Fresh Air and Fresh Start: Are Environmental Regulatory Penalties Dischargeable?

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Dechert LLPTwo courts recently answered “yes,” finding that environmental claims brought against reorganized debtors by government entities were discharged under confirmed Chapter 11 plans of reorganization. In In re Exide Techs., 613 B.R. 79 (D. Del. 2020), the District of Delaware held that pre-petition, non-compensatory air quality penalties imposed on a Chapter 11 debtor by a state regulator were subject to discharge in bankruptcy. And in In re Peabody Energy Corp., No. 18-3242, 2020 WL 2176028 (8th Cir. May 6, 2020), the Eighth Circuit reached a similar result with respect to claims brought by municipalities against a Chapter 11 debtor for its alleged contributions to global warming.

I. Exide Techs.: the Bankruptcy Code’s Exceptions to Dischargeability

a) Background

Exide Technologies and certain affiliates (collectively, “Exide”) owned and operated a battery recycling facility (the “Facility”) in California prior to filing for Chapter 11 in Delaware. Two months before Exide sought bankruptcy relief, the State of California ordered it to suspend operations for noncompliance with certain state environmental regulations. In the bankruptcy case, the South Coast Air Quality Management District (the “District”)—a California air-quality regulatory agency—filed a proof of claim against Exide for almost $40 million in liquidated penalties related to Exide’s ownership and operation of the Facility. The District alleged that Exide failed to submit required reports, exceeded airborne emissions levels, and failed to implement “good operating practices.” It subsequently filed a complaint in California state court based on the same violations cited in the proof of claim.

While Exide and the District were litigating and negotiating Exide’s liability, the Bankruptcy Court confirmed Exide’s Plan of Reorganization. The Plan provided for a broad discharge and related injunctive relief, including that all claims arising before the effective date of the Plan “shall be satisfied, discharged, and released in full, and the Debtor’s liability with respect thereto shall be extinguished completely.” The Plan also contained a permanent injunction against “commencing or continuing any action” related to claims discharged under the Plan.

When the District continued to pursue its air quality penalties claims in state court after the Plan became effective, Exide moved in the Bankruptcy Court to enforce the Plan. It argued that the alleged liabilities have been discharged and that under the Plan, the District was enjoined from continuing its action.

b) The Battle of Dischargeability: Exceptions Applicable to Corporate vs. Individual Debtors

The main issue before the Bankruptcy Court was whether the District’s claim for penalties would be discharged or would continue to be enforceable in full against the reorganized Exide (“New Exide”).

The District’s main argument was that the penalties it sought to impose on Exide were not dischargeable in Chapter 11. It argued that the penalties were excepted from discharge under Section 1141(d)(6) of the Bankruptcy Code, which provides in pertinent part that “the confirmation of a plan does not discharge a debtor that is a corporation from any debt…of a kind specified in [Section 523(a)(2)(A)] that is owed to a domestic governmental unit…” (emphasis added).

Section 523(a)(2)(A), in turn, provides an exception from discharge of debts “for money, property, services, or an extension of credit, to the extent obtained by...false pretenses, a false representation, or actual fraud” (emphasis added). The District argued that, based upon Exide’s alleged “misrepresentations, fraud, and fraud like activities,” Exide incurred penalties, constituting a “debt” under Section 523(a)(2)(A), and that, through the application of Section 1141(d)(6), which applies to corporate debtors, the District’s claim for penalties should be excepted from Exide’s discharge.

Exide disagreed. It argued that the District’s penalties were in fact an attempt to collect “ordinary noncompensable penalties” owed to a governmental unit pursuant to Section 523(a)(7), which are excepted from discharge only in the cases of individual debtors, not corporate debtors. Indeed, Section 523(a)(7) provides that, in the case of an individual debtor, debt that is “for a fine, penalty, or forfeiture payable to and for the benefit of a governmental unit, and is not compensation for actual pecuniary loss, other than a tax penalty” is not dischargeable. This exception does not apply to corporate debtors. Exide further argued that the District’s claim “did not fall within any of the other narrow exceptions to discharge the Bankruptcy Code permits in a corporate Chapter 11 case."

The Bankruptcy Court upheld Exide’s position. It held that the penalties the District sought to impose on Exide were dischargeable and, therefore, cannot be asserted against New Exide. The District appealed.

c) Pre-Petition Non-Compensatory Penalties Are Dischargeable in Chapter 11

The Delaware District Court affirmed the Bankruptcy Court’s decision, denying each of the District’s arguments on appeal. The Court explained that in Section 523 of the Bankruptcy Code, Congress “established a list of claim categories that are not dischargeable in a bankruptcy proceeding brought by an individual debtor,” only a handful of which apply to corporate debtors as well. Among the claims that are non-dischargeable against an individual in bankruptcy are government fines or penalties, covered by Section 523(a)(7), and claims by the government for money obtained by fraud, covered by Section 523(a)(2)(A). For a corporate debtor, the Court explained, “governmental penalties are dischargeable, although claims by the government for money obtained by fraud may not be subject to discharge.”

