Restructuring Among the Ruins Conference Athens, Greece May 7-9, 2006 ENVIRONMENTAL ISSUES IN UNITED STATES BANKRUPTCY PROCEEDINGS

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1 Restructuring Among the Ruins Conference Athens, Greece May 7-9, 2006 ENVIRONMENTAL ISSUES IN UNITED STATES BANKRUPTCY PROCEEDINGS Daniel M. Glosband, Esq. Macken Toussaint, Esq. Goodwin Procter LLP Exchange Place Boston, MA

2 Environmental Issues in United States Bankruptcy Proceedings 1 There are many instances in which the policies of bankruptcy law are at odds with the policies underlying federal and state environmental laws. The conflict plays out when environmental agencies seek to force debtors to correct environmental violations, even though this action would have the effect of depleting assets which would otherwise be available to repay debts owed to general creditors. 2 This paper includes a discussion of some of the most common issues produced by the overlap between bankruptcy law and environmental law. For example, provisions of the Bankruptcy Code-- such as the automatic stay, the discharge of debts, and the trustee s right to abandon burdensome property-- have been used by debtors to avoid or defer liability for the cleanup of contaminated real property. The priority of environmental claims in bankruptcy proceedings and the impact of the debtor s environmental problems on its lenders are additional issues. I. APPLICABLE NON-BANKRUPTCY LAW A. Federal More than a dozen major statutes or laws form the legal basis for the programs of the Environmental Protection Agency ( EPA ) created in 1970 to implement environmental laws and regulations. Two of such statutes are discussed below: CERCLA and RCRA. 1 2 See Generally, Cherkis and King, Collier Real Estate Transactions and the Bankruptcy Code, Chapter 6 (2004); BLI, Bankruptcy Law, Chapter 24 (2005). Penn Terra, Ltd. v. Pennsylvania Dep t of Envtl. Resources, 733 F.2d 267 (3d Cir. 1984).

3 CERCLA The Comprehensive Environmental Response, Compensation and Liability Act ( CERCLA ), 3 was enacted by Congress on December 11, The statute created a Superfund, comprising revenues from taxes on the petroleum and chemical manufacturing industries, to be used by the federal and state governments to pay for site cleanups where the responsible parties do not. CERCLA: established prohibitions and requirements concerning closed and abandoned hazardous waste sites; authorized the federal and state governments to clean up hazardous waste sites and to undertake emergency responses to releases of hazardous substances (as an alternative to a cleanup and cost recovery action, the federal government may issue an administrative order directing a responsible party to clean up a contaminated site); and provided for liability of persons responsible for releases of hazardous waste at these sites (strict liability, not based upon fault or causation). The Superfund Amendments and Reauthorization Act of 1986 amended CERCLA to provide for a lien in favor of the federal government, in the amount of cleanup costs that the government incurs, on all real property and rights to such property which (1) belong to the party liable for the cleanup costs and (2) are subject to or affected by a cleanup action. The application of CERCLA in the bankruptcy context raises several interesting issues, which are discussed below, including: 1. Whether a CERCLA claim by the EPA or other governmental agency for reimbursement of cleanup costs incurred prepetition is a dischargeable debt. 2. Whether a cleanup order under CERCLA survives a discharge U.S.C et. seq. 2

4 3. Whether abandonment of contaminated property by a bankruptcy trustee will enable the trustee to escape CERCLA liability. RCRA The Resource Conservation and Recovery Act of 1976 ( RCRA ) 4 was the first substantial effort by Congress to establish a regulatory structure for the management of solid and hazardous wastes. RCRA gave EPA the authority to control hazardous waste from the "cradleto-grave." This includes the generation, transportation, treatment, storage, and disposal of hazardous waste. RCRA focuses only on active and future facilities and does not address abandoned or historical sites (see CERCLA discussed above for closed and abandoned sites). B. State Laws In addition to the federal framework, state agencies are major participants in the implementation of environmental laws. In fact, until 1970, Congress and the states considered environmental protection to be primarily a local concern. In response to the need for a national policy of environmental protection, Congress passed many federal environmental laws that embody national goals but rely on states to implement the federal guidelines through the exercise of state police powers. Also, the federal environmental laws allow state agencies to implement their own regulations as long as the state s regulations are at least as stringent as the federal rules. 5 For a list of the state environmental agencies go to U.S.C et. seq Several states have enacted superlien statutes and have authority to impose liens upon remediated property to recoup state investigation or remediation costs. As mentioned above, the EPA has this power pursuant to CERCLA. 3

