Avoiding the Inequities Created by in Re Delco Oil, Inc.-the Need for an Innocent Vendor Exception

• Citation: Vol. 30 No. 1
• Publication year: 2013

Avoiding the Inequities Created by In re Delco Oil, Inc.-The Need for An Innocent Vendor Exception

Juan Mendoza

AVOIDING THE INEQUITIES CREATED BY IN RE DELCO OIL, INC.—THE NEED FOR AN INNOCENT VENDOR EXCEPTION

Abstract

In In re Delco Oil, Inc., the Eleventh Circuit addressed whether a chapter 7 trustee can avoid a debtor's unauthorized transfer of cash collateral to a vendor that transacts in good faith and for equivalent value. The Eleventh Circuit strictly interpreted 11 U.S.C. §§ 549 and 550 by holding that the trustee has the power to avoid such a transfer. This decision is problematic for two reasons. First, the innocent vendor had to forfeit the goods that it transferred and any cash collateral received in exchange. Second, the decision created an absurd result by preventing the innocent vendor from obtaining an administrative expense claim even though it conferred a benefit on the estate. This decision effectively prevents an innocent vendor from receiving any compensation for the sale of its goods.

This Comment argues that an innocent vendor exception would prevent the negative consequences resulting from Delco and further the goals of bankruptcy. It supports this position in several ways. First, it examines the absurd results caused by Delco and the relevant legislative history of the Bankruptcy Code. Second, it surveys the sizable burden that Delco places on vendors before engaging in transactions. Third, it analyzes other ways in which the court can police the debtor's unauthorized use of cash collateral. Fourth, it examines the extent of § 105 and other case law to delineate the authority to create such an exception.

An innocent vendor exception would ensure an equitable result in cases analogous to Delco because it would prevent an innocent vendor, as an innocent transferee, from receiving a double penalty due to the debtor's misconduct. Furthermore, such an outcome would be consistent with the goal of § 550, which is to put the estate in the same position it would have been had the transaction not occurred.

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INTRODUCTION

The reasoning underlying chapter 11 is that it is generally preferable to continue to operate and reorganize a troubled business rather than to liquidate it.¹ In light of this goal, it is important for the business to preserve its assets for equitable distribution to its creditors.² The preservation of assets, however, may create problems for innocent third parties. Consider a scenario where a vendor enters into an agreement with a company through which the vendor will provide goods in exchange for cash. Unbeknownst to the vendor, the company it is selling goods to is in chapter 11 bankruptcy and pays the vendor with its cash collateral.³ To make matters worse, there may be restrictions on the company's use of cash collateral. If the company's chapter 11 reorganization is converted to chapter 7 liquidation, the appointed trustee may seek to avoid the payment made to the vendor with the cash collateral. It seems clear that the Bankruptcy Code ("Code") authorizes such an avoidance under § 549, which allows the trustee to avoid an unauthorized transaction made postpetition.⁴ But an avoidance in this case is far from equitable, as the estate receives a windfall and the vendor is unable to receive compensation for the transfer.

Marathon Petroleum Co. v. Cohen (In re Delco Oil, Inc.), is the most recent case dealing with the issue of whether an unauthorized transfer of cash collateral by a debtor in possession, who paid for goods used in its ordinary course of business, can be avoided under § 549(a) of the Code.⁵ In this case, the Eleventh Circuit determined that a chapter 7 trustee could avoid a debtor's transfer of cash collateral made to an "innocent vendor."⁶ The court came to this ruling even though the vendor acted in good faith and arguably exchanged the goods for equivalent value.⁷ As a result of this ruling, the vendor was forced to forfeit both the cash consideration it received and the inventory it transferred to the company.⁸

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Delco has received its fair share of criticism, mainly due to the punishment it imposed on a vendor who dealt in good faith and merely exchanged valued goods in return for payment from a debtor.⁹ These innocent vendors are oftentimes not aware that the company they do business with is in bankruptcy, nor are they aware that the company may be using cash collateral to pay for goods without proper authorization.¹⁰ Notwithstanding the inequity resulting from Delco, the Eleventh Circuit asserted that there was no other way to police § 363(c)(2) of the Code, which prohibits a debtor's use of cash collateral without court authorization.¹¹

