Setoff, a powerful collection tool for creditors, is protected by §553(a) of the Bankruptcy Code—which provides, with some exceptions, that the Code "does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor that arose [pre-petition] against a claim of such creditor against the debtor that arose [pre-petition]." Thus, by the language of this provision, the Code preserves any setoff right that a creditor would have under state law.

But what happens when a creditor's claim is based on the debtor's rejection of an executory contract in a bankruptcy case? Under §365(g) of the Code, "the rejection of an executory contract or unexpired lease of the debtor constitutes a [pre-petition] breach of such contract or lease." And under §502(g), the claim that arises from such rejection is determined—and allowed or disallowed—as if such claim had arisen pre-petition.

Thus, by the plain language of §§365(g) and 502(g), it appears that a rejection damage claim is for all intents and purposes a pre-petition claim. Therefore, a rejection damage claim would be a pre-petition claim for purposes of setoff under §553. Indeed, two leading bankruptcy treatises¹ and the two bankruptcy courts that have actually ruled on this issue in published opinions concluded that a rejection damage claim can be offset under §553. However, in In re Delta Airlines Inc.,² the bankruptcy court cut against the grain, concluding that a rejection damage claim is not subject to a setoff under §553 of the Code because a rejection damage claim does not arise pre-petition, but rather post-petition at the time of rejection.

This article will (1) discuss the facts and legal analyses of the two cases that directly addressed whether a rejection-damage claim is a pre-petition claim, and (2) analyze the facts in Delta and discuss the bankruptcy court's conclusion that a rejection-damage claim is not a pre-petition claim subject to a setoff.

Rejection Damages Can Be Offset Against a Pre-Petition Debt

Express Freight Lines, Inc. v. Kelly (In re Express Freight Lines, Inc.).³ Frank C. Kelly purchased a truck terminal facility from Express Freight Lines (Express).⁴ Express financed $100,000 of the purchase price, and Kelly was obligated to make monthly payments of $2,211.83 over a 60-month period.⁵ When Express filed its chapter 11 petition, Kelly still owed $78,761 to Express.

At the time of the purchase, Kelly and Express entered into a leaseback agreement under which Kelly agreed to lease to Express a portion of the terminal facility for five years.⁶ Under this leaseback agreement, Express was obligated to make monthly payments of $12,500 to Kelly. By the terms of the promissory note, however, Kelly's monthly payments of $2,211.83 were offset against Express' monthly lease payments.⁷ Thus, Express paid $10,288.17 per month to Kelly.⁸

Express filed its chapter 11 petition on June 16, 1989, and later rejected the leaseback agreement.⁹ Kelly had a $19,099.50 pre-petition claim based on a pre-petition default and a rejection damage claim of $150,000 (based on one year's rent allowed under §502(b)(6) of the Code) for a total claim of $169,099.50.¹⁰ Kelly claimed that he had a secured claim of $78,761 (the remaining amount on his note) and an unsecured claim for the remainder.¹¹

The court concluded that "since the lease was not assumed, the rejection 'constitutes a breach of such...lease... immediately before the date of the filing of the petition.'"¹² And since §502(g) classifies rejection claims as pre-petition claims, Express' rejection of the leaseback agreement "resulted in a $169,099.50 claim for Kelly as of a point in time immediately before the filing of the petition."¹³ Thus, this satisfied the pre-petition requirement for setoff under §553 of the Code.¹⁴

The court next determined whether Kelly could offset his pre-petition claim against the remaining note payments that became due after Express filed for bankruptcy.¹⁵ First, the court looked at In re Isis Foods Inc.:¹⁶

It is patent law on the issue of setoff, however, that "the right of setoff may be asserted in the bankruptcy case, even though at the time the petition is filed one of the debts involved is absolutely owing but not presently due, or where a definite liability has accrued but is as yet unliquidated. Nor is it necessary that the debt sought to be setoff be due when the case is commenced."

Based on Isis Foods, the court concluded that it does not matter if either debt is unmatured when the bankruptcy petition is filed to determine eligibility for setoff under §553.

Moreover, the court looked at the definitions of claim and debt under §101. Since "claim" is defined as "a right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured or unsecured," and "debt" is defined as a "liability on a claim," it clearly follows that a debt owed by a creditor to the debtor can be an unmatured liability.¹⁷ Thus, pre-petition unmatured debts owed to a debtor can be accelerated to accomplish a setoff under §553 if the other requirements of setoff have also been satisfied.¹⁸ The court therefore concluded that Kelly's note was a pre-petition debt subject to a setoff.¹⁹

In re Mace Levin Associates.²⁰ Although the debtor filed for chapter 11 relief on July 21, 1987, the case was converted to chapter 7 approximately five months later.²¹ The chapter 7 trustee requested authority to proceed with pre-petition arbitration to liquidate his claim against Clairton Corp. based on a lease agreement dated Feb. 24, 1986.²² Clairton did not object to such relief as long as it obtained relief from the automatic stay to assert a counterclaim for damages arising out of the post-petition rejection of the lease.²³ The trustee argued that setoff of Clairton's rejection damage claim is not permissible under §553.²⁴

