Certainty in business translates into increased expenses for both buyers and sellers, or in the chapter 11 context, debtors and creditors. The Eleventh Circuit Court of Appeals has increased debtors’ and creditors’ costs of doing business by issuance of its opinion in Marathon Petroleum Co. v. Cohen (In re Delco Oil Inc.), 599 F.3d 1255 (11th Cir. 2010).In Delco, the court of appeals affirmed the bankruptcy court’s holding that payment for goods ordered and received by the debtor in possession (DIP) post-petition in the ordinary course of business were recoverable as unauthorized transfers. The holding was based on the fact that the debtor had not obtained approval to use cash collateral. Creditors must now perform (and debtors must cooperate with) more due-diligence when doing business with DIPs.
The Circumstances in Delco
The debtor, Delco Oil Inc., was a distributor of motor fuel and associated products. Id. at 1257. On Oct. 17, 2006 (the “petition date”), Delco filed for relief under chapter 11. Id.
Delco had a secured lender, CapitalSource Finance, who had a security interest in Delco’s personal property, including collections, cash payments and inventory. Id. On the petition date, Delco filed an emergency motion seeking authority to use cash collateral (the “cash-collateral motion”). Id. The day after the petition date, the bankruptcy court authorized Delco to continue operating its business as a DIP. Id. The court, however, did not yet rule on the cash-collateral motion. Id. Three weeks after the petition date, on Nov. 6, 2006, the bankruptcy court denied the cash-collateral motion. Id.
In the three weeks between the petition date and the denial of the cash-collateral motion, Delco paid $1.9 million in cash to Marathon Petroleum Company LLC. Id. Marathon was a supplier of petroleum products to Delco since 2003 under a sale agreement. Id. The $1.9 million paid by Delco to Marathon related to goods ordered and received by Delco in the ordinary course of business.
In December 2006, Delco voluntarily converted its chapter 11 case to a chapter 7. Id. Aaron R. Cohen was appointed as the trustee for Delco’s bankruptcy estate. Id.
Suit to Recover Post-Petition Transfers
The trustee filed an adversary proceeding against Marathon seeking to avoid and recover the $1.9 million in payments Marathon received from Delco post-petition. Id. Section 549(a) of the Bankruptcy Code authorizes a trustee to recover unauthorized post-petition transfers of estate property. Id. at 1258.
The bankruptcy court granted a summary judgment in favor of the trustee and concluded that the $1.9 million paid to Marathon was cash collateral that Delco did not have authority to use. Id. The district court affirmed the summary judgment in favor of the trustee. Id. The Court of Appeals for the Eleventh Circuit also affirmed the summary judgment. Id. at 1263.
Marathon’s Defenses Were Insufficient
The appellate court discussed Marathon’s arguments that consisted of: (1) existence of material fact issue as to characterization of funds received; (2) defense based on no harm to the estate; and (3) defense based on good faith as a matter of policy.
State Law Extinguishing Security Interest is Insufficient
Marathon argued that a material fact issue existed as to whether the $1.9 million it received were actually cash collateral. Id. at 1260. Marathon relied on Florida state law providing that a transferee of funds from a deposit account takes free of a security interest. Id. The appellate court, however, held that the funds constituted cash collateral, and thus, Delco had no authority to transfer such funds to Marathon notwithstanding the characterization of the security interest in the funds after the transfer was made. Id.
No Harm to Estate Is Insufficient
Marathon argued that the funds it received from Delco did not harm the secured lender or Delco’s estate because Marathon gave equivalent value in the form of inventory and transactions were in the ordinary course of business. Id. at 1262. The appellate court held that no “harmless” exception existed for a trustee’s avoidance powers under § 549. Id.
Innocence of Vendor Is Insufficient
Marathon argued that, as a matter of policy, an implicit defense exists under § 549 for ordinary course transfers and innocent vendors. Id. The appellate court was not persuaded. Id. at 1263. After analyzing § 363(c)(1) and (2) of the Code, the appellate court concluded that Congress did not intend to allow the use of cash collateral without approval of the interested secured creditor or bankruptcy court, even if the use of the cash collateral was in the ordinary course of business. Id. The innocence of the vendor was held by the appellate court as irrelevant to an avoidance action under § 549. Id.
Going Forward from Delco
In light of the Delco decision, vendors must confirm that a DIP has the authority to use cash collateral for the purposes of paying the vendor. This can entail reviewing the order authorizing use of cash collateral and any referenced budget and the debtor’s payments under the cash collateral budget. Whether a debtor is in budget under their authority to use cash collateral is difficult to confirm because the debtor controls the information. Vendors should consider obtaining written authorization from the debtor’s secured lender authorizing payments from the DIP to the vendor. Debtors will now have increased demands and resistance from their vendors in the early days of their reorganization when a debtor’s resources are already limited. In cases where there is any possibility that a secured lender has an interest in the debtor’s cash and the secured lender or court has not authorized payments to a vendor, a vendor risks being sued for return of such payments it receives from the debtor.