The Right of Reclamation in Bankruptcy:The Code Giveth and the Code Taketh Away
December 10, 2007
Here’s the rule for bargains:
“Do other men, for they would do you.”
That’s the true business precept.1
State law gives sellers of goods certain rights and remedies with respect to customers that may be in financial difficulty. One of the most important of these rights is the right of “reclamation,” i.e., the ability to “reclaim” goods in the hands of an “insolvent” customer. The first part of the reclamation process is simple, requiring only that sellers make a written demand on buyers within a certain period of time. Getting the goods back, however, is not so easy.
It doesn’t get any better if the buyer files for relief under the Bankruptcy Code2 before the goods can be reclaimed. Although the Bankruptcy Code recognizes and incorporates state law reclamation rights (with certain modifications), a seller’s right of reclamation in many bankruptcy cases simply does not exist; the seller will never get its goods back or any other special treatment.
There is, however, some good news for sellers. Beginning in 2005, sellers of goods became entitled to assert an administrative expense claim for goods shipped right before the bankruptcy filing. Arguably, for most sellers, this statutory gift from Congress more than makes up for losing any reclamation rights.
The purpose of this article is not to explain in detail the law of reclamation or why it may be fair or unfair to sellers, but simply to alert sellers to the issues they may confront, and to suggest ways that sellers may protect themselves. Forewarned, as they say, is forearmed.
Reclamation Under State Law
The Uniform Commercial Code (UCC), as adopted in virtually every state, provides that when a seller of goods (“Seller”) discovers that its buyer (“Buyer”) is insolvent, Seller may seek to “reclaim” those goods (i.e., actually get the goods back from Buyer).3 In order to do so, Seller first must send a written demand to Buyer within 10 days after Buyer receives the goods.4 Buyer (i) must still have the goods in its possession5 and (ii) the goods must be identifiable as such and not have been incorporated into another product.6 Further, Seller’s ability to actually recover the goods is subject to the rights of other parties, particularly “buyers in the ordinary course” (i.e., customers of the buyer who have purchased the goods from the buyer) and “good faith purchasers.”7
Given the relatively narrow time window (10 days), there is a good chance that Buyer (i) will still be in possession of the goods,8 (ii) will not have incorporated the goods into another product and (iii) will not have sold the goods to a buyer in good faith.9 The real obstacle to getting the goods back, however, is the “good faith purchaser” provision. The term “good faith purchaser” has been defined to include a secured creditor with a prior floating lien on the debtor’s assets.10 Thus, even when (i), (ii) and (iii) above are all in Seller’s favor, Seller’s rights remain subject or subordinate to those of the lien holder. What does this mean? In practice, it does not mean that Seller’s reclamation claim is necessarily extinguished, but only that Seller’s right of reclamation may be rendered valueless if the secured creditor has satisfied its claim out of the goods Seller seeks to reclaim and there are no surplus funds available after such satisfaction.11
Reclamation Under the Bankruptcy Code
As will be seen, although Sellers do not get a free ride under state reclamation law, Sellers get no ride at all when asserting reclamation claims under the Bankruptcy Code.
Section 546(c)
Under the Bankruptcy Code, Sellers may assert their state law reclamation rights if, among other things:
(i) Buyer has received goods from Seller within 45 days of the time of the bankruptcy filing (the “Petition Date”)
(ii)Seller has demanded in writing the reclamation of the goods no later than
(a) 45 days after the receipt of the goods by Buyer, or
(b) 20 days after the Petition Date if the 45-day period expires after such date12
In addition, the right to reclaim is subject to the prior rights of a secured creditor with a lien on the goods or the proceeds from the sale of the goods.13 Except for the increase in the selling period from 10 days to 45 days, and the specific
inclusion of secured creditors, the Bankruptcy Code does not create new reclamation rights, but only recognizes the validity of state reclamation law.14 Thus, if Seller either (i) does not have a valid reclamation claim under state law or (ii) has a valid reclamation claim that has no value due to prior liens, Seller will not be granted relief under the Bankruptcy Code.
