A disturbing trend in selling to Chapter 11 debtors

Joseph Hanna

by: Joseph M. Hanna

For companies who plan to sell goods to customers who are in bankruptcy you need to be aware of a case that was decided in the United States Court of Appeals for the Eleventh Circuit which covers Alabama, Florida and Georgia.

In the case of In Marathon Petroleum Co. v. Cohen [In re Delco Oil, Inc., the 11th Circuit ruled Marathon had to return $1.9 million paid by the chapter 11 bankruptcy debtor Delco Oil for petroleum products supplied, post-petition and pursuant to a pre-petition sales agreement, because the payments were considered unauthorized transfers under Section 549 of the Bankruptcy Code.

Delco filed a Chapter 11, later converted to a chapter 7 after which the chapter 7 trustee sued to recover the $1.9 million because payments made to Marathon were improperly paid from the cash proceeds of the debtor’s secured lender’s collateral. For its part, Delco made the payments despite being barred by the Bankruptcy Code from doing so without the lender’s or bankruptcy court’s express permission. Section 549(a) of the Bankruptcy Code authorizes a trustee to recover unauthorized post-petition transfers of estate property.

First, some bankruptcy law:   The purpose of the chapter 11 bankruptcy is to allow the debtor an opportunity to reorganize, come up with a plan to pay its creditors and emerge from the bankruptcy. Until that happens the debtor needs to keep operating in the ordinary course, however the Bankruptcy Code prohibits the post-petition use of assets, i.e., cash, accounts receivables, etc.,  by a trustee or a debtor-in-possession if there is a secured creditor who has an interest in those assets unless the secured party approves the use of such assets or the bankruptcy court after notice and a hearing authorizes the use of cash collateral.  Most, if not all, of the business bankruptcies involve a secured creditor.  Therefore, once a chapter 11 is filed the debtor immediately requests a court order granting use of “cash collateral”.  The purpose of this is to get court permission to use cash and payments from personal property that is subject to a security interest in order to continue operating their business, e.g., buy goods, pay utilities, rent, payroll, etc.  Court permission is also necessary for the sale of debtor assets, e.g., trucks, construction equipment, office equipment, etc.

In this case, there was a secured creditor who had a perfected security interest in all of Delco’s personal property.  Delco requested permission to use cash collateral however  the court denied the request.  Thereafter Delco purchased and paid for petroleum products from Marathon Oil.  Despite the many arguments presented by Marathon, all of which the court found to be unsupported by the facts and law, Marathon was ordered to return the money.

This 11th Circuit decision  is not controlling in California which is part of the 9th Circuit, however it does alert creditors and others to look more closely at what the debtor is doing and argue that the debtor payments to a trade vendor for post petition sales were done without permission of the court, or the cash collateral order did not include transactions with trade vendors, and therefore are avoidable as unauthorized post-petition transfers in violation of §549.

If you are considering selling product post-petition to a bankruptcy debtor you will want to protect your company by confirming the funds you receive are free from a creditor’s secured interest by reviewing the cash collateral order  (1)  to confirm there is an order permitting the debtor to pay you and, (2)  the order is worded to include transactions with your company.  If you are planning to sell in the 6 or 7 figures to a debtor in bankruptcy you will want a bankruptcy court order that specifically names your company.

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