The Negligent Operation of Nursing Homes in Bankruptcy Who Pays

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Mar 2001

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<There are approximately 17,000 skilled nursing facilities (SNFs) providing care
to approximately 1.6 million people in the United States. At the time of the
writing of this article, some of the largest operators of SNFs, with a total of
approximately 1,600 facilities, are operating under the protection of the Bankruptcy
Code; additionally, some of the largest skilled nursing home operators are in
bankruptcy, including Genesis Health Ventures, Integrated Health Services, Mariner
Post-Acute Network and Sun Healthcare Group. Because of their financial troubles,
many of these entities have difficulty maintaining the facilities at the same level of
quality that was achieved pre-petition. Many of these SNFs are leased from large
health care real estate investment trusts. The leases frequently require that the
facilities be maintained and operated at certain qualitative levels. Who pays for the
negligent post-petition operation of SNFs during a bankruptcy case? Can a debtor
reject a lease after negligently operating a facility with the result that all claims
are rendered pre-petition claims? Or are the landlords of these facilities entitled to
have the resulting claims treated as adminstrative expenses, and paid ahead of general
claims? Millions of dollars are at stake and the issues are hotly contested.

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 <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re CIS Corp., 142 B.R.
640, 643 (S.D.N.Y. 1992)</a> (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. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Beverage Canners Intern. Corp., 2000 WL
1716264</a> (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." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re R.H. Macy & Co., 170 B.R. 69, 76 (Bankr.
S.D.N.Y. 1994)</a>. For example, in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Cardinal Export Corp., 30
B.R. 682 (Bankr. E.D.N.Y. 1983)</a>, 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." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… B.R. at 685</a>.
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 <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Co. v. Brown, 391 U.S. 471, 483, 88 S.Ct.
1759, 20 L.Ed. 2d 751 (1968)</a>).

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., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Continental Airlines Inc.,
148 B.R. 207, 214-16 (D. Del.1992)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re B. Cohen and
Sons Caterers Inc., 143 B.R. 27, 29 (E.D. Pa. 1992)</a>.

<blockquote>
[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.
</blockquote>

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… on Bankruptcy, supra, ¶503.06 [3][c][n], at 503-30</a>.

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., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Vecker (In re Cukiesman), 242
B.R. 486 (B.A.P. 9th Cir. 1999)</a> (§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, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
re Trans World Airlines Inc., 145 F.3d 124 (3rd Cir. 1998)</a> (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 <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Texas Health Enterprises Inc., 255 B.R. 181, 184
(Bankr. E.D. Tex. 2000)</a> (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). <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… B.R. at 74</a>.

Similarly, in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Ernst Home Center Inc., 209 B.R. 955 (Bankr.
W.D. Wash. 1997)</a>, 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). <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 961</a>. 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." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;

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.

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Journal Authors

Samuel R. Maizel

Journal Date

Thursday, March 1, 2001 - 12:00

Bankruptcy Rule

2001