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Protection for trade creditors from Chapter 11 debtor's refusal to accept goods under post-petition contract: An administrative priority claim. (Business Law).

Introduction

A trade creditor doing business with a chapter 11 debtor may be faced with the following situation. The debtor placed an order for specially made goods to fill an order from one of its customers. After the creditor incurs the expense of manufacturing or purchasing the goods and is ready to deliver the goods, the debtor announces that it is no longer willing to accept delivery of the goods and repudiates its post-petition contract with the creditor. The debtor may be responding to a declining market for the goods, or perhaps the debtor's customer has cancelled its order with the debtor, and the debtor is attempting to pass its loss on the sale to the creditor.

The creditor could have demanded third party support to secure the debtor's obligation to accept delivery of and pay for the goods. For example, the creditor could have insisted that the debtor arrange for the issuance of a letter of credit in favor of the creditor; or the creditor could have required a guaranty of payment from a creditworthy third party; or the creditor could have negotiated for a security interest in some or all of the debtor's or a third party's assets. However, for whatever reason, either the creditor was unable to obtain a security interest or third party support to secure payment of its claim or was unable to recover from the third party or from the collateral securing its claim. What protection is then available to the creditor where the debtor repudiates its post-petition contract to purchase goods from the creditor?

A recent decision of the United States District Court for the Northern District of Mississippi in the River Oaks Furniture Inc. chapter 11 case addressed this issue. The court held that the creditor had an allowed chapter 11 administrative priority claim against River Oaks for the purchase price of certain custom made goods that River Oaks had first ordered and then refused to accept and pay for during its chapter 11 case. The court upheld the creditor's administrative priority claim despite River Oaks not receiving the goods and, therefore, allegedly deriving no benefit from them. River Oaks did not have the goods because it had refused delivery, but still benefited from the potential of filling a profitable order from one of its customers. Another victory for trade creditors!

The River Oaks Furniture Case

On March 3, 1998, River Oaks, a furniture wholesaler in Tupelo Mississippi, filed a chapter 11 petition. Following its chapter 11 filing, River Oaks had placed an order with Lifestyle Enterprises, Inc., a furniture component dealer, to purchase three lots of custom-sized furniture components from Lifestyle for a purchase price of $75,384. River Oaks had intended to use the Lifestyle components to fill an order from the furniture retailer, Heilig Meyers, for the purchase of motion sofa sets.

However, as a condition for its agreement to sell the components to River Oaks, Lifestyle required River Oaks to furnish a letter of credit in the amount of $86,000 in favor of Lifestyle to secure River Oaks' obligation to take delivery of and pay for the goods. On June 18, 1998, the Bank of New York ("BNY") issued a letter of credit in the amount of $86,000 in favor of Lifestyle. The letter of credit required BNY to pay any draft or demand for payment that Lifestyle had presented for payment, provided Lifestyle also presented all of the documents required under the letter of credit.

On July 31, 1998, Lifestyle began delivering the goods ordered by River Oaks. The goods were to be initially shipped from Hong Kong to Los Angeles and then on to their ultimate destinations in New Albany, Mississippi and Compton, California; however, it was not to be!

On August 13, 1998, Lifestyle presented a draft/demand for payment and documents to BNY under the letter of credit. Then, on August 20, 1998, Lifestyle informed River Oaks that the shipments had arrived in the United States, cleared customs and were ready for delivery. Lifestyle then requested that River Oaks accept delivery of the goods at River Oaks' warehouses. Pending delivery of the goods to River Oaks, Lifestyle had transferred the goods into storage.

BNY had refused to pay on the letter of credit. Though not discussed in the court's opinion, presumably this was because Lifestyle had failed to present to BNY all of the documents required under the letter of credit or otherwise failed to comply with the requirements of the letter of credit. Otherwise, Lifestyle would have a claim against BNY for wrongful dishonor of the letter of credit since a letter of credit issuing bank is required to make payment to a beneficiary that presents all of the documents required under the letter of credit. However, that was not at issue in the case.

In any event, Lifestyle learned on December 15, 1998 that River Oaks had refused delivery of Lifestyle's goods and had instructed BNY not to make payment to Lifestyle under the letter of credit. River Oaks' decision was driven by the decision of Heilig Meyers, then itself in chapter 11 and having decided to discontinue certain of its businesses, to cancel its order with River Oaks. Rather than being saddled with custom-made furniture components ordered from Lifestyle to fill a now-cancelled order and that River Oaks could not sell to another customer, River Oaks refused delivery of the goods from and cancelled its order with Lifestyle. Moreover, Lifestyle was stuck with specially made goods that it could not sell to another furniture manufacturer because they were furniture components specially sized to meet the specifications of River Oaks and Heilig Meyers. Sound familiar?

