72 The Alabama Lawyer 222 (2011). In Re Delco Oil, Inc-A Cautionary Tale for Vendors Doing Business with Chapter 11 Debtors.

• Author: By Rashad L Blossom and Jennifer H. Henderson

Alabama Lawyer

2011.

72 The Alabama Lawyer 222 (2011).

In Re Delco Oil, Inc-A Cautionary Tale for Vendors Doing Business with Chapter 11 Debtors

In Re Delco Oil, Inc-A Cautionary Tale for Vendors Doing Business with Chapter 11 DebtorsBy Rashad L Blossom and Jennifer H. HendersonSellers of goods and services to companies in bankraptey have to manage credit and other risks. A recent decision of the Eleventh Circuit has created a hidden risk that vendors may not be able to control. Jnlnre Delco Oil, Inc.,(fn1) the Eleventh Circuit required an innocent vendor to return almost $2.0 million in payments for goods delivered to the bankruptcy estate. Although the payments were in the ordinary course of business and for value, the Eleventh Circuit avoided the payments because the chapter 11 debtor did not have authority to use cash collateral.

Preliminary Considerations

The Chapter 11 Debtor in Possession

In most cases, a debtor in chapter 11 remains in possession and control of the bankruptcy estate and exercises the powers and duties of a trustee under title 11 of the United States Code (the "Bankruptcy Code(fn2) Moreover, under Section 1108 of the Bankruptcy Code, a debtor-in-possession (the "DIP") automatically is authorized to operate its business.(fn3)

To minimize disruption of normal operations. Section 363(c)(1) of the Bankruptcy Code authorizes the DIP to enter into transactions in the ordinary course of business without notice and a hearing.(fn4) However, Section 363(c)(2) of the Bankruptcy Code provides that the DIP may not use, sell or lease "cash collateral" without either (i) the consent of each creditor that has an interest in the cash or (ii) court authorization, granted after notice and a hearing.(fn5) Most commonly, cash collateral consists of cash, deposit accounts and other cash equivalents, such as proceeds of accounts receivable and inventory, that are subject to a lender's security interest.(fn6) A creditor's interest in cash collateral is protected further by Section 363(e), which provides that, upon request of the creditor, the bankruptcy court must prohibit or condition the DIP's use, sale or lease of property "as is necessary to provide adequate protection of such interest."(fn7)

These restrictions on using cash collateral are designed to strike a balance between the competing interests in the collateral. On one hand, the DIP has a compelling need to use cash to rehabilitate its business and meet daily operating expenses such as rent, payroll and utilities.(fn8) On the other hand, the DIP's unrestricted use of cash collateral jeopardizes the creditor's interest in the collateral,(fn9) as cash is dissipated by use.(fn10)

Avoidance Powers under the Bankruptcy Code

To maximize the value of the bankruptcy estate and ensure common treatment of similarly situated creditors, the Bankruptcy Code provides a trustee (and by extension, a DIP) with the power to avoid and recover certain transfers of the debtor's property. Common examples of the trustee's "avoidance powers" include preferences under Section 547 of the Bankruptcy Code and fraudulent transfers under Section 548 of the Bankruptcy Code. Sections 547 and 548, by definition, apply to pre-bankruptcy transfers. Section 549 of the Bankruptcy Code allows the trustee to set aside unauthorized transfers made by a debtor after filing bankruptcy. Section 549 most often applies when debtors, without court approval, pay claims that arose prior to the bankruptcy case. With the Delco Oil decision, the Eleventh Circuit has expanded the scope of Section 549 to include payments to post-petition vendors in the ordinary course of business.

The Delco Oil Decision

Prior to filing for bankruptcy protection under chapter 11 of the Bankruptcy Code, Delco Oil, Inc. ("Delco") operated as a distributor of motor fuel and associated products. CapitalSource Finance, LLC ("CapitalSource") provided financing to Delco pre-bankruptcy and obtained a pledge of essentially all of Delco's personal property, including accounts receivable and inventory and the proceeds thereof. Marathon Petroleum Company, LLC ("Marathon") sold petroleum products to Delco pre-bankruptcy pursuant to a sale agreement and continued to sell to Delco after the bankruptoy filing.

On the first day of its chapter 11 case, Delco filed a motion for authority to use cash collateral. The bankruptcy court later denied the motion. In the interim, Delco paid Marathon over $1.9 million for petroleum products supplied to Delco after the bankruptcy petition. When the bankruptcy court denied Delco's request to use cash collateral, Delco volimtarily converted its bankruptcy case to a case under chapter 7 of the Bankruptcy Code. The chapter 7 trustee sued Marathon under sections 549 and 363 of the Bankruptcy Code to recover the payments Marathon received from Delco while the case was pending under chapter 11. The bankruptcy court entered sunomary judgment in favor of the trustee, and...