Post-Petition Transactions: Ordinary Course of Business or Court Approval Needed?

In a bankruptcy case, a debtor authorized to operate a business may enter into transactions and use property of the estate in the “ordinary course of business” without notice or hearing. [1] The purpose of this rule is to authorize a debtor-in-possession to operate its business within the broad parameters of sound business judgment, and pay debts incurred in the ordinary course. [2]

Court approval after notice and a hearing is needed to use estate property other than in the ordinary course. [3] Sections 549 and 550 of the Bankruptcy Code permit a trustee to void and recover unauthorized post-petition transactions, such as those not incurred in the ordinary course. [4]

A practical problem for parties that arises therefore is determining whether a proposed transaction with a bankruptcy debtor is within the ordinary course of business. A recent example of a case in which post-petition payments made by debtor to its major secured lender (“Bank”) were claimed to be outside of the ordinary course can be seen in the T.A. Brinkoetter & Sons, Inc. case. [5]

In T.A. Brinkoetter, a chapter 7 trustee (“Trustee”) filed an adversary proceeding seeking the recovery of certain post-petition payments which had allegedly been tendered as “adequate protection” and for the sale of 5 vehicles securing the Bank’s claims, although the parties had not sought court approval for these transactions. [6] Payments in the amount of $59,944.62 were voluntarily made by a chapter 11 debtor-in-possession to the Bank before the case was converted to chapter 7. [7]

The Bank argued that the payments that it received were ordinary and necessary in the debtor’s conduct of its business operations, and hence not avoidable by the Trustee. It also argued that the payments were disclosed, since they were identified on the debtor-in-possession’s monthly operating reports. Finally, the Bank contended that the value of the vehicles was between $70,000 and $80,000 at the time of the transaction, so fair value was given to the estate. [8]

The Trustee contended that the post-petition payments made by the debtor to the Bank were made outside of the ordinary course of business, under either the vertical or horizontal tests developed by the courts. Collier on Bankruptcy explains these tests as follows:

To determine whether a particular transaction or use of property is or is not within the debtor’s ordinary course of business, courts have developed two tests. The first is the so-called “vertical” or “creditor’s expectation” test, which requires the court to determine whether a transaction subjects creditors to economic risks different from those bargained for when credit was extended. The “touchstone of ordinariness” in this context is whether the transaction is one that creditors could reasonably have expected the debtor to enter into in the normal course of its business. The second is the so-called “horizontal” test, which requires the court to consider whether the transaction is of a type commonly undertaken by companies involved in business activities that are the same as or similar to the debtor’s. [9]

The Trustee argued that the chapter 11 debtor was not authorized to make adequate protection payments to a prepetition secured creditor without approval of the court. Specifically, he argued that the failure to obtain an adequate protection order rendered the payments made non-ordinary, as creditors would have expected prior notice of the proposed payments. [10]

The Court declined to adopt the view that the failure to obtain an adequate protection order in these circumstances in itself rendered the challenged payments avoidable. In support, the Court cited to the view of courts finding that periodic payments made by a debtor to remain current on secured debt were reasonable operating expenses necessary for the continuation of the debtor’s business. [11]

The Court also noted that the lack of notice of the payments being made in this particular case did not deprive unsecured creditors of the right to substantively challenge the payments if desired in the adversary case. [12] The Court additionally noted that the Bank was only seeking to retain what it had received and not making any claim to an amount above that (thus noting that the Bank had waived any claim to such amount as adequate protection). [13]

As a result, the Court concluded that further inquiry into the ordinariness of the payments and their propriety as adequate protection was appropriate. Since in the Seventh Circuit, a debtor-in-possession’s payment of a prepetition unsecured debt is never proper (and thus always avoidable under section 549), the only way the payments on the Bank’s debt could be defended is if they were proper as adequate protection payments. The Court found that whether the payments were ordinary under the horizontal and vertical tests could not be determined on the record before it and further hearing was required. [14]

While the Court denied the Trustee’s motion for summary judgment, the case illustrates the problem and risks in potentially having reached the wrong conclusion that court approval was not necessary. As observed by the Court, the Bank will now have to prove defensively that the payments were ordinary under section 1108. [15]

The following questions are examples of those that can be asked when faced with a post-petition transaction:

  1. Is one or more of the contracting parties authorized to operate its business under an applicable Code section?
  2. Has the debtor or other contracting party proposed that the transaction be submitted to the court for approval?
  3. Are you an experienced bankruptcy practitioner?
  4. What are the business and economic investments of the parties to the transaction at issue?
  5. Do you know whether the proposed transaction is a customary transaction for the debtor?
  6. Do you know whether the transaction is a customary transaction for the nature of debtor’s business compared to other similar businesses?
  7. Do you have sufficient facts, one way or the other, to make a determination, without court approval, of whether the transaction is within the ordinary course of business?
  8. What is the risk to your client if the transaction is determined to be not in the ordinary course of business at some future point?
  9. If you are not representing the debtor, is the debtor’s counsel involved in the transaction or is the transaction emanating directly from the debtor-in-possession or an officer of the debtor?
  10. Does the debtor have a sound business reason to enter into the proposed transaction? [16]

In reviewing whether a court order is necessary to a transaction, parties should keep in mind the risk and potential pitfalls of proceeding without one, since any transaction that proposes paying prepetition creditors will be carefully scrutinized. [17] Careful review at the outset of whether a proposed transaction is consistent with a debtor-in-possession’s own business and its industry practices can certainly only help to avoid problems or be prepared to address questions down the line.

[1] 11 U.S.C. § 363(c)(1).

[2] 11 U.S.C. § 1108; Covey v Soy Capital Bank and Trust Company (In re T.A. Brinkoetter & Sons, Inc.), 2012 WL 1865485 at *4 (Bankr. C.D. Ill. May 22, 2012).

[3] 11 U.S.C. § 363(b)(1).

[4] 11 U.S.C. §§ 549(a) and 550(a); T.A. Brinkoetter, 2012 WL 1865485 at *4.

[5] Id.

[6] Adequate protection payments are payments intended to “preserve the status quo for secured creditors, specifically by protecting a secured creditor from erosion of its relative secured status due to depreciation in the value of its collateral while the automatic stay is in place.” Id. at *4 (citing In re Good, 428 B.R. 235, 241-42 (Bankr. E.D. Tex. 2010)).

[7] The debtor’s records showed that payments in the amount of $14,944.62 were made to the Bank between June 2009 and December 2009, and a final payment of $45,000.00 in January 2010, although it was not clear from the record how these payments were intended to be applied. Id. at *1, *3.

[8] Id. at *4.

[9] Id. at *5 (citing 7 Collier on Bankruptcy ¶ 1108.02[4] (Alan N. Resnick & Henry J. Sommer eds., 16th ed.)).

[10] Id. at *5.

[11] Id. at *6 (citing In re Discount Family Boats of Texas, Inc., 233 B.R. 365 (Bankr. E.D. Tex. 1999); In re Family Health Food U.S.A. Inc., 233 B.R. 250 (Bankr. S.D. Fla. 1998); Matter of Ford, 61 B.R. 913 (Bankr. W.D. Wis. 1986)).

[12] Id. at *6-7.

[13] Id. at *7.

[14] Id.

[15] Id. at *5 n.4.

[16] Michael S. Lieb, Is It or Isn’t It: Ordinary Course of Business, Michigan Business Law Journal 44-45, Summer 2003.

[17] Id. at 45.

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