The Operation of the “Operations” Rule: The Seventh Circuit’s Primer On the Priority of Postpetition Tort Claims

Contributed by Adam Lavine
It is a well-established rule that claims arising from the continued operation of a business are entitled to administrative priority – at least in chapter 11.  In In re Resources Technology Corp., 662 F.3d 472 (7th Cir. 2011), the United States Court of Appeals for the Seventh Circuit recently considered whether and how this rule should apply in chapter 7.  Concluding that the rule might apply in chapter 7 under certain circumstances, the court nevertheless held that, in this case, the claimant’s tort claim was not entitled to administrative priority.
In Resources Technology, the debtor’s business involved installing and maintaining gas collection and control systems.  Prepetition, the debtor contracted with a landfill to build and maintain the landfill’s gas collection and control system.  The debtor originally filed for chapter 11, but the case was later converted to a chapter 7 liquidation.  Four days after the chapter 7 trustee gained control of the debtor’s operations, the landfill’s gas collection and control system failed, releasing foul odors from the landfill into a neighboring Holiday Inn.  As a result of the gas system’s failure, the owner of the Holiday Inn filed a claim against the debtor’s estate, arguing that by negligently failing to maintain the system and interfering with the owner’s use and enjoyment of the property, the debtor had committed the tort of nuisance.  The Seventh Circuit agreed with this analysis and explicitly held that the debtor had committed a postpetition tort.  Resolution of the dispute, however, did not end there.  Relying on the rule that postpetition tort claims are generally entitled to administrative priority, the owner of the Holiday Inn had filed its claim as an administrative expense.  The chapter 7 trustee, on the other hand, vehemently opposed classifying such a claim as an administrative expense.
In a decision reminiscent of a model answer to a law school exam question (albeit one written by one of the preeminent legal scholars of the past century), Judge Posner commenced his analysis of the dispute by providing a succinct summary of the law on administrative claims in chapter 11, including a discussion regarding the policies behind the law.  More specifically, Judge Posner noted that administrative claims – such as the claims of parties who provide the debtor with postpetition financing – are generally claims for expenses that help “preserve and if possible enhance the value of the bankrupt estate for the benefit of its creditors.”
Unlike claimants who provide postpetition financing to a debtor, tort victims do not benefit the estate.  Nevertheless, a long line of cases dating back to the Supreme Court’s decision in Reading v. Brown, has cemented the rule that tort claims arising from the operation of a business in chapter 11 should be treated as administrative claims.  As noted by Judge Posner, this rule recognizes that “tort liability is an expense of doing business, like labor or material costs, and should be treated the same way.”  In addition, the court noted a second, more sophisticated rationale for treating tort claims as administrative expenses; namely, that if businesses operating in bankruptcy were excused from tort liability, they “would have an inefficient competitive advantage over their solvent competitors – and deficient incentives to use due care in the operation of the business.”  According to the court, the issue in Resources Technology was whether this rationale would be extended to chapter 7, “given that the goal of such a bankruptcy is liquidation of the bankrupt’s assets at the highest possible price rather than the continuation of the bankrupt’s business?”
Noting that chapter 7 liquidations may sometimes require the trustee to continue the debtor’s operations prior to the actual liquidation, the court refused to adopt a per se rule that postpetition tort claims should not be entitled to administrative priority in chapter 7.  Instead, the court concluded that when deciding if a postpetition tort claim should be entitled to administrative priority, the key inquiry remains whether the chapter 7 debtor is “operating” at the time the claim arose.  Poignantly, the court observed that “(t)he policy that supports the Reading doctrine – the policy against permitting bankrupt firms to externalize the costs of their torts – depends on whether the bankrupt firm is operating, not which part of the Bankruptcy Code (that is, whether chapter 7 or chapter 11) it is operating under.”
Ultimately, the court found that the debtor “was not operating in any meaningful sense” when the nuisance occurred because the debtor had no money, had only minimal revenue that likely could not cover costs, and had “neither the mandate nor the resources” to do anything with the debtor’s assets but liquidate them.  Accordingly, the court held that the claimant’s tort claim was not entitled to administrative priority.
In a nutshell, Resources Technology announces the following rule: to determine if a postpetition tort claim deserves administrative priority in a chapter 7 case, courts in the Seventh Circuit should consider whether the debtor is “operating” at the time the claim arises.  Adoption of this “operations” rule in chapter 7 appears to be a growing trend among courts in various jurisdictions.  See, e.g., Woburn Associates v. Kahn (In re Hemingway Transport, Inc.); In re Unidigital, Inc.; In re Heritage Leasing Corp.  The implications of this rule, however, extend well-beyond chapter 7.  Resources Technology recognizes that debtors may operate in chapter 7 and that liquidations may occur in chapter 11.  Thus, if the key to administrative priority is “operation,” tort claims arising in chapter 11 may not necessarily receive administrative priority if the chapter 11 debtor has ceased operations in order to liquidate.  Indeed, a liquidating chapter 11 debtor will be able to cite to Resources Technology in support of an argument that any torts arising after the debtor’s main “operations” have ceased should not be granted administrative priority in the debtor’s chapter 11 case.