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Before Selling to a Chapter 11 Debtor, Make Sure the Debtor is Authorized to Pay You

Commercial Bankruptcy, Restructuring and Creditors' Rights Law Update Christopher Combest

It is no surprise that there are risks inherent in doing business with a debtor in bankruptcy, including, of course, the risk that the debtor may not have the money to pay for goods sold to it on credit. Businesses can manage those risks by, for example, shortening trade credit terms, obtaining the debtor's agreement to pay on delivery or in advance for product, or obtaining a deposit or letter of credit as security. But, once a debtor has paid for goods or services it actually received, most vendors would probably assume that the transaction cannot be challenged.

Unfortunately, that assumption is not correct. In the bankruptcy case of In re Delco Oil, Inc., decided this past March by the Eleventh Circuit Court of Appeals, the court required the vendor to return more than $1.9 million that it had received from the Debtor, Delco Oil, for products delivered to Delco. Delco sold motor fuel and other petroleum products, much of which it bought from Marathon Petroleum Company. In the first three weeks of Delco's Chapter 11 case, Marathon sold product to Delco for which Delco paid Marathon over $1.9 million.

Note, first, that the general rule in Chapter 11 cases is that a debtor may operate its business, and use its property in the ordinary course of that business, without any special permission from the court. Delco had engaged in textbook ordinary-course transactions: the purchase from Marathon of essential goods for its business. Note, further, that Delco's payments to Marathon were not on account of amounts that had accrued before Delco filed its bankruptcy case, nor were they deposits for future deliveries that had not been made: Marathon actually provided petroleum products worth $1.9 million to Delco after the filing of the bankruptcy case.

The problem was that Delco had a secured lender, with a valid lien on the cash Delco used to pay Marathon, and the rules concerning a debtor's use of cash are different from the general rule described above regarding a debtor's use of its property. Because cash is uniquely susceptible to being dissipated, misdirected, or otherwise misused, federal bankruptcy law forbids a debtor from using cash that is subject to a lender's security interest (that is, "cash collateral") unless either (a) the lender consents, or (b) the court has entered an order authorizing such use. In Delco's case, the lender did not consent, nor did Delco have a court order authorizing the use of its lender's cash collateral over the lender's objection during the period when Delco paid Marathon. In fact, Delco had sought such an order on the first day of its case, but the court did not act on Delco's request until three weeks later, when it denied that request. Shortly thereafter, Delco's case converted to a liquidation under Chapter 7, and the Chapter 7 trustee sued Marathon to recover the purchase price for the product it had sold to Delco.

The trustee's argument was straightforward: under federal bankruptcy law, transfers of a debtor's property made during the bankruptcy case, but without authorization, may be declared null and void, and the transferred property recovered. Delco paid $1.9 million to Marathon without a court order and without consent, and, now, the trustee wanted it back.

Perhaps Marathon's most compelling arguments were about basic fairness: first, Marathon had, in fact provided equivalent value to Delco in exchange for the payments; second, Marathon argued that it was an 'innocent vendor,' that is, that it had sold to Delco without knowing that Delco was using cash improperly.

These may be the points of greatest concern for our clients: the court held that it did not matter that Marathon had provided valuable goods to Delco or that Marathon may not have known that the payments were unauthorized. Neither of those arguments was a defense to the trustee's right to recover that cash for the benefit of the estate. Of course, Marathon would receive a general unsecured claim in Delco's case for the $1.9 million, but, in most cases, that claim would be worth only pennies on the dollar, and, in Delco's case, it is likely worth nothing at all.

The Delco Oil case suggests that vendors should add one more item to their checklists regarding doing business with debtors in bankruptcy. In addition to negotiating protections (like those described at the beginning of this article) to insure that the debtor will pay for goods provided during the bankruptcy case, vendors should also assure themselves that debtors are permitted to pay for those goods. Your attorney can check the case docket to see if appropriate orders have been entered authorizing the debtor to use cash; at minimum, vendors should ask for evidence of the debtor's authority to use cash that may be subject to a creditor's lien. While most debtors will have no difficulty establishing that authority, failure to ask the question - as Marathon Petroleum learned - can be an expensive error.

For more information, please contact the author, Christopher Combest, at (312) 715-5091 / [email protected], your local Quarles & Brady LLP attorney, or one of the following
Commercial Bankruptcy, Restructuring and Creditors' Rights practitioners:

Phoenix       John Harris
National Group Chair
(602) 229-5406       [email protected] 
Chicago Faye B. Feinstein
Chicago/Midwest Office Chair      
(312) 715-5069 [email protected]
Madison Roy Prange (608) 283-2485 [email protected]
Tucson Susan Boswell (520) 770-8713 [email protected] 
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