5 II. AUTOMATIC STAY AND REGULATORY EXCEPTIONS A. The Automatic Stay Section 362(a) of the Bankruptcy Code provides that actions or claims against the debtor are automatically stayed when the debtor files the petition for bankruptcy to the extent such actions relate to the debtor s prepetition activities. The purpose of this provision is to give the debtor a breathing spell from his creditors. It stops all collection efforts, all harassment, and all foreclosure actions. B. Regulatory Power Exception There are several exceptions to the automatic stay under 362(b) of the Bankruptcy Code, one of which may apply in the context of environmental violations. Section 362(b)(4) provides that the stay does not apply to the commencement or continuation of an action or proceeding by a governmental unit to enforce such governmental unit s or organization s police and regulatory powers, including the enforcement of a judgment other than a money judgment, obtained in an action or proceeding by the governmental unit to enforce such governmental unit s or organization s police or regulatory powers. 11 U.S.C. 362(b)(4). The purpose behind this exception is to assure that the government is not hindered in the enforcement of its police powers, but that it also does not gain an advantage by getting paid before other creditors. This exception is often raised by government agencies attempting to bring actions and enforce judgments against debtors for violation of the environmental laws. The cases interpreting the provisions under 362(b)(4) generally focus on whether the governmental action 4

6 being challenged is one taken to enforce a police or regulatory power and generally turn on the question of whether the relief requested by the government, even if injunctive in form, is tantamount to the enforcement of a money judgment. If not money-oriented, the action is excepted from the automatic stay and can proceed; if it is money-oriented, the action comes within the exception to the exception set forth in section 362(b)(4) and is therefore stayed. III. ABANDONMENT OF CONTAMINATED PROPERTY Section 554 of the Bankruptcy Code provides that [a]fter notice and a hearing, the trustee may abandon any property of the estate that is burdensome to the estate or that is of inconsequential value and benefit to the estate. 11 U.S.C. 554(a). Presumably, this provision was intended to aid in the administration of cases by removing property from the estate that would not realize value but instead would drain its assets. Conflict arises when bankruptcy trustees want to use this doctrine to abandon property that is in violation of environmental protection statutes. In such cases, the cost of cleaning up the property is often so great that the property is a burden to the estate. However, abandoning the property means that the debtor and the bankruptcy estate escape the monetary consequences of violating the environmental protection laws, and the cleanup of the property does not get done immediately. Therefore, the question is whether the trustee s abandonment power overrides the government s interest in protecting the public from environmental hazards. There is a split of authority among courts addressing whether property may be abandoned in spite of environmental violations. In Midlantic National Bank v. New Jersey Department of Environmental Protection, 474 U.S. 494 (1985), the Supreme Court concluded that a trustee cannot abandon property when doing so would contravene a statute that is reasonably designed 5

7 to protect the public health or safety from identified hazards. Some Courts have interpreted the Midlantic holding narrowly to mean that property may be abandoned in spite of environmental violations if those violations do not present an imminent and identifiable harm. CERCLA s imposition of liability on the current owner of a facility as well as on the owner of the facility at the time hazardous substances were discharged raises the question of whether abandonment of contaminated property by the trustee will enable it to escape CERCLA liability. If the estate holds title to the property when a reimbursement claim arises or when any contamination occurred then it would appear to remain liable under CERCLA notwithstanding a subsequent abandonment. At least one court has adopted this view. Therefore, a trustee in bankruptcy could avoid CERCLA liability through abandonment if the government s claim arises after the abandonment and no contamination occurred during the period that the estate held title to the property. Note that theses cases do not deal with the fundamental practical issue that neither the debtor, the estate nor the trustee have the financial ability to implement the remediation of the property. In at least one case, the court could not find a person willing to accept appointment as trustee and consequently dismissed the bankruptcy case. IV. DISCHARGE OF ENVIRONMENTAL LIABILITIES Discharge of the debtor s debts is an essential concept in bankruptcy and is addressed in several sections of the Bankruptcy Code. 6 Most courts have found that environmental liabilities arising from prepetition contamination are dischargeable claims. However, under some 6 For instance, 1141(d)(1)(A) provides that the confirmation of a Chapter 11 reorganization plan discharges the debtor from any debts that arose before the date of confirmation. Section 727 provides that a debtor under Chapter 7 will be granted a discharge from all debts that arose prior to the date of the order for relief, subject to several exceptions also set forth in the section. Finally, 524 addresses the effect of a discharge, which is to void any judgments of personal liability against the debtor and to preclude the commencement or continuation of an action to collect or recover a debt of personal liability from the debtor. 6

