I Have To Give What Back? Are You Serious? How To Deal With The Delco Oil Decision

October 20, 2010

In the past few years, if you’ve never sold goods to a chapter 11 debtor, you may well be in the minority. Normally, you might continue doing business with someone in a chapter 11 proceeding without giving it a great deal of thought. After all, one of the key phrases that gets tossed around by debtors after they file is “no interruption in our day to day business”, “business as usual”, and similar such terms.

However, a recent decision from the 11th Circuit Court of Appeals has created a new thing to think about—one that if not dealt with correctly and thoroughly, could have a significant impact on parties supplying goods to a debtor. How significant? Think about having to give back a payment you received from the debtor for goods you sold them after the case was filed. This isn’t a “preference” case, in which you may have to return something you received before the case was filed— and as for which there are a number of defenses. In this instance we’re talking about giving back a payment you received from the debtor, in the ordinary course of business, in exchange for goods you sold to the debtor in good faith and in the ordinary course of your business after the case was filed.

In re Delco Oil, Inc. 599 F3d 1255 (11th Cir. 2010) presents what may be a somewhat uncommon set of facts. However, its implications are a little more broad. In Delco, the debtor sold motor fuel and related goods. One of its pre-petition customers was Marathon Petroleum. In mid October, 2006, the debtor filed a chapter 11 case. The same day the debtor filed the chapter 11 case, the Bankruptcy Court authorized it to continue its business as a “debtor-in-possession”, and the debtor sought authority of the court to use “cash collateral”. 

“Cash collateral” in a bankruptcy context generally means all the cash proceeds that are generated by the debtor in the ordinary course of business through the collection of accounts receivable and the sale of inventory. Thus, normally, where a lender has made a working capital loan to the debtor secured by a lien on all accounts receivable and inventory, all of the debtor’s cash will constitute “cash collateral” of the lender. The Bankruptcy Code specifically prohibits a debtor from using such cash collateral unless one of two things happens: either (a) the entity holding the lien consents, or (b) the Bankruptcy Court enters an order that allows the debtor to use the cash collateral. The basic concept is pretty simple---the debtor can’t willy nilly spend the money that is security for a secured lender’s claim after it files its bankruptcy proceeding, unless one of the two conditions is met.

Usually the debtor and the lender will come to an agreement on the terms and conditions under which the debtor can use cash collateral. Sometimes that will occur in the context of a whole new post-petition credit facility, and sometimes through an arrangement that involves no new loans at all. Such agreements are usually the subject of an order signed by the Bankruptcy Court—giving rise to the commonly used terms like “Financing Order”, “DIP Financing Order” or “Cash Collateral Order” that are bandied about in the bankruptcy world. However, in Delco, the lender, CapitalSource, objected to the debtor’s use of the cash collateral securing its claim. This meant that the Bankruptcy Court had to decide whether or not the debtor could use that “cash collateral” despite CapitalSource’s objection, and if so, on what terms.

While agreements governing the use of cash collateral are the norm, objections by secured parties are hardly unprecedented. Since the Bankruptcy Code prohibits the debtor from using cash collateral without an order of the court, if there is no agreement the Bankruptcy Court normally will hold an emergency hearing to resolve disputes, so that the question of whether or not cash collateral can be used for day to day expenses (such as, for example, payroll) can be addressed immediately. In Delco, however, although the debtor filed its motion for authority to use cash collateral on the first day of the case, it was not until November 6, 2006 that the Bankruptcy Court ruled, and when it did, it denied the debtor’s motion. The result was that the debtor, after being in the chapter 11 case for almost 3 weeks, still had no authority to spend any of the cash in its possession. The Court’s opinion tells us nothing else of what transpired during these three weeks or thereafter, other than to say that the case was converted to a liquidation proceeding in December, 2006.

During this interim period of time between October 18 and November 6, Marathon sold the debtor slightly more than $1.9 million in goods, all of which the debtor paid for, with the proceeds of CapitalSource’s cash collateral. This caught the attention of the chapter 7 bankruptcy trustee. The trustee concluded that the debtor never had authority
to pay Marathon, because (a) CapitalSource had never consented to the use of its cash collateral, and (b) the Bankruptcy Court had never authorized the debtor to use cash collateral. Thus, the trustee sued Marathon under Section 549 of the Bankruptcy Code, demanding that Marathon repay the $1.9 million it had received. Section 549 of the Bankruptcy Code allows the trustee to recover any “unauthorized transfers” made by a debtor after a case commenced—an unauthorized transfer being, generally, one which is “not authorized by the Bankruptcy Code or the court”. 11 U.S.C. 549(a). The Bankruptcy Court ruled in favor of the trustee and ordered that Marathon had to give the entire $1.9 million back to the trustee. The District Court upheld the ruling of the Bankruptcy Court, and the 11th Circuit Court of Appeals affirmed the ruling of the District Court.

