Chapter 11 of the Bankruptcy Code trusts a debtor in possession to operate its business.  In general, a debtor in possession “is free to use, sell[,] or lease property of the . . . estate in the operation of the debtor’s business.”1  This discretion is “at the heart” of the powers of a debtor in possession, 2  and courts are reluctant “to interfere, or to permit other parties in interest to interfere, in the making of routine, day-to-day business decisions.” 3  Therefore, a court will not disturb a transaction if

  1. the transaction is in the ordinary course of business and
  2. the debtor in possession articulates a business purpose for the transaction.4

Not all transactions are in the ordinary course or free from scrutiny, however.

The “Sound Business Purpose” Standard

Section 363(b)(1) of the Bankruptcy Code permits a debtor in possession, “after notice and a hearing, [to] use, sell, or lease . . . property of the estate” outside “the ordinary course of business.”5  Section 363(b)(1) does not empower a debtor in possession: 6 Section 363(b)(1)  limits its power.  Section 363(b)(1) requires “notice and a hearing,”7 but not approval of a court,8  before a debtor in possession transacts outside the ordinary course.  That is, Section 363(b)(1), which does not contain a standard by which a court could evaluate a transaction,9 simply ensures that parties in interest receive due process.10 

That said, courts, including U.S. Courts of Appeals, have inferred such a standard from the Bankruptcy Code.11  The standard is “flexible”:12 in evaluating a transaction, a court has “considerable,”13 though not unfettered,14 discretion.  Under the standard, a court should approve a transaction only if

  1. the debtor in possession articulates a “sound business purpose” for the transaction and
  2. that purpose justifies the transaction.15 

In general, the purpose of a transaction is to benefit the estate,16 but a court does not assume that every transaction does so;17 instead, a debtor in possession must show that its transaction would benefit the estate.18  Then, in determining whether the shown benefits of a transaction justify it, a court, after considering all relevant facts,19 must find that

  1. the consideration that the estate would receive is “fair and reasonable” and
  2. the counterparty is proceeding in good faith.20 

If a court finds that a “sound business purpose” justifies a transaction and “notice and a hearing” was provided to parties in interest, then the court should defer to the business judgment of the debtor in possession21 and approve the transaction.

A New Standard?

Courts have applied this standard for decades.

But in 2005, Congress amended the Bankruptcy Code by adding Section 503(c)(3), 22 which provides:

(c)  Notwithstanding [Section 503(b)], there shall neither be allowed, nor paid—

(3)    other transfers or obligations that are outside the ordinary course of business and not justified by the facts and circumstances of the case, including transfers made to, or obligations incurred for the benefit of, officers, managers, or consultants hired after the date of the filing of the petition.23

Like Section 363(b)(1), Section 503(c)(3) limits the power of a debtor in possession; however, unlike Section 363(b)(1), Section 503(c)(3) contains a standard by which a court could evaluate a transaction.  Section 503(c)(3) prohibits a transaction if it is

  1. “outside the ordinary course of business” and
  2. “not justified by the facts and circumstances of the case.”24 

This raises an interesting question: does this new standard differ from the one that courts inferred from the Bankruptcy Code?

Conflicts Between the Courts

Simply put, courts disagree on the answer.

Some courts, including the U.S. Bankruptcy Court for the Southern District of New York, have held that Section 503(c)(3) codifies the old standard.26  In In re Dana Corp.,25  Judge Lifland approved two transactions under Section 503(c)(3) because the debtors in possession “presented him with uncon[tro]verted evidence that” the transactions were

  1. “fair and reasonable” and
  2. “well within the[] business judgment [of the debtors in possession].”27  Then, in In re Dewey & LeBoeuf LLP,28 Judge Glenn, citing In re Dana Corp., explained that “[t]he requirement that a transaction be ‘justified by the facts and circumstances of the case” is the same as the business judgment standard under [S]ection 363(b).”29  At least one other court has joined Judges Lifland and Glenn: in In re Patriot Coal Corp.,30 the U.S. Bankruptcy Court for the Eastern District of Missouri, also citing In re Dana Corp., stated:

Any transfer made outside the ordinary course of business for the benefit of officers, managers[,] or consultants hired after the date of the filing of the petition must be justified by the facts and circumstances of the case, which ordinarily means that the business judgment standard of Section 363(b) applies. 31 

As Judge Glenn often writes: “[c]ourts have held that the ‘facts and circumstances’ language of [S]ection 503(c)(3) creates a standard no different than the business judgment standard under [S]ection 363(b).”32

But other courts, including the U.S. Bankruptcy Court for the Northern District of Texas, have held otherwise.33  In In re Pilgrim’s Pride Corp.,34 Judge Lynn held that Section 503(c)(3) does more than simply codify the old standard.35  She read Section 503(c)(3) as imposing a tougher standard because

  1. “read[ing] [S]ection 503(c)(3) as requiring nothing not already required by [S]ection 363(b)(1) would violate th[e] principle of construction” that “Congress is presumed to intend that independent sections of the [Bankruptcy] Code will have independent, differing impacts” and
  2. “Congress intended . . . court[s] to play a more critical role in assessing transactions . . . that fall within the ambit of [S]ection 503(c)(3).”36  

The U.S. District Court for the District of New Hampshire, the only appellate court to construe Section 503(c)(3), has agreed with Judge Lynn.37  In GT Advanced Techs. Inc. v. Harrington, 38  Judge McCafferty, citing In re Pilgrim’s Pride Corp., held that Section 503(c)(3) “directs courts to give more scrutiny to the business judgment of debtors than is permitted under the . . . business judgment test [under Section 363(b)(1)].”39  In short, courts have held that Section 503(c)(3) imposes a more demanding standard than the one that courts have applied for decades.

Finally, the U.S. Bankruptcy Court for the District of Delaware has joined both sides.  Judge Walrath has ruled that Section 503(c)(3) simply reiterates the standard that courts applied before Congress added the provision to the Bankruptcy Code:

[Section 503](c)(3) was meant to provide a standard, albeit not as clear, for any other transfers or obligations outside the ordinary course of business.

I agree that the including transfers made to officers, managers[,] or consultants hired after the petition date is not exclusive.  That’s clear from other provisions in the Bankruptcy Code.

So I do read [Section 503](c)(3) to be the catch-all and the standard under [Section 503](c)(3) for any transfers or obligations made outside the ordinary course of business are those that are justified by the facts and circumstances of the case.  Nothing more – no further guidance being provided to the Court by Congress, I find it quite frankly nothing more than a reiteration of the standard under [Section] 363 and – well, [Section] 363 under which courts had previously authorized transfers outside the ordinary course of business and[,] that is, based on the business judgment of the debtor, the court always considered the facts and circumstances of the case to determine whether it was justified.  And I’ll do the same in this case.40

In contrast, Judge Carey has construed Section 503(c)(3) as requiring “something” more than would otherwise be required:

Well, [Section 503(c)(3)] says something different and I’ve – I will say [that] I’ve interpreted it to mean something above the business judgment standard but maybe not much farther above it.  I mean, I don’t know how else to describe it.

And I guess someday if I get a chance to write on it or read the wisdom of others on the topic, you know, I may form a firmer view in my mind about precisely what it means.  But you know, that language was used and that’s what Congress chose.41 

Judges Shannon42 and Sontchi43 have avoided the fray.  Thus, in Delaware, as well as elsewhere, what Section 503(c)(3) requires is unclear.

Conclusion

In sum:

  1. Courts disagree on whether Section 503(c)(3) simply reiterates the standard that courts applied before Congress added Section 503(c)(3) to the Bankruptcy Code.
  2. The U.S. Bankruptcy Court for the District of Delaware has not decided whether the standards are identical, and two judges have expressed conflicting views in oral rulings.
  3. In the future, a “sound business purpose” could be insufficient to justify a transaction if Section 503(c)(3) controls.