8 circumstances, courts have found that the liabilities were not dischargeable, including in situations where (i) debtor failed to disclose to a purchaser that the property was contaminated; (ii) debtor s illegal prepetition mining caused damage to the environment; (iii) reclamation costs constituted debts for willful and malicious injury within 523(a)(6) of the Bankruptcy Code; and (iv) the debtor was aware of potential environmental claims but did not schedule them with the bankruptcy court. In Ohio v. Kovacs, 7 the U.S. Supreme Court considered whether the debtor s obligation under an environmental consent order constituted a debt 8 dischargeable in a personal bankruptcy proceeding. The Supreme Court, affirming the lower courts, ruled that the state was in essence seeking a monetary payment that was a dischargeable debt. 9 Subsequent cases have clarified whether a former debtor under the Code is required to comply with an order to clean up ongoing pollution notwithstanding the discharge in the bankruptcy case. Courts have held that an entity s prior status as a debtor under the Bankruptcy Code does not permit it to avoid U.S. 274, 105 S. Ct. 705 (1985). The Bankruptcy Code defines a debt as liability on a claim. A claim is defined under 101(5) as follows: (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; or (B) right to an equitable remedy for breach of performance if such breach gives rise to a right to payment, whether or not such right to an equitable remedy is reduced to judgment, fixed, contingent, matured, unmatured, disputed, secured or unsecured. However, the Court was careful to point out exactly what it was not deciding in this case: First, we do not suggest that Kovacs discharge will shield him from prosecution for having violated the environmental laws of Ohio or for criminal contempt for not performing his obligations under the injunction prior to bankruptcy. Second, had a fine or monetary penalty for violation of state law been imposed on Kovacs prior to bankruptcy, 523(a)(7) forecloses any suggestion that this obligation to pay the fine or penalty would be discharged in bankruptcy. Third, we do not address what the legal consequences would have been had Kovacs taken bankruptcy before a receiver had been appointed and a trustee had been designated with the usual duties of a bankruptcy trustee. Fourth, we do not hold that the injunction against bringing further toxic wastes on the premises or against any conduct that will contribute to the pollution of the site or the state s waters is dischargeable in bankruptcy. Finally, we do not question that anyone in possession of the site must comply with the environmental laws of the state of Ohio. 7

9 compliance with an order requiring the cleanup of ongoing pollution so long as the debtor has access to the site, and even if that pollution was caused by prepetition conduct. In other words, if the pollution is ongoing and the former debtor has access, the obligation to ameliorate pollution survives a bankruptcy discharge. A. CERCLA Claims A CERCLA claim by the EPA or other governmental agency for reimbursement of cleanup costs incurred prepetition is generally a dischargeable debt. CERCLA imposes joint and several liability on potentially responsible parties, thereby giving the CERCLA plaintiff an opportunity to pursue a more solvent defendant than the debtor. It is less clear whether a cleanup order under CERCLA survives a discharge. Some courts suggest that the incurrence of any expenses in connection with the cleanup would render the cleanup order dischargeable or that the cleanup obligation would essentially be dischargeable to the extent the debtor did not personally retain control over the site and was not able to supervise the cleanup work. More recent cases however indicate that the cleanup obligations would not be dischargeable if the debtor still had access to the site even though it was no longer in possession. Also, at least one court suggests that any cleanup order that seeks to end or ameliorate current pollution is not dischargeable. Under this standard most environmental injunctions would not be dischargeable. B. Exception From Discharge for Fines and Penalties Section 523(a)(7) of the Bankruptcy Code provides that a discharge in bankruptcy does not discharge an individual debtor from any debt for a fine, penalty or forfeiture payable to and 8