The 11th Circuit’s reasoning was pretty straightforward: Its basic conclusions were that the cash in the debtor’s hands was cash collateral, which the debtor couldn’t transfer without the authorization of CapitalSource or the bankruptcy court. Since the debtor had nonetheless transferred the money to Marathon without the permission of CapitalSource or the bankruptcy court in express violation of the Code, Marathon had to give the money back.

But, wait, cried Marathon—it’s not fair. The debtor actually received $1.9 million worth of goods from us. We acted in good faith--no harm, no foul. That didn’t matter according to the 11th Circuit:

“Marathon also argues assuming that the funds constituted cash collateral Cohen may not avoid the payments because any violation of Section 363(c)(2) caused no harm to CapitalSource or the estate. Marathon asserts it gave equivalent value in inventory for the funds transferred to it by Debtor through a series of ordinary course transactions. . . . Marathon claims CapitalSource’s interests were not diminished when Debtor received equivalent value in petroleum products from Marathon in exchange for the funds.

But a ‘harmless’ exception to a trustee’s Section 549(a) avoiding powers does not exist. . . Section 549 does not require any analysis of the adequacy of protection of secured creditors’ interests nor does it provide a harmless error exception.

Finally, Marathon argues that as a matter of policy an implicit defense exists under Section 549 for ordinary course transfers and for innocent vendors who deal with a debtorin- possession. These arguments do not persuade us. . . As to Marathon’s status as an ‘innocent vendor’, Sections 549(a) and 550(a) by their terms contain no reference to, let alone an actual defense based on the transferee’s status (vendor, purchaser, etc.) or upon its state of mind (innocent, culpable, etc.). . . . Congress knew how to create exceptions based on transferee’s status and culpability. But it chose not to do so when it came to initial transferees of post-petitions transfers of cash collateral.”

599 F3d at 1262-1263.

Yikes!----Marathon, who thought it had done nothing wrong by continuing to sell goods to the debtor, had to fork over the entire $1.9 million—and the debtor got to keep all of the inventory it received to boot. How can this be?

Looking solely at what the Code says, and using a straightforward application of the Code to what the facts looked to be, its possible to understand how the case turned out the way it did, even if the result somehow “feels” wrong. The Court’s description of what Section 549 says is accurate. But there’s a lot the opinion doesn’t tell us. Did the debtor lie to Marathon and tell them they had authority to use cash collateral? Did Marathon think that the Bankruptcy Court’s order that specifically authorized the debtor to carry on its business in the ordinary course gave it some protection? Neither of these questions are answered in the opinion.

But even if there was or is some other set of arguments that Marathon could have or should have made, the problem is that as written, Delco stands for a pretty simple proposition, which has some potential ramifications: If you received a payment the debtor wasn’t authorized to make post-bankruptcy, you have to give it back, and it doesn’t matter if the debtor received equivalent value in exchange for what it might have paid you. This raises the real question: How to avoid having this happen to you the next time you find yourself selling goods to a customer who’s in a bankruptcy proceeding?

First of all, you need to do what you can to confirm that the debtor has actual authority to pay you. The easiest way to do this is to either check the docket or have us check the docket of the bankruptcy proceeding for you, to see if an appropriate order has been entered that makes it clear the debtor has the ability to pay. Its not hard to determine whether there’s an order of the court that gives the debtor sufficient authority to make payments, or whether there’s not. As noted before, in the vast majority of cases, there will actually be some sort of court approved financing that provides the authority the debtor needs. However, as outlined a bit further below, the mere existence of an order isn’t necessarily the begin all and end all of the analysis here. There’s a few possible landmines out there that mean you’ll need to pay some level of ongoing attention to this issue, if you really want to be truly cautious.

