• The Avoidance of Post-petition Transfers: What’s a Vendor to Do after In re Delco Oil Co.?
  • September 1, 2010 | Author: Patrick R. Evans
  • Law Firm: Cadwalader, Wickersham & Taft LLP - New York Office
  • In Marathon Petroleum Co. v. Cohen (In re Delco Oil Co.),1 the Court of Appeals for the Eleventh Circuit recently held that a trustee could avoid a debtor's post-petition transfers of funds that were cash collateral, notwithstanding that the payments had been made in good faith and in the ordinary course of business. In pertinent part, the Eleventh Circuit determined that the transfers were avoidable under section 549(a) of the Bankruptcy Code because they were made without a court order or the consent of the secured party in violation of section 363(c)(2) of the Bankruptcy Code.2 This decision may alter the way vendors of goods and services do business with debtors, at least in the Eleventh Circuit, leading them to request detailed comfort orders from bankruptcy courts before continuing to serve debtors post-petition. This could create an administrative problem for debtors (and courts) and uncertainty among vendors.

    Background

    In 2003, Delco Oil, Inc., a distributor of motor fuel and owner of gas stations, began purchasing petroleum products from Marathon Petroleum Company, LLC pursuant to a sales agreement.3 In April 2006, Delco entered into a lending agreement with CapitalSource Finance LLC.4 Under the agreement, CapitalSource agreed to provide Delco up to $18 million in revolving credit in exchange for Delco's pledge of a perfected security interest in all of Delco's personal property, including cash payments, collections and inventory, as collateral.5

    In October 2006, Delco filed for voluntary relief under chapter 11 of the Bankruptcy Code in the Middle District of Florida.6 Among the first-day motions filed by Delco was an emergency request to use cash collateral and continue its operations.7 The very next day, the bankruptcy court approved Delco's request to continue its operations as debtor-in-possession, noting that "[t]he debtor-in-possession is authorized to pay all necessary and current expenses of operating its business . . . to the extent that such payments are necessary to preserve the assets or operate the business. . . ."8 However, without indicating its reasoning, the bankruptcy court deferred ruling on whether Delco was permitted to use its cash collateral.9 Ultimately, on November 6, 2006, nearly three weeks after the petition date, the bankruptcy court expressly denied Delco's request to use its cash collateral.10 In the interim, between the petition date and the November 6th ruling, Delco had paid over $1.9 million in cash to Marathon in exchange for petroleum products pursuant to the sales agreement.11

    In December 2006, Delco voluntarily converted its chapter 11 case to a chapter 7 case, triggering the appointment of a trustee.12 The trustee filed an adversary proceeding against Marathon seeking to avoid the post-petition cash transfers pursuant to sections 549(a) and 363(c)(2) of the Bankruptcy Code.13 Section 363(c)(2) of the Bankruptcy Code prohibits a debtor from using cash collateral, unless each entity that has an interest in the collateral consents or the bankruptcy court authorizes such use.14 Section 549(a) of the Bankruptcy Code grants the trustee the power to avoid unauthorized post-petition transfers of estate property.15 Pursuant to this provision, the trustee needs to demonstrate that a post-petition transfer was made, that the property transferred was property of the estate, and that the transfer was not authorized by the Bankruptcy Code or the court. The trustee can then "claw back" the unauthorized transfer of property from the recipient of the transfer under section 550(a) of the Bankruptcy Code. The bankruptcy court granted summary judgment in favor of the trustee and entered a judgment avoiding the post-petition transfer of more than $1.9 million to Marathon, ruling that Delco had used CapitalSource's cash collateral to pay Marathon without authorization from CapitalSource or the bankruptcy court.16 On appeal, the United States District Court for the Middle District of Florida affirmed the bankruptcy court's entry of summary judgment in favor of the trustee Marathon subsequently appealed to the Court of Appeals for the Eleventh Circuit.17

    The Eleventh Circuit's Decision

    Relying on the plain language of sections 363(c)(2) and 549(a) of the Bankruptcy Code, the Eleventh Circuit held that Delco's payments to Marathon were subject to avoidance because, simply stated, Delco had used CapitalSource's cash collateral without obtaining CapitalSource's consent and without a court order authorizing its use.18 The Eleventh Circuit permitted the trustee to avoid the $1.9 million in payments to Marathon even though the bankruptcy court had authorized Delco to continue its business as a debtor-in-possession under section 363(c)(1). In so holding, the Eleventh Circuit rejected Marathon's arguments that it should not have to return the payments. Specifically, Marathon first argued that the funds it received from Delco did not constitute CapitalSource's cash collateral because, under Florida law, a transferee of funds takes the funds free and clear of a security interest, with the result that the payment to Marathon was free of CapitalSource's lien as a matter of state law.19 The Eleventh Circuit rejected this argument, holding that when determining whether funds are cash collateral, a court must examine the status of the funds at the moment they were in the debtor's hands prior to the disputed transfer, not at the moment after the debtor transfers the funds.20 To hold otherwise would permit a debtor to "circumvent Section 363(c)(2)'s prohibition on the use of cash collateral without the secured creditor's or bankruptcy court's permission by distributing cash proceeds it knows are subject to a security interest as it likes, knowing that once distributed, the proceeds would not be defined as cash collateral under section 363(a) and, therefore, the transfer would not violate section 363(c)."21

