Trustee’s Obligation to Comply With State Law

Introduction

A bankruptcy trustee’s (“Trustee”) duties are set out in Section 704 of the Bankruptcy Code. The Trustee’s general obligation is to collect and reduce to money property of and close the estate as expeditiously as is compatible with the best interest of the parties. These obligations include the duties to be accountable for all property received by the Trustee, the filing of periodic reports and summaries of business operations (if authorized to continue operating) with the court, U.S. Trustee and government tax units and to file with the court and the U.S. Trustee a final account of the administration of the estate.

The Trustee may have further obligations under Section 959(b) of Title 28 of the United States Code. Section 959(b) generally requires the trustee to comply with state laws when the trustee is “managing and operating” property in possession of the Trustee. However, this is not a strict compliance statute. Analysis of Section 959(b) is required and usually begins with Midlantic[i] and, to a lesser extent, Kovacs.[ii] These cases set a framework for analysis of a Trustee’s duties as to the bankruptcy estate.

Three overarching principles have been ascribed to Section 959(b): (1) the enactment of Section 959 “provides additional evidence that Congress did not intend for the Code to pre-empt all state laws”, (2) Congress intended to prevent Trustees from insulating themselves by using the federal courts to circumvent compliance with state laws, and (3) an ongoing bankrupt business (and therefore the Trustee) should not receive unfair competitive advantages merely because it seeks to reorganize itself under the Code.

When Section 959 Applies

The majority of courts hold that a Trustee’s obligation to comply with state laws under Section 959(b) applies only when the Trustee continues to operate the debtor’s business.[iii] Courts have looked to Judge Learned Hand to understand that merely to hold matters in status quo; to mark time, to do only what is necessary to hold the assets in tact; such activities are not a continuance of business.[iv] For example, in N.P. Mining, the debtor’s mining operations had ceased; though the Trustee did engage in coal brokering to keep a contract with Scott Paper Company alive.[v] The court stated that the Trustee engaged in coal brokering merely to protect an asset of the estate and merely holding matters in status quo.[vi] The court also considered under Section 959 whether the property was in the Trustee’s possession. [vii]

However, some courts have held that Section 959(b) requires a liquidating Trustee to comply with state laws. Section 959(b) does not authorize Trustees who are liquidating assets of an estate to operate carte blanche.[viii] For example, in Wall Tube, the court stated that the Trustee’s duties are the same whether liquidating or reorganizing the estate – the bankruptcy policy to marshal and distribute assets must yield to those laws which provide for public health and safety.[ix] More specifically, Section 959(b) has been held to apply in liquidations where state laws are designed to protect the public health and safety from identified hazards.[x]

State Laws a Trustee Should Consider

Under Section 959(b), the Trustee is required to comply with the different state laws in which each specific property of the debtor is located. This duty involves laws that would apply to those who would be operating these properties outside the bankruptcy context. The courts have found that Section 959(b) requires Trustees to comply with zoning laws,[xi] anti-discrimination laws,[xii] closing of health care facilities,[xiii] partnerships,[xiv] utilities[xv] and licensing laws.[xvi] Courts usually find that compliance with state law is required where the laws protect the public health, safety and welfare.

Environmental laws are an obvious area where concern for protecting public health and safety surfaces. There are variations of when environmental issues arise, such as violations from the debtor’s prepetition actions, violations from a post-petition Chapter 11 debtor’s continued operation of its business, and when a Chapter 7 trustee inherits from the prepetition debtor a contaminated site or facility.[xvii] Examples of cases involving environmental issues follow.

In Wall Tube, the Sixth Circuit held that where violation of hazardous waste laws occurred before bankruptcy and continued afterward, the Trustee should not have maintained or possessed the property in continuous violation of law.[xviii] An environmental hazard on the estate’s property is within the Trustee’s control.[xix] The court held that expenses expended by the State to remedy the hazard would be an administrative expense.[xx]

In Globe, the Northern District of Indiana stated that Section 959(b) did not apply and the Trustee was not subject to environmental laws applicable to storage tanks because the Trustee no longer had ownership and control over that property.[xxi] However, to the extent the Trustee retains ownership and control over the tanks causing an imminent and identifiable harm to public health or safety on property the Trustee sold to a third party, the Trustee may be required to abate the circumstances.[xxii] If a Trustee is considering abandoning a property, the Trustee will likely be barred from doing so if abandonment would contravene state laws designed to protect public health or safety.[xxiii]

Claims for environmental law noncompliance could arise when rejecting leases. In Circle K, the debtor wished to reject leases despite environmental claims resulting from its operation of the property.[xxiv] The court determined that under Midlantic and Section 959 a debtor need not comply with every real or imagined environmental situation before it can reject a lease. Section 365 can adequately deal with environmental concerns.[xxv] The real property owners of the debtor’s leaseholds will have incentive to clean up site problems and bring a claim for damages against the debtor under Section 365.[xxvi] The environmental claims will be unsecured claims or possibly an administrative claim.[xxvii] Notably, this court assumed that there were no imminent serious threats to public health and safety presented by the proposed rejections.[xxviii] State environmental officials were free to proceed under the police power of Section 362(b).[xxix]

