What Happens to Environmental Costs in a Bankruptcy?

“How did you go bankrupt?” Bill asked.
“Two ways,” Mike said. “Gradually and then suddenly.”

The Sun Also RisesErnest Hemingway

Those living in Southeastern Michigan are probably learning more about bankruptcy than they ever cared to learn. Even at a 10-mile high level, surveying the complicated ways an entity can continue its business and creditors collect a fraction of what is owed them can be pretty confusing. What happens if there are environmental costs, fines and penalties? Do these costs get paid or are they dischargeable?

In essence, bankruptcy under Chapter 11 of the Bankruptcy Code allows an entity to reorganize and establishes a plan whereby creditors can get paid. Creditors make a claim on the bankruptcy estate, but a bankruptcy court may also designate certain costs as an administrative expense priority. That is, there are ongoing expenses that are incurred after bankruptcy that are required to keep an entity operating and cannot be discharged in bankruptcy.

Among the ongoing activities of an entity in bankruptcy may include the costs of environmental compliance. In essence, bankruptcy proceedings do not provide an excuse for an ongoing concern to avoid its obligation to comply with environmental laws and regulations. Otherwise, it could avoid the costs of compliance, while its solvent competitors would remain obligated to follow the law. The question gets dicier when the costs related to environmental compliance come in the form of fines and penalties.

Recently, the Court of Appeals for the First Circuit considered the issue of whether fines and penalties incurred by a debtor in bankruptcy were compensable as an administrative expense. In that case, the New Hampshire Department of Environmental Services (NHDES) notified a company that distributed fuel and owned and operated fuel in above-ground storage tanks (ASTs) that it was in violation of laws requiring that the ASTs they owned needed secondary containment, which collects escaped fuel in the event of a release from the ASTs. The company did not correct the deficiencies identified by the NHDES.

NHDES filed an enforcement action against the company, seeking injunctive relief and civil penalties for noncompliance. NHDES ultimately prevailed, and a state court required the company to brings its facilities into compliance or take them out of service. The company did not comply with the order and NHDES filed a motion to find the company in contempt.

While the motion was pending, the company filed for Chapter 11 bankruptcy. Because the matter was in bankruptcy, the state court stayed its proceedings, but the bankruptcy court ruled that the state case could proceed. The state court then issued NHDES motion for contempt against the company.

The state’s court order required the company to take all of its ASTs out of service within 10 days or face penalties of $1,000 per day. The company did not appeal the state court’s decision and later the court issued a judgment for $192,000 in civil penalties for the company’s failure to comply with court’s order. NHDES then went to the bankruptcy court and asked it to rule that the civil fines were an administrative priority claim. The bankruptcy court granted the NHDES motion.

Once an entity files for bankruptcy, claims against it are categorized as “pre-petition” and post-petition.” Those making pre-petition claims get only a portion of what they are owed, while post-petition claims usually recover their costs (so long as the entity has assets). On appeal, the company argued that the fines were the result of “pre-petition” actions and could not be considered administrative expenses. NHDES took the position that the fines resulted from the company’s actions occurring after bankruptcy.

The Court of Appeals sided with NHDES and sustained the bankruptcy court’s ruling. It found the fact that the violations of law occurred before filing as irrelevant. Instead, the Court noted that the fines were issued as a result of the company’s failure to comply with the state court’s order to come into compliance, which occurred after the company filed for bankruptcy. The Court also disagreed with the company that there was a distinction between “compensatory” fines and civil fines; both would qualify as administrative expenses and thus were given “first priority treatment.”

Citing another First Circuit opinion, the Court described its reasoning as follows:

“We reasoned that in light of ‘today’s extensive environmental regulations,’ the payment of a fine for failing to comply with those regulations is ‘a cost ‘ordinarily incident to the operation of a business.’’ * * * We also observed that ‘[d]ebtors in possession do not have carte blanche to ignore state and local laws protecting the environment against pollution.’ * * * The fact that the fine at issue did not compensate private parties * * * did not change our conclusion that it would be ‘fundamentally unfair’ * * * to allow [the party] to actively flout [the State’s] environmental laws and avoid paying a civil penalty simply because it was involved in a Chapter 11 reorganization.”

Our own Sixth Circuit Court of Appeals is in full agreement with the First Circuit as is the Supreme Court. The focus on the inquiry is when these fines are incurred. Were they incurred before filing bankruptcy or after? If some of the fines were incurred before and some after, the fines incurred after bankruptcy, even for pre-petition actions, can be considered administrative expenses. But the mere filing of bankruptcy does not protect an entity for complying with the law and fines incurred after filing will mean that money from the bankruptcy may not be available (or less available) for those filing claims.

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