Use of Cash Collateral to Pay Prepetition Debt Not Prohibited by Jevic

The ability of a bankruptcy trustee or a chapter 11 debtor-in-possession ("DIP") to use "cash collateral" during the course of a bankruptcy case may be vital to the debtor's prospects for a successful reorganization. However, because of the unique nature of cash collateral, the Bankruptcy Code sets forth special rules that apply to the nonconsensual use of such collateral to protect the interests of the secured creditor involved. The U.S. Bankruptcy Court for the Eastern District of Washington examined these requirements in In re Claar Cellars, LLC, 2020 WL 1238924 (Bankr. E.D. Wash. Mar. 13, 2020). The court authorized a debtor to use cash collateral over the objection of a secured creditor because it found that the creditor's interest in the collateral was adequately protected. Moreover, the court concluded that the use of such collateral to pay in part a prepetition, allegedly secured debt owed to an affiliated debtor did not violate the U.S. Supreme Court's prohibition in Czyzewski v. Jevic Holding Corp., 137 S. Ct. 973 (2017), against distributions that deviate from the Bankruptcy Code's priority scheme in the context of a "structured dismissal" of a chapter 11 case.

Use, Sale, or Lease of Estate Property Outside Ordinary Course

Section 363(b)(1) of the Bankruptcy Code provides in relevant part that "[t]he trustee, after notice and a hearing, may use, sell, or lease, other than in the ordinary course of business, property of the estate." Courts generally apply some form of a business judgment test in determining whether to approve a proposed use, sale, or lease under section 363(b)(1). See ASARCO, Inc. v. Elliott Mgmt. (In re ASARCO, L.L.C.), 650 F.3d 593, 601 (5th Cir. 2011); In re Stearns Holdings, LLC, 607 B.R. 781, 792 (Bankr. S.D.N.Y. 2019); In re Friedman's, Inc., 336 B.R. 891, 895 (Bankr. S.D. Ga. 2005); see generally Collier on Bankruptcy ¶ 363.02 (16th ed. 2019). Under this deferential standard, a bankruptcy court will generally approve a reasoned decision by a trustee or DIP to use, sell, or lease estate property outside the ordinary course of business. See In re Alpha Nat. Res., Inc., 546 B.R. 348, 356 (Bankr. E.D. Va.), aff'd, 553 B.R. 556 (E.D. Va. 2016). However, when a transaction involves an "insider," courts apply heightened scrutiny to ensure that the transaction does not improperly benefit the insider at the expense of other stakeholders. See In re Alaska Fishing Adventure, LLC, 594 B.R. 883, 887 (Bankr. D. Alaska 2018); In re Family Christian, LLC, 533 B.R. 600, 622, 627 (Bankr. W.D. Mich. 2015).

Special Rules for Use of Cash Collateral

If a trustee or DIP proposes to use estate property in the form of "cash collateral," special rules apply. Section 363(a) of the Bankruptcy Code defines "cash collateral" as "cash, negotiable instruments, documents of title, securities, deposit accounts, or other cash equivalents whenever acquired in which the estate and an entity other than the estate have an interest." Cash collateral also includes "the proceeds, products, offspring, rents, or profits of property . . . subject to a security interest." Section 101(51) of the Bankruptcy Code defines "security interest" as a "lien created by an agreement."

Generally, cash collateral is thought of as an asset that can dissipate or be consumed quickly, easily, and undetectably. And once gone, cash collateral is difficult to trace and recover. Because of this transient characteristic, Congress has codified special provisions in the Bankruptcy Code to account for cash collateral and restrict the use of it, to protect the rights of the creditor that holds a security interest in the cash collateral.

Under section 363(c)(4) of the Bankruptcy Code, a trustee or DIP is required to segregate and account for any cash collateral in its possession, custody, or control. This requirement applies to both cash collateral the debtor has on hand before the commencement of the bankruptcy case and any cash collateral the trustee or DIP acquires thereafter. Because the trustee or DIP has a duty to protect and maintain the cash collateral for the benefit of the one or more secured creditors that have an interest in the collateral, it is especially important to identify each secured creditor that has an interest in it.