At least one court held that a debtor in possession subject to environmental laws must comply with state law under Section 959(b), and the bankruptcy court has no authority to intervene.[xxx] In other words, there is no exception for debtors who would be inconvenienced or burdened by state laws.[xxxi]

State consumer protection laws are also implicated in bankruptcy proceedings. These laws commonly arise when the Trustee is winding down a retail business and is seeking permission from the bankruptcy court to have a “going-out-of-business sale.” Many states regulate these sales with strict laws regarding, signage, sale length, inventory and more to prevent fraud and “exploitation of the gullible.”[xxxii] Bankruptcy courts generally will grant a Trustee’s request to hold a going-out-of-business sale. However, the Trustee must comply with the consumer protection laws when holding these sales. Issues have arisen when a Trustee, or more common a debtor-in-possession, will motion the court unopposed and file with the court a proposed order authorizing the sale containing language allowing the Trustee to circumvent the duty to comply with state consumer protection laws.[xxxiii]

Case law conflicts as to a Trustee’s duty to comply with local housing codes and its authority under Section 365(h) of the Code to reject tenant leases. The District of Columbia Circuit Court held that when a Trustee rejects tenants’ leases, the Trustee still must comply with the local housing code and provide the tenants with necessities any other landlord would be obligated to provide under public law.[xxxiv] “[R]ejection of…leases under Section 365(h) releases debtors-in-possession from their privately undertaken contractual obligations, but…not of all obligations. [Where state law obligations] benefiting public health and safety are independent of private leases…rejection of leases under Section 365(h) has no bearing on the debtor-landlord’s obligations under applicable local law.”[xxxv]

In contrast, the Southern District of New York held that a Trustee rejecting tenant leases need no longer comply with the obligations imposed by the local housing code.[xxxvi] When the Trustee discontinued compliance with the local housing code, the tenants were entitled to damages, which could be unsecured claims in the bankruptcy estate for damages over and above what could be setoff against the tenants’ rent.[xxxvii] The court stated that the Trustee is also not receiving an unfair advantage over non-bankrupt landlords since the tenants had rights of setoff under Section 365 and state law.[xxxviii] The difference between the District of Columbia and New York cases, which may not be dispositive, is that the former dealt with residential leases and the latter, commercial leases.

Trustees are required to comply with all federal, state and local tax laws when in possession of property of a bankruptcy estate. Compliance with state and local taxes is mandated under Section 959(b) and Section 960 of Title 28 of the United States Code imposes compliance with all tax laws on Trustees. Under Section 960, a finding of tax liability is favorable where there is a question of whether a Trustee was under a duty to pay certain local taxes.[xxxix]

Preemption

Where there is a direct conflict between state and federal law, preemption may allow the Trustee relief. Section 365(h) of the Code, providing a Trustee’s right to reject executory contracts, is the provision under which this has often occurred. In Old Carco, the rejection of the contracts relieved the Trustee of compliance with New York dealer statutes because the statutes were in direct conflict with Section 365(h).[xl] The court added that where the state laws are protecting commercial interests and providing for economic protection, rather than public health and safety, the standard used by the court to determine compliance will be lower.[xli]

Scott Housing is another preemption example. Before filing its petition, the debtor operated its business as a nonconforming use when new county zoning ordinances were adopted. The right to continue under this nonconforming use would terminate if the use was discontinued for six months. The court held that the Section 362(a)(3)’s automatic stay tolled the running of the six month period under the local zoning resolution, otherwise the Trustee’s opportunity to familiarize himself with and administer the assets of the estate at the maximum possible price would be unduly compromised.[xlii] The automatic stay of Section 362 is a fundamental protection of the Code, is broad and pre-empts state law subject to the exceptions listed in Section 362(b).[xliii]

Liability Under Section 959

Where a violation of state law occurs while the Trustee possesses the property, generally the estate has been liable for any resulting penalty or expenses incurred.[xliv] The rationale is that Section 959(b) is not a clear unequivocal waiver of sovereign immunity on the part of the United States, and where the custodian’s violation of the law occurs in the course of custodian acting pursuant to a court order, personal liability cannot attach.

However, the Fifth Circuit recently found a Trustee personally liable for failing to timely remit state sales taxes.[xlv] The duty to comply with valid state laws in conjunction with Section 960(a), subjecting the Trustee to all federal, state and local taxes, and Section 959(a), allowing suit against a Trustee as to any of their acts or transactions in carrying on business connected with such property, was consistent with “holding trustees personally responsible for their professional conduct to the same extent as any other actors under the law.”[xlvi] A Trustee is not held to a different or higher standard under state law and the Trustee’s duty to further the best interest of the estate does not exculpate him from liability.[xlvii]

Conclusion

Bankruptcy Trustees must be aware of these obligations and their duties to comply in all respects of their practice. And Chapter 11 attorneys must remember that these duties and obligations apply equally to debtors-in-possession.

[i] Midlantic National Bank v. New Jersey Dept. of Envt’l Protection, 474 U.S. 494, 106 S.Ct. 755 (1986).

