Opinion ID: 666058
Heading Depth: 3
Heading Rank: 4

Heading: Prior Law

Text: 44 The Bankruptcy Act, like the Code, had no provision specifically permitting post-bankruptcy interest on claims in general or on tax claims in particular. 10 Under the Act, the courts adhered to the equitable principle that the accrual of interest was suspended with the filing of the petition. Sexton v. Dreyfus, 219 U.S. 339, 344, 31 S.Ct. 256, 257, 55 L.Ed. 244 (1911). As explained by Justice Holmes in Sexton, this equitable principle, derived from a well-established tenet of English law, operates to fix the moment when the affairs of the debtor are concluded. 11 Id. at 344, 31 S.Ct. at 257. Given that all claims do not bear the same rate of interest, the rule suspends accrual at filing under the rationale that [a]s this delay was the act of law, no one should thereby gain an advantage or suffer a loss. American Iron & Steel Mfg. Co. v. Seaboard Air Line Ry., 233 U.S. 261, 266, 34 S.Ct. 502, 504, 58 L.Ed. 949 (1914). In addition to avoiding unfairness as between competing creditors, the denial of postpetition interest on prepetition claims also avoided the administrative inconvenience of recomputation of interest. Bruning v. United States, 376 U.S. 358, 362, 84 S.Ct. 906, 908-09, 11 L.Ed.2d 772 (1964). As the Supreme Court explained: 45 Exaction of interest, where the power of a debtor to pay even his contractual obligations is suspended by law, has been prohibited because it was considered in the nature of a penalty imposed because of delay in prompt payment--a delay necessitated by law if the courts are properly to preserve and protect the estate for the benefit of all interests involved.... 'it is a necessary incident to the settlement of the estate.' 46 Vanston Bondholders Protective Committee v. Green, 329 U.S. 156, 163, 67 S.Ct. 237, 240, 91 L.Ed. 162 (1946) (quoting Thomas v. Western Car Co., 149 U.S. 95, 117, 13 S.Ct. 824, 833, 37 L.Ed. 663 (1893)). 47 Denial of postpetition interest on prepetition claims was not an ironclad rule, and over time, exceptions arose. The first, the solvency exception discussed supra, provided that where an estate had sufficient assets to pay all claims in full, creditors would receive postpetition interest before any surplus would be returned to the bankrupt. See City of New York v. Saper, 336 U.S. 328, 332, n. 7, 69 S.Ct. 554, 555, n. 7, 93 L.Ed. 710 (1949). A second exception allowed dividends and interest earned by securities held by the creditor as collateral to be applied to postpetition interest. Id. A third exception of more doubtful provenance provided interest for oversecured claims. See United States v. Ron Pair Enterprises, 489 U.S. 235, 246, 109 S.Ct. 1026, 1033, 103 L.Ed.2d 290 (1989). Far from being rigid categories, each of these exceptions represented the development by courts of flexible guidelines for the exercise of their equitable powers. Id. at 248, 109 S.Ct. at 1034. Animating the development of such guidelines was the underlying equitable principle first articulated by the Supreme Court in Vanston: 48 It is manifest that the touchstone of each decision on allowance of interest in bankruptcy, receivership and reorganization has been a balance of equities between creditor and creditor or between creditors and the debtor. 49 Vanston, supra, 329 U.S. at 165, 67 S.Ct. at 241. 50 The Trustee urges that this articulation of prior law governing interest on prepetition claims should govern the outcome of the decision today. Were it not for the Supreme Court's decision in Nicholas, we would be inclined to agree. Nevertheless, because that decision expressly addresses the award of interest on claims arising postpetition and during a reorganization or arrangement, as opposed to other prior law which addresses the propriety of postpetition interest on prepetition claims, Nicholas guides our analysis. 51 The Supreme Court in Nicholas addressed the question of whether to permit interest on taxes incurred during a corporate arrangement under Chapter XI of the Bankruptcy Act which was superseded by a bankruptcy proceeding. The context of Nicholas is analogous to the instant context--i.e., a debt incurred during a Chapter 11 reorganization, which is superseded by a conversion to Chapter 7. Tracing the prior law, the Nicholas Court concluded that prior decisions concerning the suspension of interest on prepetition claims reflect[ed] the broad equitable principle that creditors should not be disadvantaged vis-a-vis one another by legal delays attributable solely to the time-consuming procedures inherent