Under section 363(c)(2) of the Bankruptcy Code, a trustee or DIP may not use, sell, or lease cash collateral without either: (i) the consent of each secured creditor with an interest in the collateral; or (ii) the court's authorization. Often, a secured creditor will allow the DIP to use cash collateral for specific purposes to keep the business operational, under certain terms and conditions. This type of agreement benefits the secured creditor because it maintains the debtor's business as a going concern, thereby preserving the value of the secured creditor's interest in the collateral.

Pursuant to section 363(e), if the secured creditor and the trustee or DIP cannot agree on a proposed use of cash collateral, the court may grant such permission, provided that the secured creditor's interest in the collateral is adequately protected. Under section 363(p), the trustee or DIP bears the burden of proving that it can adequately protect the secured creditor's interest in the cash collateral. Even though section 363(c)(2) requires notice and a hearing before the court can grant permission to use cash collateral, the court may, and often does, hear motions to use cash collateral on an expedited basis—particularly at the inception of a bankruptcy case. The court may conduct a preliminary hearing on the first day of the bankruptcy case to authorize the use of cash collateral for certain urgent and vital uses on an interim basis to prevent immediate and irreparable harm to the debtor's estate. The court typically convenes a later final hearing on the use of cash collateral.

Jevic and Distributions Inconsistent With the Bankruptcy Code's Priority Scheme

Chapter 11 cases culminate by either confirmation of a plan of reorganization or liquidation that becomes effective; conversion to a chapter 7 case; or dismissal of the case. In the case of dismissal, section 349(b) of the Bankruptcy Code is designed to reinstate as nearly as possible the pre-bankruptcy status quo unless the court orders otherwise "for cause." Prior to Jevic, some courts relied on this provision to approve "structured dismissals" of chapter 11 cases that include some provisions, rights, and protections typically seen in chapter 11 plan confirmation orders, including provisions for distributions to creditors. In some instances, these distributions deviated from the Bankruptcy Code's priority scheme.

In Jevic, the Supreme Court held that bankruptcy courts may not deviate from the Bankruptcy Code's priority scheme when approving structured dismissals without the consent of creditors (without, however, offering any "view about the legality of structured dismissals in general").

The Court's 6-2 majority distinguished cases in which courts have approved interim settlements resulting in distributions of estate assets in violation of the priority rules, such as In re Iridium Operating LLC, 478 F.3d 452 (2d Cir. 2007). The majority found that Iridium "does not state or suggest that the Code authorizes nonconsensual departures from ordinary priority rules in the context of a dismissal—which is a final distribution of estate value—and in the absence of any further unresolved bankruptcy issues." In this sense, the majority explained, the situation in Iridium was similar to certain "first day" orders, where courts have allowed for, among other things, payments ahead of secured and priority creditors to employees for prepetition wages or to critical vendors on account of their prepetition invoices.

The majority further explained that "in such instances one can generally find significant Code-related objectives that the priority-violating distributions serve." By contrast, the majority noted, the structured dismissal in Jevic served no such objectives (e.g., it did not benefit disfavored creditors by preserving the debtor as a going concern and enabling the debtor to confirm a plan of reorganization and emerge from bankruptcy). Rather, the majority emphasized, the distributions at issue "more closely resemble[d] proposed transactions that lower courts have refused to allow on the ground that they circumvent the Code's procedural safeguards" (citing, among others, certain proposed section 363 asset sales).

Claar Cellars

Claar Cellars LLC ("Claar") and RC Farms ("RC"), both of which are owned by the Whitelatch family ("Whitelatch"), operate 130 acres of vineyards in Washington. After RC harvests the grapes it produces, it sends the grapes to Claar, which processes them into wine and sells the wine. Under a 1997 purchase agreement, Claar is obligated to pay RC for the grapes Claar receives.

