Setoff of Rejection Damages under 553 A Strained and Imaginative Interpretation

Journal Issue

Jul/Aug 2006

Column Name

News at 11

Citation

ABI Journal, Vol. XXV, No. 6, p. 36, July/August 2006

Bankruptcy Code

365

502

553

Topic Tags

Executory Contracts/Leases

Journal HTML Content

Setoff, a powerful collection tool for creditors,
is protected by §553(a) of the Bankruptcy Code—which
provides, with some exceptions, that the Code "does not affect
any right of a creditor to offset a mutual debt owing by such creditor

to the debtor that arose [pre-petition] against a claim of such
creditor against the debtor that arose [pre-petition]." Thus, by
the language of this provision, the Code preserves any setoff right
that a creditor would have under state law. But what happens when a

creditor's claim is based on the debtor's rejection of an executory
contract in a bankruptcy case? Under §365(g) of the Code,
"the rejection of an executory contract or unexpired lease of the
debtor constitutes a [pre-petition] breach of such contract or
lease." And under §502(g), the claim that arises from such
rejection is determined—and allowed or disallowed—as if
such claim had arisen pre-petition. Thus, by the plain language of
§§365(g) and 502(g), it appears that a rejection damage
claim is for all intents and purposes a pre-petition claim. Therefore,

a rejection damage claim would be a pre-petition claim for purposes of

setoff under §553. Indeed, two leading bankruptcy
treatises1 and the two bankruptcy courts that have actually

ruled on this issue in published opinions concluded that a rejection
damage claim can be offset under §553. However, in In re Delta

Airlines Inc.,2 the bankruptcy court cut against the
grain, concluding that a rejection damage claim is not subject to a
setoff under §553 of the Code because a rejection damage claim does

not arise pre-petition, but rather post-petition at the time of
rejection. This article will (1) discuss the facts and legal analyses

of the two cases that directly addressed whether a rejection-damage
claim is a pre-petition claim, and (2) analyze the facts in

Delta and discuss the bankruptcy court's conclusion that a
rejection-damage claim is not a pre-petition claim subject to a
setoff. Rejection Damages Can Be Offset Against a Pre-Petition
Debt Express Freight Lines, Inc. v. Kelly (In re
Express Freight Lines, Inc.).3 Frank C. Kelly purchased

a truck terminal facility from Express Freight Lines
(Express).4 Express financed $100,000 of the purchase
price, and Kelly was obligated to make monthly payments of $2,211.83
over a 60-month period.5 When Express filed its chapter 11
petition, Kelly still owed $78,761 to Express. At the time of the
purchase, Kelly and Express entered into a leaseback agreement under
which Kelly agreed to lease to Express a portion of the terminal
facility for five years.6 Under this leaseback agreement,
Express was obligated to make monthly payments of $12,500 to Kelly. By

the terms of the promissory note, however, Kelly's monthly payments of

$2,211.83 were offset against Express' monthly lease
payments.7 Thus, Express paid $10,288.17 per month to
Kelly.8 Express filed its chapter 11 petition on June 16,
1989, and later rejected the leaseback agreement.9 Kelly
had a $19,099.50 pre-petition claim based on a pre-petition default
and a rejection damage claim of $150,000 (based on one year's rent
allowed under §502(b)(6) of the Code) for a total claim of
$169,099.50.10 Kelly claimed that he had a secured claim of
$78,761 (the remaining amount on his note) and an unsecured claim for
the remainder.11 The court concluded that "since the
lease was not assumed, the rejection 'constitutes a breach of
such...lease... immediately before the date of the filing of
the petition.'"12 And since §502(g) classifies
rejection claims as pre-petition claims, Express' rejection of the
leaseback agreement "resulted in a $169,099.50 claim for Kelly as

of a point in time immediately before the filing of the
petition."13 Thus, this satisfied the pre-petition
requirement for setoff under §553 of the Code.14 The
court next determined whether Kelly could offset his pre-petition claim

against the remaining note payments that became due after Express filed

for bankruptcy.15 First, the court looked at In re Isis
Foods Inc.:16 <blockquote> It is patent law on the
issue of setoff, however, that "the right of setoff may be
asserted in the bankruptcy case, even though at the time the
petition is filed one of the debts involved is absolutely owing but not
presently due, or where a definite liability has accrued but is as
yet unliquidated. Nor is it necessary that the debt sought to be
setoff be due when the case is commenced."

