Reclamation Rights Trumped by UCCs Floating Inventory Security Interest

Reclamation Rights Trumped by UCCs Floating Inventory Security Interest

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Unsecured trade creditors, facing the prospect of an insolvent customer bankruptcy, could previously take solace that their state law reclamation rights might yield them a greater recovery on their claims. An unpaid seller's reclamation rights arise under §2-702(2) of the Uniform Commercial Code (UCC), which states as follows:

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 their receipt....

Section 546(c) of the Bankruptcy Code recognizes state law reclamation rights. Section 546(c)(1) states that a trade creditor satisfying the state law requirements for reclamation under UCC §2-702(2), as well as the additional requirements for reclamation contained in §546(c), has a valid reclamation claim. These additional requirements include the creditor sending a written reclamation demand within either 10 days of the debtor's receipt of the goods, or if the 10-day period expires after the bankruptcy filing, within 20 days of receipt.

If a trade creditor satisfies all of the state and bankruptcy requirements for reclamation, the bankruptcy court could order the buyer to return the goods. Alternatively, the court could deny reclamation, conditioned on granting the trade creditor a substitute remedy consisting of either a replacement lien in other assets of the debtor to secure payment of the reclamation claim, or an administrative expense claim in the amount of the reclamation claim, with priority over the claims of all pre-petition unsecured creditors.

The problem lies in UCC §2-702(3). It states that a seller's right of reclamation is subject to the rights of a buyer in the ordinary course or other good-faith purchaser. Under the definition of UCC Article 1 (UCC §§1-201(32) and (33) and revised UCC §§1-201(b)(29) and (30)), a purchaser includes a creditor holding a security interest or lien. Virtually all court decisions have relied on UCC §2-702(3) to hold that a creditor's security interest in the debtor's inventory has priority over an unpaid seller's reclamation rights.

The recent trend in court decisions is to deny trade creditors any recovery on their reclamation claims where the debtor's secured creditor had received all the proceeds of the sale of the reclamation goods, leaving no surplus for the reclaiming creditors. This has been all the more difficult for reclamation creditors to swallow where the debtor's secured lender was oversecured and there were sufficient collateral proceeds to fully satisfy the lender's secured claim and all reclamation claims. If this adverse trend continues, reclamation might become a less viable remedy for trade creditors.


The recent trend in court decisions is to deny trade creditors any recovery on their reclamation claims where the debtor's secured creditor had received all the proceeds of the sale of the reclamation goods, leaving no surplus for the reclaiming creditors.

The Pittsburgh-Canfield Case

The recent decision of the U.S. Bankruptcy Appellate Panel (BAP) for the Sixth Circuit, In re Pittsburgh-Canfield Corp., 309 B.R. 277 (BAP 6th Cir. 2004), the Wheeling-Pittsburgh chapter 11, demonstrates the hurdles to recovery on reclamation claims where the debtor has an unpaid, floating-inventory, secured lender. Prior to and after the chapter 11 filing, certain trade creditors of Wheeling-Pittsburgh Corp. and affiliates (collectively, Wheeling-Pittsburgh) sent written reclamation demands. Pursuant to a court-approved program for reconciling reclamation claims, the amount of their reclamation claims was fixed at approximately $450,000. Wheeling-Pittsburgh also owed its pre-petition secured lenders approximately $115 million that was secured by Wheeling-Pittsburgh's inventory, valued at approximately $245 million. Wheeling-Pittsburgh's inventory included the goods subject to the reclamation claims, so the secured lenders were vastly oversecured by about $130 million and could have obtained a full recovery without looking to the reclamation goods.

Shortly after filing chapter 11, Wheeling-Pittsburgh obtained bankruptcy court approval of a chapter 11 financing arrangement (the debtor-in-possession (DIP) financing facility). The pre-petition secured lenders were paid in full from the proceeds of the DIP financing facility, their security interests were assigned to the chapter 11 lenders, and their claims were secured by a first priority security interest in all inventory, including the reclamation goods, and by a superpriority administrative expense claim payable ahead of all other administrative expense claims.

Nearly two years after the chapter 11, Wheeling-Pittsburgh moved to deny the reclamation creditors an administrative expense claim and recharacterize their claims as general unsecured claims. Wheeling-Pittsburgh argued that reclamation claims had no value outside of bankruptcy and were therefore not entitled to recovery in bankruptcy because Wheeling-Pittsburgh had sold all the reclamation goods in the ordinary course of business and applied the proceeds in reduction of its obligations under the DIP financing facility.

