Non-operating Trustees and 28 U.S.C. 959(b) The Meter May Be Running

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Dec/Jan 1998

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You have just been appointed a chapter 7 or 11 trustee, and you have been placed in charge of an estate that is out of

compliance with state regulatory law in some form or fashion. Do you have to bring the estate into compliance with

state law? Are you incurring administrative expenses for being out of compliance? Does it make a difference if you

are operating or liquidating the estate?

In an apparent case of first impression of particular significance to liquidating trustees and regulators alike, the

Fifth Circuit recently joined several other courts in ruling that a bankruptcy trustee who is not using estate property

to generate income nonetheless has to comply with state law with respect to that estate property, under 28 U.S.C.

§959(b). State of Texas v. Lowe (In re HLS Energy Co. Inc.), 151 F.3d 434 (5th Cir. 1998). Further, the court

ruled that the cost of such compliance constituted an 11 U.S.C. §503(b)(1)(A) administrative expense.

HLS involved a state's request that its claim for reimbursement of well-plugging expenses be given

administrative expense priority in the bankruptcy of an oil and gas operator. HLS's chapter 11 trustee, and

subsequently its chapter 7 trustee, inherited several unproductive oil and gas wells for which HLS had exclusive

operating rights. Although Texas law did not require that the subject wells be plugged as of the petition date, their

continued inactivity triggered an obligation under state law to plug the wells. The estate did not have the funds at

the time to plug the wells. The state plugged the wells on behalf of the estate, then the Attorney General sought

reimbursement from the estate for the plugging expenses.

The chapter 7 trustee objected to the administrative expense treatment for the state's claim. The primary

question before the Fifth Circuit was whether the claim was a §503(b)(1)(A) administrative expense claim for

preservation of the estate. The court found that the reimbursement claim was entitled to administrative expense

priority.

It may be helpful to begin with a brief background of 28 U.S.C. §959(b) and its application in bankruptcy cases.

By its terms, §959(b) requires debtors and trustees to obey valid state law. Section 959(b) states, in pertinent part,

that "a trustee, receiver or manager appointed in any cause pending in any court of the United States, including a

debtor-in-possession, shall manage and operate the property in his possession 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."

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The HLS decision certainly suggests that the statutory and regulatory

obligations that accompany an estate's property rights cannot be

abdicated, even by a liquidating trustee.

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Courts have had no difficulty in finding that §959(b) requires operating debtors to comply with applicable state

law. In re Al Copeland Enterprises, 991 F.2d 233, 237 (5th Cir. 1993); Robins v. Mich. Cons. Gas Co. Inc., 918

F.2d 579, 585 (6th Cir. 1990); and In re N.P. Mining Co. Inc., 963 F.2d 1449, 1453 (11th Cir.1992). What was

not so well-established until recently, at least in the Fifth Circuit, was the obligation of a liquidating bankruptcy

trustee to obey state law.

In Midlantic Nat'l Bank v. New Jersey Dep't of Envtl. Protection, 474 U.S. 494, 106 S.Ct. 755 (1986), the

U.S. Supreme Court explained that §959(b) revealed that Congress did not intend for the Bankruptcy Code to

"pre-empt all state laws that otherwise constrain the exercise of a trustee's powers." 474 U.S. at 505. The Midlantic

case involved a question of whether a chapter 7 trustee could abandon certain estate property that posed an imminent

risk to human health and safety. The court, although not going so far as to state that §959(b) applied to the

liquidating trustee, ruled that the subject property had to remain part of the estate and was subject to applicable

environmental statutes.

Some circuit courts have since interpreted Midlantic as necessarily requiring that estate property that constituted

a significant health and human safety risk could not be abandoned, and that therefore such property must be

maintained or remediated in compliance with applicable law. Under those circumstances, expenses to do so were

"necessary" in a §503(b)(1)(A) context. See, e.g., In re Wall Tube & Metal Products Co., 831 F.2d 118, 123-24

(6th Cir. 1987) and Com. of Pa. v. Conroy, 24 F.3d 5678 (3rd Cir. 1994). However, both of these courts based

their decisions in large part on the significance of protecting the environment and public health.

In Wall Tube, for instance, the Sixth Circuit observed that "Midlantic...created a special emphasis on the

importance of complying with laws that protect the public health and safety." 831 F.2d 118, 122. The Wall Tube

court further found that the fact that the trustee was "liquidating...rather than reorganizing" the estate was not

relevant, "especially in the critical context of the public's welfare." 831 F.2d 118, 122. Similarly, in Conroy, the

Pennsylvania environmental regulators were awarded administrative expense status for the cost of cleaning up a

chapter 11 debtor's hazardous waste site. The Sixth Circuit noted that Midlantic apparently meant that since the

debtor could not have abandoned the site in question, it would have had to have cleaned up its site (had the state

not done it) and would thus have incurred administrative expenses. 24 F.3d 568, 569.

It is undisputed in HLS that neither the chapter 11 nor the chapter 7 trustee ever actually conducted business

using the estate property in question (i.e., exercised its right to operate the subject unproductive oil and gas wells).