Upholding the Bankruptcy Court’s findings and its analysis of the legislative history, the Court concluded that the District’s claims were “fines and penalties” which fall squarely within Section 523(a)(7), i.e., the exception to dischargeability applicable only to individual debtors. As observed by the Court, this Section applies to “non-compensatory penalties levied by a government agency."

Like the Bankruptcy Court, the District Court denied the District’s attempt to recast the penalties as claims for money obtained by fraud under Section 523(a)(2)(A). The District failed to include any allegation of fraud on Exide’s part in its proof of claim, and instead explicitly disclosed that the basis for its claim was “Fines and Penalties for environmental violations.” None of the alleged violations asserted by the District—which were of environmental nature—required a finding of falsity or fraud. The Court found that the District’s attempt to bring fraud-related allegations came too late, years after the bar date for proofs of claim. And the District’s late attempt to bring fraud-related allegations against Exide did not “relate back” to the original proof of claim.

The Court made clear that its ruling would not have been different even if the District’s fraud allegations would have related back. A prima facie element of fraud, the Court explained, is “that a creditor sustained loss and damages as a proximate result of the misrepresentations having been made.” Here, the penalties did not represent the amount of loss or damages sustained by the District that were caused by any alleged misrepresentation; rather, “they [were] noncompensatory penalties for violating emission standards.”

In other words, the District’s penalties were not fraud-based “compensation for actual pecuniary loss.” Rather, they were meant to serve a punitive purpose and, as such, fell outside the scope of the narrow exception to dischargeability applicable to corporate debtors.

II. Peabody Energy: Environmental Claims Dischargeability Carve-Outs

a) Background 

Peabody Energy Corporation, a coal company, filed for Chapter 11 protection together with its subsidiaries in April 2016 (the debtors, collectively, “Peabody”). A year later, in April 2017, Reorganized Peabody emerged from bankruptcy after its plan of reorganization (the “Plan”) became effective. After the emergence, and notwithstanding the fact that the bar date for governmental entities to file proofs of claim had passed, three California municipalities sued Peabody and more than 30 other energy companies for their alleged contributions to global warming. The lawsuits were filed in California state courts.

The municipalities’ lawsuits raised claims of strict liability and negligence for failing to warn, strict liability for a design defect, negligence, trespass, and private nuisance. They also brought two public-nuisance claims, one on behalf of the people of California seeking abatement of the nuisance, and the other on their own behalf seeking, among other things, damages and disgorgement of profits.

 b) The Bankruptcy Court Blocks the Pre-Petition Environmental Claims

Like the reorganized debtor in Exide Techs., Peabody filed a motion with the Bankruptcy Court seeking to enforce the discharge and injunction provisions of the Plan and confirmation order with respect to the municipalities’ lawsuits. The Bankruptcy Court for the Eastern District of Missouri granted the motion, explaining that the municipalities’ state court complaints focused on acts occurring from 1965 to 2015. The Bankruptcy Court further noted that the municipalities’ complaints mentioned Peabody sparingly, and, when they did, they alleged that Peabody had exported coal from California, continued to export coal from California, participated in “a national climate change science denial campaign” in 1991, and was linked to groups seeking to undermine the connection between the companies’ fossil fuel products and climate change. The Bankruptcy Court found that the municipalities’ claims pertained to pre-petition periods and were all discharged during Peabody’s bankruptcy proceedings. It therefore enjoined the municipalities from pursuing their claims against Peabody. After the District Court affirmed on appeal, the municipalities appealed to the Eighth Circuit.

c) The Eighth Circuit Finds the Claims Were Discharged under the Plan  

On appeal, the municipalities argued that two provisions in the Plan exempted their claims from discharge: (1) a carve-out exempting from discharge governmental claims brought “under any applicable Environmental Law to which any Reorganized Debtor is subject” (the “Environmental Law Carve-Out”); and (2) a carve-out exempting from discharge a governmental claim brought “under any...applicable police or regulatory law” (the “Police Power Carve-Out”).

