or bankrupt status.13 In addition, an agency may not base such action on the debtor's failure to pay a discharged or dischargeable debt under 11 U.S.C. §525. The anti-discrimination provision does not, however, prevent the regulatory agency from enforcing the law.14

Lastly, never lose sight of the fact that your debtor will likely be "living" with these same regulators after the plan is confirmed. A little care and feeding of the regulators while in a chapter 11 can mean a smoother bankruptcy proceeding and a friendlier regulatory environment post-confirmation.


1 Mr. Morris is Board-certified in business and consumer bankruptcy by the American Board of Certification. The authors are assistant attorneys general in the Bankruptcy Division. This article is the work product of Ms. Phillips and Mr. Morris in their unofficial capacity and does not reflect the official position of the Office of the Texas Attorney General or of any Texas state agency. Return to article

2 For the purposes of this article, "regulators" means all state regulatory agencies except the taxing authorities—e.g, it includes the environmental, workers compensation, securities regulation, banking, insurance and consumer protection agencies, to name a few). Return to article

3 See Midlantic Nat'l Bank v. N.J. Dept. of Envtl. Protection, 474 U.S. 494 (1986); Cournoyer v. Town of Lincoln, 790 F.2d 971 (1st Cir. 1986); In the Matter of Cajun Electric Power Coop. Inc. 185 F.3d 446 (5th Cir. 1999); In the Matter of H.L.S. Energy Co., 151 F.3d 434 (5th Cir. 1998); In the Matter of Al Copeland Enterprises Inc., 991 F.2d 233 (5th Cir. 1993); Robinson v. Michigan Consolidated Gas Co., 918 F.2d 579 (6th Cir. 1990); In re Wall Tube and Metal Prods. Co., 831 F.2d 118 (6th Cir. 1987); In re N.P. Mining Co. Inc., 963 F.2d 1449 (11th Cir. 1992); Saravia v. 1736 18th Street, 844 F.2d 823 (D.C. Cir. 1988); In re Vel Rey Properties Inc., 174 B.R. 859 (Bankr. D.C. 1994); In re Chateaugay Corp., 112 BR 513, 525 (S.D.N.Y. 1990), aff'd., 944 F.2d 997 (2nd Cir. 1991). Return to article

4 The legislative history to §362(b)(4) states, in part, that "where a governmental unit is suing a debtor to prevent or stop violation of fraud, environmental protection, consumer protection, safety, or similar police or regulatory laws, or attempting to fix damages for violation of such a law, the action or proceeding is not stayed under the automatic stay." H.R. No. 95-595, 95th Cong., 1st Sess. 342-3 (1977); S.R. 95-989, 95th Cong., 2d Sess. 51-2 (1978). Return to article

5 Environmental cases: In re Security Gas & Oil Inc., 70 B.R. 786 (Bankr. N.D. Cal. 1987); People ex rel. Ryan v. Env. Waste Resources Inc., 2002 WL 31619042 (Ill. App.3 Dist.). Licenses: In re Federal Communications Comm'n., 217 F.3d 125 (2d Cir. 2000); In re Yellow Cab Coop., 132 F.3d 591 (10th Cir. 1997); U.S. v. Kansas Personal Communications Serv. Inc., 256 B.R. 807 (D. Kan. 2000). Consumer Fraud: Board of Governors of the Fed. Reserve Sys. v. Mcorp Fin. Inc., 502 U.S. 32 (1991); SEC v. First Fin. Group of Tex., 645 F.2d 429 (5th Cir. 1981); In re Nelson, 240 B.R. 802 (Bankr. D. Maine 1999). Return to article

6 In re Cumberland Farms, 116 F.3d 16 (1st Cir. 1997); Alabama Surface Mining Comm'n. v. N P Mining Co., 963 F2d 1449, 1452-53 (11th Cir. 1992) (in a case of first impression for the Eleventh Circuit, the court found that (relying on the US Supreme Court's opinion in Reading Co. v. Brown, 391 US 471, 88 S. Ct. 1759 (1968), in which the Court accorded admin exp status to liabilities that, although normally incident to the operation of the business, did not "benefit" the estate) because 28 U.S.C. §959(b) requires the debtor to manage and operate its estate in accordance with state law, fines and penalties attributable to the actual post-petition operation of the business are §503(b) administrative expenses); and In re Chateaugay Corp., 112 BR 513, 525 (S.D.N.Y. 1990), aff'd., 944 F.2d 997 (2nd Cir. 1991). Return to article