Lifestyle's Motion for Allowance of an Administrative Priority Claim for the Purchase Price of the Goods

Lifestyle had filed a motion with the bankruptcy court for allowance of an administrative priority claim and for payment of $75,384, the purchase price of the furniture components that River Oaks had agreed to purchase during the chapter 11, and demurrage charges of $8,821.29 that Lifestyle had paid as a result of River Oaks' refusal to accept delivery of the goods. (1) The bankruptcy court awarded Lifestyle an administrative priority claim of $84,205.29, consisting of the purchase price of the goods, $75,384 and demurrage of $8,821.29. The United States District Court for the Northern District of Mississippi was called upon to deal with an appeal from the bankruptcy court's decision.

Administrative Priority Claims

In bankruptcy, claims are paid based on where they are situated on the claims priority ladder. At the top of the ladder are secured creditors who are entitled to payment from the proceeds of their collateral. Next in line are the administrative priority claims of creditors that provide goods and services to the debtor or trustee or to whom the debtor or trustee becomes indebted during the bankruptcy case. As a general rule, administrative claims must be paid in full before any payment can be made to holders of lower priority claims. Next in line are the lower level priority claims, such as certain employee wage, salary, benefit, tax and other claims. Pre-petition unsecured creditors occupy the lowest creditor rung of the priority ladder and are not entitled to any distribution until the higher priority creditors are paid in full.

According to Section 503(b) of the Bankruptcy Code, an administrative priority claim is an actual and necessary cost and expense of preserving the debtor's bankruptcy estate. For instance, a trade creditor with an unpaid claim for goods that it had sold and delivered on credit terms to a chapter 11 debtor is entitled to an administrative priority claim against the debtor with a prior right to payment of its claim ahead of the claims of the debtor's pre-petition unsecured creditors.

The Bankruptcy Code affords priority status to creditors to induce them to extend credit to and do business with a debtor or trustee during the bankruptcy case. This should increase the likelihood that the debtor will successfully rehabilitate its business and emerge from its chapter 11 as a going concern. In the absence of such protection, creditors and other third parties may refuse to extend credit to the debtor out of concern that their claims would not be paid.

The Court's Decision

The court found in favor of Lifestyle, awarding it an administrative priority claim in the amount of $84,205.29. The court stated that Lifestyle was able to prove all of the following necessary for an allowed administrative priority claim: (a) Lifestyle's claim arose from a transaction with a chapter 11 debtor, River Oaks; (b) the goods that Lifestyle had made available to River Oaks allowed River Oaks' business to function as a going concern; and (c) Lifestyle's claim for the purchase price of the goods and the other charges relating to the goods was for the actual and necessary costs and expenses of preserving River Oaks' bankruptcy estate and benefited its estate and creditors.

There was no dispute that Lifestyle's claim against River Oaks arose out of a transaction with a chapter 11 debtor. However, it was argued that Lifestyle should not be granted an administrative priority claim because River Oaks had not taken actual physical possession of the goods and, therefore, the transaction did not either benefit River Oaks and/or enhance River Oaks' ability to function as a going concern.

The court rejected this argument and upheld Lifestyle's allowed administrative priority claim of $84,205.29. The transaction benefited River Oaks and facilitated River Oaks' functioning as a going concern. Lifestyle had supplied River Oaks with the means necessary to obtain an order from Heilig Meyers to purchase custom-made furniture components. The fact that Heilig Meyers had later cancelled its purchase of the components from River Oaks has no bearing on this. River Oaks benefited from Heilig Meyers' placing of its order, which in turn would not have happened without River Oaks' transaction with Lifestyle. Section 503(b) of the Bankruptcy Code does not require that River Oaks receive the optimal or even sought after benefit from Lifestyle as a condition for granting Lifestyle an allowed administrative expense claim. Section 503(b) only requires that the goods that Lifestyle had made available to River Oaks benefited River Oaks by enabling River Oaks to obtain a substantial and potentially very profitable o rder from Heilig Meyers. As a result, the court upheld Lifestyle's allowed administrative priority claim for the purchase price of the goods ordered by River Oaks as well as all demurrage charges incurred by Lifestyle from River Oaks' refusal of the goods.

The result would have been different and Lifestyle would have been denied an administrative priority claim for its damages had River Oaks placed its order with Lifestyle prior to River Oaks' bankruptcy filing and then after the bankruptcy filing, River Oaks cancelled the order and refused to accept delivery of the goods. First, the transaction was not with a chapter 11 debtor because it occurred prior to the bankruptcy. River Oaks rejected its pre-petition purchase contract and Lifestyle was entitled to only a low priority general unsecured claim for its damages from rejection--the purchase price of the goods less any sums realized from the resale of the goods, after deducting expenses.

Lucky for Lifestyle its agreement was with a chapter 11 debtor River Oaks. As a result, Lifestyle was granted an allowed administrative priority claim for the purchase price of the goods and the demurrage charges. End of story!

(1.) Demurrage is a liquidated penalty owed for the failure to load or unload cargo by a certain time.

Bruce S. Nathan, Esq. is a partner in the law firm of Davidoff & Malito, LLP in New York. He is also a member of NACM and the American Bankruptcy Institute. He can be reached via e-mail at bsn@dmlegal.com.
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Title Annotation:court cases review and interpretation
Author:Nathan, Bruce
Publication:Business Credit
Geographic Code:1USA
Date:Mar 1, 2002
Words:1979
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