IN RE:

HNRC DISSOLUTION CO., f/k/a

Horizon Natural Resources

Company, et al. CASE NO. 02-14261

DEBTOR

Lexington Coal Company, LLC ("Lexington Coal"), one of the purchasers of assets of the former Debtors, filed an Objection to the Administrative Expense Request, Claim No. 20286, and related Proof of Claim No. 20190 (Doc. #6047), filed by Lonnie Loveridge, et al. ("the Loveridges"). The Loveridges filed their Response (Doc. #6236) to Lexington Coal’s Objection, and Lexington Coal filed a Reply (Doc. #6538). This matter was heard on July 15, 2005, and taken under consideration for decision.

On September 26, 2005, and October 21, 2005 the court entered orders directing the Loveridges to file copies of Claim Nos. 20286 and 20190, along with any supporting documentation. The Loveridges filed a Response to Orders and copies of their claims and supporting documentation (Doc. # 7048)on November 1, 2005.

1. Factual and procedural background

The Loveridges filed their Administrative Expense Request ("the Request") on December 23, 2004 seeking allowance of an administrative expense claim in the amount of $645,810.00 for alleged post-petition damages related to a pre-petition coal lease ("the Lease") originally dated March 17, 1986. The basis for their claim is that it "arises from a transaction with the debtor-in-possession and . . . directly and substantially benefitted the bankruptcy estate." The Lease was not assumed by the Debtors and was rejected under Bankruptcy Code section 365 by virtue of the order entered September 30, 2004 (a) Authorizing the Rejection of All Remaining Executory Contracts and Unexpired Leases; and (b) Establishing a Deadline for Assertion of Claims Resulting from Such Rejection ("the Rejection Order") (Doc. # 4203).

Prior to filing the Request, the Loveridges filed an unsecured proof of claim (# 20190) for damages arising from the rejection of the Lease in the amount of $645,810.00. In their Statement Accompanying the Proof of Claim for Lease Rejection Damages . . . Regarding Basis for Claim, the Loveridges state their contention that the Debtor’s post-petition use of the leased premises breached its obligations and gave rise to their administrative expense claim. They further state that their primary reason for filing the lease rejection damage claim was to preserve their right to assert an administrative expense claim, and that the lease rejection damage claim "is contingent upon, and may be mooted in whole or in part" by the court’s allowance or disallowance of their administrative expense claim. Further, neither party argued the lease rejection damage claim in its filings. This opinion therefore rules only on the administrative expense claim.

The Loveridges originally entered into the lease with Mountain Clay, Inc. The lease was amended twice. On March 7, 1995, Mountain Clay, Inc. assigned a portion of the coal and coal mining rights to Leslie Resources, one of the former Debtors ("LR" or "the Debtor"). On June 20, 2000, the Loveridges and LR executed a Third Addendum and Amendment to Coal Lease ("the Mineral Lease") to amend certain terms of the Lease, its addenda and amendments. The Loveridges base their claims on provisions found in the Mineral Lease, the most pertinent of which are found in Section 2:

. . . . Lessee hereby guarantees that Lessors shall receive a minimum production royalty in the amount of . . . $10,000.00 per month. In the event that production royalties paid to Lessors, . . ., do not equal . . . $10,000.00 per month, then Lessee shall make a deficiency payment in an amount equal to the difference between the production royalties paid and . . . $10,000.00. Said deficiency payment shall be paid to Lessors simultaneously with the production royalties and shall be fully recoupable throughout the term of the Underlying Lease Agreements, as amended herein.

Nothwithstanding the foregoing, at such time as there is insufficient coal which can be profitably mined by Lessee, to be determined in Lessee’s sole discretion, such that Lessee can fully recoup the advance royalties and deficiency payments made hereunder, then Lessee shall be relieved of its obligation to guarantee unto Lessors a minimum monthly production royalty as set forth above. Additionally, if Lessee is engaged in the reclamation process only, and no coal mining is actually occurring on the premises, then Lessee shall also be relieved of this obligation to guarantee a minimum monthly production royalty as set forth above, unless Lessee has not mined all of the mineable and merchantable coal within the No. 8 and No. 9 seams. In this event, then Lessee shall remain obligated to guarantee unto Lessors a minimum monthly royalty in the amount of . . . $10,000.00 as set forth in Section 3 below.

The Lease defines mineable and merchantable coal in Article 1 which states as follows: "Nothing herein contained shall require Lessee to mine any coal which is not mineable and merchantable. The term ‘mineable and merchantable’ as used herein, means coal which can be mined and sold at a reasonable profit to Lessee upon the market then prevailing. So long as it acts in good faith, Lessee shall be the sole judge of the mining plan." (Lease, 3/17/1986, Art. 1, p. 4)

On May 22, 2003 a letter was sent on behalf of LR informing the Loveridges that LR had determined that "there is now insufficient coal which can be profitably mined. Therefore, because Leslie Resources has mined all the mineable and merchantable coal on the property, Leslie Resources is no longer obligated to tender any payments to the Loveridges." (Exh. 7 to Loveridges’ Response). The letter further stated that the Mineral Lease would expire by its terms in June 2003.