The court stated that the fundamental issue was whether §553 permits setoff of a creditor's rejection damage claim.²⁵ The court explained that for the trustee to prevail on his argument that Clairton's rejection damage claim was a post-petition rather than a pre-petition claim, the trustee would have to overcome §§365(g) and 502(g) of the Code; these sections mandate that a rejection of an executory contract "constitutes a breach of such...lease...immediately before the date of the filing of the petition," and such claim arising from such breach is a pre-petition claim.²⁶

But the trustee argued that §502(g) is only intended to ensure that a rejection damage claim does not transform into an administrative-priority claim; to treat a rejection damage claim as a "pre-petition claim" is a mere legal fiction.²⁷ The trustee further argued that by treating a rejection damage claim as a pre-petition claim for purposes of §553, the burden on the debtor's estate would increase.²⁸

The court explained that the trustee's argument was "really an argument against setoff itself and, in enacting §553, Congress decided otherwise."²⁹ The court further explained that

[t]he characterization of rejection claims as pre-petition obligations is not simply a legal fiction created by §§365(g) and 502(g). The lease was entered into pre-petition and by virtue of this fact imposed pre-petition obligations on both parties. Given its long-term and continuing nature, however, it could have been transmuted into a post-petition obligation had the debtor assumed it.³⁰

Indeed, the court reasoned that the Code allows a debtor some time to decide whether or not to assume or reject, thereby putting leases and executory contracts "on hold in a peculiar legal limbo."³¹ It did not matter to the court that some uncertainty existed as to Clairton's claim at the time of the bankruptcy filing.³² But this uncertainty, the court explained, was not fatal to the claim's pre-petition status;³³ a "claim need not have matured or been liquidated in order to apply §553."³⁴

Rejection Damage Claim Cannot Be Offset against a Pre-Petition Debt

In In re Delta Airlines Inc.,³⁵ the Greater Orlando Aviation Authority (GOAA) requested relief from the automatic stay to offset under §553 certain credits in favor of Delta Airlines Inc. against a rejection damage claim.³⁶ The court held that "(1) as a matter of law, rejection damages under §§365(g) and 502(g) may not be set off against a pre-petition claim or debt and (2) in any event, on the facts...the credits in question were not debts or claims that existed or 'arose' pre-petition."³⁷

On June 1, 1978, Delta and GOAA entered into a lease. This lease was one of many leases that GOAA entered into with certain airlines, including Delta. Under the lease, Delta was obligated to pay certain amounts to GOAA during each fiscal year ending Sept. 30 for use and occupancy of the Orlando Airport.³⁸ The lease provided that if the airport "generated a net revenue surplus by the end of the fiscal year, that surplus would be credited after the fiscal year on a pro rata basis to each...airline."³⁹ No funds were due to any airline; rather, GOAA would make a journal entry in its books reflecting the "credit." The lease required GOAA to apply the credits as an offset against Delta's "airline fees and charges for the first three months of [the] next succeeding fiscal year."⁴⁰

At the end of fiscal year 2005, Delta was entitled to approximately $4.3 million in credits for that fiscal year. GOAA refused to apply Delta's credits as offsets for any amounts owed by Delta during fiscal year 2006. In early December 2005, Delta notified GOAA that it planned to reject the lease.⁴¹ GOAA acknowledged that it did not apply the fiscal year 2005 credits against any amounts owed by Delta during fiscal year 2006 because it anticipated that it would have a rather large rejection damage claim, which it intended to offset against Delta's credits. On Dec. 22, 2005, Delta filed its motion to reject the lease, and the court entered an order granting the motion on Feb. 22, 2005. On Jan. 5, 2006, however, GOAA filed its motion for relief from stay to offset its rejection damage claim against the credits due to Delta.⁴²

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There appear to be only two cases, In re Express Freight Lines Inc. and In re Mace Levin Associates, that have directly ruled on the rejection damage claim/setoff issue.

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The court looked at the language of §553 of the Code and concluded that §553 only applies to a right to offset mutual debts "that arose before the commencement of the case."⁴³ The bankruptcy court explained that the language of §553—"this title does not affect any right of a creditor to offset" mutual debts—confirms that §553 does not create a federal right of setoff; it does not "enhance, diminish or otherwise modify any state law right of setoff."⁴⁴ In interpreting these two points, the court could only conclude that "if no right to setoff under state law existed before the commencement of the case, none exists under §553."⁴⁵

Of course, GOAA relied upon §§365(g) and 502(g), which provide that a rejection of an executory contract constitutes a pre-petition breach and the claim that arises from such breach is allowed or disallowed the same as if the claim had arisen pre-petition.⁴⁶ But the bankruptcy court explained that the provisions of the Code cannot affect state law setoff rights: "To invoke §§365(g) and 502(g) to create a right of setoff where none exists under state law would defy [t]he unambiguous language in §553" that provides that the Code "does not affect any right of a creditor to offset a mutual debt."⁴⁷

Conclusion

There appear to be only two cases, In re Express Freight Lines Inc. and In re Mace Levin Associates, that have directly ruled on the rejection damage claim/setoff issue. Both cases based their reasoning on §§365(g) and 502(g) for concluding that a rejection damage claim is subject to a setoff under §553 since a rejection damage claim is deemed to be a pre-petition claim by operation of law.

