June 28, 2006

BAPCPA Spells Relief for Certain Trade Creditors in Chapter 11

Holland & Knight Newsletter
Lynne B. Xerras

One company’s bankruptcy indirectly affects the operations of the companies that continued to supply raw materials, parts and services on credit to the bankrupt during the months preceding the filing. Even the profitability of the most successful organization suffers when accounts receivable cannot be collected in a timely fashion, particularly when the failure to collect is caused by the bankruptcies of certain key customers. To minimize the financial harm caused by another company’s insolvency, an unpaid supplier must take certain steps during the Chapter 11 case, such as hiring outside counsel and filing a proof of claim, to ensure that it is able to cash in on the distribution ultimately offered under the debtor’s plan of reorganization to the trade class. Fortunately, in enacting BAPCPA (the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005),1 Congress has tipped the scales ever so slightly in favor of the trade creditor, such that certain pre-bankruptcy trade claims will be paid ahead of other similarly situated claims – if the debtor can afford to confirm a plan.

Through BAPCPA, the Bankruptcy Code2 has been amended to include a new provision, 11 U.S.C. § 503(b)(9). It provides that those who ship “goods” to a debtor within 20 days of the bankruptcy petition date are entitled to obtain the coveted status of administrative claimant if the goods are not paid for as of the filing date, and without making demand for reclamation under non-bankruptcy law. This provision essentially re-orders the Bankruptcy Code priority scheme followed in cases filed prior to October 17, 2005,3 by elevating what have always been rank-and-file general unsecured claims to the top rung of the priority ladder. The result is that a debtor must now pay for the “value” of goods shipped to it by trade creditors during the 20 days prior to the filing in full before the debtor can confirm a plan. Even with the advantage of newly enacted Section 503(b)(9), counsel to the trade creditor will continue to play a significant role in the process, particularly as the bankruptcy courts and the parties involved struggle to decipher the true meaning of the language chosen by Congress. No matter how interpreted, however, it is likely that the trade creditor will find itself faring better post-BAPCPA than in the Chapter 11s of days past.

Overview of Types of Claims in Bankruptcy

The Bankruptcy Code establishes a classification scheme with three primary classes of claims: (1) secured, (2) priority unsecured, and (3) general unsecured.4 In the simplest sense, a secured claim is a claim secured in part or whole by a lien, either voluntary or involuntary, on property of the estate.5 The distribution afforded to secured claimants ultimately depends on the value of the property securing the lien, and is typically satisfied from the proceeds of the secured creditor’s collateral. 6

Payment to all unsecured claimants is governed by the Bankruptcy Code priority scheme, codified at Section 507. Both pre- and post-BAPCPA, the highest priority of payment in a business bankruptcy is slated for “administrative claims allowed under section 503(b).”7 Under Section 503(b), administrative claims expressly include “the actual, necessary costs and expenses of preserving the estate,”8 such as wages, salaries or commissions owed for services rendered after the petition date and shipments delivered to the debtor that provided a benefit to the bankruptcy estate.9 Perhaps the most well-known category of administrative claims is that of the professional employed during the case seeking payment for attorneys’ or other fees. In a successful Chapter 11 case, the holder of an administrative claim is almost certain to obtain full payment, since it is a requisite to plan confirmation that the debtor pay administrative claims in full.10

The Pre-BAPCPA Trade Creditor

Until the enactment of BAPCPA, the claims held by the trade class on account of shipments and services provided in the prepetition period have been afforded the significantly lower priority of “general unsecured claims.” In contrast to administrative claims, there is no requirement that general unsecured claims be paid in full, only that the distribution on account of general unsecured claims be at least equal to what the claimants would receive if the debtor’s assets were liquidated in Chapter 7 and if the creditor did not vote to accept the plan.11 (For many debtors, this is not a significant amount.) The only opportunity for a trade creditor to obtain a higher return under the provisions of the Bankruptcy Code would be for the creditor to exercise state law reclamation rights in accordance with Section 546(c) of the Bankruptcy Code.12