Although it may simply be a question of drafting, there appears to be a split of authority as to how to value the prior security interest. The minority view is that the court looks at the total value of Buyer’s inventory as against the amount of the prior liens.15 Thus, for example, if Buyer’s prepetition secured indebtedness is $1 million and the total value of the entire inventory is $500,000, then any and all reclamation claims have no value. Although not explicitly stated, the corollary to this would be that if Buyer’s secured indebtedness is $1 million and the total value of Buyer’s inventory is $2 million, than there should be $1 million left over to be distributed first to reclamation claimants, and only then to unsecured creditors.
Unfortunately, the majority view on valuation begins the process of rendering reclamation rights worthless under the Bankruptcy Code. These courts hold that for a reclamation claim to have any value, the value of the specific goods covered by that claim must exceed the value of the entire secured indebtedness (i.e., in the example above, the goods subject to Seller’s reclamation claim would have to exceed $1 million).16 It does not take a certified bankruptcy specialist to see that in virtually every case where there is a prepetition secured lender, it is virtually a certainty that there will not be any single reclamation claim that exceeds that lender’s indebtedness.
The nullification process continues by the expansion of the phrase “subject to the prior rights of a holder of a security interest in such goods.” The modern view is that “prior” conflicting security interests are not limited to secured indebtedness existing at the time Seller delivers the goods to Buyer, but also includes post-petition indebtedness (i.e., debtor-in-possession (DIP) financing) even when such financing is used to pay off the prepetition indebtedness. This result is based on the legal fiction that the goods subject to the prepetition lender’s lien are essentially “used” or “sold” to the DIP lender in exchange for new money given to the debtor. Thus, even if the prepetition lender “releases” its lien, reclamation claims remain valueless.17
Section 503(b)(9)
While the foregoing represents the “taketh” part of the story, we should not forget that there is also a “giveth” part. Since 2005, Sellers are entitled to an administrative expense claim for the value of any goods received by Buyer within 20 days of the Petition Date.18 This relief is significantly better for Sellers than anything afforded reclamation claimants, at least for goods received during those 20 days, because (i) the existence of either a prepetition or a DIP lender is irrelevant, (ii) there is no requirement that Seller provide any notice of this claim and (iii) Seller need not have sought reclamation to assert a claim.19
While this relief is a significant plus for Sellers, it could potentially have a profound adverse impact on the ability of a chapter 11 debtor to successfully reorganize, since a plan cannot be confirmed unless all administrative expense claims are paid in full.20 In cases in which Buyer is a manufacturer or distributor, the value of goods received into inventory in the 20 days prior to the Petition Date may be many millions of dollars. Because of this, once Buyer finds itself in a precarious financial situation, it may try to over-order goods it knows it will need in the 20-day period before that period actually begins.
What Is a Seller to Do?
There is no surefire method for recovering on reclamation claims, but there are a number of things a Seller can do both pre-and post-petition.
Prepetition
The most basic thing Seller can do prepetition to avoid having to seek reclamation later is to be aware of Buyer’s financial condition. Has Buyer recently started to pay late? Has Buyer started to increase its orders over historical amounts? Has Buyer experienced recent layoffs? Has there been a general downturn in Buyer’s industry (which may also be Seller’s industry)? If there is any evidence of the foregoing, Sellers should try to (i) tighten terms by allowing for no more than 20 days open shipping, thus ensuring that all (or most) of the money owed will be treated as an administrative expense, (ii) eliminate all open terms and go to pre-payments or COD, or (iii) a combination of the two (20-day open terms and COD thereafter).
Less possible, unless Seller is a major or critical supplier, but far more efficient, is to continue to sell on credit but take a purchase money security interest in the goods sold.21 Under the UCC, a perfected purchase money security interest has priority over a prior conflicting lien.22 As a result, instead of being only a reclamation claimant, Seller becomes a secured creditor entitled to all the protections for secured creditors under the Bankruptcy Code (such as adequate protection).
Post-Petition
Notwithstanding the above, there is a possibility (though slim) that the prepetition lender’s lien will be deemed unperfected or avoidable.23 Thus, Sellers always should timely make a reclamation demand as provided under Bankruptcy Code section 546(c).
