The United States Bankruptcy Court for the Eastern District of North Carolina recently avoided several secured financing arrangements, entered into by a debtor without court approval, as illicit transfers under section 549(a) of the Bankruptcy Code. See James B. Angel v. Hyosung Motors America, Inc. (In re Britt Motorsports, LLC), Case No. 14-00058 (Bankr. E.D.N.C. April 22, 2015). The holding reminds creditors that it is better to be safe–and ask for bankruptcy court permission before entering into a postpetition transaction with a debtor–than be sorry later.
Prior to filing bankruptcy, the debtor, Britt Motorsports, LLC, was in the business of selling used motorcycles, ATVs, and watercraft and custom metric motorcycles. Hyosung Motor America, Inc. supplied the debtor with motorcycles for sale to Britt’s customers. Whenever the supplier provided motorcycles, both parties entered into a “Dealer Payment Agreement/Promissory Note,” which contained the following terms:
- the supplier would deliver the motorcycles to the debtor;
- the debtor was required to pay the supplier an initial down payment of 10% of the purchase price, followed by monthly installments;
- the supplier retained title to each motorcycle until it was sold and the supplier received full payment of the price of the motorcycle;
- whenever the debtor sold a motorcycle, it was required to immediately pay the supplier any balance owed for such unit; and
- the supplier reserved the right to pick up any unsold motorcycle at any time.
Prior to and after filing bankruptcy, without obtaining bankruptcy court approval, the debtor and the supplier entered into 5 such Dealer Payment Agreements/Promissory Notes, pursuant to which the debtor made multiple postpetition payments to the supplier, in the amount of $85,742.68.
Conversion and Avoidance
Several years after filing bankruptcy, the debtor’s case was converted to chapter 7 and a trustee was appointed. Shortly after, the trustee initiated an adversary proceeding (Adv. No. 11-07688) to avoid and recover all of the postpetition payments made to the supplier, pursuant to sections 549 and 550 of the Bankruptcy Code.
Section 549 provides, in relevant part, that a trustee or debtor may avoid a postpetition transfer of property of the bankruptcy estate that is not authorized under the Bankruptcy Code or by the bankruptcy court. 11 U.S.C. § 549(a). Section 550 imposes liability on the transferee of such property to the extent the transfer is avoided under section 549. See 11 U.S.C. § 550(a). Finally, section 541 provides that property of a bankruptcy estate includes all legal and equitable interests of the debtor in property as of the commencement of a case and any interests in property that the estate acquires postpetition. 11 U.S.C. § 541(a)(1), (7).
Through the adversary proceeding, the trustee maintained that the debtor transferred estate property (money) to the supplier and such transfers were made without proper authority. According to the trustee, while section 1108 of the Bankruptcy Code generally allows a debtor to continue operating its business postpetition as a debtor-in-possession, section 364 of the Bankruptcy Code restricts a debtor-in-possession from obtaining certain types of credit postpetition. See 11 U.S.C. §§ 1108, 364.
Specifically, section 364 requires a debtor to obtain bankruptcy court approval when obtaining unsecured credit or incurring unsecured debt outside of the ordinary course of business. See id. at § 364(b). Section 364 places even more restrictions when a debtor is seeking to obtain secured debt postpetition. See id. § 364(c). In that instance, the debtor must demonstrate to the bankruptcy court that it cannot otherwise obtain unsecured debt. See id. The debtor must also demonstrate that (a) a secured lender will not otherwise accept a superpriority administrative priority claim instead of collateral, (b) the debtor possesses unencumbered assets that it can pledge or (c) the debtor possesses encumbered assets that are valuable enough to afford a junior lien. See id. In certain circumstances, the debtor can also incur secured debt with liens that prime (or take priority over) existing liens. See id. at 364(d).
There is a solid policy reason why the restrictions on borrowing exist under the Bankruptcy Code. Whenever the debtor incurs new debt postpetition, whether secured or unsecured, it creates new claims that likely are entitled to a higher priority in recovery from other existing creditors. Thus, the new postpetition debt could diminish the return to existing creditors of a bankruptcy estate. Given that existing creditors are presumptively the beneficiaries of a bankruptcy estate, diminishing their return is not favored under the Bankruptcy Code. That is why court approval is required under section 364 when a debtor is incurring certain postpetition debts.
The problem in Britt Motorsports was that neither the debtor nor the supplier obtained court approval before entering into, and honoring, the 5 Dealer Payment Agreements/Promissory Notes. The whole case turned on whether such transactions were, in fact, restricted by section 364 of the Code.
Consignment or Secured Financing?
The supplier argued that section 364 did not apply, because the dealer agreements did not create secured financing arrangements, but rather constituted consignments. The bankruptcy court therefore endeavored to determine the nature of each of the dealer agreements.
