Seller, Beware

The United States Bankruptcy Code, Title 11 U.S.C. ' 101, et seq., generally permits a debtor-in-possession to enter into business transactions in the ordinary course of its business. Section 363(c)(1) of the Bankruptcy Code generally provides that, if a debtor's business is authorized to operate under the Bankruptcy Code, the trustee (or the debtor-in-possession) “may enter into transactions, including the sale or lease of property of the estate, in the ordinary course of business, without notice or a hearing, and may use property of the estate in the ordinary course of business without notice or a hearing.” However, a debtor's ability to enter into ordinary course transactions is specifically limited by ' 363(c)(2), which provides that:

The trustee may not use, sell, or lease cash collateral under paragraph (1) of this subsection unless– (A) each entity that has an interest in such cash collateral consents; or (B) the court, after notice and a hearing, authorizes such use, sale, or lease in accordance with the
provisions of this section. 11 U.S.C ' 363(c)(2)

The Bankruptcy Code defines cash collateral as:

cash, negotiable instruments, documents of title, securities, deposit accounts, or other cash equivalents whenever acquired in which the estate and an entity other than the estate have an interest and includes the proceeds, products, offspring, rents, or profits of property and the fees, charges, accounts or other payments for the use or occupancy of rooms and other public facilities in hotels, motels, or other lodging properties subject to a security interest ' whether existing before or after the commencement of a case under this title. 11 U.S.C. ' 363 (a)

Section 363(e) further protects a secured lender's interest in cash collateral by prohibiting or conditioning a debtor's use, sale or lease of property “as necessary to provide adequate protection of such interest.” This typically plays out through a debtor's motion for use of cash collateral, an objection by a secured lender, and then a negotiated order permitting the use of cash collateral, which order usually contains concessions by the debtor to safeguard the secured lender's interest. A debtor who transfers cash in violation of ' 363 may later avoid the transfer if the bankruptcy court determines that the transfer was not authorized by law. Specifically, ' 549(a) provides that a trustee may avoid a transfer of property of a debtor's bankruptcy estate “(1) that occurs after the commencement of the case; and ' (2)(B) that is not authorized under this title or by the court.” See 11 U.S.C. ' 549(a).

In In re Delco Oil, Inc., the Eleventh Circuit Court of Appeals upheld the entry of summary judgment in favor of a Chapter 7 trustee avoiding an approximately $2 million dollar post-petition payment from the Debtor Delco Oil, Inc. (“Debtor Delco”) to its supplier Marathon Petroleum Co., LLC (“Marathon”) for petroleum products provided to Debtor Delco post-petition pursuant to a pre-petition sales agreement between Marathon and Debtor Delco. The Court of Appeals held that the payment must be returned to the bankruptcy estate pursuant to 11 U.S.C. ' 549(a) because the funds transferred to Marathon were cash collateral belonging to Debtor Delco's secured lender, and the payments to Marathon were never consented to by the secured lender nor authorized by the bankruptcy court. Here, the Court of Appeals concluded that the payment made by Debtor Delco to Marathon had not been “authorized by law” and thus had to be returned to the estate pursuant to 11 U.S.C. ' 549(a).

Facts of the Case

On the petition date (Oct. 17, 2006) Debtor Delco filed an emergency motion with the bankruptcy court to approve its use of cash collateral in order to continue its operations. The next day, the bankruptcy court authorized Debtor Delco to continue operating its business as a debtor-in-possession. However, the bankruptcy court did not authorize Debtor Delco's use of its cash at that time. Instead, almost three weeks later (on Nov. 6, 2006), the bankruptcy court denied Debtor Delco's request to use its cash collateral. However, between the petition date and the date the bankruptcy court denied Debtor Delco's request to use cash collateral, Debtor Delco transferred more than $1.9 million to Marathon as payment for Debtor Delco's post-petition purchase of petroleum from Marathon. After Nov. 6, 2006, Debtor Delco's Chapter 11 bankruptcy case was converted to a bankruptcy case under Chapter 7, and the Chapter 7 trustee initiated an action on behalf of the estate to avoid the post-petition transfers to Marathon, in accordance with 11 U.S.C. ' 549(a). The bankruptcy court entered summary judgment in favor of the trustee.

