When it Comes to Administrative Expenses Under Section 503(b) of the Bankruptcy Code, Hindsight Isn’t Always 20/20

Contributed by Christopher Hopkins
An important factor in many successful chapter 11 reorganizations is the debtor’s ability to procure necessary goods and services postpetition.  Without some additional incentive, however, third parties would be unlikely — if not altogether unwilling — to do business with a debtor postpetition.  To this end, the Bankruptcy Code includes a number of provisions aimed at encouraging third parties to conduct business with chapter 11 debtors.  One of the Bankruptcy Code’s most powerful incentives in this regard is section 507(a)(2)’s grant of priority for the “actual, necessary costs and expenses of preserving the estate” allowed as administrative expenses under section 503(b)(1).  These provisions ensure that vendors providing postpetition goods and services to the debtor will generally receive payment ahead of the debtor’s prepetition unsecured creditors.
More often than not, the debtor does not dispute that goods and services provided to the debtor postpetition qualify as “actual and necessary.”  If a dispute does arise, though, the party seeking payment must move for allowance and payment of its claim as an administrative expense under section 503(b).  As a general matter, a movant may establish a prima facie case for section 503(b) allowance by showing that the claim (i) arose from a transaction with the debtor and (ii) benefitted the debtor’s estate.  The “benefit” requirement has no independent basis in the Bankruptcy Code.  Rather, it is merely a way of testing whether a particular expense was “necessary” to the estate.
Parties seeking allowance under section 503(b) often face opposition from other interested parties (typically, prepetition unsecured creditors) that challenge the allowance of the claim on the grounds that it does not benefit the estate.  What happens if it is the debtor that opposes the motion — with the benefit of hindsight, and only after the third party has performed under the contract — on the grounds that the goods or services provided did not actually benefit the estate?  As odd as this may seem, that is precisely what happened in In re ATP Oil & Gas Corp.
ATP Oil involved a severe case of buyer’s remorse.  After filing for bankruptcy, ATP Oil & Gas entered into a contract with Omega Natchiq whereby Omega agreed to provide various repair and maintenance services — all at ATP’s direction — to various properties operated by ATP.  One of these properties, a production platform known as the “Innovator,” later became the subject of a “shut-in order” issued by the U.S. Bureau of Safety and Environmental Enforcement.  ATP timely complied with the shut-in order.
Throughout this period, Omega continued to perform under its agreement with ATP.  In addition to its normal repair and maintenance services, Omega performed certain “safe out” work related to making the Innovator safe for abandonment after ATP received the shut-in order.  Omega diligently submitted invoices for the work it performed, and there was no dispute as to the amount owed or the quality of Omega’s work.  Nonetheless, ATP Oil did not pay Omega, and Omega was forced to file a motion seeking allowance of the amounts it was owed as an administrative expense under section 503(b).
ATP opposed the motion, arguing that Omega had failed to adequately describe how the services benefitted the estate.  In fact, ATP flatly asserted that, even though Omega performed services that ATP, in its own business judgment, directed Omega to perform, such services ultimately failed to benefit the estate.  ATP argued that because Omega’s services did not benefit “the continuation of [its] business as a going concern,” Omega was not entitled to an administrative expense.
The United States Bankruptcy Court for the Southern District of Texas rejected ATP’s arguments and found that Omega was entitled to an administrative expense for all of the postpetition services it provided to ATP.  The court rejected ATP’s interpretation of the benefit requirement as too narrow, finding instead that the benefit requirement can be satisfied even though the services did not increase ATP’s production capacity and were ultimately unprofitable for the estate.  The court divided Omega’s services into three categories, based largely on the timing and character of the services provided, and explained why each category of services benefitted the estate.
A. Pre-Shut-In Services
The court refused to find that the services Omega performed on the Innovator prior to the shut-in order did not benefit the estate solely because ATP was subsequently unable to sell that property.  Because Omega’s services prevented the “deterioration and corrosion” of the Innovator and were deemed necessary by ATP when it directed Omega to perform them, the court found that these services satisfied the benefit requirement and, accordingly, Omega was entitled to an administrative expense for the amounts it charged for such services.
B. Post-Shut-In Services
The court also found that Omega’s post-shut-in repair and maintenance services were entitled to administrative expense under section 503(b) even though such services were unnecessary because the Innovator could no longer be operated or sold as a result of the shut-in order.   ATP argued that Omega should have known of the shut-in order and ceased providing such services once it realized they would no longer benefit the estate.  Further, ATP alleged that allowing Omega an administrative expense for such services would “encourage similarly situated vendors of troubled debtors to hide their heads in the sand to the detriment of the debtors’ estates.”  But again the court rejected ATP’s argument, reasoning that the debtor in possession — rather than the vendor — is better suited to make business judgments on what services are beneficial to the estate.  The court stated that placing such a requirement on third parties would chill the vendor’s willingness to provide goods and services, diminishing both the effectiveness of section 503(b)’s incentives and the debtor’s chances of a successful rehabilitation.
C. Safe Out Work
The court held that Omega’s safe out work — work performed solely to make the Innovator safe for abandonment —provided sufficient benefits to ATP to entitle Omega to an administrative expense for such work.  Here, the court relied on ATP’s obligation under state law to make the Innovator safe for abandonment and reasoned that “expenses incurred to bring a debtor into compliance with state law are actual and necessary costs” of preserving the estate.
The final nail in ATP’s coffin was the court’s holding that Omega was entitled to an administrative expense regardless of whether its services benefitted the estate under the Supreme Court’s so-called “Reading Exception.”  In Reading, the Supreme Court stated that “actual and necessary costs of preserving the estate should include costs ordinarily incident to the operation of a business.”  Similarly, the bankruptcy court in ATP Oil found that, to the extent that Omega’s services may not have conferred an “actual benefit” on ATP’s estate, Omega was still entitled to an administrative expense under the Reading Exception as the costs were “incidental” to the operation of ATP’s business.
Section 503(b)(1) of the Bankruptcy Code aims to encourage third parties to continue to provide goods and services to the debtor postpetition so that the debtor may successfully reorganize its business.  ATP Oil advances this purpose by shielding third parties from an ex-post determination by a debtor that the goods and services provided did not ultimately benefit the estate.  The debtor, as the party most familiar with its own business, is in the best position to determine whether a particular cost or expense is actual and necessary for the preservation of the estate.  To hold otherwise would chill third parties’ willingness to do business with a debtor.