A Paper Tiger: The Reclaiming Seller In Bankruptcy

Tuesday, April 1, 2008 - 01:00

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) attempted to give stronger rights to sellers to insolvent debtors by revising the Bankruptcy Code. The time period in which sellers could reclaim goods sold to an insolvent buyer was increased to 45 days and a new provision was added which allows sellers to assert an administrative claim for goods delivered to the debtor within 20 days before the bankruptcy filing. However, the promise of these new provisions often has proven illusory as courts have begun to interpret the new law.

Getting the Goods: A Primer On Reclamation

Under the Uniform Commercial Code, a seller has a right to reclaim goods sold on credit to an insolvent buyer by making written demand upon the buyer within 10 days after the goods are received by the buyer.1Where solvency has been misrepresented by the buyer within three months before delivery, the ten-day limitation does not apply.2

Reclamation rights under state law have long been recognized in bankruptcy. However, the recent Bankruptcy Code amendments purported to grant broader reclamation rights in bankruptcy cases than are available under the UCC.

First, the Code was amended to expand the reach-back period from 10 days to 45 days.As a result, sellers have much more time to reclaim their goods under the Bankruptcy Code than under state law. If the buyer files for bankruptcy, the seller's reclamation right extends to goods delivered up to 45 days beforehand.

Second, the amendments also expanded the grace period, giving the seller 20 days after a bankruptcy filing to deliver a reclamation notice. The seller is also given up to 20 days after the bankruptcy filing to send its reclamation notice where the 45-day reclamation period expires after the bankruptcy filing. The effect of these changes is to give a seller as much as 65 days after delivery of goods to a buyer (45 day reach-back plus 20 day period to deliver reclamation notice) to reclaim them.

Finally, the amendments give a seller an administrative claim equal to "the value of any goods received by the debtor within 20 days before [the date of the bankruptcy filing] in which the goods have been sold to the debtor in the ordinary course of such debtor's business."3

All of these amendments look good on paper, but the reality is that the right of reclamation has proven largely illusory. The Bankruptcy Code, while extolling a seller's reclamation rights, has failed to "deliver the goods."

Reclamation has always been a difficult remedy to obtain. Courts often rule that the goods must be identifiable and in the possession of the debtor on the date of the reclamation demand. Thus, goods that were resold by the buyer, incorporated into finished products, or otherwise consumed in the buyer's operations could not be reclaimed.4The bankruptcy amendments change none of this.

However, the greatest impediment to a seller's reclamation rights is the existence of a secured creditor with a prior perfected security interest in the buyer's inventory. The bankruptcy amendments provide that the reclamation claimant's right is "subject to the prior rights of a holder of a security interest in such goods or the proceeds thereof."5This creates significant, or perhaps insurmountable, problems for reclaiming sellers.

Cases interpreting BAPCPA have not been particularly helpful to reclaiming creditors. In In re Advanced Marketing Services, Inc. , 360 B.R. 421 (Bankr. D. Del. 2007), publisher Simon & Schuster (S&S) delivered over $5.1 million worth of goods to the debtor within the 45-day reclamation period, which the publisher timely sought to reclaim after the buyer filed a bankruptcy petition. The bankruptcy court denied S&S's request for a TRO, holding that S&S failed to prove that it was likely to succeed on the merits of its reclamation claim due to the priority of senior lenders' liens on substantially all of the debtors' assets, including inventory and the goods. The pre-petition lender agreed to provide post-petition debtor-in-possession (DIP) financing, with the pre- and post-petition financing being cross-collateralized. The bankruptcy court held that "the senior lenders' pre-petition and post-petition liens on the debtors' inventory are superior to [S&S's] reclamation claim."6Once the senior lenders' liens were satisfied through the sale of inventory, S&S's reclamation claim would likely be valueless.

Similarly, in In re Dana Corporation , 367 B.R. 409 (Bankr. S.D.N.Y. 2007), the debtor challenged the reclamation claims filed by hundreds of sellers, arguing that they were "subject to" pre-existing liens on the goods sought to be reclaimed. The court ruled in favor of the debtor. Pre-petition collateral, including the reclaimed goods, was subject to the secured creditors' pre-petition lien. Under the Court-approved debtor loan agreement, the debtors were authorized to use the lenders' pre-petition collateral, with a replacement lien in all pre- and post-petition collateral and proceeds. The pre-petition indebtedness was refinanced and paid off using the proceeds of the new loan. The court held that the reclaimed goods were either liquidated in satisfaction of the pre-petition indebtedness or were pledged as collateral for the DIP loan. In either event, the reclaimed goods were effectively disposed of, rendering the reclamation claim valueless.

Section 503(b)(9) Administrative Claims

Perhaps because the reclamation provisions of the Code provide so little benefit, BAPCPA's addition of new Section 503(b)(9) has been heralded as a significant seller protection. Section 503(b)(9) grants a seller an administrative expense7equal to "the value of any goods received by the debtor within 20 days before the date of commencement of a case under [the Bankruptcy Code] in which the goods have been sold to the debtor in the ordinary course of the debtor's business." 11 U.S.C. § 503(b)(9).

