This may sound as an odd question to ask. It was recently sent to us by one of our readers who wrote to say that his firm had been approached by a well known company who was in Chapter 11 reorganization and they wanted to purchase product on COD terms. The reader went on to explain that his company had never had any business dealings with this company although the sales department had attempted to sell to the company several times prior to the bankruptcy filing with no success. Prior to the bankruptcy the bankrupt company purchased product from a competitor but had not had any dealings with them since the bankruptcy filing. The reader went on to write that the president of his company was "very excited about doing business with the bankrupt company" and had personally been involved in negotiating the contact executed between the two firms. He also wrote that the credit department had not been asked to participate in the decision to sell to the bankrupt company. Their only involvement, to date, was to set up an account for the bankrupt company. Still, he was curious as to whether there was any reason that his company should avoid selling to the bankrupt company. The negotiated agreement had the potential of contributing over seventeen million to his companys’ revenues over the next three years while the bankrupt company reorganized its’ business.

Our initial response was that his question was a legal one and he should consult with the company attorney.  A few days later we heard back from the reader who wrote that his company did not employ a full time legal department and the attorney the firm used for this transaction was a friend of the president. Our reader was uncomfortable contacting her for fear the president would find out and think he was questioning the presidents’ judgment, especially when he played no role in the transaction. Well, we thought, this is exactly what he is doing but then we propositioned he also could have the best interest of the company in mind as well as his job.

Still, it was a legal question that we were not qualified to answer. So we went to one of our legal sources, Gilland Chenault. Gill is not only one of the best civil lawyers in North Texas but he also teaches business law at one of the state universities in Denton, Texas.

We presented the readers question to Gill. Gill's response was that on the surface the question would bring an immediate no. The company had no prior business dealings with the bankrupt so there wasn't any issue of pre-petition debt to consider. There is "new value" along with "exchange of goods for equivalent value" and most importantly there is no question that the payments would qualify as "normal course of business" since the payment terms are COD and there are no pre-petition transactions involving a different set of terms.

"All in all", Gill said, "Based on the information provided this appears to be a clean transaction”. On that note we were ready to bring an end to our meeting. We had already begun mentally composing a response to our reader that our legal source saw no opposition to his firm selling post-petition to the bankrupt company when Gill casually remarked, "Of course, there is the question of any secured party collateral".

"What do you mean”? We asked. "Well, I'm assuming that either the bankrupt company has no secured creditors with a security interest in cash or the Court has issued an order allowing for the use of pre-petition cash to pay for new debt and there is no objection by any secured creditor", he replied.

“If new value, exchange for goods of equivalent value and normal course of business has been established how does the debtors’ cash, secured or not, affect this transaction”? we asked.

"Sit back down", Gill said, "I’ll explain how this all really works". Gill then gave us a condensed course in bankruptcy and secured assets, specifically cash collateral.

“In a Chapter 11 bankruptcy filing”, he began, “ after the filing has occurred the debtor now debtor-in-possession usually files a motion and order with the Court allowing the debtor-in-possession to use, sell, or lease property of the estate for the purpose of paying all necessary and current expenses to operate its business to the extent that the payments are necessary to preserve the assets and/or keep the business afloat while preparing its plan to exit Bankruptcy. This is found in Bankruptcy Code Section 363. In fact, Section 363(c)(1) permits a Chapter 11 debtor to use, sell or lease property of the estate in the ordinary course of the debtor’s business, without any notice or hearing. However, Section 363(c)(2) says the debtor may not use a secured creditors cash collateral, even in the ordinary course of business, to make payments only for post-petition obligations, unless either the secured creditor or the bankruptcy court has given their approval”.