</blockquote>Based on Isis Foods, the court concluded that

it does not matter if either debt is unmatured when the bankruptcy
petition is filed to determine eligibility for setoff under §553.

Moreover, the court looked at the definitions of claim and debt under

§101. Since "claim" is defined as "a right to
payment, whether or not such right is reduced to judgment, liquidated,

unliquidated, fixed, contingent, matured, unmatured, disputed,
undisputed, legal, equitable, secured or unsecured," and
"debt" is defined as a "liability on a claim," it
clearly follows that a debt owed by a creditor to the debtor can be an

unmatured liability.17 Thus, pre-petition unmatured debts
owed to a debtor can be accelerated to accomplish a setoff under
§553 if the other requirements of setoff have also been
satisfied.18 The court therefore concluded that Kelly's note
was a pre-petition debt subject to a setoff.19 In re
Mace Levin Associates.20 Although the debtor filed for
chapter 11 relief on July 21, 1987, the case was converted to chapter 7

approximately five months later.21 The chapter 7 trustee
requested authority to proceed with pre-petition arbitration to
liquidate his claim against Clairton Corp. based on a lease agreement
dated Feb. 24, 1986.22 Clairton did not object to such
relief as long as it obtained relief from the automatic stay to assert

a counterclaim for damages arising out of the post-petition rejection
of the lease.23 The trustee argued that setoff of Clairton's

rejection damage claim is not permissible under §553.24

The court stated that the fundamental issue was whether §553
permits setoff of a creditor's rejection damage claim.25
The court explained that for the trustee to prevail on his argument
that Clairton's rejection damage claim was a post-petition rather than

a pre-petition claim, the trustee would have to overcome
§§365(g) and 502(g) of the Code; these sections mandate that

a rejection of an executory contract "constitutes a breach of
such...lease...immediately before the date of the filing of the
petition," and such claim arising from such breach is a
pre-petition claim.26 But the trustee argued that
§502(g) is only intended to ensure that a rejection damage claim
does not transform into an administrative-priority claim; to treat a
rejection damage claim as a "pre-petition claim" is a mere
legal fiction.27 The trustee further argued that by treating
a rejection damage claim as a pre-petition claim for purposes of
§553, the burden on the debtor's estate would
increase.28 The court explained that the trustee's
argument was "really an argument against setoff itself and, in
enacting §553, Congress decided otherwise."29 The

court further explained that <blockquote> [t]he characterization of
rejection claims as pre-petition obligations is not simply a legal
fiction created by §§365(g) and 502(g). The lease was
entered into pre-petition and by virtue of this fact imposed
pre-petition obligations on both parties. Given its long-term and
continuing nature, however, it could have been transmuted into a
post-petition obligation had the debtor assumed it.30

</blockquote>Indeed, the court reasoned that the Code allows a
debtor some time to decide whether or not to assume or reject, thereby

putting leases and executory contracts "on hold in a peculiar
legal limbo."31 It did not matter to the court that
some uncertainty existed as to Clairton's claim at the time of the
bankruptcy filing.32 But this uncertainty, the court
explained, was not fatal to the claim's pre-petition
status;33 a "claim need not have matured or been
liquidated in order to apply §553."34
Rejection Damage Claim Cannot Be Offset against a Pre-Petition
Debt In In re Delta Airlines Inc.,35 the
Greater Orlando Aviation Authority (GOAA) requested relief from the
automatic stay to offset under §553 certain credits in favor of
Delta Airlines Inc. against a rejection damage claim.36 The