2. Discussion

Lexington Coal contends that the Loveridges have not demonstrated that their claim constitutes an "actual, necessary cost[] and expense[] of preserving the estate" pursuant to Bankruptcy Code section 503(b)(1)(A). It cites In re Sunarhauserman, 126 F.3d 811 (6th Cir. 1997) for its two-part analysis in applying this provision:

[A] debt qualifies as an ‘actual, necessary’ administrative expense only if (1) it arose from a transaction with the bankruptcy estate and (2) directly and substantially benefitted the estate. The benefit to the estate test limits administrative claims to those where the consideration for the claim was received during the post-petition period.

Id. at 816. A claimant has the burden of proving entitlement to an administrative expense by a preponderance of the evidence. Further, "[t]he claimant must demonstrate that the benefit is more than a speculative or potential benefit." In re Kmart Corp., 290 B.R. 614, 621 (Bankr. N.D. Ill. 2003).

[T]here must be a strict construction of the terms ‘actual’ and ‘necessary’ therefore requiring that the estate actually receives a real benefit from the transaction, before administrative priority will be granted on claims against the estate. . . . The focal point of the allowance of a priority is to prevent unjust enrichment of the estate, not to compensate the creditor for its loss. . . . Thus, a court looks to the actual benefit to the estate and not the loss sustained by a creditor.

In re Globe Metallurgical, Inc., 312 B.R. 34, 40 (Bankr. S.D. N.Y. 2004)(internal quotes and citations omitted). See also In re WorldCom, Inc., 308 B.R. 157 (Bankr. S.D. N.Y. 2004).

As to the requirement that the transaction in question be with the post-petition debtor, Lexington Coal maintains that the Loveridges have failed to prove that the basis for their claim arose post-petition. While Lexington Coal acknowledges that Leslie Resources did business with the Loveridges and then ceased mining under the Lease post-petition, the Lease was rejected by the Rejection Order. Pursuant to Bankruptcy Code section 365(g), a rejected contract is deemed to have been breached "immediately before the date of the filing of the petition," and, therefore, according to Lexington Coal, any claim the Loveridges have is a pre-petition claim.

Lexington Coal also contends that the Loveridges have failed to prove a direct and substantial benefit to the estate. It points out that the mere fact that an obligation may have arisen post-petition does not make that obligation an administrative claim. Lexington Coal argues that the Loveridges have not provided sufficient evidence to support the claim that any of the amounts related to the cessation of mining and the reclamation of the property under lease provided any benefit to the estate.

The Loveridges respond that notwithstanding the general principle that a creditor’s claim arising from rejection of a contract will be considered a pre-petition claim, that claim may rise to the status of an administrative expense claim if the claimant can demonstrate that it falls within the purview of section 503(b)(1)(A). The Loveridges contend that they have so demonstrated. First of all, they argue, there is no question that their claim arose from a transaction with the post-petition Debtor, i.e., the Debtor’s decision to cease mining their property and then to initiate and substantially complete a reclamation of that property. They state that reclamation made the mining of the remaining coal cost-prohibitive and rendered that coal unmineable.

As to the issue of whether the cessation of mining and reclamation of the property directly and substantially benefitted the estate, the Loveridges contend that the reclamation made sixty percent of the bonds posted to secure the reclamation of the underlying permits issued by the Commonwealth of Kentucky Natural Resources and Environmental Protection Cabinet eligible for release pursuant to KRS 350.093 and 405 KAR 10:020 et seq. They state that they "understand" that the bonds posted totaled two to three million dollars and are guaranteed by a surety who "presumably" holds significant collateral of the Debtor to secure performance.

The Loveridges do not attempt to prove a direct and substantial benefit to the estate, however, but propose that the court follow the line of cases that began with Reading Co. v. Brown, 391 U.S. 471, 88 S.Ct. 1759 (1968), and which recognize exceptions to the "benefit to the estate" requirement. In Reading the Supreme Court held that fundamental considerations of fairness and logic required that damages caused by the post-petition negligence of a receiver in a Chapter XI case be treated as actual and necessary costs of administration of the estate, even if the estate received no substantial benefit. See also In re Mammoth Mart, Inc., 536 F.2d 950, 955 (1st Cir. 1976)(post-petition tort claim treated as administrative expense in fairness to victims of trustee’s negligence); In re Al Copeland Enters., Inc., 991 F.2d 233 (5th Cir. 1993)(state was harmed by debtor’s tax delinquency and fairness required treating accumulated statutory interest as administrative expense). In United Trucking Serv., Inc. v. Trailer Rental Co., Inc. (In re United Trucking Serv., Inc.), 851 F.2d 159 (6th Cir. 1988), the court carved out an exception based on unjust enrichment. The Loveridges maintain that their claim comes within the Reading exception in that it arose from the operation of the Debtor’s business post-petition, and it would be fundamentally unfair to disallow their administrative expense request.