in the administration of the bankruptcy laws. 384 U.S. at 683, 86 S.Ct. at 1679. The Court, nevertheless, while recognizing the strong considerations of equity and administrative convenience underpinning this rule, declined to treat identically interest on claims arising prepetition and those arising postpetition during a period of arrangement: 52 To be sure, the amount of interest that accumulates on a debt incurred during a Chapter XI arrangement depends upon the duration of a proceeding that takes place under the direction and authority of the bankruptcy court. But interest claimed on such a debt does not arise through a delay of the law in any meaningful sense. The underlying obligation of the debtor in possession is incurred as part of a judicial process of rehabilitation of the debtor that the procedures of Chapter XI are designed to facilitate. Interest on a current Chapter XI obligation is therefore different in kind from interest claimed during the arrangement period on a debt incurred before the Chapter XI petition was filed. 53 Id. at 684-85, 86 S.Ct. at 1680 (internal citation omitted). 54 The Court also determined that where the arrangement period is interrupted by the subsequent filing of a bankruptcy petition, the equitable rationale fueling the Court's earlier decisions would apply to suspend the accrual of interest. Id. at 685, 86 S.Ct. at 1680. Thus, the Court held that the accumulation of interest on a debt must be suspended once an enterprise enters a period of bankruptcy administration beyond that in which the underlying interest-bearing obligation was incurred. Id. Thus, the treatment of interest would correspond to which of the three relevant periods of bankruptcy in which the claim arose. 55 The Court found support for this division from the threefold hierarchy of priorities for tax claims under the Bankruptcy Act. First, Sec. 63a(4) provided that taxes incurred in the pre-arrangement period received fourth priority in distribution. Second, taxes incurred during the arrangement period received first priority under Sec. 64a(1). Finally, the last sentence of Sec. 64a(1) subordinated arrangement expenses within that priority to expenses of the superseding bankruptcy administration. 56 With substantial refinements, the current Code parallels the threefold hierarchy of priorities for tax claims under the Bankruptcy Act. Section 507(a)(7), analogous to Sec. 63a(4), accords seventh priority to claims for taxes not entitled to administrative expense priority pursuant to Sec. 503(b)(1)(B). Section 507(a)(1) in turn parallels Sec. 64a(1) by according administrative expense priority to those taxes incurred by the estate as defined in Sec. 503(b)(1)(B). 12 See Sec. 726(a)(1). Section 726(b) duplicates Sec. 64a(1)'s subordination of arrangement expenses by providing that administrative expenses incurred during liquidation take precedence over reorganization expenses accorded administrative expense priority pursuant to Sec. 503(b). 57 In examining the applicability of the threefold hierarchy rationale to trade claims, the Code supports an analogy. Prepetition trade debts would generally be unsecured and under Sec. 726(a)(2) would be paid after distribution of Sec. 507 claims (which includes taxes distributed pursuant to Sec. 507(a)(7)). Trade debts incurred during Chapter 11 and accorded administrative expense priority, as are tax claims, would be distributed, pursuant to Sec. 726(a)(1), as first priority claims under Sec. 507(a)(1) as defined in Sec. 503(b)(1)(A). Finally, Sec. 726(b) subordinates administrative expenses, whether such expenses are trade debts satisfying the criteria of Sec. 503(b)(1)(A) or taxes as defined in Sec. 503(b)(1)(B), incurred during reorganization to those administrative expenses attendant to a Chapter 7 liquidation. Accordingly, the structure of the Code supports the thesis that the Nicholas rationale embraces trade debts as well as taxes. 58 The next question that arises is whether the policy rationale of Nicholas offers any explanation of whether taxes and trade debts should be treated differently. The Supreme Court articulated the policy rationale as follows: 59 The allowance of interest on Chapter XI debts until the filing of a petition in bankruptcy promotes the availability of capital to a debtor in possession and enhances the likelihood of achieving the goal of the proceeding the ultimate rehabilitation of the debtor. Disallowance of interest on Chapter XI debts might seriously hinder the availability of such funds and might in many cases foreclose the prospect of the debtor's recovery. 