court held that "(1) as a matter of law, rejection damages under
§§365(g) and 502(g) may not be set off against a
pre-petition claim or debt and (2) in any event, on the facts...the
credits in question were not debts or claims that existed or 'arose'
pre-petition."37 On June 1, 1978, Delta and GOAA
entered into a lease. This lease was one of many leases that GOAA
entered into with certain airlines, including Delta. Under the lease,
Delta was obligated to pay certain amounts to GOAA during each fiscal
year ending Sept. 30 for use and occupancy of the Orlando
Airport.38 The lease provided that if the airport
"generated a net revenue surplus by the end of the fiscal year,
that surplus would be credited after the fiscal year on a pro
rata basis to each...airline."39 No funds were due

to any airline; rather, GOAA would make a journal entry in its books
reflecting the "credit." The lease required GOAA to apply the
credits as an offset against Delta's "airline fees and charges
for the first three months of [the] next succeeding fiscal
year."40 At the end of fiscal year 2005, Delta was
entitled to approximately $4.3 million in credits for that fiscal
year. GOAA refused to apply Delta's credits as offsets for any amounts

owed by Delta during fiscal year 2006. In early December 2005, Delta
notified GOAA that it planned to reject the lease.41 GOAA
acknowledged that it did not apply the fiscal year 2005 credits
against any amounts owed by Delta during fiscal year 2006 because it
anticipated that it would have a rather large rejection damage claim,
which it intended to offset against Delta's credits. On Dec. 22, 2005,

Delta filed its motion to reject the lease, and the court entered an
order granting the motion on Feb. 22, 2005. On Jan. 5, 2006, however,
GOAA filed its motion for relief from stay to offset its rejection
damage claim against the credits due to Delta.42

<blockquote><blockquote>
<hr>
<big><center>
There appear to be only two cases, In re Express Freight Lines
Inc. and In re Mace Levin Associates, that have directly ruled

on the rejection damage claim/setoff issue.
</center></big>
<hr>
</blockquote></blockquote>

The court looked at the language of §553 of the Code and
concluded that §553 only applies to a right to offset mutual
debts "that arose before the commencement of the
case."43 The bankruptcy court explained that the
language of §553—"this title does not affect any right

of a creditor to offset" mutual debts—confirms that §553

does not create a federal right of setoff; it does not "enhance,
diminish or otherwise modify any state law right of
setoff."44 In interpreting these two points, the court

could only conclude that "if no right to setoff under state law
existed before the commencement of the case, none exists under
§553."45 Of course, GOAA relied upon
§§365(g) and 502(g), which provide that a rejection of an
executory contract constitutes a pre-petition breach and the claim
that arises from such breach is allowed or disallowed the same as if the

claim had arisen pre-petition.46 But the bankruptcy court
explained that the provisions of the Code cannot affect state law
setoff rights: "To invoke §§365(g) and 502(g) to create

a right of setoff where none exists under state law would defy [t]he
unambiguous language in §553" that provides that the Code
"does not affect any right of a creditor to offset a mutual
debt."47 Conclusion There appear to be only

two cases, In re Express Freight Lines Inc. and In re Mace
Levin Associates, that have directly ruled on the rejection damage

claim/setoff issue. Both cases based their reasoning on
§§365(g) and 502(g) for concluding that a rejection damage
claim is subject to a setoff under §553 since a rejection damage
claim is deemed to be a pre-petition claim by operation of law.

Thus, the bankruptcy court in Delta is the first court, it
appears, to conclude in a published opinion that for purposes of
§553, a rejection damage claim arises post-petition by relying
solely on the language of §553. The Delta court would
conclude that an interpretation in which a rejection damage claim is
treated as a pre-petition claim for purposes of §553 is a
"strained or imaginative interpretation...not constituent with the
plain and ordinary usage and meaning of the statutory language"
of §55348—even though §§365(g) and
502(g) state otherwise. It is safe to say that the other courts that
decided that a rejection-damage claim is subject to offset based on
the plain language of §§365(g) and 502(g) would conclude
that the Delta court is the one engaging in strained and
imaginative statutory interpretation. In any event, few courts have
analyzed this issue and it will be left for the bankruptcy courts and
other federal courts to determine exactly who is employing a strained
or imaginative interpretation of the Code.