7 In re Cumberland Farms, 116 F.3d 16 (1st Cir. 1997). Return to article

8 It is worth noting that 11 USC §106 (which appears to deprive states of their 11th Amendment immunity) has been widely held to be unconstitutional. Five circuit courts have concluded that under Seminole Tribe, Congress may not validly abrogate state sovereign immunity relying on its bankruptcy clause powers. See Nelson v. La Crosse County Dist. Attorney (In re Nelson), 301 F.3d 820, 832 (7th Cir. 2002); Mitchell v. Franchise Tax Bd. (In re Mitchell), 209 F.3d 1111, 1121 (9th Cir. 2000); Sacred Heart Hosp. of Norristown v. Pennsylvania (In re Sacred Heart Hosp. of Norristown), 133 F.3d 237, 243 (3d Cir. 1998); Fernandez v. PNL Asset Mgmt. Co. LLC (In re Fernandez), 123 F.3d 241, 243 (5th Cir.), amended by 130 F.3d 1138, 1139 (5th Cir. 1997); Schlossberg v. Maryland (In re Creative Goldsmiths of Washington, D.C.), 119 F.3d 1140, 1145-46 (4th Cir. 1997), cert. denied, 523 U.S. 1075, 118 S.Ct. 1517, 140 L.Ed.2d 670 (1998). These circuits have relied primarily on Seminole Tribe's broad language barring Congress from abrogating state sovereign immunity pursuant to its Article I powers. But, see contra, In re Pamela Hood v. Tenn Student Assistance Corp., 2003 WL 214962, 2003 FED App. 0038P (6th Cir. Feb 3, 2003), holding that Congress could lawfully abrogate a state's 11th Amendment immunity. Return to article

9 Note that while various nursing home debtors in the Third Circuit have obtained post-petition financing orders that explicitly enjoined state Medicaid agencies from taking certain actions with respect to Medicaid monies payable to the debtors (see, e.g., In re Sun Healthcare Group Inc., 245 B.R. 779 (Bankr. D. Del. 2000)), the authors believe that such efforts would ultimately be found to be improper on appeal. Appeals to the Third Circuit and to the U.S. District Court in the subject cases were mooted, however, by confirmation of plans or settlement of the nursing home debtors' disputes with the state(s). Return to article

10 Verizon Md. Inc. v. Pub. Serv. Comm' n. of Md., 122 S. Ct. 1753, 1759 n.3 (2002). Return to article

11 Debtors' counsel in the Conseco case has done an exemplary job of keeping the regulators and their bankruptcy counsel "in the loop" since before the petition was filed, with periodic updates about the status of the proceedings, and as a result, engendered regulatory support for the proposed plan. Return to article

12 Suggested language: "Notwithstanding anything to the contrary in any purchase or sale agreement or this Order, nothing in this Order or any purchase or sale agreement (i) releases or nullifies any liability to [the state environmental regulatory agency] under statutes or regulations to which that entity would be subject as the owner or operator of the property after the date of entry of this Order, just as if this sale had taken place outside bankruptcy, or (ii) impairs or restricts the ability of [the state environmental regulatory agency] to pursue all of its rights and remedies in state court against any entity which is the owner or operator of the property after the date of entry of this Order." Return to article

13 A state agency may not "deny, revoke, suspend or refuse to grant" a "license, permit, charter or other similar grant" based solely on the fact of the debtor's insolvency or because the debtor is in bankruptcy. See Duffey v. Dollison, 734 F.2d 265, 271 (6th Cir. 1984); In re Christmas (Christmas v. Maryland Racing Commission), 102 B.R. 447, 453 (Bankr. D. Md. 1989); see, also, Perez v. Campbell, 402 U.S. 637 (1971). In Duffey, an Ohio statute required proof of financial responsibility by any person who failed "to satisfy judgment for damages arising from an automobile accident" before the state would renew a person's driver's license. 734 F.2d at 266. The debtors, while in chapter 7, complained that the statute requiring proof of financial responsibility violated §525 because the statute required them to post bond solely because they were in bankruptcy. Id. at 271. However, the court found that the statute did not discriminate, for it applied to all persons. Return to article

14 For an extensive discussion of §525, see FCC v. NextWave Personal Communications Inc., ___ U.S. ___, 123 S.Ct. 832 (2003). Return to article

Bankruptcy Code: 
Journal Date: 
Tuesday, July 1, 2003