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Reclamation Rights Not Extinguished When Goods Are Sold to Satisfy DIP Lender's Claims

The Bankruptcy Code generally preserves the rights of vendors under applicable nonbankruptcy law to reclaim goods sold to an insolvent buyer, providing in most cases that a reclaiming seller that makes a timely demand is entitled either to the goods or equivalent compensation such as an administrative claim. Even though the statute was amended in 2005 to clarify that reclamation rights are subordinate to the rights of any creditor asserting a security interest in the goods, a number of unsettled issues endure concerning the impact of a bankruptcy filing on reclamation rights. One such issue — whether sale of the goods during a chapter 11 case to satisfy a DIP lender’s claims effectively extinguishes the seller’s reclamation right — was the subject of a ruling recently handed down by the Sixth Circuit Court of Appeals in Phar-Mor, Inc. v. McKesson Corp.

Reclamation Rights

Under section 2-702 of the Uniform Commercial Code (“UCC”) and common law, a seller of goods generally has the right to reclaim goods sold to an insolvent buyer by making a reclamation demand within a prescribed period of time. The goods must be in the buyer’s possession at the time reclamation is sought, and they must be identifiable. In addition, a seller’s reclamation rights are subject to the rights of any ordinary-course buyer or good-faith purchaser of the goods.

Section 546(c) of the Bankruptcy Code preserves and even expands a seller’s reclamation rights under nonbankruptcy law to a limited extent. It provides that a bankruptcy trustee’s avoidance powers are subject to any right the seller has to reclaim goods sold to an insolvent debtor in the ordinary course of the seller’s business if the debtor received such goods within 45 days of filing for bankruptcy. To activate its reclamation right, the seller must make written demand for reclamation of the goods not later than 20 days after the date of commencement of the bankruptcy case.

If a seller fails to provide notice within the 20-day period prescribed in section 546(c), it may nevertheless assert a right to an administrative claim for the value of the goods under section 503(b)(9) of the Bankruptcy Code. Enacted in 2005 as part of the Bankruptcy Abuse Prevention and Consumer Protection Act (“BAPCPA”), section 503(b)(9) confers administrative-expense priority on the claims of vendors for the value of the goods sold to the debtor in the ordinary course of business during the 20 days prior to the commencement of a bankruptcy case. Section 546(c) does not preclude a seller’s right to pursue other nonbankruptcy remedies, such as the right to stop goods in transit, although such rights may be abrogated by operation of the automatic stay or superseded by the trustee’s avoidance powers.

For many years, a dispute has existed in the courts concerning the enforceability of reclamation rights with respect to goods subject to a blanket security interest. At the heart of the dispute is whether a creditor asserting a blanket lien qualifies as a “good-faith purchaser” under applicable bankruptcy law, even though the UCC incorporates within the definition of “good-faith purchaser” a creditor holding a security interest or lien. Some courts have taken the position that reclamation rights are effectively extinguished by the superior interest of a secured creditor in the goods. According to this view, if a seller’s reclamation right is superseded under applicable nonbankruptcy law by the superior rights of a secured creditor, the seller has no rights under section 546(c) and holds merely an unsecured claim for the value of the goods. This approach is sometimes referred to as the “prior lien defense.” Other courts, representing the minority view, have concluded that such rights survive regardless of a secured creditor’s superior right, and the seller should be compensated in the form of an administrative claim in the amount of the value of the goods or a lien on other assets of the bankruptcy estate.

In an attempt to resolve this dispute, section 546(c) was amended in 2005 as part of BAPCPA to provide that a seller’s right of reclamation is “subject to the prior rights of a holder of a security interest in such goods or the proceeds thereof.” Post-2005 court rulings, however, indicate that the meaning of “subject to” is unclear.

Amended section 546(c) also: (i) expanded the reclamation look-back period before a bankruptcy filing, during which goods may be subject to reclamation, from 10 days to 45 days; and (ii) expanded the grace period, which gives a seller additional time after a bankruptcy filing during which to file its notice of reclamation, from 10 days to 20 days. The seller is also given up to 20 days after the bankruptcy filing to transmit its reclamation demand if the 45-day reclamation-demand period expires after the bankruptcy filing.

Section 546(c) was also amended in 2005 to remove the reference to the “statutory or common law right” of the seller. Lawmakers did not explain the reason for the deletion in BAPCPA’s legislative history. Some commentators have suggested that deletion of the reference to state law in amended section 546(c) means that the provision no longer incorporates the state-law right of reclamation and instead creates an entirely new reclamation right under federal bankruptcy law. Bankruptcy judge Burton R. Lifland rejected this interpretation in In re Dana Corp., observing that “[i]f amended §546(c) created an independent federal reclamation right that replaced state law, then in bankruptcy a reclaiming seller would conceivably have broad rights superior to those of buyers in the ordinary course of business, lien creditors or good-faith purchasers other than a holder of a prior security interest.” Congress, Judge Lifland remarked, “could not have intended to permit reclamation of goods that have been sold to consumers or other good-faith purchasers.”

