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The continuing evolution of a seller's right to reclamation and administrative expenses for goods sold prepetition under the bankruptcy code.

As the manufacturing and retail sectors continue to decline, creditors, especially those involved in just-in-time relationships, are increasingly at risk for goods delivered to a debtor just prior to the debtor's bankruptcy filing. Unfortunately, it is not uncommon for a debtor to create, but not pay for, a reserve of goods or a parts bank for use during the initial stages of its bankruptcy. However, as discussed in a myriad of recent articles, creditors, after the enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) are provided with certain protections for the goods that they sell to a debtor on credit just prior to a debtor's bankruptcy filing. Recent issues of Business Credit have focused on a creditor's right not only to reclaim goods sold to the debtor within 45 days of the bankruptcy filing, but also a creditor's right to an administrative expense claim for the goods it sells to the debtor within the 20 days prior to the petition date under Section 503(b)(9) of the Bankruptcy Code.

This article attempts to supplement earlier discussions by alerting creditors to a debtor's potential objection to administrative expense claims arising under Section 503(b)(9) where the creditor has drop-shipped goods pursuant to the express terms of its contract with the debtor. The article also briefly discusses a recent decision from the Sixth Circuit Court of Appeals holding that, despite a secured lender's lien on all of a debtor's personal property, sellers of goods within the requisite reclamation period may nonetheless be entitled to an administrative expense under the pre-BAPCPA reclamation statute.


Section 503(b)(9) Administrative Expenses: Actual Physical Possession v. Drop-ship Relationships

As many readers are undoubtedly now aware, Section 503(b)(9) provides, in pertinent part, that there shall be an allowed administrative expense for "the value of any goods received by the debtor within 20 days before the date of commencement of a case under this title in which the goods have been sold to the debtor in the ordinary course of such debtor's business." 11 U.S.C. [section] 503(b)(9); see In re Dana Corp., 367 B.R. 409, 415 (Bankr. S.D.N.Y. 2007).

The legislative history of Section 503(b)(9) "suggests that it was aimed at providing relief to sellers of goods who fail to give the required notice under the reclamation provision of Section 546(c)." In re Brown & Cole Stores, LLC, 375 B.R. 873, 875 n. 3 (B.A.P. 9th Cir. 2007) (citing Shirley S. Cho, The Intersection of Critical Vendor Orders and Bankruptcy Code [section] 503(b)(9), 29 Cal. Bankr. J. 7, 11 (2007)).

Upon review of the express terms of Section 503(b)(9), creditors typically assumed that they are entitled to an administrative expense if they sell goods to a debtor in the ordinary course of the debtor's business within the 20 days prior to the date of the bankruptcy filing. However, recently a new and admittedly creative argument has been raised by debtors and trustees seeking to disallow administrative expense claims under Section 503(b)(9). According to these trustees and debtors, it is not enough for a creditor to simply have sold goods to the debtor. Rather, the goods that were sold to the debtor allegedly must also have been "received" by the debtor.

The Bankruptcy Code does not provide a definition of the word "received" in Section 503(b)(9) or anywhere else in its text. However, the Uniform Commercial Code (the UCC) does contain a definition of the word "receipt." The UCC defines "receipt" as "actual physical possession." UCC [section] 2-103(c)(1). As such, it has been asserted that in order for a creditor to hold an allowed administrative expense under Section 503(b)(9), the debtor must have taken physical possession of the goods.

Such a scenario is extremely problematic in a situation, for example, where a debtor has issued a purchase order to the creditor for the purchase of goods and provided payment directly to the creditor for such goods, but instructed the creditor on the purchase order itself to ship the goods to a third party unrelated to the debtor. Upon review of Section 503(b)(9), it is unclear whether it is necessary for the "goods [to be] received" by the debtor, or whether the statute simply requires that "value [is] received" by the debtor and such value is related to goods. Arguably, the prepositional phrase "of the goods" serves only to modify the term "value." As such, Section 503(b)(9) requires a debtor to have received value, which such value is related to goods, in order for the selling party to be entitled to an administrative expense.

Applying the aforementioned analysis to a drop-ship relationship, it would seem that a debtor would obtain value from the goods it purchases from a creditor as soon as the creditor fulfills its contractual obligation by shipping the goods to the third party. In simple terms, the creditor would have contracted with the debtor, and the debtor, in turn, would have entered into a separate transaction with the third party who receives the goods (and, in all likelihood, pays some form of consideration to the debtor in exchange for the goods).

Adopting the interpretation that the goods must actually be in the physical possession of the debtor would render the well-recognized commercial practice of drop-shipping virtually useless in a commercial context. In some instances, such interpretation would lead to situations where the debtor that issued the purchase order would take constructive possession of the goods and derive a benefit (i.e., value), but deny the creditor an administrative expense under Section 503(b)(9). Notwithstanding the economic benefits of drop-ship arrangements, sellers would be deterred from doing business with a distressed purchaser because the creditor would be subject to the requirement that the debtor take actual physical possession in order to receive the protections under Section 503(b)(9) of the Bankruptcy Code.

