Beware When Dealing with Bankrupts: The Bank’s Liens Always Come First

February 25, 2011
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Why You Should Beware When Dealing with a Bankrupt

The United States Court of Appeals has severely reprimanded a company which innocently sold goods to a bankrupt. This reinforces the need for extreme care in doing business with someone in bankruptcy.

Delco Oil filed Chapter 11 bankruptcy in October. Its secured lender, CapitalSource Finance, had a pre-bankruptcy lien on all assets, including inventory, receivables, and cash. Delco asked the bankruptcy court for permission to use its cash to continue business operations. The court refused. However, in the six weeks between the bankruptcy filing and the court’s refusal, Delco bought new inventory from Marathon Petroleum and paid Marathon nearly $2 million. Marathon admittedly had no idea that CapitalSource claimed a lien in Delco’s cash.

The Bankruptcy Code holds a debtor’s cash and cash equivalents to be a secured lender’s “cash collateral.” The Code prohibits a debtor from using “cash collateral” – even in the ordinary course of business – unless the lender consents or the court so directs. Neither occurred in Delco’s case. In fact, the bankruptcy trustee sued Marathon for the $2 million.

The court, in Marathon Petroleum Company v. Cohen, found for the trustee, despite Marathon in good faith having delivered goods worth the full $2 million. As the court noted, the Bankruptcy Code contains nothing excusing Marathon because of good faith or provision of fair value.

The Bankruptcy Code generally lets a bankrupt continue to operate its business. That being said, one must exercise due care to avoid being in Marathon’s position. If in doubt, consult counsel.