Section 503(b)(9) applies to any seller, whether or not the seller has a reclamation right. In fact, Section 503(b)(9) was intended to "provid[e] relief to sellers of goods who fail to give the required notice under the reclamation provision of section 546(c)."8 Section 503(b)(9) applies even if the goods are no longer in the possession of the debtor or are not identifiable. It applies even if the reclamation claim under Section 546(c) is determined to be valueless because the goods are encumbered by a senior security interest.9Section 503(b)(9) applies to both reorganization and liquidation cases.10

It all sounds impressive, but the application of Section 503(b)(9) is something else again. Although the right to an administrative claim is provided for under Section 503(b)(9), there can be significant cost to exercising that right. The Bankruptcy Code and Rules do not specify how a Section 503(b)(9) claim is to be asserted. This uncertainty leads many sellers to retain attorneys to file a request for payment of an administrative expense. If challenged, discovery may be needed to determine the value of goods received by the debtor within 20 days of the bankruptcy filing and a trial may be ordered to fix the value of the seller's claim.

Even if the seller succeeds in proving entitlement to an administrative claim, the claim may not get paid. The chapter 11 estate might be administratively insolvent, in which case the Section 503(b)(9) claim may not be paid in full (or perhaps at all).

Debtors may also manipulate the timing of payment of seller claims. Under the Bankruptcy Code, a debtor is not required to pay administrative claims until the effective date of the chapter 11 plan.11Two recent decisions have considered when Section 503(b)(9) administrative claims must be paid. Declaring that Section 503(b)(9) is a "rule of priority, not of payment," both courts held that the administrative claimants were not entitled to immediate payment of their claims.12

Seller administrative claims also may be subject to setoff if a debtor holds a pre-petition claim against the creditor. Unlike other administrative priority claims, which arise post-petition, these are pre-petition claims which arise within the 20-day period before the bankruptcy filing. Therefore they may be subject to setoff if the debtor possesses pre-petition claims against the vendor.13

Debtors have also discounted the payment of seller administrative claims by obtaining orders that grant the debtor the discretion to pay such claims on terms favorable to the estate. Debtors then use the promise of quick payment as leverage to induce the seller to reduce the amount of its administrative claim or to provide favorable credit terms going forward.

What's A Seller To Do?

In short, the bankruptcy amendments do not reliably provide trade creditors with a preferred status. However, there are actions that a seller can take to improve its position in a bankruptcy.

1. The best advice is to avoid being a reclamation claimant altogether. A seller who suspects that its buyer is on the verge of insolvency should either refuse to extend credit or take a purchase money security interest in the goods that it supplies.

2. Section 503(b)(9) claimants can band together to form an ad hoc committee to "remind" the debtor and the secured lenders that trade creditors are critical to the debtor's successful reorganization.

3. Whether by committee or by itself, a seller with a significant reclamation claim should carefully examine, and if appropriate, strongly object to post-petition financing that could effectively destroy the validity of its claim.

4. When faced with an administratively insolvent case, Section 503(b)(9) claimants may have as their only leverage to obtain payment the filing of a motion to dismiss or convert the case to Chapter 7. Of course, dismissal or conversion is not likely to result in payment of seller claims unless there is some benefit to be achieved by liquidating. If so, then dismissal or conversion may provide sellers with some ability to negotiate prompt payment of their claims.

Conclusion

Although touted as providing greater seller protections, the new bankruptcy provisions have turned out to be more of a paper tiger. Unless courts change their analysis or these provisions are further amended to satisfy seller concerns, sellers should not count on the Bankruptcy Code to rescue them from improvident buyers.

1 UCC § 2-702(2).

2 UCC § 2-702(2).

3 11 U.S.C. § 503(b)(9).

4In re Charter Oil Co . , 54 B.R. 91, 92-93 (Bankr. M.D. Fla. 1985); In re Flagstaff Foodservice Corp . , 14 B.R. 462 (Bankr. S.D.N.Y. 1981).

5 11 U.S.C. § 546(c).

6 Advanced , 360 B.R. at 426 .

7 An administrative claim is the highest level priority claim (but for certain domestic support obligations) in bankruptcy cases, but ranks under secured claims in entitlement to payment. 11 U.S.C. §§ 503(b), 507(a)(2).

8In re Brown & Cole Stores, LLC , 375 B.R. 873, 875 n.3 (9th Cir. BAP 2007).

9Id, 375 B.R. at 878 n.7; In re Dana Corp . , 367 B.R. 409 (Bankr. S.D.N.Y. 2007).

10Brown & Cole Stores, 375 B.R. at 875 n.3.

11 11 U.S.C. § 1129(a)(9).

12In re Global Home Products, LLC , 2006 Bankr. LEXIS 3608 (Bankr. D. Del. Dec. 21, 2006); In re Bookbinders' Restaurant, Inc., 2006 Bankr. LEXIS 3749 (Bankr. E.D. Pa. Dec. 28, 2006) (timing of payment of Section 503(b)(9) claims is within court's discretion).

13Brown & Cole Stores, 375 B.R. at 879. Section 503(b)(9) claims may also be subject to disallowance if the seller received preferential payments from the debtor pre-bankruptcy. 11 U.S.C. § 502(d).

Simon Kimmelman is a Member and Princeton Chair of the Creditors' Rights and Reorganization Practice Group of Sills Cummis & Gross P.C. and Co-Managing Partner of its Princeton office. Valerie Hamilton is Of Counsel to the Firm. The views and opinions expressed in this article are those of the authors and do not necessarily reflect those of Sills Cummis & Gross P.C.

Please email the authors at skimmelman@sillscummis.com or vhamilton@sillscummis.com with questions about this article.