60 Nicholas, 384 U.S. at 687, 86 S.Ct. at 1681. 61 This policy applies with equal, if not greater, force in the context of trade debts. Whereas tax obligations accrue as a matter of law, the debtor and creditor voluntarily create trade debts to continue the business as a going concern. The taxing authority as an involuntary creditor does not choose its debtors; the presence or absence of interest is irrelevant to the government's choice to become a creditor. However, disallowance of interest may properly be viewed as a disincentive to voluntary creditors. Thus, the Nicholas rationale--that disallowance of interest may hinder the availability of funds--operates with greater force in the instant context involving voluntary creditors than in the Nicholas context itself. Further, there is no reason why postpetition creditors, whether involuntary or voluntary, should fund the debtor's rehabilitation with interest-free loans. As noted by the Supreme Court, [i]n most situations, interest is considered to be the cost of the use of the amounts owing a creditor and an incentive to prompt repayment and, thus, an integral part of a continuing debt. Bruning v. United States, 376 U.S. 358, 360, 84 S.Ct. 906, 908, 11 L.Ed.2d 772 (1964). A business unable to meet the current costs of doing business, costs which include the time value of money, will be unable ultimately to successfully reorganize and to continue as a going concern. Although reorganization may afford the debtor certain accommodations, such accommodations are not without limit: 62 'Although the fundamental goal of Chapter 11 is the ultimate rehabilitation of the debtor, the treatment of administrative expenses as debts entitled to first priority status suggests an overriding policy that a debtor's efforts to reorganize shall be financed by the debtor, not the debtor's post-petition creditors....' 63 In re Allied Mechanical Serv., Inc., 885 F.2d 837, 839 (11th Cir.1989) (quoting In re Gould & Eberhardt Gear Machinery Corp., 80 B.R. 614, 617 (D.Mass.1987)). 64 The structure of the Code also supports treating the interest on trade debts accorded administrative expense priority similarly to interest on tax claims accorded such priority. The Nicholas Court alluded to the principle that the Bankruptcy Act placed administrative expenses on a parity, including claims for taxes. 384 U.S. at 691, 86 S.Ct. at 1683. See, e.g., Davis v. Pringle, 268 U.S. 315, 317, 45 S.Ct. 549, 550, 69 L.Ed. 974 (1925); Guarantee Title & Trust Co. v. Title Guaranty & Surety Co., 224 U.S. 152, 159-60, 32 S.Ct. 457, 460, 56 L.Ed. 706 (1912). The Code similarly provides that claims allowable pursuant to Sec. 503(b) as administrative expenses share equally without sub-priorities. 3 Collier on Bankruptcy p 503.03, at 503-16 (15th Ed.1993). 13 See In re Western Farmers Assoc., 13 B.R. 132, 134 (Bankr.W.D.Wash.1981) (and cases cited therein). The concept of parity for administrative expenses flows from the premise underlying the category. The threshold requirement for an administrative expense is that it be actual and necessary to the preservation of the estate; the benefit must run to the debtor and be fundamental to the conduct of its business. In re Continental Airlines, 146 B.R. 520, 526 (Bankr.D.Del.1992). Administrative expense priority prevents unjust enrichment from this benefit: 65 The principal purpose of according administrative priority to claims for benefit to the estate is to prevent unjust enrichment of the debtor's estate, rather than simply to compensate the claimant. Conceptually, the costs of administration are a kind of priority afforded to those who either help preserve and administer the estate or who assist with the rehabilitation of the debtor so that all creditors will benefit. 66 In re Coal-X Ltd. 76, 60 B.R. 907, 912 (Bankr.D.Utah 1986). To the extent that creditors otherwise on a parity are treated differently with respect to interest, the debtor is unjustly enriched. Thus, if one claimant is to be preferred over others, the purpose should be clear from the statute. Nathanson v. NLRB, 344 U.S. 25, 29, 73 S.Ct. 80, 83, 97 L.Ed. 23 (1952). 67 Thus, our analysis concludes that the language of the Code gives no guidance as to the priority of interest on administrative expense trade debts, that neither the statute nor the legislative history indicate a clear intent to abrogate the prior law, and thus that it is appropriate for us to look for guidance to the prior law. For the reasons discussed above, we conclude that the Nicholas rationale provides an appropriate analogy in the prior law. 68 However, the Trustee argues that the Seventh Circuit's decision in In re Brooks and Woodington, Inc., 505 F.2d 794 (7th Cir.1974), not Nicholas, represents prior law. Brooks held that accountants employed by the bankruptcy trustee were not entitled to an administrative expense claim for interest on their underlying claim for accountant's fees rendered on behalf of the estate. 