In re Chugiak Boat Works, Inc., Bankruptcy No. 3-80-00386.

• Decision Date: 11 March 1982
• Docket Number: Bankruptcy No. 3-80-00386.
• Citation: 18 BR 292
• Parties: In re CHUGIAK BOAT WORKS, INC., Debtor.
• Court: U.S. Bankruptcy Court — District of Alaska

18 B.R. 292 (1982)

In re CHUGIAK BOAT WORKS, INC., Debtor.

Bankruptcy No. 3-80-00386.

United States Bankruptcy Court, D. Alaska.

March 11, 1982.

James D. Sourant, Sourant & Strandberg, Anchorage, Alaska, for Silver King River Runners.

Mark P. Worcester, Perkins, Coie, Stone, Olsen & Williams, Anchorage, Alaska, for Alaska Renewable Resources Corp.

MEMORANDUM OPINION

J. DOUGLAS WILLIAMS, II, Bankruptcy Judge.

Silver King River Runners (Silver King) has filed an application asking the Court to order disbursement of a deposit paid to Chugiak Boat Works, Inc., (Chugiak), while the latter was operating as a debtor in possession pursuant to Chapter 11 of the Bankruptcy Reform Act of 1978 (Code), 11 U.S.C. § 101 et seq. Chugiak has subsequently converted the case to one under Chapter 7 of the Code. Silver King argues that its claim has priority as an administrative expense pursuant to § 507(a)(1) of the Code, 11 U.S.C. § 507(a)(1). The application has been opposed by Alaska Renewable Resources Corporation (ARRC), a secured creditor of Chugiak, which argues that Silver King's claim does not qualify as an administrative expense but is a rejected executory contract, which must be treated as a prepetition claim pursuant to § 502(g) of the Code. Having considered the arguments of the parties, this Court finds that Silver King's claim, which arises from an executory contract entered into during the Chapter 11 reorganization but before conversion to Chapter 7, constitutes an administrative expense within the meaning of § 503(b) of the Code and is entitled to priority pursuant to § 507(a)(1).

I. Facts

Chugiak Boat Works, Inc., filed a petition for relief under Chapter 11 of the Bankruptcy Code on December 12, 1980. The corporation carried on its business as debtor in possession until May 28, 1981, when it voluntarily converted the proceeding to a case under Chapter 7. A trustee is now administering the affairs of the Debtor.

On or about March 20, 1981, after the order for relief under Chapter 11 but before Chugiak's conversion to Chapter 7, Silver King paid to Chugiak $4,150 as a down payment on a boat to be manufactured by Chugiak in the ordinary course of its business for Silver King. Silver King filed a proof of claim on July 28, 1981.

At the hearing of this matter, the Trustee asserted that the estate would be able to pay at least twenty-five percent of all administrative expenses.

II. Applicant's Claim Constitutes an Administrative Expense

This Court finds that where a customer makes a deposit pursuant to an agreement to receive the essential goods or services provided in the ordinary course of business by a debtor in possession during a Chapter 11 reorganization, the obligation to return the deposit constitutes an administrative expense should the debtor subsequently convert its case to one under Chapter 7 and fail to perform under the agreement. Where the obtaining of such deposits was necessary to a successful reorganization, the obligation represents a necessary cost of preserving the estate, pursuant to § 503(b)(1)(A). The history of the bankruptcy law's treatment of executory contracts, together with the provisions of the Code, particularly sections 365(g) and 363(c)(1), compel the conclusion that the Court is authorized to treat such obligations as administrative expenses. The policy of Congress of encouraging alternatives to liquidation bolsters this conclusion, since the protection of potential customers of a debtor in possession is necessary to foster a successful reorganization.

The obligation to repay Silver King is an administrative expense entitled to priority under § 507(a)(1)¹ because it represents an actual and necessary cost of preserving the estate within the meaning of § 503(b)(1)(A).² The incurring of such obligations was, at the time, necessary to the preservation of the estate as a going concern. Without such agreements there would have been no possibility of a successful reorganization.

ARRC relies on two provisions of the Code to argue that a claim arising from an executory contract entered into in the course of a Chapter 11 reorganization and subsequently rejected after conversion to Chapter 7 does not give rise to an administrative expense but must be treated as a claim which arose prior to the original Chapter 11 petition. The first of these provisions is § 348(d), which reads:

(d) A claim against the estate or the debtor that arises after the order for relief but before conversion in a case that is converted under section 1112 or 1307 of this title, other than a claim specified in section 503(b) of this title, shall be treated for all purposes as if such claim had arisen immediately before the date of the filing of the petition.