In January 2020, Claar and RC filed for chapter 11 protection in the Eastern District of Washington. RC asserted a secured claim against Claar in the amount of $330,000 on the basis of a state law creating a statutory lien for grape growers on the inventory and accounts receivable of wine producers to which the growers provide grapes.

As of the petition date, Claar and RC owed secured lender HomeStreet Bank ("HomeStreet") approximately $2 million. HomeStreet's prepetition collateral included personal property owned by both companies (including cash collateral) as well as real property owned by RC and a Whitelatch family trust.

After filing for bankruptcy, both debtors, whose cases were not consolidated, filed motions seeking court authority to use HomeStreet's cash collateral for the purpose of maintaining the real property (in the case of RC) and continuing operations. In the budget accompanying the motions, Claar proposed to make seven monthly payments to RC during 2020 in the aggregate amount of approximately $163,000 for grapes shipped to Claar prepetition. This amount represented roughly half of RC's prepetition secured claim. RC's representative testified that RC could not operate without the payments.

HomeStreet objected, arguing that: (i) the debtors were not adequately protecting HomeStreet's interest in its cash collateral; (ii) the proposed $163,000 in payments to RC would improperly satisfy a prepetition debt outside of a confirmed chapter 11 plan, thereby violating Jevic; and (iii) because the validity of RC's lien was questionable—an issue that needed to be adjudicated in an adversary proceeding—the court could not rely on the secured status of RC's claim to permit Claar's postpetition payments.

The adequate protection issue with respect to RC was resolved after RC agreed to grant HomeStreet a lien on another parcel of unencumbered real property and the court found that the value of the overall adequate protection package significantly exceeded the amount of HomeStreet's claim. HomeStreet, however, still objected to the proposed $163,000 in payments by Claar to RC.

The Bankruptcy Court's Ruling

The bankruptcy court overruled HomeStreet's objections to the debtors' proposed uses of cash collateral.

At the outset of its opinion, the court stated that section 363(b)(1) is one of many provisions in the Bankruptcy Code "providing broad and flexible powers for courts to deploy to facilitate the rehabilitation of a given debtor based on the context of that debtor's case." Explaining its ruling, however, the court observed that "section 363(b)(1) is not a tool to obviate prohibitions found elsewhere in the Bankruptcy Code, no matter how inconvenient those prohibitions may be in a particular case." The court noted that the provision, while straightforward, is cabined, complicated, and throttled by other provisions of the Bankruptcy Code, applicable nonbankruptcy law, and judicially crafted limitations. This last group of limitations, for example, includes the prohibition against section 363(b) asset sales that amount to sub rosa chapter 11 plans evading the detailed confirmation requirements set forth in the Bankruptcy Code (citing PBGC v. Braniff Airways, Inc. (In re Braniff Airways, Inc.), 700 F.2d 935, 940 (5th Cir. 1983)).

Against this backdrop, and applying heightened scrutiny to the transaction because of RC's status as an insider, the bankruptcy court approved the use of HomeStreet's cash collateral to make the payments to RC. According to the court, approval was warranted for five reasons:

(i) It was clear that RC possessed a secured claim against Claar in "some amount," and RC "articulated a colorable basis" under which it might be oversecured, which warranted periodic cash payments to RC as a form of adequate protection of its interest in Claar's property;

(ii) The payments to RC were essential to RC's continued viability, which in turn justified RC's pledge of additional collateral to adequately protect HomeStreet's interest and "avoid[ed] the inequity that would result if the Claar estate got a completely fair ride on RC's credit support";

(iii) Claar received other indirect benefits from the continued viability of RC, including greater enterprise value generated by any sale of the Whitelatch-owned businesses as a consolidated package;

(iv) The risk associated with the payments was minimal because of the relatively small "value leakage" and the ability for "recalibration" of the amount realized by RC on its remaining claim in the claims resolution process; and

(v) An adversary proceeding was not required before Claar could make any periodic payments to RC, given that courts frequently approve partial payments to secured creditors, "despite potentially viable challenges to the validity, priority, or extent of the underlying lien that could be finally determined only via adversary proceeding."