On appeal, the supplier Marathon argued that the payments should not be avoided because Marathon had: 1) accepted Debtor Delco's payments in good faith and in the ordinary course of business without collusion; and 2) provided product to Debtor Delco of reasonably equivalent value to that of the payments it received, and, therefore, the secured lender was adequately protected. Marathon also argued that the products it provided were necessary for Debtor Delco to continue to operate as a motor fuel distributor and therefore helped to preserve the value of Debtor Delco's non-cash property in which the lender held a security interest.

The Eleventh Circuit rejected Marathon's defenses and concluded that the trustee could avoid the unauthorized post-petition transfer by Debtor Delco. The Court of Appeals reasoned that: 1) there is no “harmless” exception to a trustee's ' 549(a) avoiding powers; 2) ' 549 does not consider whether a secured creditor was adequately protected; and 3) Congress' prohibition on the use of cash collateral does not have an “ordinary course” exception. Delco, 599 F.3d at 1262-63. Section 549 of the Bankruptcy Code does not provide for an exception or a defense based on the fact that a transferee did not know that the entity to whom it was supplying goods had filed for bankruptcy. See 11 U.S.C. ' 549(a). Generally, ' 549(c) prevents the avoidance of a transfer of an interest in real property to a good faith purchaser for the present fair equivalent value of the property, if the purchaser did not have knowledge of the commencement of the bankruptcy case. See 11 U.S.C. ' 549(c). However, Delco clearly holds there is no good faith or “harmless exception” defense to an avoidance of a transfer under
' 549(a). Therefore, before shipping to a debtor, suppliers should protect themselves by confirming the debtor's authority to use its cash to pay for the post-petition shipment.

Implications of Delco

Although a debtor bears the burden of negotiating and seeking authority to use its cash collateral, the holding in Delco seemingly shifts to those doing business with a debtor some of the risks related to the debtor's operation of its business in the ordinary course. Payments to suppliers for post-petition shipments may later be avoided if such payments, even when made in the ordinary course of a debtor's business, are not consented to by a secured lender or approved by the bankruptcy court. Note that a supplier who is a party to a pre-petition contract with a debtor to supply goods or services is generally obligated to perform under the contract post-petition. However, a supplier should always first confirm that a debtor has obtained either the consent of its secured lender or a court order authorizing the use of cash collateral to pay for any post-petition shipment. In order to protect itself before it ships post-petition to a debtor, in some circumstances a supplier may make a demand for adequate assurance pursuant to UCC ' 2-609, which includes a demand for assurance that a debtor has obtained either consent or court authorization to use its cash.

Conclusion

An entity supplying goods or services to a debtor in bankruptcy should thus confirm that the debtor has authorization to use its cash collateral in the ordinary course of its business. Unfortunately, Delco implies that ignorance of the debtor's bankruptcy filing does not protect the supplier from the avoidance of a payment from the debtor. The ruling also supports that establishing an ordinary course of business and/or adequate protection defense will not bar recovery of the payment by the estate. Therefore, even where neither the debtor nor the secured lender is harmed by the transaction, the post-petition payment to a supplier could be avoided as a transfer not authorized by law. Finally, a supplier who is caught in this circumstance after-the-fact and who is defending an avoidance action should consider its state law remedies. In some circumstances, if payment to a supplier is avoided, then the supplier may avail itself of certain state law remedies to recover the goods shipped to the debtor, and/or to assert potential claims against the debtor or its principals.

Ann Marie Uetz ([email protected]) is a partner with Foley & Lardner LLP, chair of the Detroit office Litigation Department, and vice-chair of the firm's national Bankruptcy and Business Reorganizations Practice. Jennifer Hayes ([email protected]) is an associate with the firm, and a member of its Bankruptcy and Business Reorganizations Practice.

Companies that continue to supply to a customer after the customer files for Chapter 11 bankruptcy protection should take note of a recent decision from the Eleventh Circuit that required a supplier to return the money it was paid by a Chapter 11 debtor ' for goods shipped to the debtor post-petition ' because the debtor did not have authority to make the payment in the first place. The case, In re Delco Oil, Inc. (Marathon Petroleum Co., LLC v. Cohen), 599 F.3d 1255 (11th Cir. 2010), serves as an important reminder for suppliers to monitor a customer's bankruptcy filing and to confirm the rules for doing business before delivering goods to a debtor.

