A recent bankruptcy case merits the attention of credit managers and others involved in credit decisions. To avoid credit risk when dealing with a chapter 11 debtor in possession, you must verify that the debtor has court authority to use cash collateral prior to shipping or accepting payment.

What Happened: In a recent case before the federal court of appeals for the Eleventh Circuit (covering the states of Florida, Alabama and Georgia), Marathon Petroleum was forced to return almost $2 million in cash paid to it by chapter 11 debtor Delco Oil. Marathon had sold the petroleum to Delco for cash in advance and thus did not believe it was incurring any credit risk. Nonetheless, because the bankruptcy court never entered a requested order allowing Delco to use its "cash collateral," the bankruptcy court ordered Marathon to return the payments to the chapter 7 trustee who was appointed after the chapter 11 case was converted to a liquidation case. The Eleventh Circuit agreed.  

Use of Cash Collateral in Bankruptcy Cases

Under the Bankruptcy Code, a chapter 11 debtor in possession cannot use pledged current assets, such as accounts receivable and the cash proceeds of inventory unless the secured creditor consents or the bankruptcy court enters an order allowing the use of the cash collateral. Because most chapter 11 debtors have pre-petition current asset secured financing, they can only spend their money with consent of the secured creditor or a court order. Because the secured creditor will almost never consent without a court order, a court order is customarily required before a chapter 11 debtor in possession can spend money.  

In most chapter 11 cases an interim cash collateral order or a debtor in possession financing order is entered at the very beginning of the case, allowing the debtor to spend money. A final order then is usually entered about a month into the case. If there is no such order in effect, the debtor cannot spend money and will soon be forced to shut down. Because most debtors and their attorneys know this rule, it is rare that a debtor spends money improperly without an active order in place. However, although Delco asked the bankruptcy court to enter an order allowing the use of cash collateral at the beginning of the case, the court did not do so. Nonetheless, over the first three weeks of the case, Delco Oil inappropriately paid Marathon more than $1.9 million for fuel.  

What This Means for You  

Particularly where large amounts of money are involved, a supplier dealing with a debtor in possession needs to verify that a cash collateral order has indeed been entered prior to delivering goods to or accepting payment from a chapter 11 debtor. To be perfectly safe, the creditor also would have to check to be sure that the authorization has not been revoked prior to subsequent shipments and payments.  

This can best be done by checking the docket sheets available online on each bankruptcy court's website through the federal court "PACER" system. A "PACER" ID and password is required and a very minimal amount, cents per page, is charged for access to the system.