10 for the benefit of a governmental unit, and is not compensation for actual pecuniary loss 11 U.S.C. 523(a)(7). 10 Courts have suggested that the exception from discharge for governmental fines and penalties under section 523(a)(7) of the Bankruptcy Code may be applicable to permit postdischarge recovery for environmental damage. For a debt to be considered nondischargeable under this section, the debt must be for the benefit of a government unit and must be penal in nature. The particular penalty must serve some punitive or rehabilitative governmental aim, rather than a purely compensatory purpose. 11 V. PRIORITY OF CLAIMS Section 503 of the Code provides that the actual, necessary costs and expenses of preserving the estate shall be treated as administrative expenses. 11 U.S.C. 503(b)(1)(A). Administrative expenses are given priority over unsecured claims with respect to payment. 11 U.S.C. 507(a)(2). In bankruptcy cases where there have been environmental law violations and a government agency 12 has incurred costs post-petition to remedy them, the party usually seeks to have those response costs treated as administrative expenses so that it can be paid ahead of unsecured creditors. Since many of these cases involve post-petition costs relating to prepetition conduct, the debtor or trustee usually first argues that the costs are dischargeable claims. If that Section 523(a)(6) of the Bankruptcy Code also provide an exception from discharge for willful and malicious injury by the debtor to another entity or to the property of another entity. See In re Strong, 305 B.R. 292 (B.A.P. 8 th Cir. 2004). The allowance standards for administrative priority claims, and the allowed amounts of those claims that are deemed to have administrative priority, are much less clear in the case of a private party seeking reimbursement or damage recoveries against an estate arising from prepetition conditions. 9

11 is unsuccessful, the trustee will oppose the treatment of response costs as administrative expenses because that leaves fewer funds to pay off other creditors. Courts have not been uniform in their treatment of this issue. Some courts have held that environmental response costs are entitled to administrative expense priority because they are actual, necessary costs of preserving the estate. Other courts have held that environmental response costs are not entitled to administrative expense priority, but rather, are to be treated as general unsecured claims. Where the environmental costs were penalties, rather than reimbursement for actual costs expended in cleaning up the debtor s property, they have also been held not to be administrative expenses. VI. LENDER ISSUES The CERCLA definition of a potentially liable owner or operator excludes a person, who, without participating in the management of a..., facility, holds indicia of ownership primarily to protect his security interest in the... facility. Several cases have addressed the issue of under what circumstances CERCLA liability may be imposed upon a lender, both as an operator prior to foreclosure and as an owner after foreclosure. In United States v. Fleet Factors Corp., 13 the first federal appeals court case to address the scope of the secured creditor exemption under CERCLA, the court held that a lender may be liable for cleanup costs under CERCLA even though the lender did not participate in day-to-day management of the facility or in decisions regarding the disposal of hazardous wastes, provided that the lender had the power to influence those decisions F.2d 1550 (11 th Cir. 1990), cert. denied, 498 U.S. 1046, 111 S. Ct. 957 (1991). 10

12 On April 29, 1992, in response to concerns expressed by secured lenders because of the broad language in recent cases interpreting the secured creditor exemption, particularly Fleet Factors, the EPA published a final regulation designed to interpret the statutory terms indicia of ownership, primarily to protect [a] security interest and participating in the management. 14 The new regulation, which became law on September 30, 1996, implicitly rejected the suggestion in Fleet Factors that a lender s capacity to influence the hazardous waste policies of a borrower is alone sufficient to deprive a secured creditor from the protection of the exemption. In that regard, the new regulation provided that participation in the management of a facility requires actual participation in the management or operational affairs of the vessel or facility by the holder, and does not include the mere capacity to influence or the ability to influence, or the unexercised right to control facility operations. In spite of the safe harbors provided by the 1996 amendments to CERCLA, lenders should carefully consider their response to environmental problems arising during the term of a mortgage loan. Lenders must also recognize that the presence of toxic wastes on mortgaged property creates the risk of collateral impairment as well as the possibility that their security interest may be subordinated to or consumed by a governmental claim for clean up costs. LIBC/ During the past few years, a few states have also enacted legislation or promulgated regulations that either add provisions limiting the liability of financial institutions and fiduciaries under state environmental laws or which clarify the scope of the existing lender liability provisions. 11

DRAFT LIENS AND SUPERLIENS

DRAFT LIENS AND SUPERLIENS I. Definition of Liens and Superliens A lien is a legal claim against the title of property to secure the payment of a debt or the performance of an obligation. Once such a claim