A Chapter 11 debtor must obtain the consent of certain parties or the permission of the bankruptcy court before it can do many things it was able to do on its own prior to filing a petition for bankruptcy. Chief among these is that, if anyone has a lien on the debtor's cash (including a blanket lien on accounts receivable, as is often the case with a secured lender), the debtor must obtain either the lender's consent or bankruptcy court approval in order to use that cash for any purpose ' including to pay for goods received in the ordinary course of business. Seeking such permission is known as a request or motion for the debtor's use of cash collateral.

Applicable Law

The United States Bankruptcy Code, Title 11 U.S.C. ' 101, et seq., generally permits a debtor-in-possession to enter into business transactions in the ordinary course of its business. Section 363(c)(1) of the Bankruptcy Code generally provides that, if a debtor's business is authorized to operate under the Bankruptcy Code, the trustee (or the debtor-in-possession) “may enter into transactions, including the sale or lease of property of the estate, in the ordinary course of business, without notice or a hearing, and may use property of the estate in the ordinary course of business without notice or a hearing.” However, a debtor's ability to enter into ordinary course transactions is specifically limited by ' 363(c)(2), which provides that:

The trustee may not use, sell, or lease cash collateral under paragraph (1) of this subsection unless– (A) each entity that has an interest in such cash collateral consents; or (B) the court, after notice and a hearing, authorizes such use, sale, or lease in accordance with the
provisions of this section. 11 U.S.C ' 363(c)(2)

The Bankruptcy Code defines cash collateral as:

cash, negotiable instruments, documents of title, securities, deposit accounts, or other cash equivalents whenever acquired in which the estate and an entity other than the estate have an interest and includes the proceeds, products, offspring, rents, or profits of property and the fees, charges, accounts or other payments for the use or occupancy of rooms and other public facilities in hotels, motels, or other lodging properties subject to a security interest ' whether existing before or after the commencement of a case under this title. 11 U.S.C. ' 363 (a)

Section 363(e) further protects a secured lender's interest in cash collateral by prohibiting or conditioning a debtor's use, sale or lease of property “as necessary to provide adequate protection of such interest.” This typically plays out through a debtor's motion for use of cash collateral, an objection by a secured lender, and then a negotiated order permitting the use of cash collateral, which order usually contains concessions by the debtor to safeguard the secured lender's interest. A debtor who transfers cash in violation of ' 363 may later avoid the transfer if the bankruptcy court determines that the transfer was not authorized by law. Specifically, ' 549(a) provides that a trustee may avoid a transfer of property of a debtor's bankruptcy estate “(1) that occurs after the commencement of the case; and ' (2)(B) that is not authorized under this title or by the court.” See 11 U.S.C. ' 549(a).

In In re Delco Oil, Inc., the Eleventh Circuit Court of Appeals upheld the entry of summary judgment in favor of a Chapter 7 trustee avoiding an approximately $2 million dollar post-petition payment from the Debtor Delco Oil, Inc. (“Debtor Delco”) to its supplier Marathon Petroleum Co., LLC (“Marathon”) for petroleum products provided to Debtor Delco post-petition pursuant to a pre-petition sales agreement between Marathon and Debtor Delco. The Court of Appeals held that the payment must be returned to the bankruptcy estate pursuant to 11 U.S.C. ' 549(a) because the funds transferred to Marathon were cash collateral belonging to Debtor Delco's secured lender, and the payments to Marathon were never consented to by the secured lender nor authorized by the bankruptcy court. Here, the Court of Appeals concluded that the payment made by Debtor Delco to Marathon had not been “authorized by law” and thus had to be returned to the estate pursuant to 11 U.S.C. ' 549(a).

Facts of the Case

On the petition date (Oct. 17, 2006) Debtor Delco filed an emergency motion with the bankruptcy court to approve its use of cash collateral in order to continue its operations. The next day, the bankruptcy court authorized Debtor Delco to continue operating its business as a debtor-in-possession. However, the bankruptcy court did not authorize Debtor Delco's use of its cash at that time. Instead, almost three weeks later (on Nov. 6, 2006), the bankruptcy court denied Debtor Delco's request to use its cash collateral. However, between the petition date and the date the bankruptcy court denied Debtor Delco's request to use cash collateral, Debtor Delco transferred more than $1.9 million to Marathon as payment for Debtor Delco's post-petition purchase of petroleum from Marathon. After Nov. 6, 2006, Debtor Delco's Chapter 11 bankruptcy case was converted to a bankruptcy case under Chapter 7, and the Chapter 7 trustee initiated an action on behalf of the estate to avoid the post-petition transfers to Marathon, in accordance with 11 U.S.C. ' 549(a). The bankruptcy court entered summary judgment in favor of the trustee.

