Debtor Misconduct and Administrative Rejection Claims

Can a debtor's conduct give rise to an administrative rejection claim? The answer to this question was set forth in a memorandum opinion issued by U.S. Bankruptcy Judge Mary F. Walrath on March 31 in The Matter Fleming Cos. Inc., et al., debtors, Case No. 03-10945.

The factual background in this case is that on Dec. 4, 1998, the debtors' LaCrosse Division entered into a refrigeration supply agreement with Wisvest Corp. for services to be performed at the debtors' LaCrosse warehouse. After entering into this agreement, Wisvest assigned it to Northstar Refrigeration LLC.

On April 1, 2003, the debtor and several of its affiliates filed voluntary petitions under Chapter 11 of the Bankruptcy Code. At the time of the filing of the petitions, the debtors were in the wholesale grocery distribution business, including the retail grocery business and the convenience store distribution business.

Subsequently, the debtors filed a motion to sell substantially all of their wholesale distribution business assets, including the LaCrosse warehouse. The court entered an order approving the asset purchase agreement between the debtors and C&S Wholesale Grocers Inc. The sale order granted the debtors authority to transfer the LaCrosse Warehouse to C&S, and further provided that C&S could require the debtors to assume or reject certain leases or executory contracts, upon notice to the contract parties.

Subsequently, the debtors provided notice of their intention to transfer the LaCrosse Warehouse to Supervalu (a designated third-party purchaser). Northstar, the successor to the refrigeration supply contract, filed a limited objection to the transfer because the sale did not provide for the purchase of its refrigeration equipment or the assumption and assignment of the refrigeration supply agreement. The court entered a supplemental order approving the sale of the LaCrosse warehouse to Supervalu.

Supervalu subsequently directed the debtors, as permitted in the asset purchase agreement, to file a motion to reject the refrigeration supply agreement pursuant to Section 365(a) of the Bankruptcy Code. The other party to the refrigeration supply agreement objected to the rejection asserting that the debtors failed to satisfy their post-petition contractual obligations under the agreement.

The court pointed out that Chapter 11 U.S. Code Section 365(a) provides that a debtor in possession may reject an executory contract or unexpired lease upon court approval. The decision to reject an executory contract is a matter within the sound business judgment of the debtor.

Northstar did not object to the debtors' right to reject the refrigeration supply agreement but argued that it must first satisfy its post-petition obligations under the agreement.

The court then pointed out that when a debtor rejects an executory contract, the rejection constitutes a breach of such contract occurring immediately before the date the debtor filed its bankruptcy petition as stated in Chapter 11 U.S.C. Section 365(g). Typically, damages on such rejected executory contracts have priority as a general unsecured creditor. (N.L.R.B. v. Bildisco and Bildisco, 465 U.S. 513, 531 (1984).)

Northstar asserted, however, that the debtors' post-petition conduct created an administrative claim under Section 365(d)(10), and thus its claim was outside the scope of Section 365(g).

Section 365(d)(10) provides that “the trustee shall timely perform all of the obligations of the debtor … arising from or after 60 days after the order for relief under an unexpired lease of personal property … until such lease is assumed or rejected.”

The Third Circuit Court of Appeals has not specifically addressed the application of Section 365(d)(1) under these circumstances. It has, however, addressed substantially similar language. In In Re Montgomery Ward, 268 F.3d 205 (3d Cir. 2001), the Third Circuit, in applying Section 365(d)(3), concluded that a debtor must timely perform all leasehold obligations as they come due and that “such an obligation arises when one becomes legally obligated to perform.”

Thus, the court in the Montgomery Ward case concluded that the debtor was responsible for all obligations that arose post-petition and prior to rejection, including those limited to annual real estate taxes that were billed post-petition even though they were for a pre-petition period.

The bankruptcy court, in In re Muma Services Inc., 279 B.R. 478 (Bankr. D. Del. 2002), addressed the application of Montgomery Ward to Section 365(d)(10). In the Muma Services Inc. matter, the court concluded that the Third Circuit would construe Section 365(d)(10) in the same manner that it construed Section 365(d)(3).

