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Reclamation rights vs. floating inventory lien: a victory at last!

Introduction

The prospects of a trade creditor prevailing on its reclamation claim have been looking more and more bleak where the debtor has a secured creditor with a floating inventory lien. However, the taw is a wonderful maiden and there is always the chance (or at least hope) that a court could grant relief on a reclamation claim despite the existence of a competing floating inventory security interest.

That is precisely what happened in the recent decision of the United States Bankruptcy Court for the District of South Carolina in In re Georgetown Steel Company LLC The bankruptcy court granted the reclamation creditors' allowed administrative claims and denied the debtor's motion to reclassify reclamation claims as general unsecured claims or, alternatively, value them at $0, despite the existence of a floating inventory lien when the debtor filed Chapter 11.

Bottom line, a trade creditor might be entitled to relief on its valid reclamation claim, despite the debtor's floating inventory lien secured lender, when the lender is fully secured and there is substantial surplus inventory and other collateral to fully pay the lender's claim. The debtor was also precluded from contesting reclamation rights after the debtor had obtained a bankruptcy court order that precluded reclamation creditors from enforcing their rights and lulled them into believing that they would have an allowed administrative expense claim for their valid reclamation claims. So, folks, do not give up on your reclamation rights!

Grounds For Reclamation Rights

Section 2-702 of most states' Uniform Commercial Code ("UCC") governs reclamation rights. Section 546(c) of the Bankruptcy Code recognizes state law reclamation rights. A trade creditor seeking reclamation must prove all of the following:

(1) The creditor sent a written reclamation demand within either 10 days of the debtor's receipt of the goods, or, if the 10-day period expired after the bankruptcy filing date, within 20 days of the debtor's receipt of the goods;

(2) The creditor had sold the goods in the ordinary course of business;

(3) The debtor was balance sheet insolvent (liabilities exceed assets if the customer is in bankruptcy) when it received the goods; and

(4) The debtor was in possession of the goods.

If a trade creditor satisfies these requirements, the bankruptcy court could order the buyer to return the goods, grant the creditor a security interest in the goods or other assets to secure payment of the reclamation claim, or grant the creditor a first priority administrative expense claim for the amount of the reclamation claim that would be payable ahead of the claims of general unsecured creditors.

A seller's reclamation rights are subject to the rights of a good faith purchaser. The UCC defines a "good faith purchaser" to include most inventory secured creditors. That means creditors, secured by a floating lien in the debtor's inventory, have priority over the rights of a reclaiming setter.

The Facts Of The Georgetown Steel Co. Case

On October 21, 2003, the debtor, Georgetown Steel Co. LLC, filed Chapter 11. The debtor owned a steel mill located in Georgetown, South Carolina which produced carbon steel wire rods. Three trade creditors, Progress Rail Services Corporation, Heraeus Electro-Nite Co. and Foseco Metallurgical, Inc. (collectively, the "Reclamation Creditors") asserted reclamation claims against the debtor.

The debtor also had two secured lenders, The CIT Group/Business Credit Inc. and Midcoast Industries LLC. CIT had outstanding loans due from the debtor secured by substantially all of the debtor's assets, including inventory. The debtor owed CIT approximately $26,260,000 when the debtor filed Chapter 11. Midcoast also had a security interest in most of the debtor's assets, including inventory, and a mortgage on the debtor's real property, as collateral security for payment of its $5,850,000 claim against the debtor.

On October 24, 2003, the court approved an order governing reclamation claims (the "Reclamation Order"). The Reclamation Order provided that all valid reclamation claims were to be treated as administrative expense claims with priority over the rights of the debtor's prepetition general unsecured creditors. The Reclamation Order also enjoined reclamation creditors from seeking to reclaim, or otherwise interfere with the delivery of, their goods. The Reclamation Order was silent about the possibility that reclamation creditors could subsequently lose their administrative claims or be required to make payments to CIT or Midcoast.

The debtor ultimately moved for court approval of the sale of its assets, including the goods subject to reclamation. At about the same time, the debtor and the Reclamation Creditors had entered into Consent Orders to induce the Reclamation Creditors to go along with the sale. The Consent Orders stated that Progress had a valid reclamation claim of $80,000; Heraeus had a valid reclamation claim of $74,089.93 and Foseco had a valid reclamation claim of $21,875. As a result, they claimed entitlement to administrative claims in these amounts under the Reclamation Order.