Of course, Sellers can simply do nothing and accept an unsecured claim for goods received by Buyer beyond the 20-day period and an administrative claim for goods received within the 20 day period. It is possible that Congress had this approach in mind when it amended section 546(c) and added section 503(b)(9).
Conclusion
Unfortunately, most Sellers do not realize that their reclamation rights in bankruptcy may be rendered valueless. By being aware of this likely outcome, however, Sellers will be ready to take action – before it is too late.
For more information, email Peter A. Zisser at peter.zisser@hklaw.com or call toll free, 1-888-688-8500.
1 Charles Dickens, Martin Chuzzlewit (1844), Ch. 11.
2 11 U.S.C. §§ 101 et seq. On April 20, 2005, President Bush signed into law the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), which, for the most part, applies to all cases commenced after October 17, 2005. For purposes of this analysis, unless otherwise stated, all references to particular sections of the Bankruptcy Code refer to those sections as amended by BAPCPA.
3 UCC §2-702.
4 UCC §2-702 (2).
5 See, e.g., In re Adventist Living Ctrs., Inc., 52 F.3d 159, 163 (7th Cir. 1995); In re Pester Refining Co., 964 F.2d 842, 845 (8th Cir. 1992); In re Rawson Food Serv., Inc., 846 F.2d 1343, 1347 (11th Cir. 1988).
6 See Galey & Lord Inc. v. Arley Corp. (In re Arlco, Inc.), 239 B.R. 261, 266-67 (Bankr. S.D.N.Y. 1999) (citing Party Packing Corp. v. Rosenberg (In re Landy Beef Co., Inc.), 30 B.R. 19, 21 (Bankr. D. Mass. 1983)).
7 UCC§2-702 (3).
8 Obviously, this assumption would not apply to many perishable goods.
9 This article does not discuss the “just-in-time” inventory system, where goods may be shipped, delivered and incorporated into other products all within a few hours.
10 See, e.g., In re Reliable Drug Stores, Inc., 70 F.3d 948, 949-50 (7th Cir. 1995) (cites cases which have equated a security interest to the rights of a good faith purchaser under the UCC); Pester, 964 F.2d at 844-45; Stowers v. Mahon (In re Samuels & Co., Inc., 526 F.2d 1238, 1244 (5th Cir.), cert. denied, 429 U.S. 834 (1976).
11 See Pester, 964 F.2d at 847; accord In re Dairy Mart Convenience Stores, Inc., 302 B.R. 128, 135 (Bankr. S.D.N.Y. 2003). As discussed in Pester, the prior lienholder’s decision concerning its security interest in the goods will determine the value of Seller’s right to reclaim. The lienholder could decide to satisfy its claim out of other property or release its claim in favor of other treatment. See, e.g., In re Nitram, Inc., 323 B.R. 792, 799 (Bankr. M.D. Fla. 2005); In re Georgetown Steel Co., LLC, 318 B.R. 340, 347-48 (Bankr. D.S.C. 2004).
12 11 U.S.C. § 546(c)(1).
13 11 U.S.C. § 546(c)(1)(A), (B). Prior to BAPCPA, section 546(c)(1) provided only that Seller had all statutory and common law rights of reclamation, but did not specifically make such rights subject to a prior security interest. That was left to the courts’ interpretation of “good faith purchaser.” See n. 10 supra and accompanying text. It should be noted that the specific reference to security interests in section 546(c) as amended, does not affect the state law ability of a buyer in the ordinary course or other good faith purchaser to prime Seller’s reclamation rights. See In re Dana Corp., 367 B.R. 409, 417-18 (Bankr. S.D.N.Y. 2007). Thus, even if Buyer has no secured creditors, Seller may not be able to reclaim its goods if, for example, the goods have already been sold to a third party.
14 See In re Phar-Mor, Inc., 301 B.R. 482, 496 (Bankr. N.D. Ohio 2003) (“The legislative history and the plain language of § 546(c) do not suggest that Congress intended to expand the state law rights of reclaiming sellers at the expense of unsecured creditors in bankruptcy. Rather, the legislative history reflects Congress’ intention to recognize the validity of the state law rights of reclaiming sellers.”); accord In re Quality Stores, Inc., 289 B.R. 324, 332-33 (Bankr. W.D. Mich. 2003).
