Priority of administrative expenses is not guaranteed for post-petition defaults by debtors
March 15, 2022 – Parties to contracts with a company filing for Chapter 11 bankruptcy are often asked to continue doing business with the debtor after they file to avoid business interruption for all parties . In doing so, the contracting parties often assume that they will be entitled to a claim for administrative costs for any breach of the agreement by the debtor after the request. However, Judge James Garrity’s decision in In re Ditech Holding Corp.No. 19-10412 (JLG) (Bankr. SDNY Oct. 21, 2021) provides a warning that knowledgeable businesses should keep in mind when engaging in business with bankrupt debtors.
One of the debtors of Ditech, Reverse Mortgage Solutions, Inc. (Obligor), was a party to Reverse Mortgage Sub-Service Agreements (the Agreements) with Liberty Home Equity Solutions, Inc. and Finance of America Reverse LLC (the Plaintiffs). Under these agreements, the debtor arranged the reverse mortgages for the claimants in exchange for servicing fees.
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While the agreements were to expire before the debtor filed for bankruptcy, the debtor and each of the plaintiffs entered into a series of agreements to extend the term without otherwise altering the other terms or conditions of the agreements (the pre-extending agreements). petition). Following the pre-petition extension agreements, the agreements were still in effect when the debtor filed for Chapter 11 in February 2019.
The debtor and the plaintiffs also entered into a series of agreements after the petition to extend the duration of the agreements, until September 30, 2019 (the post-petition extension agreements and with the pre-petition extension agreements , extension agreements) . Like the pre-petition extension agreements, the post-petition extension agreements extended the terms without otherwise altering the other terms or conditions of the agreements. The debtor performed under the extension agreements and received management fees for doing so.
The debtor sold its reverse mortgage business under its confirmed plan, and the sale was completed on September 30, 2019. The agreements expired on their own terms prior to the effective date of the debtor’s plan, and debtor has not assigned the agreements to buyer. The Debtor’s plan provided that any enforceable contract not assumed would be rejected.
The Claimants subsequently filed claims seeking payment of administrative costs. They argued that the debtor violated the agreements after the petition by committing various service errors and other material breaches of the agreements. Plaintiffs argued that each Extension Agreement was a new Agreement under applicable state law that superseded and superseded existing Agreements; thus, the breaches that occurred were breaches of post-petition agreements with the debtor.
In support of their argument, the plaintiffs asserted that the debtor had received substantial consideration for entering into the extension agreements, including management fees. They further argued that their claims were not in the nature of the dismissal damages claims since the debtor could not dismiss the extension agreements, which were entered into after the petition.
Alternatively, the plaintiffs asserted that they were entitled to priority payment of administrative costs for the debtor’s breach of the agreements after the petition because, even though the debtor had neither accepted nor rejected the agreements, the debtor continued to execute these agreements after the request and received the benefits therefrom.
Arguments of the plan administrator
The Debtor’s plan administrator objected to the administrative expense claims and sought to reclassify them as general unsecured claims, arguing that they were in fact claims for rejection of the Settlements. The plan administrator also stated that it was clear from the extension agreements that the parties did not intend to enter into new agreements, but only to extend the term of existing agreements while the parties negotiated the terms of the new agreements.
The court agreed with the plan administrator, upheld the objection and reclassified the claims as general unsecured claims. The court first found that by executing the post-petition extension agreements, the debtor was not entering into new agreements with the plaintiffs and that the extension agreements did not supersede or supersede the agreements.
Instead, the clear terms of the extension agreements provided that the debtor merely extended the original agreements under the same terms and conditions while the parties attempted to enter into a new agreement. Accordingly, since the extension agreements were not new post-petition agreements, the court held that claims under them were not entitled to priority of administrative expenses.
The court then considered whether claims for damages resulting from the debtor’s breach of the agreements after the petition were nevertheless entitled to the priority of administrative costs. The court ruled that they were not. The court assumed that the Bankruptcy Code determines when a claim arises and defines a claim as including a possible right to payment. Building on this basic premise, the court noted that when parties contemplate the possibility of a future breach of their contracts, those breaches are treated as conditional pre-petition claims rather than post-petition claims.
Accordingly, the court concluded that since the agreements provided for the possibility of remedying errors and established procedures for dealing with such errors, the claims were conditional pre-petition claims rather than post-petition claims, which the debtor rejected the agreements or they expired by their terms. The fact that the Debtor received post-petition compensation for its services did not transform the claims into priority claims for administrative expenses.
It is widely accepted that a debtor-in-possession breach of an agreement entered into after petition gives rise to a priority claim for administrative costs for the full amount of damages provided for in the contract. Indeed, the operation of the debtor’s business during the bankruptcy case benefits the creditors before the petition and, therefore, any claim resulting from the operation is entitled to priority payment.
However, the Ditech The ruling appears to overturn what was accepted as the black letter law and suggests that a debtor’s breach of contract after petition can never create a priority claim for administrative costs if the terms of the contract contemplated a potential breach. The contracting parties should not assume that they will be entitled to priority of administrative costs for their claims if the debtor continues to act after the request, but nevertheless breaches the contract. Under Ditechthere is a real risk that these claims will be treated as general unsecured claims.
The editors are regular and joint bankruptcy law columnists for Reuters Legal News and Westlaw Today.
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