April 2010

Most businesses assume that payments they receive from an entity in bankruptcy for post-petition transactions can be kept. A new bankruptcy case instructs those doing business with entities in bankruptcy to exercise more caution than commonly occurs. Suppliers should not make post-petition sales until their customer in bankruptcy provides a cash collateral order that protects payments from subsequent recovery. This applies equally to “Cash on Delivery” or COD sales.

Most debtors have at least one secured creditor with a blanket lien over most assets, including cash in the bank account. Current assets like cash, receivables and inventory are commonly called “cash collateral”. The Bankruptcy Code prohibits a debtor from using collateralized assets without either the bankruptcy court’s or the secured lender’s approval. In most cases, immediately upon filing a bankruptcy petition, (i) the debtor seeks a court order for permission to use its cash collateral in the ordinary course of its business, and (ii) such permission is granted on an emergency basis promptly after the bankruptcy filing.

In Marathon Petroleum Co. v. Cohen

[In re Delco Oil, Inc.], Case No. 09-11759, (11th Cir., March 16, 2010), the debtor (i.e., Delco) filed for Chapter 11 bankruptcy protection, and concurrently filed an emergency motion requesting authorization to use cash collateral. Three weeks later, the bankruptcy court denied the use of cash collateral. Around a month later, Delco voluntarily converted its bankruptcy to a Chapter 7 proceeding and the bankruptcy court appointed Cohen as trustee.

In the three-week period between the filing of the emergency motion to use cash collateral and its denial, Marathon Petroleum sold Delco around $2 million of inventory. Marathon was paid for these sales. The bankruptcy court required that the payments be returned to the debtor, leaving Marathon as a creditor of the bankruptcy estate. There was no dispute that:

  1. The product sold by Marathon was worth what it was paid;
  2. Delco needed Marathon’s product, and benefited from the transaction;
  3. The secured creditor’s collateral position did not decrease because of the Marathon transactions, and
  4. Marathon was unaware any security interest existed, and/or that the debtor did not have the typical cash collateral order which would have authorized the purchases.

In a straightforward opinion that relies on statutory language, the Eleventh Circuit agreed with the bankruptcy court that the payment must be returned to the bankruptcy estate. The ruling is summarized as follows:

“ [Marathon argues] Cohen may not avoid the payments because any violation of Section 363(c)(2) caused no harm to CapitalSource [the secured lender] 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. Because CapitalSource admittedly had a perfected security interest in all of Debtor’s personal property, 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. All Cohen needs to demonstrate to avoid the transfers under Section 549(a) is: (1) an unauthorized transfer occurred; (2) the property transferred was property of the estate; and (3) the transfer occurred post-petition. Section 549 does not require any analysis of the adequacy of protection of secured creditors’ interests nor does it provide a harmless error exception. No genuine doubt exists that Debtor’s transfers to Marathon were unauthorized because Debtor completed them without the permission of CapitalSource or the bankruptcy court in express violation of Section 363(c)(2).
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 debtor-in-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-petition transfers of cash collateral. We will not create such exceptions in Congress’s absence. [Footnotes and additional citations omitted]

Although Marathon obtains an administrative priority for its post-petition transaction, this does not mean that Marathon will be paid. Administrative claimants stand behind the secured creditor, who likely benefited from Marathon’s sale and now-forced credit.

Fulcrum Inquiry performs forensic accounting and bankruptcy and troubled company restructuring.