Prior to BAPCPA’s effective date, a vendor who had sold goods on credit to a bankrupt entity was able to demand that the debtor return the goods – through reclamation – by transmitting a writing to the debtor within 10 days of receipt of the goods by the debtor, or, if the 10 days had not passed as of the filing of the bankruptcy petition, within 20 days of the debtor’s receipt of the goods.13 A vendor’s reclamation rights, however, were expressly limited by nonbankruptcy law, or Article 2-702 of the Uniform Commercial Code. That provision provides that a vendor’s right to reclaim is subject to the rights of a “good faith purchaser”14 – a description that courts have consistently ruled includes a buyer’s secured lender. In other words, even if a vendor was found to have a valid reclamation claim, if the debtor’s lender had a lien on inventory and the lender was undersecured, the vendor’s reclamation rights were often cut off. In addition, reclamation rights of a vendor are subject to the rights of a buyer in the ordinary course – if the goods were sold by the debtor before the reclamation demand was made, then the vendor’s reclamation rights were foreclosed. In the unusual case where the goods were not sold, the vendor’s inventory was unencumbered, or where there was equity in the inventory above and beyond the lender’s claim, Section 546(c) of the Bankruptcy Code provided that if the bankruptcy court denied reclamation, the court was required to either grant the vendor an administrative priority claim under Section 503(b) or a lien on the goods sold to the debtor. If the vendor could prove that a valid reclamation claim existed, and the bankruptcy court approved the reclamation, the debtor was required to return the goods in satisfaction of the claim.

The Enhanced Treatment of the Trade Creditor Under BAPCPA

Under the current version of Section 546(c) of the Bankruptcy Code, a vendor’s reclamation rights have been enhanced. That provision now provides that a vendor who has sold goods to an insolvent debtor within 45 days of the filing date may seek to reclaim those goods by making written demand on the debtor within 45 days of receipt by the debtor of the goods, or, if that period had not expired as of the filing of the bankruptcy, within 20 days after the bankruptcy was filed.15 Hence, a trade vendor now has the ability to reclaim up to 45 days’ worth of shipments, if not paid for and if in the possession of the debtor, in contrast to 10 days’ worth. This change is particularly beneficial to those suppliers who ship products that turn over at a slow rate.

On the other hand, reclamation rights are now made expressly “subject to the prior rights of a holder of a security interest in such goods or the proceeds thereof” in Section 546(c).16 This language essentially eliminates any ability of a vendor to challenge a lender’s status as a “good-faith” purchaser, as that term is used in Article 2-702 of the Uniform Commercial Code such that the rights of an undersecured lender to assert a lien in the goods sold by the vendor are superior.17 In addition, Section 546(c)(2) is no longer in effect, removing the express power of a court to deny a right of reclamation if the court granted an administrative claim or secured the reclamation claim by a lien.18 Using the plain meaning of the statute, a court may now be powerless to direct an alternate remedy when reclamation is available to the trade creditor.

In any event, a trade creditor need not rely solely on Section 546(c) to obtain payment of its prepetition claim. In perhaps one of the most notable amendments to the Bankruptcy Code through BAPCPA, Congress has modified the pre-existing priority scheme to provide that trade vendors will receive an administrative claim under newly enacted Section 503(b)(9) for the “value of any goods [sold to a debtor in the ordinary course of business] received by the debtor within 20 days before commencement of the case.” 19 As a result, what have always been classified as general unsecured claims at the bottom of the priority scheme are now converted to first priority administrative claims, which must be paid upon confirmation of a plan. Pursuant to Section 503(b), this new administrative claim will only be allowed after “notice and hearing.” Thus, it remains to be seen whether litigation will result over the “value” of the goods shipped by the trade vendor, or whether the items supplied qualify as “goods.” Nevertheless, a trade creditor seeking an administrative claim for goods shipped on credit to a debtor within 20 days of the filing date need not make demand for reclamation in order to preserve this claim.20


The amendments that directly affect the treatment of certain trade creditors through BAPCPA are certainly a victory for the vendor. Prior to October 17, 2005, the trade creditor’s only hope for full payment on a prepetition claim would be if it could convince the debtor to treat the supplier as a “critical vendor” and obtain a court order permitting the debtor to pay the prepetition claim in full in order to continue the post-bankruptcy relationship, or to establish a valid reclamation claim. Because the courts are split on whether the violation of the Bankruptcy Code priority scheme involved in entering “critical vendor” orders was permitted under the pre-BAPCPA statute, even if the debtor agreed to file the critical vendor motion, success was not guaranteed.21 What remains to be seen is whether the increased amount of cash needed to confirm a plan will ultimately lead to the failure of many business reorganizations with substantial pre-bankruptcy trade debt. If so, then the trade vendor may find itself in the same position it held pre-BAPCPA – recovering a nominal distribution on its claim, but this time, in a Chapter 7 case.

