Suppliers to chapter 11 debtors-in-possession should always ensure that they are not being paid from the debtor’s “cash collateral” without court approval. Marathon Petroleum Company supplied products to debtor Delco Oil in the ordinary course of its business during the bankruptcy case, but was forced to return all of the postpetition payments it received from Delco, pursuant to section 549 of the Bankruptcy Code. Marathon was required to return these payments because they were deemed part of the cash collateral that was secured by Delco’s pre-petition creditor, CapitalSource Finance. Marathon provided valuable goods to Delco in exchange for payment, and was unaware that Delco was using cash collateral to make payment. Unfortunately for Marathon, section 549 strictly mandates the return of unauthorized post-petition payments. Further, UCC 9-332(b) (which outside of bankruptcy cases ordinarily protects innocent transferees of deposit accounts from claims by prior lien claimants) did not apply because the issue was not one of lien priority, but of unauthorized transfers.

FACTUAL BACKGROUND

On October 16, 2007, Delco Oil, Inc. filed for chapter 11 bankruptcy protection, and was permitted by the court to continue operating its business as a debtor-in-possession. Delco moved for approval to use its cash collateral, which was secured by properly perfected UCC-1 filings by CapitalSource, but the court denied the motion on CapitalSource’s objection. (Section 363(a) of the Bankruptcy Code defines “cash collateral” to include cash, negotiable instruments, deposit accounts, and other cash equivalents, whether existing before or after the filing of a bankruptcy petition.)

Marathon, which supplied products to Delco pre-petition, continued to do so after the bankruptcy filing. After its bankruptcy filing, but before the court ruled on its motion to use its cash collateral, Delco paid $1.9 million in cash to Marathon in exchange for the products. (The funds for these payments came from what turned out to be covertly created bank accounts hidden from CapitalSource. Marathon was not aware of Delco’s machinations.) Ultimately, Delco voluntarily converted its case to chapter 7, and the newly appointed chapter 7 trustee initiated actions against Marathon to avoid the payments under section 549(a) of the Bankruptcy Code. The bankruptcy trustee successfully recovered the postpetition payments to Marathon, and Marathon appealed.

COURT ANALYSIS

The Bankruptcy Code prohibits the post-petition use of cash collateral by a debtor-in-possession or a trustee, unless the secured party or the bankruptcy court authorizes the use of the cash collateral. As part of its decision to authorize the use of cash collateral, the bankruptcy court must find that the secured party’s interest in the cash collateral is adequately protected.

Section 549(a) of the Bankruptcy Code allows a trustee to recover unauthorized post-petition transfers of property. To avoid such a transfer, the trustee need only show that a transfer of property of the debtor’s estate was made following the filing for bankruptcy, and that the transfer was not authorized by the Code or the court.

The chapter 7 trustee successfully avoided the payments to Marathon under the deceptively simple theory that the post-petition payments to Marathon were made from Delco’s cash collateral without the court’s or CapitalSource’s approval, and were thus not authorized under section 363(a). Because the transfers were not authorized, section 549(a) mandated their return.

Marathon raised several failed arguments in its attempt to keep the $1.9 million. First, Marathon argued that the funds were not cash collateral under state UCC law. Specifically, UCC section 9-332(b) provided that transferees take funds from deposit accounts free of a security interest, so long as the transferee did not collude to violate the rights of the secured party. The court disposed of the argument as irrelevant. The issue was not whether CapitalSource had a priority lien over the cash under the UCC, but whether the debtor was permitted to transfer the cash in the first place. Because the debtor clearly did not have the requisite authorization, the transfers to Marathon fell squarely within the prohibitions of section 549(a).

Marathon also argued that a material question of fact existed as to whether the funds it received were identifiable proceeds of CapitalSource’s secured collateral. Marathon suggested that the cash may have come from some other source, but failed to provide sufficient evidence to contravene CapitalSource’s blanket security interest. Although the issue was not addressed in the opinion, it is ironic (and unfortunate for Marathon) that the source of the cash funds in the accounts may very well have come from Delco’s sale of Marathon’s products.

Marathon also argued that, because it had given Delco inventory in exchange for the money, it had given equivalent value, and thus no harm had been done to the bankrupt estate or CapitalSource. The court rejected this argument as well, pointing out that there was no “equivalent value” defense under section 549.

The Circuit Court denied each of Marathon’s arguments, and held that the trustee could avoid and recover the payments made to Marathon.

PRACTICAL CONSIDERATIONS

Creditors and suppliers to debtors-in-possession must be extra cautious about the source of post-petition payments coming from the debtor. Bankruptcy courts typically permit a debtor-in-possession to use its cash and other assets to continue operating. After all, one of the purposes of chapter 11 is to allow a debtor a chance to reorganize its affairs through the continued operations of its businesses. Nevertheless, it is clear that a debtor cannot use cash collateral that is secured by one of its creditors, to pay its suppliers or other creditors, unless the debtor obtains either the secured creditor’s permission or a court order allowing it to do so.

The lesson is quite clear: any party that plans to supply products to a debtor-inpossession should get assurances and should independently investigate whether the debtor is paying from its cash collateral. In Marathon’s case, the fact that CapitalSource had objected to Delco’s request to use its cash collateral, and the fact that CapitalSource had a blanket lien on Delco’s assets, were red flags that warranted extra investigation.