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The Negligent Operation of Nursing Homes in Bankruptcy Who Pays

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Creditors prefer to have their monetary obligations against a debtor treated as an administrative expense rather than as a claim because an administrative expense must be paid first and generally in full at the end of the case. Section 503(b) of the Bankruptcy Code describes six general non-exclusive categories of claims entitled to administrative expense status and, therefore, entitled to first priority of distribution under §507(a) of the Bankruptcy Code. The first of these categories is described by §503(b) (1)(A) as "the actual and necessary costs and expenses of preserving the estate." Generally, for a debt to qualify as a necessary preservation expense, it must satisfy two requirements: (1) it must have arisen from a transaction with the estate, and (2) it must have benefited the estate in some demonstrable way. There are essentially three arguments that the landlord of a SNF in bankruptcy can make to support its assertion that its damages arising out of the debtor's post-petition operation of the SNF is entitled to treatment as administrative expenses.

First, operation of the SNF may have provided a "benefit" to the estate in the form of revenues and the use of the facility. See In re CIS Corp., 142 B.R. 640, 643 (S.D.N.Y. 1992) (use of property is a benefit to the estate). Under §503(b)(1)(A), the costs of preserving the estate that provide a benefit to the estate are compensable as an administrative expense. In CIS, the court noted that an "allowance for administrative expense should be narrowly construed," and that a potential claimant must establish two elements: (1) the debtor-in-possession (DIP) incurred the transaction or the claimant furnished the consideration to the DIP, and (2) that the transaction resulted in a direct benefit to the DIP. The court held that benefit is furnished to the DIP, in the context of a lease, where the DIP uses the object of the lease. In many cases where the leased SNF is generating a negative cash flow for the debtor, the debtor may want to argue that negative cash flow shows that the SNF is not producing a benefit to the estate. This argument is more difficult for the debtor if the facility has a "positive cash flow." In any event, even the use by a debtor of an SNF could suffice to show benefit. Thus, the costs of repairs a landlord has to make or lost economic value because the debtors failed to comply with §365(d)(3) should be compensable as providing a benefit to the estate.

The recent decision in In re Beverage Canners Int'l. Corp. illustrates this principle. In Beverage Canners, a creditor satisfied its burden of demonstrating actual "benefit" to the chapter 11 estate from the debtor's post-petition use of licensed trademarks, and was entitled to an administrative expense claim for its pro rata share of the royalty payment, based on the debtor's full use of the trademark on bottled water products that it sold. It did not matter what the debtor's motive was for using the trademark, or whether the debtor's use of the trademark had resulted in increased sales. "Benefit" to the estate, of a kind required for an administrative expense claim, was not equated with profit, and it was unnecessary for profit to be shown in order for administrative priority to be warranted for a debtor's post-petition use of another's property. In re Beverage Canners Intern. Corp., 2000 WL 1716264 (Bankr. S.D. Fla., Judge Mark).

However, courts have limited the utility of this test by limiting those entitled to administrative expense status "to include only those creditors that perform services that are the actual and necessary to preserve the estate or that enable it to maintain its business." In re R.H. Macy & Co., 170 B.R. 69, 76 (Bankr. S.D.N.Y. 1994). For example, in In re Cardinal Export Corp., 30 B.R. 682 (Bankr. E.D.N.Y. 1983), the bankruptcy court denied a landlord's assertion of an administrative expense arising out of the debtor's failure to clean the facility prior to returning it to the landlord, despite lease provisions requiring that the premises be returned "broom clean." 30 B.R. at 685. Finally, in In re Integrated Health Services Inc., No. 00-389 (MFW) (Bankr. D. Del. July 7, 2000), the court found that no benefit was conferred on the debtor by a claimant's requirement for a new roof and laundry equipment despite lease obligations that required the debtor to make such improvements.

Second, if the post-petition operation of the SNF damaged the landlord, even if there is no discernible benefit to the estate, courts, including the Supreme Court, have long recognized that "considerations of fundamental fairness and logic required the allowance of a claim of administrative priority for damages resulting from the post-petition negligence" of a DIP or trustee. 4 Lawrence P. King, Collier on Bankruptcy, ¶503.06 [3][c], at 503-28 (15th ed. rev. 2000) (citing Reading Co. v. Brown, 391 U.S. 471, 483, 88 S.Ct. 1759, 20 L.Ed. 2d 751 (1968)).