Thus, the bankruptcy court in Delta is the first court, it appears, to conclude in a published opinion that for purposes of §553, a rejection damage claim arises post-petition by relying solely on the language of §553. The Delta court would conclude that an interpretation in which a rejection damage claim is treated as a pre-petition claim for purposes of §553 is a "strained or imaginative interpretation...not constituent with the plain and ordinary usage and meaning of the statutory language" of §553⁴⁸—even though §§365(g) and 502(g) state otherwise. It is safe to say that the other courts that decided that a rejection-damage claim is subject to offset based on the plain language of §§365(g) and 502(g) would conclude that the Delta court is the one engaging in strained and imaginative statutory interpretation. In any event, few courts have analyzed this issue and it will be left for the bankruptcy courts and other federal courts to determine exactly who is employing a strained or imaginative interpretation of the Code.

 

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Footnotes

1 See Norton, William L. Jr., 3 Norton Bankruptcy Law and Practice 2D §63:4 ("the timely post-petition rejection of an executory contract creates a pre-petition claim subject to setoff by the operation of the 'relation-back' rule of 502(g)"); King, Lawrence P., 5 Collier on Bankruptcy |553.03(i)(i) ("claims based upon the debtor's rejection of an executory contract or unexpired lease, which are specifically designated as pre-petition in nature [under] §§365(g) and 502(g), are eligible for setoff against mutual pre-petition debts").

2 341 B.R. 439 (Bankr. S.D.N.Y. 2006).

3 130 B.R. 288 (Bankr. E.D. Wis. 1991).

4 Id. at 289.

5 Id.

6 Id.

7 Id.

8 Id. at 290.

9 In re Express Freight Lines Inc., 130 B.R. at 290.

10 Id.

11 Id.

12 Id. at 291-92. The court's conclusion implies that if a debtor assumes an executory contract, then the post-petition contractual obligations of the debtor are post-petition obligations. Compare United States v. Gerth, 991 F.2d 1428 (8th Cir. 1993) ("assumption of an executory contract does not alter when the obligations arose... If...the contract terms are such that [the] obligation to pay arose pre-petition, then a holding by this court that simply assuming the contract causes the obligation to arise post-petition would have the effect of modifying those contract terms"). This case was cited in Norton Bankruptcy Law and Practice 2D as support for its conclusion that a rejection-damage claim is subject to a setoff. See Norton, supra at n. 1.

13 In re Express Freight Lines Inc., 130 B.R. at 290 (emphasis in original).

14 Id.

15 Id. at 292.

16 24 B.R. 75, 77 (Bankr. W.D. Mo. 1982) (quoting 4 Collier on Bankruptcy |553.10(2) (1982)).

17 In re Express Freight Lines Inc., 130 B.R. at 292-93.

18 Id. at 293.

19 Id. at 293.

20 103 B.R. 141 (Bankr. N.D. Ohio 1989).

21 Id. at 142.

22 Id.

23 Id.

24 Id.

25 Id. at 143.

26 In re Mace Levin Assocs., 103 B.R. at 143.

27 Id. at 143.

28 Id. at 143.

29 Id. at 143.

30 Id. at 144.

31 Id.

32 In re Mace Levin Assocs., 103 B.R. at 144.

33 Id.

34 Id.

35 In re Delta Airlines Inc., 341 B.R. 439 (Bankr. S.D.N.Y. 2006).

36 Id. at 441.

37 Id.

38 Id.

39 Id.

40 Id. Despite the language of the lease, GOAA would offset the credits against the amounts owed by the airlines during any of the 12 months of the next fiscal year in accordance with the direction of each airline. Id.

41 In re Delta Airlines Inc., 341 B.R. at 442.

42 Id.

43 Id. at 443.

44 Id.

45 Id. at 445. The bankruptcy court also concluded that a plain language analysis of §553 could only lead to its conclusion: "Congress could have written §553 to permit offset of rejection claims against pre-petition debts owed to the debtor, or not permit such offset, without doing violence to any overreaching policy or objective embodied in the Bankruptcy Code or any cosmic notion of justice or fairness." Id. at 446.

46 Id. at 446.

47 In re Delta Airlines Inc., 341 B.R. at 446-47.

48 Id. at 445.