15 See, e.g., Quality Stores, 289 B.R. at 335 (“The court has found that the value of all collateral in this estate is not more than $205,000,000. The Prepetition Lenders’ indebtedness is approximately $337,000,000. Therefore, because no residual value remains after partial satisfaction of the Prepetition Lenders’ secured claim, there is no value left to maintain Reclamation Claimants’ subordinate position.”) (internal citations omitted); In re Leeds Bldg Prods., Inc., 141 B.R. 265, 270 (Bankr. N.D. Ga. 1992) (“If the value of the inventory is insufficient to pay [secured creditor’s] priority claim in full, as is the case with most debtors, then Sellers would, in effect, have a valueless right to reclaim outside of bankruptcy, since all of the goods sold to Debtor would be subject to [secured creditor’s] claim.”).
16 See In re Pittsburgh-Canfield Corp., 309 B.R. 277, 287 (6th Cir. BAP 2004) (“[T]he reclaiming seller is entitled to a lien or administrative expense claim only to the extent that the value of the specific inventory in which the reclaiming seller asserts an interest exceeds the amount of the floating lien in the debtor’s inventory.”) (emphasis in original); accord Dana, 367 B.R. at 419; Dairy Mart, 302 B.R. at 135-36; In re Primary Health Sys., Inc., 258 B.R. 111, 116-17 (Bankr. D. Del. 2001); Arlco, 239 B.R. at 273.
17 See Dana, 367 B.R. at 419; In re Advanced Mktg. Servs., Inc., 360 B.R. 421, 426-7 (Bankr. D. Del. 2007); Dairy Mart, 302 B.R. at 135-36; see also Pittsburgh-Canfield, 309 B.R. at 288-89 (holding that the unopposed order granting a superpriority lien primed reclamation claims). But see Phar-Mor, Inc., 301 B.R. at 497 (finding that when a prepetition secured creditor has been paid out of the DIP financing without an assignment of the prepetition liens to the DIP lender, and such liens are released, the DIP financing does not affect the value of the reclamation claims). The Phar-Mor court also held that because the DIP lenders had notice of the reclamation claims, they could not qualify as good faith purchasers under the UCC. However, section 546(c), as revised under BAPCPA, no longer relies on the good faith purchaser status with respect to secured lenders. See n. 13 supra and accompanying text.
18 11 U.S.C. § 503(b)(9). See also Dana, 367 B.R. at 411-12 (“Suffice it to say that in light of the section 503(b) amendment, section 546(c) is no longer an exclusive remedy for a prepetition seller.”).
19 As with all administrative expense claims allowed under Bankruptcy Code section 503, the timing of the actual payment is within the discretion of the Court. Thus, Seller may have to wait until the end of the case to be paid. See In re Bookbinders’ Rest., Inc., 2006 WL 3858020, *7 (Bankr. E.D. Pa. Dec. 28, 2006) (rejecting demand for immediate payment of administrative expense under Bankruptcy Code section 503(b)(9)).
20 See 11 U.S.C. § 1129(a)(9).
21 See Arlco, 239 B.R. at 274; In re Steinberg’s, Inc., 226 B.R. 8, 11 (Bankr. S.D. Ohio 1998); see also Goodman, Determining the Proper Application of § 546(c) To a Seller’s Right to Reclaim When There is a Prior Secured Creditor: a Two Part Test, Emory Bankr. Dev. J., pp. 427-449, Vol. 20 (2004).
22 See UCC § 9-324(b), (c).
23 See, e.g., In re Tucker, 329 B.R. 291, 301 (Bankr. D. Ariz. 2005) (unperfected inventory lien did not trump reclamation claim). It should be noted that Tucker was a chapter 7 case, thus there was no DIP lender. To the best of the author’s knowledge, the courts have not yet ruled on what would happen to reclamation claims if there is both a prepetition lien and post-petition superpriority DIP financing and the prepetition lien is deemed unperfected or avoided.
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