    Marathon also argued that Delco's payment of the CapitalSource cash collateral to Marathon did not harm CapitalSource or the estate, and thus should not be subject to avoidance.22 Marathon reasoned that it provided equivalent value to the estate in the form of inventory (i.e., the petroleum products).23 Thus, Marathon argued, the value subject to CapitalSource's security interest could not have been diminished because Delco had replaced the cash with something of equal value.24 The Eleventh Circuit instead looked to the plain language of section 549(a), stating that "a 'harmless' exception to a trustee's Section 549(a) avoiding powers does not exist" and thus the payment failed to meet the requirements of section 549(a).25

    Finally, the Eleventh Circuit struck down Marathon's argument that it should prevail as a matter of policy on the basis that an implicit defense exists under section 549 for innocent vendors who do business with a debtor-in-possession and receive payments from a debtor in good faith and in the ordinary course of business.26 Again, the Eleventh Circuit dismissed this argument on the basis that sections 549(a) and 550(a) contain no reference to a transferee's status or state of mind, and this exception should not be read into the Bankruptcy Code. The fact that Delco did not receive court approval prior to using cash collateral to pay Marathon drove the Eleventh Circuit's determination that the Debtors failed to satisfy the standards of section 363(c)(2).27 Specifically, the Eleventh Circuit stated, "Congress evidently did not intend to allow the use of cash collateral without the permission of the interested secured creditor or the bankruptcy court, even if used in the ordinary course of business."28 For these reasons, the Eleventh Circuit upheld the District and Bankruptcy Court's decisions, permitting the trustee to avoid the $1.9 million transfer to Marathon.

    Analysis

    Broadly applied, the Eleventh Circuit's ruling in Delco casts doubt on how, or whether, a vendor can be paid for providing goods and services to a debtor in the early days of a chapter 11 filing. Faced with the risk of having to return payments for post-petition goods and services, cautious vendors may require "comfort orders" that confirm the debtor is authorized to pay them, rather than simply providing the debtor with the goods and services necessary to continue operating in the ordinary course of business and survive the critical first days of a new case. If the demand for "comfort orders" becomes widespread, the resources devoted to vendor relations could impact a debtor's ability to maintain its business operations. This could potentially diminish the estate to the detriment of the debtor's other creditors.

    Will Delco lead to a significant change in how vendors deal with newly-filed debtors? It bears noting that Delco is a case with unusual facts. Typically, bankruptcy courts do not authorize debtors to continue their business operations as debtors-in-possession and then allow weeks to lapse before ruling on the debtors' ability to use cash collateral. Instead, bankruptcy courts ordinarily address cash collateral issues at the first-day hearing (at least on an interim basis) and there are no periods of time during which it is ambiguous whether the use of cash collateral is permitted. Particularly after Delco, if a debtor wants to continue operations post-petition, it is critical that the debtor receive authorization to use its cash collateral from the outset, so that it can continue to pay vendors and ensure that it will continue to receive key goods and services without interruption due to an inability to pay.

    Conclusion

    Regardless of its unique facts, vendors engaging in post-petition transactions with debtors should note the results of this case, especially when doing business with debtors in the Eleventh Circuit. For a vendor to protect itself, it may no longer be enough to just demand payment in advance or on delivery, which prior to Delco was how many cautious vendors ensured that their debtors would pay them. Rather, and particularly in cases where cash collateral issues are not addressed at the first-day hearing, a cautious vendor should place the burden on the debtor to explicitly demonstrate that the debtor is authorized to continue making payments to it. To that end, in addition to demanding to see a copy of the cash collateral order approved by the bankruptcy court, vendors may begin demanding from debtors a specific line item on a cash collateral or DIP financing budget that specifically references them and authorizes their continued payments. Although the Eleventh Circuit's decision may seem inequitable to innocent vendors, who provide goods or services and are paid for doing so, the plain language of the Bankruptcy Code led the appeals court to this decision and the court rejected several arguments for a more lenient approach. The best defense against this outcome would be to take steps to avoid being a recipient of an unauthorized post-petition transfer in the first place.


    1
    599 F.3d 1255 (11th Cir. 2010).
    2 Id. at 1263.
    3 Id. at 1257.
    4 Id.
    5 Emergency Motion to Direct Appointment of a Chapter 11 Trustee, Case No. 06-03241 (PMG) (Bankr. M.D. Fla. Oct. 19, 2006) (D.I. 20).
    6 Delco, 599 F.3d at 1257.
    7 Emergency Motion for Authority to Use Cash Collateral and to Provide Adequate Protection and Request for Expedited Hearing, Case No. 06-03241 (PMG) (Bankr. M.D. Fla. Oct. 17, 2006) (D.I. 2).
    8 Order Authorizing Debtor-In-Possession to Operate Business, Case No. 06-03241 (PMG) (Bankr. M.D. Fla. Oct. 18, 2006) (D.I. 12).
    9 Notice of Hearing on Emergency Motion for Authority to Use Cash Collateral and to Provide Adequate Protection, Case No. 06-03241 (PMG) (Bankr. M.D. Fla. Oct. 18, 2006) (D.I. 10).
    10 Hearing Proceeding Memo, Case No. 06-03421 (PMG) (Bankr. M.D. Fla. Nov. 6, 2006) (D.I. 75).
    11 Delco, 599 F.3d at 1257.
    12 Id.
    13 Id.
    14 11 U.S.C. § 363(c)(2).
    15 Id. at § 549(a).
    16 Delco, 599 F.3d at 1257.
    17 Id.
    18 Id.
    19 Id. at 1259.
    20 Id. at 1260.
    21 Id. at 1260-61.
    22 Id. at 1262.
    23 Id.
    24 Id.
    25 Id.
    26 Id. at 1262-63.
    27 Id. at 1263.
    28 Id.