For more information, e-mail Lynne B. Xerras at lynne.xerras@hklaw.com.

1 On April 17, 2005, Congress approved the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) in a sweeping overhaul of federal bankruptcy law

2 11 U.S.C. §§ 101, et seq.

3 With certain exceptions, BAPCPA became effective for cases filed on or after October 17, 2005.

4 Chapter 5 of the Bankruptcy Code addresses the allowance, characterization and priority of claims in bankruptcy proceedings. 11 U.S.C. §§ 501 et seq.

5 See, 11 U.S.C. § 541 for definition of “property of the estate.”

6 See, 11 U.S.C. § 506(a). The protections afforded to secured creditors under the Bankruptcy Code generally adhere to the principle that a secured creditor is entitled to priority payment out of its collateral. See 4 Collier on Bankruptcy ¶ 506.02 (15th ed. rev. 2006).

7 11 U.S.C. § 507(a).

8 11 U.S.C. § 503(b).

9 See In re Hemingway Transp., Inc., 954 F.2d 1, 5 (1st Cir. 1992) (quoting In re Mammoth Mart, 536 F.2d 950, 954 (1st Cir. 1976)) (requiring that administrative claimant prove benefit to the estate); see also In re D.M. Kaye & Sons Transp., Inc., 259 B.R. 114, 119 (Bankr. D. S.C. 2001); In re Mid-American Waste Sys., Inc., 228 B.R. 816, 821 (Bankr. D. Del. 1999); In re Amarex, Inc., 853 F.2d 1526, 1530 (10th Cir. 1988); but see Reading Co. v. Brown, 391 U.S. 471, 88 S.Ct. 1759, 20 L.Ed.2d 751 (1968) (administrative claim awarded for fire damages resulting to neighbor property due to the debtor’s operations).

10 See 11 U.S.C. § 1129(a)(9).

11 See 11 U.S.C. § 1129(a)(7).

12 As is discussed briefly in this article, courts have allowed certain vendors deemed “critical” to be paid in full before shipping post-petition. However, the ability of a court to issue critical vendor orders under the Bankruptcy Code has been called into doubt, including in the K-Mart decision referenced at note 21.

13 The version of Section 546(c) in effect through the effective date of BAPCPA provided that: (c) Except as provided in subsection (d) of this section, the rights and powers of a trustee under Sections 544(a), 545, 547 and 549 of this title are subject to any statutory or common-law right of a seller of goods that has sold goods to the debtor, in the ordinary course of such seller’s business, to reclaim such goods if the debtor has received such goods while insolvent, but –

(1) such seller may not reclaim any such goods unless such seller demands in writing reclamation of such goods –

(A) before 10 days after receipt of such goods by the debtor; or

(B) if such 10-day period expires after the commencement of the case, before 20 days after receipt of such goods by the debtor; and

(2) the court may deny reclamation to a seller with such a right of reclamation that has made such a demand only if the court—

(A) grants the claim of such a seller priority as a claim of a kind specified in Section 503(b) of this title; or (B) secures such claim by a lien.

14 See Uniform Commercial Code § 2-702.

15 11 U.S.C. § 546(c)(1)(A)-(B).

16 11 U.S.C. § 546(c).

17 See In the Matter of Reliable Drug Stores, Inc., 70 F.3d 948 (7th Cir. 1995) (discussing varying views on whether a lender is a “good-faith purchaser”).

18 It is also worthwhile to note that Congress modified the language of the prior version of Section 546(c) that provided that a trustee’s avoidance powers were subject to “any statutory or common-law right” of reclamation to now reference a “right” of reclamation. This could arguably mean that reliance on the Uniform Commercial Code is no longer necessary.

19 11 U.S.C. § 503(b)(9).

20 See 11 U.S.C. § 546(c)(2).

21 See In the Matter of: Kmart Corp., 359 F.3d 866 (7th Cir. 2004) (ruling that court lacked the ability to permit payment of prepetition claims of “critical vendors” without substantial justification).

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