The Court found that neither of these carve-outs covered the municipalities’ claims:

i. The Environmental Law Carve-Out

The Court found that the Environmental Law Carve-Out was inapplicable because the municipalities’ claims did not arise under “Environmental Law” as defined in the Plan. That term was defined to mean “all federal, state and local statutes, regulations and ordinances concerning pollution or protection of the environment, or environmental impacts on human health and safety, including [ten federal statutes] and any state or local equivalents of the foregoing.” The federal statutes listed included the Atomic Energy Act; the Clean Air Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the Federal Insecticide, Fungicide, and Rodenticide Act.

The municipalities argued that that their common-law claims were “state or local equivalents” of “statutes, regulations and ordinances concerning pollution” because they were raised to “protect the environment.” The Eighth Circuit disagreed. It upheld the Bankruptcy Court’s conclusion that when the definition of Environmental Law mentioned “state or local equivalent[s]” it was “talking about equivalents to the ten federal statutes listed,” not equivalents to “statutes, regulations and ordinances concerning pollution.” The Court further found that “if the drafters of this carveout had meant for it to include common-law claims they would have explicitly said so, or at a minimum would not have specifically limited Environmental Law to ‘statutes, regulations and ordinances.’”  

The Court did find that the municipalities’ nuisance claims were a “closer call” because they “rely on specific California statutes, bringing them at least arguably more in line with the plan’s definition of Environmental Law.” But that was not close enough. The Court concluded that “unlike the federal statutes listed, nuisance claims have their roots in the common law and are often referred to as common-law claims.” The Court reasoned that the federal statutes listed are designed to remedy particular environmental problems while nuisance law does not focus on particular environmental problems. In fact, the Court explained, “a nuisance can be something with no effect whatsoever on the environment—like something indecent or offensive to the senses or the sale of illegal drugs.”

ii. The Police Power Carve-Out

Here, too, the Eighth Circuit upheld the Bankruptcy Court’s view that the Police Power Carve-Out did not cover the municipalities’ claims. The Court’s analysis relied on Section 362(b)(4) of the Bankruptcy Code, which excepts a government’s attempt to enforce its “police and regulatory power” from the automatic stay. Under Eighth Circuit law construing Section 362(b)(4), when the government’s actions “would result in an economic advantage to the government or its citizens over third parties in relation to the debtor’s estate,” then the government is not exercising its police or regulatory power. It is acting as a creditor. Applying this so-called “pecuniary-interest rule,” the Bankruptcy Court concluded that if the municipalities’ claims were successful, they would obtain a pecuniary advantage over other creditors because they were seeking damages and disgorgement of profits. They were therefore not seeking to enforce police or regulatory power. The Eighth Circuit upheld that conclusion.

d) Public Nuisance Claims Also Discharged

The municipalities also asserted that even if the Plan did not exempt their claims from discharge, their public nuisance claim brought on behalf of the people of California did not constitute a claim under bankruptcy law (and thus cannot be discharged), because California law does not permit them to recover damages under nuisance theory; they can only obtain an equitable decree ordering Peabody to abate the nuisance.

The Eighth Circuit rejected this argument. Reiterating the broad nature of the term “claim” under bankruptcy law as “virtually all obligations to pay money,” the Court explained that even though California law limits the recovery on the public nuisance claim to equitable relief, that relief can include obligations to pay money. In California, the Court explained, “a party who commits a public nuisance can be ordered to pay into a fund, overseen by a receiver, to remedy or eliminate the hazard complained of rather than being ordered to clean up the nuisance themselves.” The Court did not see a reason to deviate from this conclusion even if the funds were to be directed to a receiver overseeing an abatement fund. Even if the municipalities cannot deposit abatement-fund payments into their general treasuries, “it is the municipalities and their people who stand to benefit from them.”

Takeaways

Exide Techs. and Peabody Energy both demonstrate the importance of understating the scope (and limits) of a Chapter 11 debtor’s discharge, and particularly in connection with environmental liabilities. The ability to discharge debts and liabilities is a crucial component of Chapter 11 that could largely impact the post-emergence landscape. Exide Techs., which is currently on appeal before the Third Circuit, provides an important analysis distinguishing the narrow dischargeability exceptions applicable to corporate debtors from those applicable to individuals. Debtors, creditors, and other parties in interest negotiating plans of reorganization should be vigilant and carefully map liabilities that may survive emergence from bankruptcy. Peabody Energy Corp. teaches a similar lesson. Plan drafters should design dischargeability carve-outs and related definitions with care, making sure not to exclude from the general discharge more than what is required. And creditors should carefully scrutinize these provisions to protect their claims. 

Although the environmental claims were held discharged in both cases, in light of the rising profile of environmental protection and climate change, we believe that this is merely the opening act in the fight over the dischargeability of environmental claims.

Read the Exide Techs. opinion >> 

Read the Peabody Energy Corp. opinion >> 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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