He could see that we understood and were about to ask the question when he put up a hand and said, “let me continue”. “If there exists a secured creditor who has a financing statement in cash or the proceeds of account receivable and/or inventory, the secured creditor has the right, under Section 363(c)(2) to file a motion to object to their collateral being used to pay post petition obligations of the debtor-in-possession.” “The Court than has three choices, rule in favor of the secured creditor, rule in favor of the debtor-in-possession or take the motion under advisement and rule at a later date”. “Now, if the Court rules in favor of the debtor-in-possession they can use the assets of the secured party to pay those post-petition obligations as conveyed in the Courts order on the debtor-in-possessions Section 363 motion. But if the Court rules in the secured parties favor or takes the objection under advisement and does not rule, then the debtor-in-possession is prohibited from using the secured parties assets to pay post-petition obligations until the Court rules. So the original order under Section 363 or Section 363(c)(1) that permits payments of all necessary and current expenses of operating the business, excludes the use of any objecting secured parties cash assets.”

“OK”, we said,” “but let’s say the debtor ignores the Court’s specific order under Section 363(c)(2) and uses the secured parties cash collateral to pay post-petition expenses under Section 363 and eventually emerges from Chapter 11 bankruptcy, where is the harm?” “Or more to the point where is the risk?” We asked.  

A wide grin began to form at the corners of Gill’s mouth and he quietly said, “What if the debtor fails to emerge from Chapter 11?” “What if they don’t?” we challenged. “Well if they don’t”, Gill said, “The majority convert to a Chapter 7, voluntarily or in-voluntarily, and that’s when the fun starts”.

“In Chapter 7”, Gill went on, “The debtor-in-possession is replaced by a trustee. The role of the trustee is to gather all of the debtors’ assets for liquidation and to recover all avoidable preferences and post-petition payments. Any use of secured party cash collateral to pay post-petition obligations without an order from the Court or the permission of the secured creditor is an avoidable post-petition preference and the trustee has the right to recover from the party who received it. This is found in Bankruptcy Code Section 549(a), the trustee’s right to avoid a debtors’ post-petition transfer, and 550(a), the trustee’s right to recover improperly transferred property.”

“OK”, we responded, “That’s a lot of legal jargon. What if the post-petition creditor was operating in good faith under the purposes of Chapter 11 and for lack of a better term is an innocent vendor?” Gill started to reply but we continued. “And what about new value, and equivalent value of exchange, and ordinary course of business? Would those acceptable defenses not be a satisfactory response to any avoidable preference brought against a post-petition creditor by the trustee?”

Gill turned and looked at the shelves of law books behind him, finally he grabbed one off the shelf and thumbed through it. He eventually looked up from the page he was reading and said, “There is nothing in Section 549 or any other section of the Code I can find or know of that allows for an innocent vendor or ordinary course of business defense for a vendor who has received an un-authorized post-petition transfer of estate property.” “Even if an equivalent value of exchange exists and the creditor was acting in good faith, there is nothing in the Code that provides the post-petition payment to be unavoidable.”

“So what would your counsel be in this type of scenario?” We asked. Gill looked at his watch and asked “Are we on the clock? Just joking”, he said. “Seriously, my advice would be to first check for any outstanding UCC filings against the bankrupt company and determine if there are any secured creditors with cash or proceeds as security. Secondly, regardless if there are secured creditors or not I would want a copy of the Bankruptcy Court’s order giving the debtor-in-possession the right to use all assets including cash to pay post-petition expenses and obligations. If I did not have that order in hand I would strongly recommend to walk away from any offer to sell to the debtor-in-possession regardless of the amount or terms of sale, simply because there is the risk that one day you may have to return the money”.

We thanked Gill for his time and sent an email to the reader informing him what we had learned. We also asked him to keep in touch and let us know how things eventually turn out. We’ll provide an update to this story when and if we hear back from him.

We have been in the credit profession close to forty years and it never ceases to amaze us how little we know. We can’t tell you how many times we have sold post-petition to company’s in bankruptcy believing that our only risk was the possibility of losing the present outstanding sale amount. 

We began this column with the sentence “This may sound as an odd question to ask”.

We’ll end by saying there is no such thing as an odd or stupid question. The questions that go unasked may cost you millions for not asking.

We wish you well.  

The information provided above is for educational purposes only and not provided as legal advice. Legal advice should be obtained from a licensed attorney in good standing with the Bar Association and preferably Board Certified in either Creditor Rights or Bankruptcy.