The court added that §§ 549 and 550 did not explicitly include an "innocent vendor" exception.¹² The court's plain meaning interpretation of §§ 549 and 550 is another important critique of the Eleventh Circuit's decision, because this approach arguably led to an absurd result.¹³ By strictly interpreting §§ 549 and 550, the court prevented an innocent vendor from obtaining an administrative expense claim from the estate, and effectively rendered the innocent vendor's claim unsecured.¹⁴ Additionally, the court failed to address whether the secured creditor or the estate was entitled to receive the avoided funds.¹⁵

There are ways to avoid these absurd results. Other courts have addressed this issue without resorting to the plain meaning interpretation of §§ 549 and 550, and have instead considered other factors to determine whether unauthorized payment of cash collateral should be avoided.¹⁶ These courts looked beyond the plain meaning of the statute, and considered whether injury to the estate occurred, and whether the result was inequitable and contrary to the purpose of the Code.¹⁷

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Additionally, the result of Delco runs contrary to the goals and underlying policy of chapter 11. It places a sizable burden on vendors to investigate whether the company it conducts business with is in chapter 11, and if it is, whether it has proper authorization to use cash collateral.¹⁸ Performing this due diligence can be costly and may discourage vendors from conducting further business with companies in reorganization.¹⁹

This Comment will advocate for a judicial exception for innocent vendors in narrow circumstances similar to Delco—where a vendor transacts in good faith and for equivalent value with debtors that paid with cash collateral without proper authorization. This will prevent the negative consequences that result from Delco. Part I of this Comment will discuss some relevant provisions of the Code. Part II of this Comment will first discuss Delco to understand the court's analysis. Second, it will introduce the criticism that followed Delco and assess its validity. More importantly, this section will delve into the absurd results of Delco. Part III of this Comment will consider the burden that Delco imposes on vendors, and how this burden will likely affect the way vendors will deal with chapter 11 debtors in the future. Part IV will show that, contrary to the Eleventh Circuit's decision in Delco, there are other ways of policing § 363(c)(2). Part V of this Comment will show alternative ways courts can avoid the negative consequences caused by Delco. First, it will analyze cases similar to Delco, where a party looks to avoid a postpetition transfer, to demonstrate that there are other ways to deal with unauthorized postpetition transfers of cash collateral by a debtor. Second, it will look to the authority that courts can use to exempt innocent vendors from §§ 549 and 550. More specifically, it will show how courts can draw authority from § 105 of the Code to prevent the problems from the Delco decision. Finally, Part VI will analyze how the proposed exception will further the goals of Code and prevent the absurd results created by Delco.

I. Background

A better understanding of §§ 549 and 550 and cash collateral, as well as their respective purposes, is essential to understanding the consequences that result from punishing innocent vendors under § 549(a). The avoidance and

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recovery provisions provided by the Code under §§ 549 and 550 were created to prevent harm to the estate caused by postpetition transfers.²⁰

A. Section 549(a)

Section 549 is an avoidance provision that allows the trustee or debtor in possession to avoid unauthorized postpetition transfers of property of the estate with the goal to "pursue as equal a distribution of assets to creditors as possible."²¹ "To avoid means to make void [or] annul."²² The purpose of this section is to prevent postpetition transfers of the debtor's property from diminishing the estate.²³ Section 549(a) states:

(a) Except as provided in subsection (b) or (c) of this section, the trustee may avoid a transfer of property of the estate —

(1) that occurs after the commencement of the case; and
(2) (A) that is authorized only under section 303(f) or 542(c) of this title or by the court; or

(B) that is not authorized under this title or by the court.²⁴

This provision has been widely applied, even when there is fraud by the debtor or good faith on part of the transferee.²⁵

B. Section 550(a)

Section 550(a) works in conjunction with § 549(a) to promote one of the main goals of bankruptcy law—to preserve the estate's assets for an equitable distribution to creditors.²⁶ Once a transfer has been avoided under § 549(a), § 550(a) provides:

(a) except as otherwise provided in this section, to the extent that a transfer is avoided under section 544, 545, 547, 548, 549, 553(b), or 724(a) of this title, the trustee may recover, for the benefit of the estate, the property transferred, or, if the court so orders, the value of such property, from —

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(1) the initial transferee of such transfer or the entity for whose benefit such transfer was made; or
(2) any immediate or mediate transferee of such initial transferee.²⁷

Therefore, the purpose...