The Sixth Circuit BAP upheld the denial of an administrative expense claim or lien in favor of the reclamation creditors. The court followed the majority view that reclamation creditors are not entitled to recover more in bankruptcy under §546(c) than they could otherwise recover under state law. If a seller's reclamation rights have no value under state law, likewise they should have no value in bankruptcy. Reclamation rights have value under state law only to the extent the value of the reclamation goods exceeds the amount of the secured lender's floating lien claim.1

The court rejected the minority view relied upon by the reclamation creditors that once they satisfy the §546(c) requirements for reclamation, they are automatically entitled to a lien or administrative expense claim for the full amount of their reclamation claims. In this case, they satisfied §546(c) and proved that they had valid reclamation claims because (1) they sold inventory to Wheeling-Pittsburgh in the ordinary course of business, (2) Wheeling-Pittsburgh was insolvent when it received the inventory, (3) the reclaiming creditors made timely written demands for reclamation of their goods and (4) Wheeling-Pittsburgh had possession of the goods subject to reclamation when it received the demands. See In re Bosler Supply Group, 74 B.R. 250 (Bankr. N.D. Ill. 1987); In re Sunstate Dairy & Food Products Co., 145 B.R. 341 (Bankr. M.D. Fla. 1992); In re Diversified Food Service Distributors Inc., 130 B.R. 427 (Bankr. S.D.N.Y. 1991); In re Roberts Hardware Co., 103 B.R. 396 (Bankr. N.D.N.Y. 1988); In re Melvin Liquid Fertilizer Co. Inc., 37 B.R. 587 (Bankr. S.D. Ohio 1984); In re Wathen's Elevators Inc., 32 B.R. 912 (Bankr. W.D. Ky. 1983); In re Davidson Lumber Co., 22 B.R. 775 (Bankr. S.D. Fla. 1982); In re Western Farmers Ass'n., 6 B.R. 432 (Bankr. W.D. Wash. 1980).

The Sixth Circuit BAP criticized the minority view for failing to take into account whether a reclaiming seller had a right of recovery on its reclamation claim under state law. A reclamation claim that has no value under state law, in the face of a claim secured by a floating inventory secured claim, has no value in bankruptcy.

The pre-petition lenders' $115 million secured claim dwarfed the value of the reclamation goods, worth a fraction of that amount. The Sixth Circuit BAP concluded that the reclamation creditors would not have obtained any recovery under state law if they had been required to fully pay the pre-petition lenders' secured claim as a condition for reclaiming the reclamation goods. The reclamation creditors should not be entitled to any greater recovery in bankruptcy.

The court also gave no special credence to Wheeling-Pittsburgh's use of the proceeds of the DIP financing arrangement to pay off the pre-petition secured lenders' claims. The DIP lenders were granted a first-priority security interest in all of Wheeling-Pittsburgh's inventory, including the reclamation goods, and a superpriority administrative expense claim payable ahead of all other administrative expense claims. The DIP lenders succeeded to all of the rights of Wheeling-Pittsburgh's pre-petition secured lenders, whose $115 million secured claim effectively cut off reclamation rights.

The Sixth Circuit BAP also felt that the reclamation creditors could have avoided their dire predicament by obtaining a valid and perfected purchase money security interest (PMSI) in the reclamation goods. Reclaiming creditors with a valid PMSI would have had priority over the rights of the pre-petition secured lenders and the DIP lenders. Without PMSI protection, Wheeling-Pittsburgh was able to commingle and use the reclamation goods, and the reclamation creditors could not trace and recover their inventory.


The courts have upheld an unpaid seller's right to stop delivery of goods over the objection of the debtor's floating inventory secured lender, thereby making stoppage of delivery a more effective trade creditor remedy than reclamation.

The Sixth Circuit BAP's decision appeared to backtrack from the recent holding of the U.S. Bankruptcy Court for the Northern District of Ohio in In re Phar-Mor Inc., 301 B.R. 482 (Bankr. N.D. Ohio 2003). The court in Phar-Mor granted trade creditors relief on their reclamation claims, notwithstanding Phar-Mor's pre-petition secured lenders' approximately $100 million floating inventory lien claim that was far in excess of the value of the goods subject to reclamation. The payment of Phar-Mor's pre-petition secured lenders' claims from the proceeds of Phar-Mor's DIP secured loan facility, and not from any proceeds of the sale of the reclamation goods, preserved the value of the reclamation claims, and reclamation creditors were entitled to relief. But, see In re Dairy Mart Convenience Stores Inc., 302 B.R. 128 (Bankr. S.D.N.Y. 2003) (reclamation claims rendered valueless, notwithstanding payment of pre-petition secured lenders from DIP facility loan proceeds and not necessarily from reclamation goods).

The Sixth Circuit BAP also rejected the reclamation creditors' invocation of the equitable principal of marshaling to force Wheeling-Pittsburgh's secured lenders to first look to their surplus collateral, other than the reclamation goods, to pay their secured claims. The lenders' $245 million of inventory collateral, with a built-in cushion of $130 million, should have been sufficient to fully pay their claims without their having to liquidate the reclamation goods. Nice try, but no cigar!

The remedy of marshaling applies when a senior secured creditor has a security interest in, and can collect its claim from, multiple properties of the debtor, while a junior secured creditor can proceed only against one or a subset of these assets. A junior secured creditor that successfully invokes marshaling can compel the senior secured creditor to first realize upon the property in which the junior has no interest before looking to the junior's collateral. That increases the likelihood of the junior's recovery from its own collateral.

