In the opening day(s) of many chapter 11 cases, the debtors will request authority from the court to use cash collateral and to enter into debtor-in-possession (DIP) financing. It is a rare situation when a trade vendor is given sufficient notice of these "first-day pleadings," but in the instances when a trade vendor does appear, the parties typically give little, if any, credence to any issues raised by such a vendor. However, the courts should give special credence to the reclamation rights of trade creditors and, if appropriate, provide "adequate protection" to trade creditors for their reclamation rights prior to approving the debtors' use of cash collateral or the DIP financing.

Reclamation Rights

When Congress enacted the Bankruptcy Code, it included 11 U.S.C. §546(c) in order to recognize any right of reclamation that a seller of goods may have under non-bankruptcy law. In re Arlco Inc., 239 B.R. 261, 266 (Bankr. S.D.N.Y. 1999). The Code does not create any new right to reclaim goods, but merely affords a seller the opportunity to take advantage of any reclamation right that may exist under state law. Id.

In almost every state, the right of a seller of inventory to reclaim goods is derived from the Uniform Commercial Code (UCC). For example, in Texas, Tex. Bus & Comm. Code §2.702 (UCC §2-702) states, in pertinent part:

(b) Where the seller discovers that the buyer has received goods on credit while insolvent he may reclaim the goods upon demand made within 10 days after the receipt...
(c) The seller's right to reclaim under subsection (2) is subject to the rights of a buyer in ordinary course or other good-faith purchaser under this Article...

U.C.C. §2-702(b)-(c). Based on the provisions of UCC §2-702(b), courts generally require a reclaiming creditor to show that (1) the seller sold the goods in the ordinary course of its business, (2) the purchaser received the goods while insolvent, (3) the seller demanded return of the goods in writing within 10 days after the purchaser received the goods and (4) the purchaser was in possession of the goods when it received the seller's reclamation demand. See, e.g., In re Pester Refining Co., 964 F.2d 842, 845 (8th Cir. 1992).

The Rights of a Reclaiming Creditor Are Lien Rights

Reclamation is the right of a seller to recover goods delivered by the seller to an insolvent buyer. See In re Pester Refining Co., 964 F.2d at 844. The right to reclaim the goods is based on the theory that the seller has been defrauded. See Id. While most courts have not gone so far, the court in In re Shattuc Cable Corp., 138 B.R. 557, 563 (Bankr. N.D. Ill. 1992), has stated that the reclamation right is a property right that a seller has in the goods sold. See, also, In the Matter of PFA Farmers Market Ass'n., 583 F.2d 992, 1001 (8th Cir. P. 1978) ("most courts" have concluded that the right of reclamation is a specific property right). Id. Since the reclamation right is a property right in the inventory to secure repayment, §101(37) defines such rights as a lien under the Bankruptcy Code.

---

[T]he mere existence of a pre-petition lender's lien on the reclaimed goods does not extinguish the seller's reclamation rights or the seller's right to recover from the reclaimed goods.

---

General Limitations on a Seller's Reclamation Rights

In response to an argument that the reclaiming seller has a lien right in inventory, the debtors, lenders and courts raise concerns that a pre-petition floating lien on inventory destroys the reclamation rights. It is true that a seller's reclamation rights can be diminished by UCC §2-702(3), which provides that the seller's reclamation right is "subject to the rights of a buyer in ordinary course or other good-faith purchaser." UCC §2-702(3). Indeed, almost all the pre-petition lenders will be a good-faith purchaser with lien rights in the reclaimed goods that are superior to the seller's reclamation rights. However, the mere existence of a pre-petition lender's lien on the reclaimed goods does not extinguish the seller's reclamation rights or the seller's right to recover from the reclaimed goods. For example, the Fifth Circuit has held that when a seller of goods has met the requirements of UCC §2-702, and when all prior lienholders have been satisfied through the proceeds of a foreclosure sale, the reclaiming seller is entitled to the surplus proceeds. United States v. Westside Bank, 732 F.2d 1258, 1265 (5th Cir. 1984). See, also, In re Arlco Inc., 239 B.R. at 276-277 (citing Westside with approval). Similarly, where a prior lienholder releases its security interests in goods subject to reclamation, the seller is entitled to the reclaimed goods. Pester Refining Company v. Ethyl Corp., 964 at 848. See, also, In re Arlco Inc., 239 B.R. at 276-277 (citing Pester Refining with approval).