A number of lower court cases from other circuits have stated that §959(b) was an attempt by Congress to prevent

bankrupt entities from gaining an unfair advantage by being spared the cost of complying with state law, unlike their

competitors. See, e.g., In re Valley Steel Products Co., 157 B.R. 442, 448 (Bankr. E.D. Mo. 1993) and Matter of

Borne Chemical Co. Inc., 54 B.R. 126, 135 (Bankr. D. N.J. 1984). Urging those cases, the chapter 7 trustee in

HLS argued that §959(b) could therefore not apply to him (or to the chapter 11 trustee) because they were not

"managing and operating" the estate.

The Fifth Circuit rejected that argument, finding that §959(b) did obligate the non-operating trustee to comply with

state law (in this case, the obligation to plug the unproductive wells). The HLS decision is noteworthy, too, in that

it was not explicitly limited to environmental cases, in spite of the fact that plugging the wells was designed to

prevent or mitigate environmental problems.

Given that the court found that the non-operating trustee was obligated to comply with state law with respect to

estate property, the question then turns to the priority given the state's reimbursement claim. The Code provides

that an administrative expense under §503(b)(1)(A) must be an "actual, necessary cost[s] and expense[s] of

preserving the estate, including wages, salaries, or commissions for services rendered after the commencement of the

case..."

In assessing whether the "actual and necessary" test has been met, courts have typically looked to see if the

expense benefited the estate. N.L. Indus. Inc. v. GHR Energy Corp., 940 F.2d 957, 966 (5th Cir. 1991). In HLS,

the appellant trustee urged that the estate was not benefited by the state's plugging the wells. The court addressed

this contention by declaring that the requirement of "benefit" was only a "gloss" on the concept of what is an actual

and necessary cost of preserving the estate. To the contrary, fulfilling the estate's duties under state law could "only

be seen as a benefit to the estate," explained the court. HLS, 151 F.3d at 438. The HLS decision certainly suggests

that the statutory and regulatory obligations that accompany an estate's property rights cannot be abdicated, even by

a liquidating trustee. HLS, 151 F.3d at 437.

The Fifth Circuit discussed the 1968 Supreme Court decision in Reading Co. v. Brown, 391 U.S. 471, 88

S.Ct. 1759, because it set out an "expansive interpretation of what is an 'actual, necessary cost'" of preserving the

estate, for §503(b)(1)(A) purposes. HLS, 151 F.3d at 437. The Reading court had awarded administrative expense

priority to a tort claim for damages that arose as a direct result of the trustee's negligent operation of the estate

property. That decision had been applied to hold the trustee liable for expenses "normally incident" to the estate's

business, even if there was no "benefit" to the estate. In re N.P. Mining Co. Inc., 963 F.2d 1449, 1453 (11th

Cir.1992) (civil penalties for post-petition violation of state strip mining laws are administrative expenses).

Although the trustee in HLS never operated the subject oil and gas wells, the court found that the liability to plug

the wells at the conclusion of their productivity was tantamount to the "salvage work that lies at the heart of the

administrative expense priority." HLS, 151 F.3d at 438.

The Reading case, as noted above, involved the aspect of "damages resulting from negligence of receiver."

Applying Reading, the court theorized that a trustee would be obligated to repair a sagging roof to prevent further

damage to the structure or injury to passersby, and that it followed that "[t]he laws of the State of Texas compelled

action in this case just as surely as would the laws of physics in (the court's roof analogy). The unplugged

unproductive wells operated as a legal liability on the estate, a liability capable of generating losses in the nature of

substantial fines every day the wells remained unplugged." HLS, 151 F.3d at 438. The HLS court also was

concerned with additional liabilities resulting from the trustee's failure to fulfill its state law obligations. The

trustee's failure to perform, noted the court, was similar to the situation found in its Al Copeland decision. 991

F.2d 233 (5th Cir. 1993). In Copeland, the raised issue was what priority should be given to post-petition interest

accrued under state law on taxes that the debtor had collected but failed to remit. The court found them to be

administrative expenses. Because state law, to which the debtor was subject under §§959(b) and 960, required it to

pay the taxes to the state, the Fifth Circuit likened the liability for interest accruing on those taxes as not unlike the

damages that resulted from the Reading receiver's negligence. HLS, 151 F.3d at 438.

In sum, the HLS case is significant for a variety of reasons. It plainly states that trustees are subject to valid state

law, apparently regardless of whether they are using a state property to conduct business. In addition, the cost of

complying with applicable law will give rise to administrative expenses, without the literal and absolute

requirement that the expenditure provided a benefit to the estate in the most conventional sense. The Fifth Circuit's

HLSopinion, together with its Al Copeland decision, underscores the importance to both debtors and trustees alike

of compliance with state law provisions that affect the property of the estates they oversee, even if they are doing

nothing more than liquidating that property.

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<h3>Footnotes</h3>

<a name="1">1</a> The views expressed herein are those of the author and do not necessarily reflect the views of the Office of the Attorney General of Texas, its client agencies, or the State of Texas. <a href="#1a">Return to article</a>

Journal Authors

E. Stuart Phillips

Journal Date

Tuesday, December 1, 1998 - 12:00