Judge Walrath accurately pointed out that if a lease obligation arises after the 60th day of the bankruptcy case, and prior to the rejection of the lease, Section 365(d)(10) requires the debtor to timely pay the obligation unless the court provides otherwise based on the equities of the case.

It is based upon this conduct on the part of the debtors that Northstar asserted its administrative claim

arising under the refrigeration supply agreement. In particular, Northstar asserted that by selling the LaCrosse Warehouse (and its perishable inventory) before rejecting the refrigeration supply agreement, the debtors triggered paragraph 8 of that agreement.

Paragraph 8 of the agreement provides that “if during the term of the lease the debtor shall enter into an agreement for sale of the building, the debtor shall purchase the refrigeration equipment.” Accordingly, Northstar contended that it has an administrative claim based on this purchase obligation.

The debtors' argument is that the claim does not rise to an administrative claim because the debtors did not assume the agreement and the court never approved the assumption of the agreement.

The bankruptcy court pointed out that under Section 365 (d)(10), assumption of the contract is not required for the enforcement of a lease obligation triggered by the debtors' post-petition conduct. In this matter, the uncontested facts clearly establish that the debtors did not reject the refrigeration supply agreement until after it sold the LaCrosse Warehouse.

Obviously this decision was not inadvertent and was planned conduct on the part of the debtors. The debtors had sold both the warehouse and its inventory (which obviously was refrigerated), and the buyer delayed rejection of the refrigeration supply agreement until it could dispose of the perishable inventory. The court, by applying Montgomery Ward and its decision in Muma, concluded that the debtors are obligated under Section 365(d)(10) to satisfy the contractual obligations triggered by their post-petition and pre-rejection conduct.

Accordingly, the court concluded that the debtors were obligated to buy the refrigeration equipment from Northstar, the successor party to the supply contract. Furthermore, since that obligation arose post-petition and prior to rejection, it is an administrative claim.

Comment

Asset purchase agreements under the Bankruptcy Code are complex. Counsel should investigate the ramifications of such sale of equipment leases and executory contracts during the negotiation period. After the sale is approved by the court, it may be too late, as this case clearly points out. All business contingencies should be reviewed by counsel.

This article originally appeared in The Legal Intelligencer, an American Lawyer Media publication.

Can a debtor's conduct give rise to an administrative rejection claim? The answer to this question was set forth in a memorandum opinion issued by U.S. Bankruptcy Judge Mary F. Walrath on March 31 in The Matter Fleming Cos. Inc., et al., debtors, Case No. 03-10945.

The factual background in this case is that on Dec. 4, 1998, the debtors' LaCrosse Division entered into a refrigeration supply agreement with Wisvest Corp. for services to be performed at the debtors' LaCrosse warehouse. After entering into this agreement, Wisvest assigned it to Northstar Refrigeration LLC.

On April 1, 2003, the debtor and several of its affiliates filed voluntary petitions under Chapter 11 of the Bankruptcy Code. At the time of the filing of the petitions, the debtors were in the wholesale grocery distribution business, including the retail grocery business and the convenience store distribution business.

Subsequently, the debtors filed a motion to sell substantially all of their wholesale distribution business assets, including the LaCrosse warehouse. The court entered an order approving the asset purchase agreement between the debtors and C&S Wholesale Grocers Inc. The sale order granted the debtors authority to transfer the LaCrosse Warehouse to C&S, and further provided that C&S could require the debtors to assume or reject certain leases or executory contracts, upon notice to the contract parties.

Subsequently, the debtors provided notice of their intention to transfer the LaCrosse Warehouse to Supervalu (a designated third-party purchaser). Northstar, the successor to the refrigeration supply contract, filed a limited objection to the transfer because the sale did not provide for the purchase of its refrigeration equipment or the assumption and assignment of the refrigeration supply agreement. The court entered a supplemental order approving the sale of the LaCrosse warehouse to Supervalu.

Supervalu subsequently directed the debtors, as permitted in the asset purchase agreement, to file a motion to reject the refrigeration supply agreement pursuant to Section 365(a) of the Bankruptcy Code. The other party to the refrigeration supply agreement objected to the rejection asserting that the debtors failed to satisfy their post-petition contractual obligations under the agreement.