Unfortunately, at least one court has held that Section 503(b)(9) requires the debtor to take actual physical possession in order for the seller to hold a valid administrative expense. See In re Pridgen, 2008 WL 1836950 (Bankr. E.D.N.C. April 22, 2008). In Pridgen, the creditor was a distributor of gasoline to a gas station operated by the debtors. After the debtors filed for bankruptcy, the creditor filed an application for an administrative expense under Section 503(b)(9) for gasoline delivered to the debtors in the 20 days prior to the petition date. The agreement between the debtors and the creditor provided that the gasoline was sold on a consignment basis by the debtors. Specifically, the relationship contemplated retention of possession by the creditor until the gasoline was pumped by, and sold to, a third party customer of the gas station. The court concluded that based on the relationship between the parties, the debtors never obtained actual physical possession of the gasoline nor did the debtors "receive" the gasoline as contemplated by the definition of "receipt" in the UCC. Therefore, the court held that the creditor was not entitled to the an administrative expense under Section 503(b)(9).

The Pridgen decision seems limited to its facts and is distinguishable from a typical drop-ship arrangement. Pridgen addressed an agreement whereby the debtor did not take possession of, or presumably title to, the gasoline until it was pumped and sold to a third party. A drop-ship relationship is arguably not akin to a consignment relationship. Instead, in a typical drop-ship relationship, a creditor will have completed all performance under the applicable contract upon shipment of the goods to the third party and no contingency exists for the reversion of the goods back to the creditor.

Furthermore, even if another court finds the definition of "receipt" under the UCC persuasive, the UCC supplements "receipt" by providing for a situation where physical possession is accomplished through receipt by a buyer's representative or subpurchaser. See UCC [section] 2-705 cmt. 2. Therefore, the court in Pridgen seemingly overlooked the more comprehensive scope of "possession" in the UCC itself.

Despite the fact that Pridgen is clearly distinguishable from drop-ship relationships, it is likely that debtors and trustees will assert Pridgen as a basis for objecting to Section 503(b)(9) administrative expenses where a drop-ship relationship is involved. At the very least, debtors and trustees are likely to attempt to convince a creditor that it does not hold a valid administrative expense on that basis in the hope that the creditor will not pursue the argument further. Creditors, however, should not be deterred. Instead, creditors should continue to pursue their right to an administrative expense by (i) relying on the fact that value was received by the debtor in accordance with the plain meaning of the statute, (ii) distinguishing Pridgen and (iii) raising other arguments such as constructive possession and the existence of an agency relationship between the debtor and the third party who receives the goods.

Reclamation Claims Under Section 546(c): Entitlement to an Administrative Expense After All? Prior to the enactment of BAPCPA, creditors were often deterred from making reclamation demands because a majority of courts have held that when goods subject to reclamation are sold to satisfy a secured creditor's superior claim, the goods subject to reclamation are gone and the creditor's right to an administrative expense likewise disappears. However, a recent decision from the Sixth Circuit Court of Appeals contradicts this rationale and possibly reopens the door for reclamation claimants.

In Phar-Mor, Inc. v. McKesson Corp., 534 F.3d 502 (6th Cir. 2008), the creditor sent a timely reclamation claim pursuant to section 546(c) of the Bankruptcy Code (prior to the enactment of BAPCPA) and Section 2-702 of the UCC to recover goods delivered to the debtors on credit. Thereafter, the debtors proposed that creditors asserting reclamation claims be granted an administrative expense under Section 503(b) in the amount (if any) of their allowed reclamation claims. The debtors then requested that the bankruptcy court reclassify all reclamation claims as general unsecured claims because the creditors' administrative expense was extinguished when the goods subject to reclamation were sold and the proceeds used to pay off the debtors' post-petition lenders. The bankruptcy court denied the motion and held that even though the reclamation claims were subject to the post-petition lenders' rights, the creditors' properly filed reclamation claims were nonetheless entitled to an administrative expense. After the district court affirmed the bankruptcy court, the debtors appealed to the Sixth Circuit.

On appeal, the debtors argued that the creditor did not have a right to reclaim the goods because its rights are subject to the rights of a good faith purchaser or a lien creditor (e.g., secured lender) and the debtors sold the goods to satisfy the secured lenders' claim. However, the Sixth Circuit noted that in a reclamation situation, the debtor, and thus the secured creditor whose rights are no greater than those of the debtor, never obtain title to the goods. According to the court, the reclaiming seller is merely attempting to retake its own property. Therefore, because the goods were still the seller's even after the goods were delivered, the court observed, the secured creditor acquired no rights in the goods.

The Sixth Circuit noted that pre-BAPCPA, a court could deny reclamation to a seller only if the court either (i) grants the seller an administrative expense, or (ii) secures such claim by a lien. As such, because the bankruptcy court denied actual reclamation of the goods, the seller was entitled to either an administrative expense or a lien pursuant to the express requirements of the statute.

Without question, the Sixth Circuit's decision enhances the rights of reclaiming sellers under the Bankruptcy Code prior to the enactment of BAPCPA. What is unclear, however, is whether the rationale applied by the Sixth Circuit applies to the reclamation rights provided to sellers under BAPCPA. BAPCPA excluded any reference to the requirement that a bankruptcy court award an administrative expense or a lien in the event that the court disallowed the seller's right to reclamation.

Until the Sixth Circuit's rationale is tested against the revisions to a seller's reclamation rights in BAPCPA, it is uncertain whether a seller's reclamation claim will be deemed valueless. Nonetheless, creditors should view the Sixth Circuit's decision as yet another reason to demand reclamation of goods sold to a debtor even though it appears reclamation claims will be "subject to" the prior rights of a secured creditor.

John Gregg, Esq. is an attorney with Barnes & Thornburg LLP in Grand Rapids, MI. Mr. Gregg represents creditors in bankruptcy cases throughout the country. He can be contacted at
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Author:Gregg, John
Publication:Business Credit
Article Type:Column
Geographic Code:1USA
Date:Jan 1, 2009
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