The Pester Refining case is quite instructive in its evaluation of the rights of a reclaiming seller vis-à-vis a secured lender with a floating lien on inventory. In Pester Refining, Ethyl Corp. sold approximately $127,000 of goods in the ordinary course of its business to Pester on credit. Shortly after delivery, Pester filed for bankruptcy, and Ethyl made a timely reclamation demand. Though the goods were on hand as of the petition date, the goods were also subject to a floating inventory lien securing a $42 million loan. Since the secured lender was undersecured, the parties agreed that pursuant to UCC §2-702(3), the secured lender, as of the petition date, had priority in the inventory as a good-faith purchaser over Ethyl. However, since the secured lender ultimately released its lien on the goods, Ethyl prosecuted its right to reclaim the goods. The bankruptcy court, district court and ultimately Eighth Circuit Court of Appeals upheld Ethyl's right of reclamation.

In the case, Pester argued that the mere existence of the floating inventory lien extinguished Ethyl's right to reclaim the goods. The Eighth Circuit disagreed:

This contention does obvious violence to the statutory language. In the UCC context, when the right to reclaim is "subject to" the rights of secured creditors, that means the right is subordinate or inferior to the security interests, not that it is automatically and totally extinguished... Therefore, after the secured creditor's superior interests have been satisfied or released, the reclaiming seller retains a priority interest in the remaining goods, and in any surplus proceeds from the secured creditor's foreclosure sale.

Pester Refining, 964 F.2d at 846 (citations omitted). Thus, the court concluded that the right to reclaim goods survives the existence of a floating lien.

The Pester Refining court noted that concluding that a right to reclaim exists is far easier to determine than the value of such right. Pester argued that since the secured lender was undersecured as of the petition date, Ethyl's right to reclaim the goods had no value. The court disagreed, noting that the contention was inconsistent with §546(c) of the Code:

Once again, our §546(c) analysis must begin with state law. Under the UCC, if an undersecured secured creditor forecloses on the goods to be reclaimed and uses the entire proceeds to pay down its secured debt, the seller's reclamation right is extinguished. Even if the buyer has additional assets, the seller's right to reclaim affords it no priority interest in those assets; it is relegated to its unsecured claim for the purchase price. See UCC §2-504(4). On the other hand, if the secured creditor releases its security interest in the goods to be reclaimed, the seller may enforce its right to reclaim, even if the resulting reduction in the buyer's assets impairs the secured creditor's position. In other words, in the non-bankruptcy context, the secured creditor's decision with respect to its security interest in the goods will determine the value of the seller's right to reclaim.

Pester Refining, 964 F.2d at 847. Consequently, the court concluded that the value of a seller's rights to reclaim goods depended on the actions of the secured lender with the superior rights in the goods. Pester Refining, 964 F.2d at 847-848.

Finally, the Eighth Circuit turned to the disposition of the reclaimed goods. Pester confirmed a plan of reorganization in which (1) Pester transferred its refining assets, including the reclaimed goods, to Derby Refining; (2) Derby Refining transferred to Pester 54 service stations; (3) the secured lender released its liens on Pester's refining assets, including the reclaimed goods; (4) the secured lender agreed to accept payment over time from Pester with the plan payments secured by the assets Derby Refining transferred to Pester; and (5) the secured lender's pre-petition claims were deemed satisfied by the plan. The court noted that it was apparent that the secured lender released its security interest in the goods that Ethyl sought to reclaim in exchange for payment from other sources. Consequently, the Eighth Circuit held that Ethyl's right to reclaim the goods moved from a subordinate position to the senior position on the reclaimed goods and affirmed the lower courts' order that Pester pay Ethyl in full. Pester Refining, 964 F.2d at 848.

Reclaiming Sellers Entitled to "Adequate Protection"

Since reclaiming sellers have "lien" rights in inventory, §§363 and 364 require the courts to provide "adequate protection" to the reclaiming creditors before authorizing the use of inventory or authorizing post-petition financing secured by liens on the inventory. In the event the court "denies" the reclaiming seller the right to recover the goods, the "adequate protection" rights of reclaiming sellers is limited by §546 to administrative claims or liens. However, §546 does not relieve the court of the obligation to provide "adequate protection" to reclaiming sellers.