Almost every cash collateral order has some provision that limits the use of cash collateral in several ways. Typically, the order will only allow the debtor to use cash collateral to pay categories of expenses, which are often described in a “budget” that is attached to the order. These “budgets” can range from incredibly detailed to incredibly generic. Part of any review of an order should include looking at any such budget, to see if you fit within its terms. A more generic budget may be better for you than a more specific one, since a budget that has a line item described simply as “suppliers” arguably covers everyone supplying goods to the debtor. But what if you have a detailed budget, and you can’t find what you supply on it? Does that mean a payment to you isn’t authorized? Delco doesn’t address that, and its a potential issue you need to be wary of.

Cash collateral orders also typically have termination dates and a detailed provision that shuts off the debtor’s ability to use cash if the debtor violates the various terms of the order. Many times the order will provide that the authorization to use cash collateral terminates automatically upon a default, but that the lender has to obtain an order of the court, after notice, before it can exercise rights and remedies on account of the violation. This creates a little bit of a potential problem. How does a supplier know if the cash collateral order has “terminated”?

There may be no good answer to this question. Debtors want their suppliers to know it’s safe to ship too, so we can expect debtors to try to address this issue in future orders. Creditors committees should also be in tune to this problem when they address proposed cash collateral orders. However, not every case has a committee appointed, and you can’t necessarily assume they will be on top of this issue. Absent finding some specific language in a cash collateral order specifically addressing this termination issue when you have it reviewed, you will need to monitor the case docket on an ongoing basis. The likelihood is that if there has been an event which gives rise to termination of a cash collateral order, some kind of action by the lender isn’t far behind. The minute you see that the lender has filed a pleading seeking to take action, you may have no alternative but to consider ceasing shipment immediately if you want to fully protect yourself. By monitoring carefully, the result may be that your risk is reduced or even eliminated, as a practical matter. But the key is careful monitoring.

This leads to a few of the other problems and concerns raised by Delco. Stopping shipment until you are sure you can be paid is always going to be an answer, but probably not the most palatable one. But what if you’re a party to a supply agreement that requires you to ship, and you can’t confirm the debtor has authority to pay you? What if you know that if you don’t ship the debtor’s production line might shut down and you fear a damage claim being asserted against you, but you can’t confirm authority to use cash? Or, what if you simply fear that if you stop shipping, your customer will just go to someone else and you’ll lose the business for good?

The problem with shipping if you’re unsure about the debtor’s authorization to pay is that if they pay and turn out not to have been authorized, the 11th Circuit’s decision seems to create almost a strict liability standard for suppliers. But what’s the greater risk? Having to return a payment or two, or losing the business? Your volume of business, and ship cycle may well be a determining factor in what you do in one of these situations. The answer may also depend on the terms of your purchase orders and releases. Do those documents really obligate you to ship when you don’t have assurance that the debtor is authorized to pay you? Is the problem dealt with in some fashion by a demand for adequate assurance of performance under Article 2 of the UCC? Or does the fact that the debtor is in a bankruptcy proceeding, and the accompanying automatic stay prevent you from making demand for adequate assurance?

So far, there do not appear to be any subsequent decisions providing more color on this topic. But, because there are indicators these claims are being asserted in other cases, you’ll need to be vigilant in your dealings with debtors, and willing to engage in some ongoing due diligence that you might not have had to do before if you want to protect yourself. You may need to be prepared to take affirmative action aggressively, under certain circumstances, and may find yourself having to make some tough business decisions. We’ll continue to monitor these evolving concepts carefully, and be available to work with you as circumstances dictate.

Daniel F. Gosch is a member in Dickinson Wright’s Grand Rapids office, with more than 27 years of experience in insolvency, bankruptcy, and debtorcreditor related matters. In 2010 he was selected as one of the “Best Lawyers in America” in the field of bankruptcy and banking law, and he has been listed as a Michigan “Super Lawyer” since 2007. He actively represents many of the largest commercial banks in western Michigan in insolvency, debtor-creditor, and banking matters, and recently he led the successful Chapter 11reorganization proceedings of Gainey Corporation, in the United States Bankruptcy Court for the Western District of Michigan. He is a long time member of the American Bankruptcy Institute, a contributing author to “Strategies for Secured Creditors in Workouts and Foreclosures,” published by ALI-ABA in 2004, and a frequent speaker at both the American Bankruptcy Institute’s Central States Bankruptcy Workshop, and the Federal Bar Association for the Western District of Michigan’s annual Bankruptcy Seminar. He can be reached at 616.336.1015 or dgosch@dickinsonwright.com.