[ii] Ohio v. Kovacs, 469 U.S. 274, 105 S.Ct. 705 (1985).

[iii] In re Globe Bldg. Materials, 345 B.R. 619, 637 (2006).

[iv] In re N.P. Mining Co., 963 F.2d 1449, 1460 (11th Cir. 1992) (citing to Judge Learned Hand’s interpretation of 28 U.S.C. §125, the predecessor to 28 U.S.C. §959).

[v] N.P. Mining, 963 F.2d at 1461.

[vi] Id.; see also In re Old Carco, 424 B.R. 633, 648 (S.D.N.Y. 2010).

[vii] In re Valley Steel Products Co., 157 B.R. 442, 447 (1993).

[viii] Matter of Scott Housing Sys., 91 B.R. 190, 196 (S.D. Ga. 1988).

[ix] In re Wall Tube & Metal Products, 831 F.2d 118 (6th Cir. 1987).

[x] Scott Housing, 91 B.R. at 196; see also Old Carco, 424 B.R. at 647; In re St Lawrence, 239 B.R. 720, 727 (Dist. N.J. 1999).

[xi] Lawson v. Town of Sardinia (In re Chaffee Aggregates, Inc.), 300 B.R. 170, 172 (Bankr. W.D.N.Y. 2003).

[xii] In re Sheehan Memorial Hospital, 377 B.R. 63, 69 (Bankr. W.D.N.Y. 2007).

[xiii] Norris Sq. Civic Ass’n v. St. Mary’s Hosp. (In re St. Mary’s Hospital), 86 B.R. 393 (Bankr. E.D.Pa. 1988).

[xiv] In re San Vincente Medical Partners, 962 F.2d 1402 (9th Cir. 1992).

[xv] Robinson v. Michigan Consol Gas Co., 918 F.2d579 (6th Cir. 1990).

[xvi] Missouri v. U.S. Bankruptcy Court for E.D. of Arkansas, 647 F.2d 768 (8th Cir. 1981) (Trustee was required to obtain state license to operate grain warehouse); Go West Entertainment v. New York State Liquor Auth. (In re Go West Entertainment, Inc.), 387 B.R. 435 (Bankr. S.D.N.Y. 2008); Wilner Wood Products Co. v. State of Maine, Dept. of Envtl Prot., 128 B.R. 1 (D.Me. 1991) (State law required trustee to obtain air emission license).

[xvii] Globe Bldg., 345 B.R. at 628

[xviii] Wall Tube, 831 F.2d at 122.

[xix] Id.

[xx] Id. at 123.

[xxi] Id. at 639

[xxii] Id.; Wall Tube, 831 F.2d at 123.

[xxiii] See Globe Bldg., 345 B.R. at 635 (interpreting the Midlantic decision).

[xxiv] In re Circe K Corp., 1991 WL 349900, at *17 (D. Ariz. 1991).

[xxv] Id. at *17.

[xxvi] Id. at *13.

[xxvii] Id. at *16.

[xxviii] Id. at *18.

[xxix] Id.

[xxx] Wilner, 128 B.R. at 2- 4

[xxxi] Id. at 2.

[xxxii] In re White Crane Trading, Co., 170 B.R. 694 (Bankr. E.D.Cal. 1994).

[xxxiii] See id.

[xxxiv] Savaria v. 1736 18th Street, N.W., Ltd. P’ship, 844 F.2d 823, 827 (D.C.Cir. 1988).

[xxxv] Id. (emphasis in original).

[xxxvi] In re Stable Mews Associates, 41 B.R. 594 (1984).

[xxxvii] Id. at 599.

[xxxviii] Id. at 599-600.

[xxxix] In re Penn Cent. Transp. Co., 325 F.Supp. 294 (E.D.Pa.1970), aff’d 452 F.2d 1107, cert. denied 92 S.Ct. 2040, 406 U.S. 944, 32 L.Ed.2d 331, cert. denied 92 S.Ct. 2043, 406 U.S. 944, 32 L.Ed.2d 331.

[xl] Old Carco, 424 B.R. at 647.

[xli] Id. The court further stated that even if the dealer laws included some concern for the health and safety of the general public, there is no allegation of an imminent and identifiable hazard. Id.

[xlii] Id. at 195.

[xliii] Id. at 195-97.

[xliv] In re Markos Gurnee P’ships, 182 B.R. 211 (Bankr. N.D.Ill. 1995); In re Sundance Corp., 149 B.R. 641 (1993); N.P. Mining, 963 F.d at 1458-59, 1461.

[xlv] Texas Comptroller of Public Accounts v. Liuzza (In re Texas Pig Stands), 610 F.3d 937 (5th Cir 2010).

[xlvi] Id.

[xlvii] Id. at 942. Additionally, the U.S. Trustee Manual and U.S. Trustee’s Chapter 11 Trustee Handbook inform trustees of the risk of failing to comply with tax laws. Id. at 943. A trustee should also follow the terms of the debtor’s confirmed Chapter 11 plan and trust agreement. See id. at 944.