In Reading, the Supreme Court held that claims of a victim of a fire caused by the trustee's negligence were entitled to administrative priority. These claims were viewed as a "cost of doing business" that the definition of "fairness" required be paid ahead of pre-petition claimants. The finding that a post-petition action causing harm, such as violation of a statute or a tort, creates an administrative expense is recognized in bankruptcy courts. See, e.g., In re Continental Airlines Inc., 148 B.R. 207, 214-16 (D. Del.1992); In re B. Cohen and Sons Caterers Inc., 143 B.R. 27, 29 (E.D. Pa. 1992).

[This doctrine], recognizing an exception to the usual requirement of a demonstrable benefit to the estate, is sound. Section 503(b)(1)(A) allows administrative expenses for the necessary costs of preserving the estate. Damages or compensatory penalties arising from post-petition operation of the business of the estate may well be seen as "necessary" for the estate's preservation. This is because a decision to continue business operations post-petition is made to preserve the going-concern value of the estate for the benefit of pre-petition creditors, and the possibility of the estate incurring damages and compensatory penalties as a result of its operations is a foreseeable risk of that decision.
Collier on Bankruptcy, supra, ¶503.06 [3][c][n], at 503-30.

Third, §365(d)(3) of the Bankruptcy Code requires that debtors "timely perform all the obligations of the debtor...arising from and after the order for relief under any unexpired lease of non-residential real property, until such lease is assumed or rejected." Courts have held that the Bankruptcy Code provision entitles the non-debtor party to a lease to an administrative expense priority for damages suffered post-petition and pre-rejection. See, e.g., Cukiesman v. Vecker (In re Cukiesman), 242 B.R. 486 (B.A.P. 9th Cir. 1999) (§365(d)(3) entitles a landlord of non-residential real property to an administrative claim for any and all obligations arising under an unexpired lease during the post-petition, pre-rejection period, and is not limited to administrative expense claims for unpaid rental obligations); accord, In re Trans World Airlines Inc., 145 F.3d 124 (3rd Cir. 1998) (TWA). In TWA, the Third Circuit allowed an aircraft lessor an administrative claim for the debtor's failure to comply with the maintenance and repair covenants in its post-petition agreement to maintain and repair the aircraft. The agreement was based on §1110's provision that the automatic stay remains in effect against aircraft equipment lessors if the debtor agrees to "perform all of the obligations of the debtor that become due" under the equipment lease. The wording of §1110 is identical to that of §365(d)(3), and the analysis is applicable according to landlords. Thus, the Bankruptcy Code, it is argued, imposes the obligation to comply with the terms of a SNF lease when the debtors elect to use the landlord's facilities and not reject or abandon the leases.

None of these arguments are without a response by debtors operating SNFs. Debtors can assert that leases for SNFs are leases for residential real property. Therefore, §365(d)(3), which is limited to leases of non-residential real property, would not apply. See In re Texas Health Enterprises Inc., 255 B.R. 181, 184 (Bankr. E.D. Tex. 2000) (SNF lease is for property with characteristics of both residential and non-residential real property and, therefore, §365(d)(3) does not apply). Moreover, arguments can be made that some requirements under unexpired leases are not the kind of "obligations" intended to be covered by §365(d)(3). For example, in Macy, the court distinguished among various kinds of obligations for a lease, saying that "each and every lease covenant which could conceivably be pigeon-holed into the term 'obligation'" is not suitable for treatment under §365(d)(3). 170 B.R. at 74.

Similarly, in In re Ernst Home Center Inc., 209 B.R. 955 (Bankr. W.D. Wash. 1997), the debtor was the anchor tenant at a mall and, during the bankruptcy, closed in violation of a continuous-use convenant. Other tenants asserted that their leases allowed them to abate their rent or terminate their leases entirely if the anchor tenant's store went "dark" for a period of time. The landlord moved for payment of administrative expenses, including the rent it had lost as a result of the other tenant's rent abatement, relying on §365(d)(3). The court, after examining §365(d)(3)'s legislative history, concluded that consequential damages were not contemplated by Congress and that only obligations "that can be identified and quantified by the express terms of the lease" were appropriately considered as controlled by §365(d)(3). Id. at 961. Excluded from §365(d)(3)'s control were claims "which require resort to litigation and proof before both the entitlement to and amount of damages can be determined." Id.

In summary, lessors of SNFs have powerful arguments that they are entitled to administrative expense status and payment. However, as a practical matter, because their decisions have far-reaching consequences, bankruptcy judges will be narrowly construing requests for such status.

Journal Date: 
Thursday, March 1, 2001

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