The bankruptcy court approved the sale for a cash price of $18,000,000. At the time of the sale, CIT was owed approximately $2,500,000 and Midcoast was still owed $5,850,000. Their secured claims were paid from the sales proceeds, leaving significant surplus proceeds, totaling approximately $10,000,000, that were available for distribution to administrative priority and unsecured creditors. This kind of sounds like some recent cases where reclamation creditors were denied relief despite the existence of a substantial equity cushion. Yet--here they won. Read on folks, to see why!

Summary Of Arguments

The debtor argued that the claims of the Reclamation Creditors should be reclassified as general unsecured claims or valued at $0. Section 546(c) of the Bankruptcy Code gives reclamation creditors no greater rights than they had under state law. The Reclamation Creditors' claims were worthless under state law because of the existence of the senior secured claims of CIT and Midcoast that exceeded the value of the reclamation goods. The Reclamation Creditors were also not entitled to relief because they could not trace their goods to the remaining sales proceeds, following payment of the secured claims.

The Reclamation Creditors asserted administrative claims based on the Reclamation Order and the Consent Orders. They also argued that they were prejudiced by the Reclamation Order's prohibition against their taking any action to protect or enforce their reclamation rights. They would have acted sooner to oppose the sale of their goods, or at least seek a segregation and tracing of their goods and proceeds, had they known, at the relevant points in time, about the debtor's intention to subsequently deprive them of any recovery on their reclamation claims. Finally, they claimed the availability of substantial surplus collateral proceeds, after the full payment of CIT's and Midcoast's secured claims, to fully pay their reclamation claims.

The Different Line Of Cases Regarding The Impact Of A Floating Inventory Lien On Reclamation Rights

The court reviewed the current state of the law on the impact of a floating inventory secured lender's claim on reclamation rights. One line of cases holds that as long as a reclaiming seller satisfies the state law and bankruptcy requirements for reclamation, the seller is automatically entitled to either an administrative expense claim or a replacement lien in the amount of its allowed reclamation claim, notwithstanding the existence of a secured creditor with a floating lien in the debtor's inventory. Reclamation rights are subordinate to, but not extinguished by, the rights of a floating inventory secured creditor, in its capacity of a good faith purchaser under the UCC. While these courts deny reclamation due to the seller's subordinate status, they, nevertheless, grant the reclaiming seller one of two alternative remedies provided in Section 546(c) of the Bankruptcy Code--an administrative expense claim or a replacement lien.

A second line of cases, which is in the ascendancy, follows a valuation approach. The courts hold that the value of a reclamation claim must be considered as of the commencement of the bankruptcy, after taking into account floating inventory secured claims. A reclaiming creditor may not recover its goods if the debtor had a floating inventory secured creditor when it filed for bankruptcy, and any request for an administrative expense claim must be denied. These courts focus on the secured creditor's right to control the disposition of their inventory collateral A seller's reclamation rights would be valueless under state law if the goods were worth less than the secured claim because of the secured creditor's prior security interest in the goods.

The Georgetown Steel Co. Decision

The Georgetown Steel court punted on which approach it preferred. The court concluded that the Reclaiming Creditors would have been entitled to relief even under the more restrictive valuation approach. This was not a case like the Pittsburgh-Canfield decision of the Sixth Circuit Bankruptcy Appellate Panel, discussed in the author's article entitled "Are Reclamation Claims Heading For Oblivion Where The Debtor Has A Secured Inventory lender" that appeared in the September 2004 edition of Business Credit, where all the goods subject to reclamation were sold and the sates proceeds were paid to the debtor's secured tender. Even the Pittsburgh-Canfield court recognized that a seller's reclamation claim might have some value under state taw where the debtor's floating inventory secured creditor was oversecured and paid from goods other than the reclamation goods, leaving traceable proceeds for reclamation creditors.