According to the bankruptcy court, authorizing the use of HomeStreet's cash collateral to pay part of RC's prepetition claims did not offend Jevic because the "payments are 'interim' distributions under any meaning of that word in Jevic" and because the distributions "advance significant bankruptcy objectives without causing material (or perhaps any) harm to any other creditor."

HomeStreet also argued that the proposed payments to RC could not be approved as a first-day "critical vendor" motion, which some courts have sanctioned under the "doctrine of necessity." However, because the debtors could not establish that RC was a critical vendor and disclaimed any reliance on this theory to justify the payments, the court declined to address the continued viability of the practice.

Outlook

Claar Cellars is a primer on section 363(b) and the circumstances under which a DIP can use cash collateral over the objection of a secured creditor. However, the ruling is also notable for its commentary on the scope of Jevic in the context of a proposed non-ordinary course use, sale, or lease of estate property under section 363(b).

Claar Cellars is not the only recent court ruling concluding that Jevic has limited application to proposed transactions under section 363(b). For example, in In re Old Cold LLC, 879 F.3d 376 (1st Cir. 2018), the U.S. Court of Appeals for the First Circuit ruled that Jevic did not apply to an asset sale under section 363(b). The court rejected the argument that a winning bid in an auction sale that provided for the payment of certain unsecured claims before administrative claims impermissibly violated the priority rules in contravention of Jevic. Instead, the court applied section 363(m) of the Bankruptcy Code to render statutorily moot an appellate challenge to a sale to a good-faith purchaser because the sale order had not been stayed pending appeal. According to the First Circuit, "Section 363(m) sets forth only two requirements: that there is a good faith purchaser, and that the sale is unstayed." It concluded that "[n]othing in Jevic appears to add an exception to this statutory text."

In In re Daily Gazette Co., 584 B.R. 540 (Bankr. S.D.W. Va. 2018), the bankruptcy court ruled that Jevic's prohibition against nonconsensual structured dismissal settlements that deviate from the Bankruptcy Code's priority scheme did not affect a chapter 11 debtor's ability to sell its assets with the intention of using the sales proceeds to pay administrative claims followed by a distribution to a secured creditor holding a blanket lien on the debtor's assets.

In In re Nine W. Holdings, Inc., 588 B.R. 678 (Bankr. S.D.N.Y. 2018), the bankruptcy court approved a DIP's motion to retain and compensate a distressed management consultant under section 363(b) rather than the provisions of the Bankruptcy Code traditionally relied upon for professional retention and compensation requests in chapter 11 cases. According to the court, Jevic recognized that priority-skipping distributions are permissible when there are "significant Code-related objectives that the priority-violating distributions serve."

In In re Veg Liquidation, Inc., 931 F.3d 730, 739 (8th Cir. 2019), the U.S. Court of Appeals for the Eighth Circuit noted that "even if the reasoning of Jevic on priority rules were extended to § 363 sales, it would not apply in the context of a consummated sale." According to the court, "Whatever force the Bankruptcy Code's priority rules might have at a sale approval hearing or on direct review of a § 363 sale, . . . a deviation from those rules does not render final judgments 'void.'"

Finally, although the court in Claar Cellars declined to address the continued viability of the "doctrine of necessity" in approving first-day critical vendor motions post-Jevic, other courts have held that the practice is sanctioned by the Supreme Court's ruling. For example, in In re Murray Metallurgical Coal Holdings, LLC, 2020 WL 1307378 (Bankr. S.D. Ohio Mar. 18, 2020), the court approved the payment of critical vendors at the inception of a bankruptcy case under section 363(b). Citing many other cases in which the practice has been sanctioned post-Jevic, the court wrote that "[t]he Supreme Court has recognized with apparent approval" the practice of authorizing payments to critical vendors where the payments would enable a successful reorganization, benefiting even disfavored creditors.