The second provision, which, according to ARRC, reaffirms in the case of executory contracts the general rule of § 348(d), is § 502(g), which reads:

(g) A claim arising from the rejection, under section 365 of this title or under a plan under Chapter 9, 11 or 13 of this title, of an executory contract or unexpired lease of the debtor that has not been assumed shall be determined, and shall be allowed under subsection (a), (b), or (c) of this section or disallowed under subsection (d) or (e) of this section, the same as if such claim had arisen before the date of the filing of the petition.

Neither of the provisions relied on by ARRC is dispositive of the issue before the Court, which is whether an executory contract reasonably entered into in the course of a Chapter 11 reorganization but rejected after conversion to Chapter 7 constitutes an administrative expense. Section 348(d) specifically excepts from its reach administrative expenses. Section 502(g) concerns only executory contracts which were entered into by the debtor prior to the commencement of the Chapter 11 proceeding and which have never been assumed by the debtor in the reorganization proceeding.³ Cf. 1A Bkr.L.Ed. § 6:193, at pp. 299-300 (1981). The provisions of the Code, particularly sections 365(g) and 363(c)(1), when viewed in the light of the history of the treatment of executory contracts under the Bankruptcy Act of 1898, show a legislative intent to authorize the bankruptcy court to treat executory contracts entered into during a Chapter 11 reorganization and later rejected, as administrative expenses when the Court views those contracts as having been reasonably made in the ordinary course of the debtor's business.

Courts interpreting the administrative expense provisions of the Bankruptcy Act of 1898 held that those provisions, which were very similar to those contained in the present Code,⁴ authorized the courts to treat as administrative expenses executory contracts entered into during reorganization but before conversion to straight bankruptcy. In In re Avorn Dress Co., 78 F.2d 681, 683 (2nd Cir. 1935), for example, the Court held that obligations arising from purchases and sales made by the debtor in possession in the ordinary course of business before conversion to straight bankruptcy would constitute administrative expenses, with no need for prior court approval of the transactions. And in In re California Eastern Airways, 95 F.Supp. 348, 350-351 (D.Del.1951), the Court in describing a claim for debtor's breach of an airplane lease agreement made in the ordinary course of debtor's business, declared:

In reorganization or arrangement proceedings, and to a more limited extent, in straight bankruptcy proceedings, a trustee or debtor in possession may be authorized to enter into contracts which are necessary or expedient for the administration of the estate of the debtor or bankrupt and a commitment thus made will constitute a priority claim as an expense of administration under the provisions of §§ 62, and 64 of the Bankruptcy Act.

In 1967, Congress amended Chapters X, XI, and XII of the Bankruptcy Act of 1898 to sanction the result that had been reached by the Courts under the administrative expense provisions of the Act. The amendment explicitly provided that any executory contract entered into or assumed during the reorganization proceeding but rejected after conversion to straight bankruptcy constituted an administrative expense of the reorganization proceeding.⁵ The legislative history indicates that the amendment was intended to resolve confusion over how such executory contracts should be treated and to recognize the rights of those parties "who have dealt with an officer of the court in the debtor relief proceeding." Senate Report No. 90-749, 90th Cong. 1st Sess. (1967), reprinted at U.S.Code Cong. & Admin.News 1967, pp. 2002, 2005. Thus, pursuant to the 1967 amendment, all executory contracts originally entered into during the reorganization as well as all executory contracts assumed during that time were automatically granted administrative expense priority.

Although ARRC argues that sections 348(d) and 502(g) radically change prior law concerning the treatment of executory contracts, a review of the Code convinces this Court that Congress intended to work only a subtle change in this aspect of the bankruptcy law. Section 365(g) of the Code clearly grants automatic administrative expense priority to executory contracts assumed during a reorganization and later rejected after conversion, thus continuing the practice under the Bankruptcy Act. In light of the virtual identity in effect of contracts initially entered into during reorganization and contracts assumed during that time, the administrative expense provisions of the Code must be read to authorize the Court also to treat contracts initially entered into during reorganization as administrative expenses, with one difference: while assumed contracts, having already been approved by the Court pursuant to § 365(a) of the Code, are automatically granted administrative expense priority by § 365(g), initially entered contracts will be subject to Court scrutiny under § 503(b) to determine whether the priority...