The court relied on two cases that suggest an expansion of the valuation approach. In In re Phar-Mor, the United States Bankruptcy Court for the Northern District of Ohio upheld reclamation rights where the debtor's prepetition secured lender was paid in full from the proceeds of a post petition debtor-in-possession lending facility and not from the sale of reclamation goods, and the prepetition tenders had released their liens. And in In re Pester Refining Co., the Eighth Circuit Court of Appeals upheld reclamation rights where the secured creditors had released their inventory liens in the reclamation goods as part of a confirmed Chapter 11 plan. Bottom line, reclamation creditors were entitled to relief where the debtor's secured lenders had released their security interests in the reclamation goods.

The Georgetown Steel court questioned earlier decisions that followed the valuation approach and presumed that a senior secured creditor would always assert its superior interest in the reclamation goods at the expense of reclamation rights. That did not happen in Phar-Mor and Pester Refining. Similarly, in Georgetown Steel, there were surplus sales proceeds, after payment of CIT's and Midcoast's secured claims. The debtor's secured lenders did not need or choose to satisfy their liens from, and released their security interests in, the reclamation goods because they were fully paid from other inventory and assets.

The court also excused the reclamation creditors from any requirement to trace their reclamation goods to the assets the debtor had sold. CIT and Midcoast did not have to look to the reclamation goods for payment of their secured claims as they were paid from other assets and substantial additional proceeds were still available. The debtor's actions also discouraged, if not foreclosed, the Reclamation Creditors, from seeking a tracing or segregation of their goods prior to the sale of the debtor's assets. The debtor had filed its motion to deny reclamation relief after passage of the deadline for the Reclamation Creditors to object to the sale. The Reclamation Creditors had been assured they had administrative expense claims and the Reclamation Order had otherwise prevented them from protecting or enforcing their reclamation fights. Had they known of the debtor's intention to wipe out their reclamation claims, they would have been more active in tracing or seeking segregation of their goods from the sale, particularly since the debtor's assets had sold for $18 million cash and only $8 million was needed to fully pay the secured creditors. Simply stated, the debtor could not have its cake and eat it too, trying to sell its assets, including the reclamation goods, while lulling the Reclamation Creditors into a false sense of security that they would obtain relief on their reclamation claims, and then sandbagging them following the sale, by attempting to wipe out their reclamation rights!

The Reclamation Creditors were also entitled to relief on their reclamation claims based on the principle of "equitable estoppel". Equitable estoppel arises when one party makes a misleading representation to another party and the other party reasonably relies on that representation to his or her detriment. The doctrine applies in bankruptcy when (1) the estopped party knew the relevant facts; (2) the estopped party intended for its conduct to be relied or acted upon by the innocent party and the innocent party had the right to rely upon the conduct that was so intended; and (3) the innocent party was ignorant of the true facts and relied on the estopped party's conduct to its detriment.

The court concluded that the requirements of equitable estoppel were satisfied in this case. First, the debtor had sought the injunctive relief in the Reclamation Order, that prevented the Reclamation Creditors from acting to recover the goods, in order to maintain the status quo. Second, the Reclamation Order granted an administrative claim for all valid reclamation claims. Third, the Reclamation Creditors retied upon the administrative claims they were obtaining under the Reclamation Order and were not aware of the debtor's intention to subsequently move to wipe out these claims. As a result, they did not pursue any course of action that might have otherwise been available to obtain possession of the goods. Taken together, these actions preclude the debtor from defeating their reclamation claims.

A win for reclamation creditors!

Conclusion

My recent columns on reclamation have been depressing because of the recent trend in court decisions that denied relief to reclamation creditors where the debtor had a secured creditor with a floating inventory lien at the time of the bankruptcy filing. The Georgetown Steel decision is a refreshing reminder that reclamation creditors might be entitled to relief when the debtor's secured lender is oversecurecl and there is substantial excess inventory and other collateral, after payment of the secured creditor's claim. So folks, continue to pursue you reclamation rights: there is renewed hope based upon the Georgetown Steel decision!

Bruce S. Nathan, Esq. is a Partner in the law firm of Lowenstein Sandier PC in New York, NY. He is also a member of NACM and the American Bankruptcy Institute. He can be reached via e-mail at bnathan@lowenstein.com.
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Title Annotation:Credit Column
Author:Nathan, Bruce S.
Publication:Business Credit
Geographic Code:1USA
Date:Apr 1, 2005
Words:2392
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