Protecting Manufacturers And Distributors In Bankruptcy - Explaining Priority Status For Goods Received By A Debtor

Monday, July 5, 2010 - 00:00

It is a harrowing scenario for any seller of goods: a trading partner files for bankruptcy and leaves the seller with thousands, even millions of dollars in unpaid invoices. In many instances, some of these goods were delivered only days before the bankruptcy filing. While a creditor may be able to assert reclamation rights, those rights are often difficult to enforce in bankruptcy and may be subordinate to the interests of an all assets lender.

However, Congress has provided some relief to such creditors through § 503(b)(9) of the Bankruptcy Code, which was enacted in 2005 as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). Section 503(b)(9) provides creditors with administrative expense priority for the value of any goods sold to the debtor in the ordinary course of the debtor's business and received by the debtor within 20 days prior to the bankruptcy filing. Administrative expense priority in bankruptcy is highly desirable because administrative expenses must be paid in full as a condition of confirmation of the chapter 11 plan for reorganization. General unsecured claims, on the other hand, are paid after administrative expenses and priority claims and in many cases pennies on the dollar.

Traditional administrative expenses arise post-petition (after the filing of the bankruptcy case), providing creditors that do business with a debtor-in-possession some protection. Section 503(b)(9), in contrast, grants administrative expense priority to claims arising before the commencement of the bankruptcy case.

Administrative expense priority under § 503(b)(9) is often preferable to the other remedy available to pre-petition sellers - reclamation of the goods under state law or other provisions of the Bankruptcy Code. Reclamation was the primary remedy available to pre-petition sellers prior to the enactment of § 503(b)(9). However, reclamation has its pitfalls. A seller must comply with strict notice requirements by stating its intent in writing to reclaim the goods within certain statutorily prescribed deadlines. In addition, the goods supplied to a debtor may be subject to a secured creditor's blanket lien to which the reclaiming seller takes a junior position.

Obtaining Administrative Expense Priority

In contrast to reclamation remedies, § 503(b)(9) affords administrative expense priority to sellers of goods on credit in the period immediately preceding bankruptcy regardless of whether reclamation requirements are met or even attempted.

In order to obtain administrative expense priority, a creditor must file an application for payment and notice the application for hearing. 11 U.S.C. § 503. The Bankruptcy Code requires that such application be made "timely." Courts may enter an order establishing the procedures and setting the bar dates for the filing of an application for payment of an administrative expense under § 503(b)(9). Although administrative expense applicants normally need not file a proof of claim, in some cases, courts have required creditors to file a "proof of claim" for their § 503(b)(9) expenses.

Unlike proofs of claim, which are "deemed allowed," administrative expenses are allowed only after notice and a hearing. Allowance of an administrative expense under § 503(b)(9) does not necessarily entitle the creditor to immediate payment thereon and the timing of the payment is ultimately within the discretion of the court. Regardless, in a chapter 11 case, all administrative expenses, including those under § 503(b)(9) must be paid in full upon the effective date of the plan.

In order to be entitled to a Section 503(b)(9) claim, a creditor must show that: (1) goods were sold; (2) the goods must have been received by the debtor within 20 days prior to the commencement of the bankruptcy case; and (3) the goods must have been sold in the ordinary course of business.

However, the Bankruptcy Code does not define several key terms in § 503(b)(9). For example, the Bankruptcy Code does not define the term "goods." In defining "goods," the prevalent approach taken by courts has been to adopt the definition of goods set forth in the Uniform Commercial Code (UCC): "all things (including specially manufactured goods) which are movable at the time of identification to the contract for sale other than the money in which the price is to be paid " Courts have differed, however, in the treatment of hybrid contracts that involve the sale of both goods and services. Some have adopted the "predominate purpose test" developed in non-bankruptcy UCC cases, which deems a hybrid contract to be for the sale of goods if the sale of goods portion of the contract predominates. Other courts have provided administrative expense priority to any sale of goods, even if the sale of goods occurred through a contract primarily for the provision of services.

Debtor's Defenses

Debtors have raised several defenses to the allowance of administrative expenses under § 503(b)(9). One defense is § 502(d) of the Bankruptcy Code, which empowers a court to disallow a claim of creditor if the creditor is adjudged liable to the bankruptcy estate under one of several enumerated sections of the Bankruptcy Code and has not turned over the amount for which it is liable to the bankruptcy estate. For example, a creditor who received a payment from an insolvent debtor within 90 days before the filing of the bankruptcy petition may be the recipient of a "preferential transfer" from the debtor. A trustee or debtor-in-possession may seek to avoid and recover the amount of the preferential transfer for the bankruptcy estate. Under the § 502(d) defense theory, if a creditor is found liable to the estate for receipt of a preferential transfer, such creditor's administrative expense claim under § 503(b)(9) should be disallowed unless the creditor turns over the amount of preferential payments to the bankruptcy estate.

Some debtors have taken this defense one step further and asserted that § 502(d) may be creditor's liability to the estate and even before a complaint alleging the creditor's liability has been brought before the court. Some courts have agreed and temporarily disallowed millions of dollars of administrative expense claims "up to the amount potentially recoverable on account of preferential transfers allegedly avoidable." Nevertheless courts have split on the issue of whether § 502(d) is even applicable as a defense to administrative expenses under § 503(b)(9).

An additional defense raised by debtors is the right to setoff under state law, which is preserved by the Bankruptcy Code. Debtors have sought to offset certain amounts, including receivables, chargebacks and returns, against administrative expenses claimed under § 503(b)(9). The few courts that have considered the setoff defense have held that it is applicable to § 503(b)(9) expenses.

Conclusion

Section 503(b)(9) clearly provides additional protection to creditors doing business with a company that files for bankruptcy protection. However, the developing case law has just begun to address the many issues raised by the enactment of § 503(b)(9). As more creditors apply for an administrative expense under § 503(b)(9), additional disputes concerning the application of the section are likely to arise.

H. Jason Gold has more than 25 years of experience counseling clients on restructuring and insolvency matters. In recent years, the focus of his practice has been on major automotive, media, retail, real estate, aviation and telecommunications cases. He has also served as a bankruptcy trustee for more than 20 years and has successfully liquidated or participated in the restructure of dozens of businesses. He can be reached at (202) 719-4136. Dylan G. Trache represents both debtor and creditor clients on a variety of bankruptcy and insolvency issues in bankruptcy courts throughout the country. His experience includes representing chapter 11 debtors in many industries, including mass media, aviation, retail and manufacturing. He can be reached at (202) 719-2829.

Please email the authors at jgold@wileyrein.com or dtrache@wileyrein.com with questions about this article.