Comparison between Canadian and American post-filing obligations

Not paid today and may not be paid tomorrow: Developments in post-filing obligations of CCAA debtors

| Jacob Babad

The United States Bankruptcy Code takes a different approach in principle from the CCAA with respect to post-filing obligations. American legislators, however, have codified specific post-filing obligations towards employees and taxation authorities in greater detail than the CCAA.

Chapter 11 and administrative expense priority

Unlike the CCAA, the U.S. Bankruptcy Code expressly provides for priority for post-filing obligations. Section 503 of the Code provides for the payment of administrative expenses, which include “[t]he actual, necessary costs and expenses of preserving the estate including… wages, salaries, and commissions for services rendered after the commencement of the case.”

Payments allowed under this section receive the highest priority in claims against an estate, only after domestic support obligations, which do not apply in the case of debtor corporations. All priority claims not only must be paid before non-priority general unsecured claims, but they must be paid in full as a condition to confirmation of a plan of reorganization, and administrative claims must be paid in full, in cash, no later than the effective date of the plan.

While section 503 expressly applies to employees of the debtor corporation, it also applies to goods and services, which generally qualify as “actual, necessary costs and expenses of preserving the estate.”

The rationale for section 503, as articulated by the Supreme Court of the United States, mirrors the discussion in Quintette. First, for contracts which are necessary for the continuation of the debtor’s business, it is necessary to provide priority recovery to encourage third party supplier to continue to do business with the debtor-in-possession. Second, the debtor-in-possession continues to operate for the benefit of its pre-filing creditors. It is they, not the post-filing third party creditors, who should bear the risk of post-filing liabilities.

At the moment, when an arrangement is sought, the debtor is insolvent. Its existing creditors hope that by partial or complete postponement of their claims they will, through successful rehabilitation, eventually recover from the debtor either in full or in larger proportion than they would in immediate bankruptcy. Hence the present petitioner did not merely suffer injury at the hands of an insolvent business: it had an insolvent business thrust upon it by operation of law.

It is on this understanding that U.S. courts have taken a broader view to the payment of post-filing obligations than Canadian courts’ narrow interpretation of section 11.01. U.S. Courts have rejected a narrow reading of “actual, necessary costs” in favour of the “the Reading exception,” so named for the U.S. Supreme Court case Reading Co. v. Brown. In Reading, the trustee’s negligence led to a fire that damaged a neighboring third party, who asserted its claim as an administrative expense. The Court rejected the trustee’s narrow interpretation of section 503 that priority is only given to expenditures without which the business of the debtor could not function. Instead, the Supreme Court departed from the rigid terms of the statute and employed a standard of “fairness to all persons having claims against an insolvent.” The Court held that “actual and necessary costs of preserving an estate should include costs ordinarily incident to the operation of a business.” The claim for fire damage was deemed an administrative expense.

The broad reading of section 503 from Reading has provided for priority claims for expenses that do not directly add value to the estate, for example environmental clean-up and the plugging of oil wells.13 It is also a striking difference from the narrow interpretation given to section 11.01 in Nortel and Smith Brothers. While Canadian courts appeared to chafe at the possibility of section 11.01 limiting the ability of the court to facilitate a restructuring, the U.S. courts do not seem to share this concern.

Nonetheless, it is noteworthy that the remedy in both regimes fundamentally differ. In Canada, under section 11.01, a creditor has a self-help remedy to demand immediate payment but no priority or charge short of that demand. Section 503 offers a strong priority claim, which will generally ensure eventual payment of post-filing obligations by the debtor, but not always. In certain cases, if a debtor under Chapter 11 is administratively insolvent—i.e., it is unable to pay administrative expenses—then the creditor who provided goods or services may be left with pennies on the dollar. The 2001 case of Winstar Communications is one of the more notorious cases of administrative insolvency, that left administrative creditors with a 20–30% recovery.14 More recently, Toys “R” Us became administratively insolvent when disappointing holiday sales in 2017 failed to keep the company afloat in Chapter 11, leaving administrative creditors with unfulfilled claims.

Other post-filing obligations under Chapter 11

While it may lack a section comparable to section 11.01 of the CCAA, Chapter 11 does impose more specific post-filing obligations in two areas: employees and taxation authorities.

As noted above, post-filing wages and salaries for employees are explicitly addressed in section 503(b)(1)(A)(i)-(ii) of the Code, allowing for protection in the ordinary course of business. The broad approach to interpreting this provision has given U.S. courts more latitude when considering what types of payments to employees may be included. For example, unlike Canada and the approach seen in Nortel, it is generally accepted in the U.S. that severance pay as part of an employee retention plan established post filing will qualify as administrative expenses and, subject to notice and a hearing, may be protected. Where U.S. courts have had more difficulty is determining whether pre-filing severance programs deserve the same treatment. Prepetition severance programs have been the subject of many Chapter 11 cases, with the general attitude being they are not protected under section 503. However, in certain cases where courts have found that the enforcement of pre-filing severance programs are necessary to incentivize continued service with the debtor, courts have granted these programs section 503 protections. Although some have advocated for stronger protections for U.S. employees, at least with respect to payment in the ordinary course, U.S. employees have greater protections than their Canadian counterparts.

Where Chapter 11 truly deviates from Canadian statutes and case law is in the treatment of post-filing obligations to pay taxes. The payment of taxes is an administrative expense, with the appropriate priority, as discussed above. Taxes are defined broadly as “any tax—incurred by the estate, whether secured or unsecured, including property taxes for which liability is in rem, in personam, or both.”

Post-filing debtor companies are expected to pay taxes as they come due. Notably, in contrast to the CCAA, section 503(b)(1)(B) has been interpreted to generally apply to state and local taxes.15 Indeed, court documents and guidelines from various jurisdictions available on the Department of Justice website specifically mention the importance of continuing to pay taxes after seeking protection under Chapter 11, including taxes at the state and local levels.16

Chapter 11 lays out significant penalties for debtor companies that miss payments. Section 1112 of the Bankruptcy Code gives the court power to convert a case under Chapter 11 to a case under Chapter 7 (bankruptcy) for “failure timely to pay taxes owed after the date of the order for relief or to file tax returns due after the date of the order for relief,” including failure to pay local taxes.17 The requirement in the U.S. to pay taxes post-filing is so well established, some advise those considering Chapter 11 that a court will refuse to grant protection if it is not convinced the debtor has the resources to pay taxes coming due.

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13 See e.g., In re Coal Stripping Inc, 222 BR 57 (Bankr WD Pa 1998), Texas v Lowe (In re HLS Energy Co), 151 F3d 434 (5th Cir 1998). See also White, supra note 82.

14 See “Moody’s comments on debtor in Possession Lending 304.”

15 Roy F Kiplinger, “Bankruptcy basics and tips for collection of property taxes from taxpayers in bankruptcy” (August 5, 2010), online (pdf): State of Indiana (accessed October 4, 2018). See also Holywell Corp v Smith, 503 US 47 (1992).

16 See e.g., Department of Justice, “Operating and reporting requirements for Chapter 11 cases” (January 11, 2018), online (pdf): U.S. Government (accessed October 4, 2018); Department of Justice, “United States Trustee Region 8—Guidelines for debtors-in-possession,” online: U.S. Government.

17 See In the Matter of Nancant, Inc, Debtor, 8 BR 1005 (1981).

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