The problem with the Loveridges’ Reading argument is that their claim is essentially a contract claim, and courts have limited the application of Reading to tort cases or cases of intentional misconduct on the part of the trustee or the debtor-in-possession. In re Economy Lodging Sys., Inc., 234 B.R. 691, 697 (6th Cir. B.A.P. 1999). Further, the debt for which a creditor seeks priority must have arisen post-petition. In Economy Lodging, a creditor sought an administrative expense priority on the basis of its having continued to perform under a pre-petition agreement that was not assumed. The panel opined that the creditor could not satisfy the Sunarhauserman test for administrative expense priority because the agreement giving rise to the claim arose pre-petition. The panel went on to say in regard to the creditor’s reliance on Reading that "[t]he Sixth Circuit has made it clear that Reading’s exception is a limited one: ‘Reading’ does not eliminate the requirement that a debt arise post-petition in order to be accorded administrative expense priority.’" Id. at 697, quoting In re Sunarhauserman, 126 F.3d at 817. Simply continuing to do business with the post-petition debtor is not enough.

Lexington Coal’s response to the Loveridges’ arguments is that they have no "premature reclamation claim." Lexington Coal’s position is that once the Debtor stopped mining, it was required by statute and regulation to reclaim the property commencing no more than "sixty (60) calendar days" after mining ceased. 405 KAR 16:020. According to Lexington Coal, the Debtor’s reclamation activities did not breach the Lease and did not harm the Loveridges or unjustly enrich the Debtor. Lexington Coal makes reference to Article 17 of the Lease which expressly granted the Debtor the unconditional right to enter the property to perform reclamation "in conformance with the laws of the Commonwealth of Kentucky, of the United States or their political subdivisions." Lexington Coal concludes that because the Lease both required and permitted the Debtor’s reclamation activities, it could not have violated the Lease by engaging in premature reclamation activities.

The Mineral Lease also gives the Debtor sole discretion to determine whether there is sufficient coal than can be profitably mined, and relieves the Debtor of the obligation to guarantee the minimum monthly production royalty if that determination is made and if reclamation is the only activity occurring on the property, although that obligation is not relieved if the Debtor has not mined all of the mineable and merchantable coal within the No. 8 and No. 9 seams. In that event, the Debtor remains obligated to guarantee the minimum monthly royalty to the Loveridges.

The Loveridges’ proffer of evidence that mineable and merchantable coal remains in the No. 8 and No. 9 seams consists only of Exhibits 5 and 6 to their Response. In response to the court’s orders of September 26, 2005 and October 21, 2005, the Loveridges have tendered three letters from Ertel L. Whitt, Jr.,("Whitt") a professional engineer. These letters address the issues of lost coal on the Loveridge property, the status of related reclamation bonds, and the status of reclamation, and are dated June 23, 2003, July 16, 2003, and August 5, 2003, respectively. In his June 23, 2003 letter, Whitt states:

I have examined the maps and remaining reserves calculations that Mr. Loveridge left in my office on June 4, 2003. Using the several sets of maps that he provided I have recomputed the remaining reserves and have enclosed my calculations on the attached spreadsheet. My calculations vary only slightly from those given to Mr. Loveridge by Leslie Resources, bearing a date of 4/22/03. The most glaring difference is that the maps used for their calculations for both the Hazard #8 and #9 seams omitted some acreage along the outcrop of "9 Knob." None of the pit maps show these areas to be mined, but one of the earlier maps shows them as reserves.

My calculations conclude that Mr. Loveridge is owed $645,810 for lost coal less any minimum royalty accrued since the last mining was done.

As Whitt himself states, the information contained in the letter is not appreciably different from that contained in Exhibits 5 and 6, the LR tables showing surface reserves for the Loveridge areas. As stated above, absent bad faith, the decision to mine or not to mine these reserves was in the Debtor’s sole discretion. Whitt’s letter does not offer an opinion as to whether the remaining coal is "mineable and merchantable," and it does not appear to support any contention that the decision to stop mining was not justified.

If the court concludes that the Debtor’s decision to stop mining was within its discretion, the court must further conclude that the Debtor’s decision to proceed with reclamation was justified as well. Any argument that the Debtor benefitted financially from the commencement of reclamation activities is therefore unavailing. The court must agree with LCC that once the Debtor made the decision to cease mining operations, it was required by Kentucky statute to begin reclaiming the property. In view of these conclusions, it is the opinion of this court that the Loveridges have not demonstrated that they are entitled to an administrative expense priority claim, and that LCC’s objection to their claim should be sustained. An order in conformity with this opinion will be entered separately.

Copies to:

John S. Talbott, Esq.

Gregory R. Schaaf, Esq.