Proceed With Caution When Servicing Chapter 11 Companies

By HunterMaclean Attorneys

Published in Business in Savannah

In a recent decision handed down by the Eleventh Circuit Court of Appeals in March 2010, a vendor dealing with a company operating in Chapter 11 was ordered to give back almost $2 million in payments on post-bankruptcy invoices – because, unbeknownst to the vendor, the debtor did not have authority to expend its cash. When considering any business transactions with companies operating within bankruptcy proceedings, it is essential to protect yourself from a similar situation that subsequently can result in significant losses.

When an operating business files for Chapter 11 bankruptcy protection, vendors and others who do business with the debtor post-filing are given the protected status of “administrative expense claims,” having a priority over pre-bankruptcy claims. The bankruptcy code gives vendors this favored treatment in order to encourage them to do business with debtors in bankruptcy. Chapter 11 debtors are expected to pay their post-bankruptcy bills on a current basis as a condition of being allowed to use the bankruptcy process to restructure their affairs. If the debtor fails to pay the vendor or creditor, they can seek payment by court order for the Chapter 11 “administrative expense.”

As a result, people doing business with companies operating in Chapter 11 believe they are protected, and in many ways this is true.

However, the Bankruptcy Court also grants protections to a Chapter 11 debtor’s secured lenders. Cash, deposit accounts, securities and negotiable instruments pledged as collateral for loans, as well as cash proceeds of other collateral such as inventory and receivables, constitutes “cash collateral” under the bankruptcy laws. A debtor may not use or spend cash collateral unless the lender consents, or the court enters an order upon a finding that the lender’s interests are adequately protected.

In the case of In re Delco Oil, the debtor was paying its vendors with funds that constituted cash collateral, but it did not have a court order or a stipulation. In fact, the lenders were objecting and subsequently the bankruptcy court denied the debtor’s motion for leave to use cash collateral.

The vendors were ordered to return the payments they received, even though they were unaware that he debtor did not have authority to use cash collateral, and despite a provision of the Uniform Commercial Code that generally protects parties receiving disbursements from a deposit account in which someone else asserts a security interest. The Eleventh Circuit found that the Bankruptcy Code trumped the UCC as well as any “innocent party” or “good faith” defenses.

The Delco Oil decision seems to leave vendors strictly liable to return payments that were unauthorized due to the lack of authority to use cash collateral. As a result, vendors transacting business with companies in Chapter 11 need to take the initiative and ask for assurances that the debtor has authority to use and spend its cash. The debtor ought to be able to provide that quickly and easily in the form of a docketed court order and/or a stipulation.

To protect your business when dealing with companies operating in Chapter 11, verify that the debtor has the authority to spend cash collateral. Whether you are a debtor, creditor or vendor, it is always a good idea to seek legal help in all instances in which bankruptcy comes into play.