Section 366(c)(2): Electric BoogalooS.D.N.Y. Court Affirms Order Approving Debtors’ Contested Adequate Assurance to Utility Providers

Contributed by Doron P. Kenter.
In the first days of a chapter 11 case, a flurry of activity occurs.  One of the most common “first-day” motions is a motion to approve a debtor’s proposed form of adequate assurance of future payment to utility providers and to establish procedures to resolve objections by utility providers to such adequate assurance.  Such a motion is necessary because, pursuant to section 366(c)(2) of the Bankruptcy Code, a utility provider may alter, refuse, or discontinue service if, during the first thirty days of the chapter 11 case, it does not receive “adequate assurance of payment for utility service that is satisfactory to the utility.”  Section 366(c)(3) then provides that “[o]n request of a party in interest and after notice and a hearing, the court may order modification of the amount of an assurance of payment under [section 366(c)(2)].”  Accordingly, debtors often seek to establish procedures for the bankruptcy court to determine adequate assurance, rather than risk a utility company terminating critical service.
A debtor’s proposed form and amount of such adequate assurance are frequently challenged by utility providers, but such disputes are rarely litigated.  Rather, utility providers and debtors often settle on some consensual form of security deposit or other form of mutually satisfactory adequate assurance.  A rare exception to this occurred earlier this year in A&P’s chapter 11 cases in the United States Bankruptcy Court for the Southern District of New York, when various utility providers challenged the relief sought in debtors’ utilities motion and the proposed form and amount of adequate assurance provided therein.  Ruling from the bench, Judge Drain approved the debtors’ “utilities motion” over the utility providers’ objections.
In a recent decision, in In re The Great Atlantic & Pacific Tea Co., Inc., the United States District Court for the Southern District of New York affirmed the bankruptcy court’s order over vigorous appeals from several utility providers.  The district court’s decision provides a useful roadmap for understanding how to approach utilities motions and requests for adequate assurance.
In challenging A&P’s utilities motion, the objecting utility providers argued that (i) under the Bankruptcy Code, only utility providers may make an initial demand for adequate assurance, and it is the debtor’s burden to show that such request is unreasonable, (ii) the debtors’ proposed deposits, in an amount equal to two weeks of each utility provider’s service, were insufficient, and the proper deposits should have been equal to two months’ service, (iii) the form of security deposit (in a segregated interest-bearing escrow account) was not proper, (iv) the utilities order was, in effect, an injunction (enjoining the utility providers from altering, refusing, or discontinuing service) and that accordingly, any such relief must be sought via an adversary proceeding, and (v) the debtors’ failure to serve the utility providers with sufficient notice of the utilities motion tainted the relief granted in the bankruptcy court.
The district court rejected each of those arguments.  First, the court acknowledged the split of authority regarding the interpretation of section 366 of the Bankruptcy Code, but held that the only proper construction of that section is that which construes it as providing a debtor with thirty days after commencing a bankruptcy case to either (i) reach an agreement with the utility provider or (ii) obtain a court order under section 366(c)(3) determining what qualifies as reasonable adequate assurance of payment.  The court noted that the utility providers’ proposed interpretation – which would mean that only utility providers may, in the first instance, make requests for adequate assurance, which requests it would be the debtors’ burden to refute – was contrary to the clear language of the statute and the underlying policy of section 366 of the Bankruptcy Code.  The court further stated that this interpretation would be “unworkable” and “could lead to absurd results” and would either place a debtor in a position where it could lose the protections of section 366 based on a utility provider’s inaction or could hamstring the bankruptcy court’s ability to set the amount of adequate assurance.
Second, the court affirmed the amount of the adequate assurance authorized by the bankruptcy court – namely, an amount equal to two weeks’ worth of service (as opposed to the two months’ service requested by the utility providers).  The district court further rejected the argument that state law tariffs, which contemplate additional deposits, somehow govern the proper adequate assurance deposit amounts, which are matters of federal bankruptcy law, and not state law.  Instead, the court concluded that Judge Drain had not committed clear error in finding that such amounts constituted adequate assurance of payment because the debtors had shown that their cash flows, cash on hand, and postpetition financing were sufficient to continue making payments to utility providers.  Further, the district court observed that Judge Drain specifically noted that the utility providers could return to court to ask for additional adequate assurance if changed circumstances of the debtors’ chapter 11 cases ever militated in favor of such additional adequate assurance.  Moreover, a deposit equal to payments for two weeks’ service had been routinely deemed appropriate in other chapter 11 cases, and any additional amounts would require the debtors to “put[] up cash that it could otherwise be using to run its business just to sit there” – which would be of little benefit to the debtors’ estates.
Third, the court held that segregated interest-bearing escrow accounts, while not listed among the forms of “assurance of payment” set forth in section 366(c)(1)(A) of the Bankruptcy Code, were proper forms of adequate assurance, as such accounts are the equivalent of letters of credit or cash deposits, which are specifically enumerated as acceptable mechanisms for providing adequate assurance.
Fourth, the court rejected the utility providers’ arguments that utilities motions should be brought as adversary proceedings, affirming Judge Drain’s determination that the injunctive relief afforded by section 366(c) of the Bankruptcy Code is not relief that requires the bringing of a complaint, but is, instead, a statutory injunction, much like the relief afforded by the automatic stay, as set forth in section 362 of the Bankruptcy Code.
Lastly, the court noted that the debtors should have served the utility providers with the debtors’ utilities motion as they would serve any parties to a “contested matter” (pursuant to Bankruptcy Rule 9014), but that any deficiencies in service did not affect the outcome, as the utility providers were afforded adequate due process in asserting their opposition to the utilities motion.
In opposing the debtors’ utilities motion, the utility providers may have attempted to tilt the scales of adequate assurance in their favor.  Although the bankruptcy court’s bench decision and the district court’s subsequent affirming opinion were tailored to the facts of that case, these decisions set forth clear standards and protocols regarding the form and amount of adequate assurance pursuant to section 366 of the Bankruptcy Code.  Debtors and utility providers alike would be well-advised to consider these decisions in determining how best to proceed with their utilities motions and requests for adequate assurance.