<blockquote><blockquote> </blockquote></blockquote><hr><h3>Footnotes</h3>

1 See Norton, William L. Jr., 3 Norton Bankruptcy Law and
Practice 2D §63:4 ("the timely post-petition rejection
of an executory contract creates a pre-petition claim subject to
setoff by the operation of the 'relation-back' rule of 502(g)");
King, Lawrence P., 5 Collier on Bankruptcy |553.03(i)(i)
("claims based upon the debtor's rejection of an executory
contract or unexpired lease, which are specifically designated as
pre-petition in nature [under] §§365(g) and 502(g), are
eligible for setoff against mutual pre-petition debts"). 2

341 B.R. 439 (Bankr. S.D.N.Y. 2006). 3 130 B.R. 288 (Bankr. E.D.
Wis. 1991). 4 Id. at 289. 5 Id. 6

Id. 7 Id. 8 Id. at 290. 9
In re Express Freight Lines Inc., 130 B.R. at 290. 10
Id. 11 Id. 12 Id. at 291-92. The
court's conclusion implies that if a debtor assumes an executory
contract, then the post-petition contractual obligations of the debtor

are post-petition obligations. Compare United States v.
Gerth, 991 F.2d 1428 (8th Cir. 1993) ("assumption of an
executory contract does not alter when the obligations arose...
If...the contract terms are such that [the] obligation to pay arose
pre-petition, then a holding by this court that simply assuming the
contract causes the obligation to arise post-petition would have the
effect of modifying those contract terms"). This case was cited
in Norton Bankruptcy Law and Practice 2D as support for its
conclusion that a rejection-damage claim is subject to a setoff.

See Norton, supra at n. 1. 13 In re Express
Freight Lines Inc., 130 B.R. at 290 (emphasis in original).
14 Id. 15 Id. at 292. 16 24 B.R. 75,
77 (Bankr. W.D. Mo. 1982) (quoting 4 Collier on Bankruptcy

|553.10(2) (1982)). 17 In re Express Freight Lines Inc.,

130 B.R. at 292-93. 18 Id. at 293. 19 Id. at

293. 20 103 B.R. 141 (Bankr. N.D. Ohio 1989). 21

Id. at 142. 22 Id. 23 Id. 24
Id. 25 Id. at 143. 26 In re Mace Levin
Assocs., 103 B.R. at 143. 27 Id. at 143. 28

Id. at 143. 29 Id. at 143. 30 Id. at
144. 31 Id. 32 In re Mace Levin Assocs., 103

B.R. at 144. 33 Id. 34 Id. 35 In
re Delta Airlines Inc., 341 B.R. 439 (Bankr. S.D.N.Y. 2006).

36 Id. at 441. 37 Id. 38 Id.
39 Id. 40 Id. Despite the language of the
lease, GOAA would offset the credits against the amounts owed by the
airlines during any of the 12 months of the next fiscal year in
accordance with the direction of each airline. Id. 41

In re Delta Airlines Inc., 341 B.R. at 442. 42 Id.
43 Id. at 443. 44 Id. 45 Id.
at 445. The bankruptcy court also concluded that a plain language
analysis of §553 could only lead to its conclusion: "Congress
could have written §553 to permit offset of rejection claims
against pre-petition debts owed to the debtor, or not permit such
offset, without doing violence to any overreaching policy or objective

embodied in the Bankruptcy Code or any cosmic notion of justice or
fairness." Id. at 446. 46 Id. at 446.

47 In re Delta Airlines Inc., 341 B.R. at 446-47.
48 Id. at 445.

Journal Authors

Kenneth Michael Misken

Journal Date

Saturday, July 1, 2006 - 12:00

Bankruptcy Rule

2006

none