State law governs whether a transaction is a secured transaction or a consignment. In particular, in most states, Article 9 of the Uniform Commercial Code defines each type of transaction. Pursuant to section 9-102 of Article 9, a consignment is defined as follows:
“Consignment means a transaction, regardless of its form, in which a person delivers to a merchant for the purpose of sale and:
a. The merchant:
- Deals in goods of that kind under a name other than the name of the person making delivery;
- Is not an auctioneer; and
- Is not generally known by its creditors to be substantially engaged in selling the goods of others;
b. With respect to each delivery, the aggregate value of the goods is one thousand dollars or more;
c. The goods are not consumer goods; and
d. the transaction does not create a security interest that secures an obligation.
See N.C. Gen. Stat. § 25-9-102 (emphasis added). The bankruptcy court found that, notwithstanding the title of the dealer agreements, the nature of the transactions covered by such agreements depended on the intent of the parties at the time they entered into the transactions. Citing In re Oriental Rug Warehouse Club, Inc., 205 B.R. 407, 410 (Bankr. D. Minn. 1997.) Intent, in turn, is determined by examining the “economic realities of the transaction rather than the subjective intent of the parties.” If a dispute later arises as to the parties’ intent, then the acts of the parties prevail over their designation of the transaction.
Under North Carolina law, factors that support the conclusion that the parties intended a secured transaction include:
- the setting of a resale price by the consignee;
- billing the consignee upon shipment;
- commingling sale proceeds and failure to keep a proper accounting by the consignee; and
- mixing consigned goods with goods owned by the consignee.
Factors supporting a true consignment include whether:
- the consignor retained control over the resale price of the consigned property;
- the consignee needs authority from consignor to sell the property;
- the consignor may recall the goods;
- the consignee receives a commission but not a profit from the sale;
- the consigned property was segregated from other property of the consignee;
- the consignor is entitled to inspect sales records and the physical inventory of the goods in the consignee’s possession; and
- the consignee has no obligation to pay for the goods unless they are sold.
See id. at 410-11.
Ultimately, the bankruptcy court found that the 5 Dealer Payment Agreements/Promissory Notes created a security interest, rather than a consignment, because
- the debtor was obligated to pay for the motorcycles, by a down payment and monthly installments;
- the debtor (not consignor) set its own prices for the motorcycles;
- the debtor was billed upon shipment of the motorcycles (not upon sale);
- the debtor commingled proceeds from sales with his own property; and
- the debtor received a profit from each sale.
While the supplier retained the right to recover its motorcycles at any time and the debtor was required to permit inventory inspections, these factors did not outweigh those favoring a secured transaction. Indeed, the court found that the debtor’s obligation to pay was likely the most important factor in demonstrating a secured transaction.
The court also rejected affidavit testimony regarding the subjective intent of the parties, finding that the majority of factors objectively demonstrated that the dealer agreements created secured transactions. Accordingly, the court held that such transactions were restricted by section 364 of the Code, and the debtor and supplier violated these restrictions when they failed to obtain court approval before entering into and honoring the financing transactions postpetition.
The opinion focused on the nature of the transactions between the parties and whether the parties properly obtained court approval. The court, however, did not discuss the fact that the supplier actually provided significant value to the debtor postpetition, by virtue of motorcycles that were delivered. Arguably, the supplier would, at least, be entitled to an administrative priority claim under section 503(b) for the value provided and such claim would be entitled to distributions from the debtor’s estate before any other unsecured claim. See 11 U.S.C. §§ 726, 507, 503(b).
The opinion also does not discuss whether the dealer agreements created unsecured debt in the debtor’s ordinary course of business. It appears, at face, that the supplier always kept title to the motorcycles (until sold) and therefore was not required to obtain collateral before extending loans to the debtor. Without collateral, there is no secured loan. Furthermore, there is little question that buying motorcycles for resale was in the debtor’s ordinary course of business. Had this issue been explored a little more closely, the bankruptcy court may have concluded that the dealer agreements actually created unsecured debt in the ordinary course of business, which debt is specifically authorized by section 364(a) of the Code.
In the end, the opinion serves as a strong reminder that a bankruptcy court can characterize or recharacterize any agreement based on the economic realities of the transaction. Thus, parties would be wise to seek bankruptcy court approval in any case where there is doubt about how an agreement can be characterized. The irony in Britt Motorsports is that the bankruptcy court would likely have authorized the debtor’s entry into the postpetition financing with the supplier, because such transactions brought value to the debtor’s estate (in the form of profits). It appears, however, that the supplier relied too much on the ordinary course nature of the transactions in proceeding without court approval. The supplier also forgot that a chapter 7 trustee can revisit any transaction after a case is converted and is not bound by the debtor’s subjective intent prior to conversion. In short, the supplier did not properly anticipate where the debtor’s case could be headed.