The Sixth Circuit BAP rejected marshaling as a remedy for reclamation creditors to force Wheeling-Pittsburgh's secured lenders to initially look to collateral other than the reclamation goods. First, the reclamation creditors were not eligible to invoke marshaling because they were not secured or lien creditors, which is one of the prerequisites for marshaling, and unsecured creditors cannot invoke marshaling. See In re Arlco Inc., 239 B.R. 261 (Bankr. S.D.N.Y. 1999). See, also, In re Gibson Group Inc., 151 B.R. 133, 134-35 (Bankr. S.D. Ohio 1993) (unsecured creditors lack standing to invoke marshaling). The court was also concerned that the reclamation creditors' successful invocation of marshaling might force Wheeling-Pittsburgh to look to other vendors' reclamation goods, thereby rendering their reclamation claims valueless. That would have amounted to discriminatory treatment of similarly situated creditors that the court would not condone.

The dissent offered the only silver lining for the reclamation creditors. The dissent argued that the Bankruptcy Code has a substitutionary remedy where the debtor seeks to use goods subject to a valid reclamation claim: a junior lien subordinated to the DIP lenders' senior security interest. The value of that junior lien should be determined later in the case in connection with some proposed disposition of the inventory, such as through a plan or a sale.

An Unpaid Seller's Right to Stop Delivery of Goods: A Preferable Alternative to Reclamation

UCC §§2-702, 703 and 705 grant an unpaid seller the right to stop delivery of goods that an insolvent buyer did not receive. An unpaid seller can stop delivery of goods in the seller's possession or in the possession of a carrier or other third-party bailee. The seller must instruct the carrier or other third-party bailee not to release the goods to the buyer. The carrier or other bailee must then hold and deliver the goods according to the seller's instructions. The seller is liable for all charges and damages the carrier or other third party incurs in stopping delivery of the goods. UCC §2-705(3).

A seller loses the right to stop delivery of goods in transit upon the occurrence of any of the following: (1) the buyer received the goods, (2) the bailee, other than a carrier, acknowledges to the buyer that it is holding the goods for the buyer, (3) the carrier transporting the goods acknowledges to the buyer that the carrier is holding the goods for the buyer by either reshipping them according to the buyer's instructions or holding them as the buyer's warehouse, or (4) a negotiable document of title for the goods has been issued or negotiated to the buyer, or a non-negotiable document has been issued to someone other than the seller. UCC §2-705(2).

An unpaid seller can stop delivery of its goods even where title and/or risk of loss had already passed to the buyer. The seller can also exercise its stoppage of delivery rights whether or not the buyer is in bankruptcy, and notwithstanding the §362 automatic stay. See In re National Sugar Refining Co., 27 B.R. 565 (S.D.N.Y. 1983). The seller's exercise of stoppage of delivery rights is also not an avoidable preference. See In re Fabric Buys, 34 B.R. 471 (Bankr. S.D.N.Y. 1983). Following the seller's stoppage of delivery of its goods, the buyer might pay for the goods or agree to their being re-invoiced and paid as an administrative claim in the chapter 11. Alternatively, the seller could move for relief from the automatic stay to recover possession of, resell and/or obtain payment for the goods.

The courts have upheld an unpaid seller's right to stop delivery of goods over the objection of the debtor's floating inventory secured lender, thereby making stoppage of delivery a more effective trade creditor remedy than reclamation. For example, in Trico Steel Co. LLC v. Cargill Inc. (In re Trico Steel Co. LLC), 302 B.R. 489 (D. Del. 2003), the court noted that stoppage-of-delivery rights are not subject to the rights of a good-faith purchaser, such as a floating-inventory, secured lender. As a result, the inventory lender's security interest is subject to the prior rights of an unpaid seller that has stopped delivery of its goods. In stark contrast, reclamation rights are subject to the rights of good-faith purchasers and therefore subordinate to the rights of the debtor's inventory lender. Also, a trade creditor's right to stop delivery is not a security interest and therefore is not subject to the priority rules of UCC Article 9. As a result, a trade creditor exercising stoppage of delivery rights is not subordinate to the rights of an inventory secured lender. See, also, Crocker Nat'l. Bank v. Ideco Div. of Dresser Industries Inc., 839 F.2d 1104 (5th Cir. 1988); In re Kellstrom Industries Inc., 282 B.R. 787 (Bankr. D. Del. 2002).


Footnotes

1 See In re Quality Stores Inc., 289 B.R. 324 (Bankr. W.D. Mich. 2003); In re Bridge Info Sys. Inc., 288 B.R. 133 (Bank. E.D. Mo. 2001); In re Houlihan' Rest. Inc., 286 B.R. 137 (Bankr. W.D. Mo. 2002); In re Primary Health Sys. Inc., 258 B.R. 111 (Bankr. D. Del. 2001); In re Arlco Inc., 239 B.R. 261 (Bankr. S.D.N.Y. 1999). Return to article

Journal Date: 
Monday, November 1, 2004