Byline: Paul S. Arrow, Esq.

Focus Column

In a recent Focus article titled “Insolvency Profits” (Sept. 14), the author described the rights of a seller to reclaim goods sold to an insolvent purchaser under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. The author also offered advice to reclaiming sellers for maximizing recovery. Those rights are described, and the advice given, from a reclaiming seller’s perspective. Not surprisingly, the rights of a reclaiming seller appear very different from the perspective of a secured creditor whose collateral includes those very same goods.

Much of the litigation surrounding both the pre-and post-BAPCPA versions of Bankruptcy Code Section 546(c) centers on the tension between the rights of secured creditors and the rights of reclaiming sellers. Viewed in the light of the statutory protections afforded to secured creditors, as well as the case law that has developed around the issue, the developments heralded in “Insolvency Profits” appear unlikely to change the balance of power.
Statutory Protection

From its beginning, the modern Bankruptcy Code protected the primacy of a secured creditor’s rights in its collateral over the rights of a reclaiming seller of goods. Former Section 546(c) accomplished that goal by incorporating state-law concepts. A seller was entitled to its existing statutory or common-law rights to reclaim goods sold to an insolvent debtor. Typically, the source of the seller’s reclamation right was Section 2-207 of the Uniform Commercial Code. In re Dana Corp., 367 B.R. 409 (Bankr. S.D.N.Y. 2007). Although Section 2-702 created a right of reclamation, the right was subject to the rights of a “buyer in the ordinary course or other good faith purchaser.” Section 2-702(3). Courts quickly established that a secured creditor with an after-acquired property clause qualified as a good-faith purchaser entitled to priority.

Whether the act simply streamlined prior reclamation rights and exceptions or created a new federal right of reclamation, one thing is certain: The primacy of prior lien rights remains paramount. The new section states that reclamation rights are “subject to the prior rights of a holder of a security interest in such goods.” Section 546(c). From the beginning of the Bankruptcy Code through the most recent revisions, Congress consistently has protected the rights of secured creditors against the rights of reclaiming sellers.
New Case Law

Although litigation under new Section 546(c) is just beginning to wend its way through the courts, the “prior lien defense” to reclamation rights remains robust. In one of the first decisions under new Section 546(c), a Delaware bankruptcy court held that a secured lender’s pre-petition and post-petition debtor-in-possession liens were superior to a seller’s reclamation right. In Simon & Schuster v. Advanced Marketing Services Inc (In re Advanced Marketing Systems Inc.), 360 B.R. 421 (Bankr. Del. 2007), the debtor distributed books to membership warehouse clubs, and its vendors were large publishers, including Simon & Schuster. On the day the debtor began its bankruptcy case, Simon made a reclamation demand for $5 million in goods delivered pre-petition.

The debtor enjoyed a working capital line of credit from a group of lenders, under which the lenders held a security interest in substantially all of the debtor’s assets, including a floating lien on its inventory. Shortly after the case began, the bankruptcy court entered an interim order approving post-petition financing from the lenders. The new facility was structured as a “creeping roll-up” in which the pre-petition obligations were paid down over time from the collection of receivables and disposition of assets.

The new facility also provided that the pre-petition liens were preserved in favor of the post-petition lenders in order to secure the post-petition advances. The court held that “under the express language of section 546(c) of the Bankruptcy Code, as amended, the lenders’ pre-petition and post-petition liens on the debtor’s inventory are superior the vendor’s reclamation claim.” Advanced Marketing. The court also noted that it would have reached the same result under the prior version of Section 546(c).

Simon nonetheless argued that its reclamation rights were subject only to the lenders’ pre-petition liens, and that, because the pre-petition obligations would be paid off soon through the “creeping roll-up,” it likely would succeed on its claim. The court rejected the argument for three reasons.

First, the argument ignored the fact that the pre-petition obligation existed and, although it might be paid off at some time, Simon could not establish when that would occur and whether any of its goods would be in the debtor’s possession. Second, the argument ignored the terms of the new facility providing that the pre-petition liens continued to secure the post-petition advances. Thus, whether the pre-petition obligations were satisfied was irrelevant. Third, Simon’s reliance on In re Phar-Mor Inc., 301 B.R. 482 (Bankr. N.D. Ohio 2003), a case in which reclamation rights were held superior to the liens of a post-petition lender, was misplaced. In Phar-Mor, the pre-petition lenders’ claim was satisfied from the proceeds of the post-petition facility, not from the liquidation of the collateral. Finally, the court noted that Simon was really asking the court to invoke the equitable doctrine of marshaling, which is unavailable to unsecured creditors.

Three months after publication of Advanced Marketing, a New York bankruptcy court went one step further, holding not only that reclamation claims were subject to the rights of a secured creditor but also that, as a result, the claims were entirely valueless. In re Dana Corp., 367 B.R. 409 (Bankr. S.D.N.Y. 2007). The theory is that, if the secured obligation is larger than any single reclamation claim, then the reclamation claims are not only subordinate to the secured obligation but also extinguished altogether. Like the prior-lien defense, the “valueless argument” is not new to the amended version of Section 546(c). It has been a vital concept in the reclamation discussion for some time. See, for example, In re Dairy Mart Convenience Stores Inc., 302 B.R. 128 (Bankr. S.D.N.Y. 2003). 
Locating Leverage

Given the protections Congress and the courts afford secured creditors, “Insolvency Profits” author’s advice for maximizing a reclaiming seller’s recovery is unlikely to prove effective.

For example, the author suggests that reclaiming sellers object to post-petition financing agreements that do not provide for payment of reclamation claims or do not carve out from the lender’s collateral sufficient funds to pay reclamation claims. A “carve-out” is nothing more than a voluntary subordination of lien rights. Although carve-outs are common in post-petition financing, they are usually limited to very specific claims. Typically, they are used to ensure payment of post-petition fees owed by the debtor to the Office of the United States Trustee and payment of professionals employed by the bankruptcy estate. Carve-outs are not typically used to ensure payment of pre-petition claims.

More important, given that the primacy of a lender’s rights in its collateral is statutorily protected, why would a secured lender voluntarily give up that protection? Absent unusual circumstances, a reclaiming seller simply has no negotiating leverage to gain that concession.

The author also suggests that reclaiming sellers seek an order establishing a method for determining the validity and amount of reclamation claims. Establishing an orderly procedure for the determination makes sense, and such orders are common. Yet, if the magnitude of the secured creditor’s claim exceeds the value of any single reclamation claim (and that is usually the case), the reclamation claims are valueless and extinguished. Thus, the amount of the claims will be set at zero. That is exactly what happened in Dana. As a result, the reclaiming seller will be left only with its claim for goods sold.

Finally, the author suggests that the reclamation procedures may supplant the automatic stay permitting the reclaiming seller to take physical possession of the goods. There is simply no support for the suggestion. Although Bankruptcy Code Section 362 provides a number of exceptions to the stay, no exception is given for enforcement of reclamation claims. 11 U.S.C. Section 362(b). Likewise, Section 546(c) contains no exemption from the stay, or even a suggestion that reclamation rights supplant the stay. Second, proceeding in violation of the stay could prove very costly in some cases. An individual willful-stay violator is subject to compensatory and punitive damages. 11 U.S.C. Section 362(h).

Although the post-BAPCPA version of Bankruptcy Code Section 546(c) expands the time frame for reclamation claims, it does nothing to improve a reclaiming seller’s position if a secured creditor holds a lien on the goods sold. The balance of power continues to strongly favor the secured creditor.
Paul S. Arrow is a shareholder of Buchalter Nemer in Los Angeles. He represented the secured lenders in Advanced Marketing.