The court pointed out that Chapter 11 U.S. Code Section 365(a) provides that a debtor in possession may reject an executory contract or unexpired lease upon court approval. The decision to reject an executory contract is a matter within the sound business judgment of the debtor.

Northstar did not object to the debtors' right to reject the refrigeration supply agreement but argued that it must first satisfy its post-petition obligations under the agreement.

The court then pointed out that when a debtor rejects an executory contract, the rejection constitutes a breach of such contract occurring immediately before the date the debtor filed its bankruptcy petition as stated in Chapter 11 U.S.C. Section 365(g). Typically, damages on such rejected executory contracts have priority as a general unsecured creditor. ( N.L.R.B. v. Bildisco and Bildisco , 465 U.S. 513, 531 (1984).)

Northstar asserted, however, that the debtors' post-petition conduct created an administrative claim under Section 365(d)(10), and thus its claim was outside the scope of Section 365(g).

Section 365(d)(10) provides that “the trustee shall timely perform all of the obligations of the debtor … arising from or after 60 days after the order for relief under an unexpired lease of personal property … until such lease is assumed or rejected.”

The Third Circuit Court of Appeals has not specifically addressed the application of Section 365(d)(1) under these circumstances. It has, however, addressed substantially similar language. In In Re Montgomery Ward, 268 F.3d 205 (3d Cir. 2001), the Third Circuit, in applying Section 365(d)(3), concluded that a debtor must timely perform all leasehold obligations as they come due and that “such an obligation arises when one becomes legally obligated to perform.”

Thus, the court in the Montgomery Ward case concluded that the debtor was responsible for all obligations that arose post-petition and prior to rejection, including those limited to annual real estate taxes that were billed post-petition even though they were for a pre-petition period.

The bankruptcy court, in In re Muma Services Inc., 279 B.R. 478 (Bankr. D. Del. 2002), addressed the application of Montgomery Ward to Section 365(d)(10). In the Muma Services Inc. matter, the court concluded that the Third Circuit would construe Section 365(d)(10) in the same manner that it construed Section 365(d)(3).

Judge Walrath accurately pointed out that if a lease obligation arises after the 60th day of the bankruptcy case, and prior to the rejection of the lease, Section 365(d)(10) requires the debtor to timely pay the obligation unless the court provides otherwise based on the equities of the case.

It is based upon this conduct on the part of the debtors that Northstar asserted its administrative claim

arising under the refrigeration supply agreement. In particular, Northstar asserted that by selling the LaCrosse Warehouse (and its perishable inventory) before rejecting the refrigeration supply agreement, the debtors triggered paragraph 8 of that agreement.

Paragraph 8 of the agreement provides that “if during the term of the lease the debtor shall enter into an agreement for sale of the building, the debtor shall purchase the refrigeration equipment.” Accordingly, Northstar contended that it has an administrative claim based on this purchase obligation.

The debtors' argument is that the claim does not rise to an administrative claim because the debtors did not assume the agreement and the court never approved the assumption of the agreement.

The bankruptcy court pointed out that under Section 365 (d)(10), assumption of the contract is not required for the enforcement of a lease obligation triggered by the debtors' post-petition conduct. In this matter, the uncontested facts clearly establish that the debtors did not reject the refrigeration supply agreement until after it sold the LaCrosse Warehouse.

Obviously this decision was not inadvertent and was planned conduct on the part of the debtors. The debtors had sold both the warehouse and its inventory (which obviously was refrigerated), and the buyer delayed rejection of the refrigeration supply agreement until it could dispose of the perishable inventory. The court, by applying Montgomery Ward and its decision in Muma, concluded that the debtors are obligated under Section 365(d)(10) to satisfy the contractual obligations triggered by their post-petition and pre-rejection conduct.

Accordingly, the court concluded that the debtors were obligated to buy the refrigeration equipment from Northstar, the successor party to the supply contract. Furthermore, since that obligation arose post-petition and prior to rejection, it is an administrative claim.

Comment

Asset purchase agreements under the Bankruptcy Code are complex. Counsel should investigate the ramifications of such sale of equipment leases and executory contracts during the negotiation period. After the sale is approved by the court, it may be too late, as this case clearly points out. All business contingencies should be reviewed by counsel.

This article originally appeared in The Legal Intelligencer, an American Lawyer Media publication.