14 The court's discussion of the interest issue was very cursory, with no reference to Nicholas, although denying interest accrued on claims incurred during the reorganization proceeding would directly contradict the Supreme Court's decision. Id. at 799. It is noteworthy that the argument for interest was not even raised until the reply brief, id., and that this fact was one of the grounds of the decision disallowing interest: 69 In the light of the generally prevailing bankruptcy rule applicable to interest-bearing claims and particularly in view of the manner in which the claim for interest has been asserted in this particular appeal, we hold that appellants are not to be allowed interest on the amount of their claim. 70 Id. (emphasis supplied). Further, the court's reference to the prevailing bankruptcy rule was obviously to the Sexton rule, although the court offered no explanation of why this rule represented a suitable analogy. Interest on postpetition administrative claims incurred during a period of reorganization implicates different policy considerations from the award of postpetition interest on prepetition claims. As articulated by the court in In re Far West Corp., 120 B.R. 551 (Bankr.E.D.Cal.1990): 71 The rationale for according certain postpetition claims priority status was to prevent the reorganization or administration of the estate from being jeopardized by a creditor's refusal to deal with the debtor postpetition while the policy considerations behind the general rule suspending the accrual of interest on prepetition claims were premised upon notions of equity and administrative convenience. 72 Id. at 554 (internal citations omitted). For the foregoing reasons, we decline to accord precedential value to the Brooks decision. 73 The Trustee also argues that the analogy to interest on postpetition taxes, and the analogy to Nicholas, is misplaced because first priority for such interest flows from Sec. 503(b)(1)(C) (specifically providing that penalties relating to an administrative expense claim for taxes carry the same priority as the tax). The Trustee observes that if Congress intended penalties attendant to taxes to carry the same priority as the tax, Congress must also have intended that interest attendant to taxes should carry the same priority. Finally, the Trustee notes that there is no provision similar to Sec. 503(b)(1)(C) from which we might infer a Congressional intent that interest on an administrative expense trade debt should carry the same priority as the trade debt. Although we acknowledge the inference from Sec. 503(b)(1)(C), and the absence of a similar provision with respect to administrative expense trade debts, we nevertheless conclude that the Nicholas rationale is applicable. At the time Nicholas was decided, there was no statutory provision similar to Sec. 503(b)(1)(C). Thus, the instant context, in which there is also no such similar statutory provision, is similar to the context addressed by the Supreme Court in Nicholas. We find that it is appropriate to employ the Nicholas rationale. Also, the Nicholas opinion uses language suggesting that the rationale applies generally to administrative expense debts and not merely to administrative expense taxes. 384 U.S. at 687, 689, 86 S.Ct. at 1681, 1683. Finally, as discussed above, the similar structure of the relevant statutes and the similarity of policy concerns indicate that the analogy to Nicholas is appropriate. 74 In summary, because the language of the Code is silent, and the statute and legislative history indicate no clear intent to abrogate prior law, we look to the prior law. As indicated in the foregoing discussion, we conclude that the most reasonable reading of the prior law is that the priority accorded to interest on trade debts incurred as administrative expenses during Chapter 11 should be determined pursuant to the Nicholas rationale. Accordingly, we hold that interest on trade debts incurred as administrative expenses during Chapter 11 enjoys the same priority as the administrative expense itself, but that upon conversion to Chapter 7, the interest accruing thereafter enjoys only the fifth priority pursuant to Sec. 726(a)(5).