Finally, section 546(c) was altered in 2005 to remove language providing that, if the bankruptcy court denied reclamation, it was obligated to compensate the seller by means of an administrative-priority claim or lien. Instead, section 546(c) now states that any seller failing to provide timely notice of its reclamation claim “still may assert the rights contained in section 503(b)(9),” which, as noted, confers administrative status on claims for the value of goods provided to the debtor within 20 days of a bankruptcy filing.

Amendment of section 546(c) in 2005 did not end the debate on reclamation rights. Another issue that continues to cause problems, for example, concerns the impact on a seller’s reclamation right if the goods in question are sold to satisfy a secured creditor’s claims, so that such goods are no longer in the buyer’s possession or identifiable. The Sixth Circuit recently had an opportunity to address this question in Phar-Mor, a pre-BAPCPA case.

Phar-Mor

Phar-Mor, Inc. (“Phar-Mor”), a chain of discount drugstores based in Youngstown, Ohio, filed for chapter 11 bankruptcy protection in September 2001. Several vendors, including McKesson Corporation (“McKesson”), filed reclamation claims for goods shipped to Phar-Mor immediately before its bankruptcy filing. The bankruptcy court approved Phar-Mor’s proposal that each such vendor be granted a priority administrative claim in lieu of returning the goods.

The court subsequently authorized Phar-Mor to incur up to $135 million in DIP financing with super-priority secured and super-priority administrative status. Phar-Mor, however, continued to lose money and eventually conducted a going-out-of-business sale. It was able to repay the $135 million loan from the proceeds but was left with only $30 million toward satisfaction of more than $185 million in general unsecured claims.

Phar-Mor moved to reclassify McKesson’s reclamation claim as a general unsecured claim, arguing that the vendor’s priority was extinguished when the goods subject to reclamation were sold and the proceeds used to satisfy the claims of the DIP lenders. Phar-Mor contended that the DIP lenders, by virtue of the after-acquired property clause in their security agreement, were good-faith purchasers and, because McKesson’s reclamation claims were “subject to” the lenders’ security interests, McKesson had no right to reclaim the goods. The bankruptcy court denied the motion, holding that even though the reclamation right was rendered “subject to” the DIP lender’s super-priority liens, McKesson’s properly filed reclamation claim still had administrative-expense priority. Phar-Mor appealed to the Sixth Circuit after the district court upheld that determination on appeal.

The Sixth Circuit’s Ruling

Phar-Mor fared no better with the court of appeals. Because Phar-Mor filed for bankruptcy prior to 2005, the pre-amendment version of section 546(c), which, as noted, did not make reclamation rights expressly “subject to the prior rights of a holder of a security interest in such goods or the proceeds thereof,” governed McKesson’s reclamation right. According to the Sixth Circuit, if McKesson had a right under applicable nonbankruptcy law (here, Ohio law) to reclaim the goods and properly asserted that claim, the bankruptcy court was obligated under section 546(c) to grant the request or to grant McKesson either an administrative-expense priority claim or a lien on the proceeds resulting from the use of the goods by the debtor. The court of appeals concluded that the “subject to” caveat in the UCC as enacted in Ohio “does not allow a secured creditor’s claim to defeat” a seller’s reclamation right.

Disposition of the goods to satisfy the DIP lender’s claims, the court emphasized, did not extinguish McKesson’s valid reclamation right. Citing to its prior decisions, the Sixth Circuit court noted that “[a] priority in bankruptcy should not depend for its existence upon the contingency of whether specific assets are within the bankrupt’s estate” and that “[i]t would certainly be unjust to subject to the payment of the debts of their fraudulent vendee, goods [the vendee] had improperly obtained from [the aggrieved vendors], and which in equity, [the vendors] were entitled to reclaim.” The court of appeals was critical of other court rulings (including Dana) finding that reclamation rights are extinguished pursuant to the “prior lien defense” upon disposition of the goods to satisfy the secured lender’s claims, observing that “[t]hese holdings are not practical and their reasoning is not compelling.”

Analysis

Even though the Sixth Circuit was applying the pre-amendment version of section 546(c) in Phar-Mor, the ruling indicates that there are enduring disputes concerning reclamation rights in bankruptcy. Given the Sixth Circuit’s determination that the rights of a secured creditor with a blanket lien do not extinguish a seller’s reclamation right, it is difficult to predict whether the outcome would have been different if the court of appeals were applying the amended version of the statute, which expressly makes reclamation rights subject to the rights of a creditor asserting a pre-existing security interest in the goods and, apparently, limits the availability of administrative claims to claims qualifying for priority under section 503(b)(9).

Reclamation claims under amended section 546(c) have decreased significance because, by virtue of new section 503(b)(9), goods delivered to a debtor in the 20 days prior to a bankruptcy filing will have automatic administrative priority. As such, the utility of reclamation claims relates primarily to goods delivered in the 21 to 45 days prior to the bankruptcy filing. By expanding the reclamation period and adding section 503(b)(9), the 2005 amendments to the Bankruptcy Code may increase the potential for administrative claims, and to the extent that is the case, debtors will require greater financial resources to reorganize successfully.

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Phar-Mor, Inc. v. McKesson Corp., 534 F.3d 502 (6th Cir. 2008).

In re Dana Corp., 367 B.R. 409 (Bankr. S.D.N.Y. 2007).
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