On appeal, the supplier Marathon argued that the payments should not be avoided because Marathon had: 1) accepted Debtor Delco's payments in good faith and in the ordinary course of business without collusion; and 2) provided product to Debtor Delco of reasonably equivalent value to that of the payments it received, and, therefore, the secured lender was adequately protected. Marathon also argued that the products it provided were necessary for Debtor Delco to continue to operate as a motor fuel distributor and therefore helped to preserve the value of Debtor Delco's non-cash property in which the lender held a security interest.

The Eleventh Circuit rejected Marathon's defenses and concluded that the trustee could avoid the unauthorized post-petition transfer by Debtor Delco. The Court of Appeals reasoned that: 1) there is no “harmless” exception to a trustee's ' 549(a) avoiding powers; 2) ' 549 does not consider whether a secured creditor was adequately protected; and 3) Congress' prohibition on the use of cash collateral does not have an “ordinary course” exception. Delco, 599 F.3d at 1262-63. Section 549 of the Bankruptcy Code does not provide for an exception or a defense based on the fact that a transferee did not know that the entity to whom it was supplying goods had filed for bankruptcy. See 11 U.S.C. ' 549(a). Generally, ' 549(c) prevents the avoidance of a transfer of an interest in real property to a good faith purchaser for the present fair equivalent value of the property, if the purchaser did not have knowledge of the commencement of the bankruptcy case. See 11 U.S.C. ' 549(c). However, Delco clearly holds there is no good faith or “harmless exception” defense to an avoidance of a transfer under
' 549(a). Therefore, before shipping to a debtor, suppliers should protect themselves by confirming the debtor's authority to use its cash to pay for the post-petition shipment.

Implications of Delco

Although a debtor bears the burden of negotiating and seeking authority to use its cash collateral, the holding in Delco seemingly shifts to those doing business with a debtor some of the risks related to the debtor's operation of its business in the ordinary course. Payments to suppliers for post-petition shipments may later be avoided if such payments, even when made in the ordinary course of a debtor's business, are not consented to by a secured lender or approved by the bankruptcy court. Note that a supplier who is a party to a pre-petition contract with a debtor to supply goods or services is generally obligated to perform under the contract post-petition. However, a supplier should always first confirm that a debtor has obtained either the consent of its secured lender or a court order authorizing the use of cash collateral to pay for any post-petition shipment. In order to protect itself before it ships post-petition to a debtor, in some circumstances a supplier may make a demand for adequate assurance pursuant to UCC ' 2-609, which includes a demand for assurance that a debtor has obtained either consent or court authorization to use its cash.

Conclusion

An entity supplying goods or services to a debtor in bankruptcy should thus confirm that the debtor has authorization to use its cash collateral in the ordinary course of its business. Unfortunately, Delco implies that ignorance of the debtor's bankruptcy filing does not protect the supplier from the avoidance of a payment from the debtor. The ruling also supports that establishing an ordinary course of business and/or adequate protection defense will not bar recovery of the payment by the estate. Therefore, even where neither the debtor nor the secured lender is harmed by the transaction, the post-petition payment to a supplier could be avoided as a transfer not authorized by law. Finally, a supplier who is caught in this circumstance after-the-fact and who is defending an avoidance action should consider its state law remedies. In some circumstances, if payment to a supplier is avoided, then the supplier may avail itself of certain state law remedies to recover the goods shipped to the debtor, and/or to assert potential claims against the debtor or its principals.

Ann Marie Uetz ([email protected]) is a partner with Foley & Lardner LLP, chair of the Detroit office Litigation Department, and vice-chair of the firm's national Bankruptcy and Business Reorganizations Practice. Jennifer Hayes ([email protected]) is an associate with the firm, and a member of its Bankruptcy and Business Reorganizations Practice.