Environmental Liability: Relief Through Bankruptcy Or Not?

In re Appalachian Fuel, LLC, 521 B.R. 779 (Bankr. E.D. Ky. 2014) –

A state department of environmental protection (DEP) filed an administrative expense application in the bankruptcy cases of coal mining debtors for reclamation costs and penalties for postpetition environmental violations.  After the initial ruling of the bankruptcy court was affirmed in part and vacated in part, the bankruptcy court addressed on remand (1) the liability of one of the debtors in connection with permits held by another debtor, and (2) whether the DEP claims should be given administrative expense priority.

Coal mining is regulated under the federal Surface Mining Control and Reclamation Act (although a state may assume primary responsibility for regulation and enforcement).  A permit is required to engage in surface coal mining activities.  Generally before leaving a mine site the surface land must be restored and polluted water must be properly treated.  In this case the mining permit and related permits (including an NPDES permit) were held by a subsidiary debtor (KDC):

KDC had no employees, mining or reclamation equipment or any assets other than the KDC Permits.  KDC did not enter into contracts or make payments and had no bank accounts or other financial resources.  It had no independent management or decision-making authority.

Instead, an indirect sister company (AppFuels) operated the mines, including oversight of reclamation activities and permit compliance.

AppFuels experienced financial difficulty, and along with its affiliates, agreed to an assignment for the benefit of creditors.  Subsequently, an involuntary bankruptcy was filed, and the pre-bankruptcy liquidator was appointed post-bankruptcy as chief liquidating officer (CLO) of the debtor.  The retention order directed him to manage the debtors “in full compliance with all state and federal laws, as required by 28 U.S.C. §959(b).”  Among other things, the CLO was to cause the debtors to perform all reclamation obligations.

Mining activities ceased after the bankruptcy was filed, although reclamation work continued.  To avoid impairing the opportunity to sell the debtor’s assets, the DEP exercised its discretion to delay issuing certain violation notices, including citations of AppFuels for reclamation and water treatment violations in connection with the KDC permits.

Substantially all of the debtor’s mining assets were sold, but expressly excluding the KDC permits.  AppFuels, the buyer and the DEP entered into a reclamation transition agreement relating to the transfer of obligations in connection with the permits that were assigned.  Although there had been an attempt to transfer all permits, the KDC permits basically represented reclamation liability and had virtually no value to the holder.  So, the buyer specifically did not assume any obligations in connection with the KDC permits.

When the debtor filed a proposed plan of reorganization, the DEP objected on the basis that its claims were not adequately addressed.  It estimated reclamation liability of $4.5-4.6 million.  After various rounds of plan objections, motions for substantive consolidation and plan revisions, the DEP agreed to withdraw its objection on the condition that it retained the right to pursue its administrative expense claims.

Eventually the DEP filed an administrative expense application seeking (1) ~$3.5 million consisting of (a) reclamation costs of ~$1.9 million, plus (b) $2.6 million for a trust to fund the estimated cost of water treatment in perpetuity, minus (c) ~$1 million in reclamation bond proceeds, and (2) ~$1.1 million for postpetition penalties.

The first issue was whether only KDC was liable for reclamation in connection with its own permits.  However, on appeal it had been determined that AppFuels could be held directly liable as an operator.  Further a party remains liable until the reclamation work is done even if mining operations have ceased.  Given that AppFuels took all actions in connection with the KDC permits, and KDC “existed as a hollow shell, only nominally the holder of the KDC Permits,” the court had no trouble finding that AppFuels was liable as an operator.

On the issue of administrative expense priority, the court analyzed a series of cases that in effect held that a trustee must insure that a bankruptcy complies with applicable environmental law, and consequently expenses arising from compliance must be given administrative expense priority.

In this case there was the additional complication that the DEP was asking to recover expenses that would be expended in the future, as opposed to reimbursement of the funds already spent. However, the court determined that the claim arose at the time the debtors incurred liability, not when the funds were expended.

Although the trustee argued that liability did not arise until the DEP had followed procedures to make a claim for unreimbursed costs, the court believed that the procedures merely liquidated an existing claim arising from the failure to comply with the permits.  At a minimum, the debtors’ proposed abandonment of the KDC permits without making any provision for continuation of required reclamation was a noncompliance. Thus “at least as of the instant before the Court’s entry of the Confirmation Order,” reclamation liability became certain since it arose prior to confirmation and was an actual expense.

On the issue of whether expenses were necessary, the court agreed with the approach that damages arising from a postpetition failure to perform should be treated as benefiting the estate since it redirected resources elsewhere for the benefit of creditors.  On the question of whether the expenses were of particular “benefit to the estate” in this case, the court noted the accommodation by the DEP that assisted in the efforts to sell the debtor’s assets.

The trustee also argued that the DEP had waived its claim for various reasons.  For example, the plan provided that the DEP claims were to be treated as unsecured claims.  However, the confirmation order expressly preserved the DEP’s right to assert administrative expense priority.

On the issue of whether the penalty could be considered an administrative expense, the trustee cited cases holding that only penalties associated with active mining activities could be treated as an administrative expense.  The court did not agree with these cases and found no basis for distinguishing between active and inactive mining operations.  Consequently it gave the penalties administrative expense priority.

On the issue of whether the DEP estimates were sufficient to support a claim, the court decided to require that funds in the estimated amount be set aside, with payment delayed until work was completed.  It adopted this approach in part because of the possibility that its decision might be reversed on appeal and in part to give the DEP an incentive to keep costs as low as possible.

In the final paragraph, the court issued a “mea culpa.”  The court felt that it should not have confirmed the plan without addressing more directly payment of the KDC permit reclamation costs.  To the extent that the plan could be interpreted as shifting liability from the debtor to the state, the plan would not comply with the Bankruptcy Code.  The court expressed the hope that its current rulings would be used to facilitate an interpretation of the plan that was consistent with the Bankruptcy Code.

Environmental remediation claims can create quite a morass.  There is substantial room for argument about when a claim arises (when the conditions occur, when somebody discovers them, and or only after there are manifest adverse impacts?) and how to handle uncertain future costs (since remediation may require long term activities). Courts often seem to struggle with how to resolve these issues – particularly given the overlay of concern about public health and safety.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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