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Section 546(h): An Unsecured Trade Creditors Friend (Part I)

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The Bankruptcy Reform Act of 1994 added a new subsection (g) (referred to herein as subsection (h)1 to §546 of the Bank-ruptcy Code. This new subsection permits the debtor to return goods shipped by a supplier-creditor before the commencement of the case for credit in the amount of the purchase price of the goods against the creditor’s pre-petition claim.

 

Such a return must have the consent of the supplier, and the court must determine that the return is in the best interests of the estate. This section provides a strategic tool for both unsecured trade vendors and debtors when goods shipped by the vendor to the debtor pre-petition would be more valuable in the hands of the creditor than in the hands of the debtor.

Section 546(h) states:

Notwithstanding the rights and powers of a trustee under §§544(a), 545, 547, 549 and 553, if the court determines on a motion by the trustee made not later than 120 days after the date of the order for relief in a case under chapter 11 of this title and after notice and a hearing, that a return is in the best interests of the estate, the debtor, with the consent of a creditor, may return goods shipped to the debtor by the creditor before the com-mencement of the case, and the creditor may offset the purchase price of such goods against any claim of the creditor against the debtor that arose before the commencement of the case.

Section 546(h)’s legislative history reflects the underlying purpose of this reform legislation. As Sen. Howell Heflin (D-Ala.) explained:

This section allows for the consensual return of goods, which are in the possession of the debtor, to the seller-creditor. This section would allow the value of such returned goods to be offset against the value of any pre-petition claim of such a creditor. This section provides for court approval for such an action, and further provides that such an action may only take place when it is in the best interests of the reorganizing company. This offset procedure will relieve the bank-ruptcy estate of the burden of keeping unwanted or unsalable goods, and relieve the estate of unnecessary liabilities. This return will be particularly valuable when the goods are of greater value to the seller of the goods than to the debtor-purchaser.

Although courts have allowed such return procedures, the Bankruptcy Code does not explicitly deal with this issue. Allowing the consensual return of goods would permit more efficient reorganizations of bank-ruptcy debtors, and other creditors’ interests will be protected by requiring notice and hearing before a reclamation could take place. This section simply recognizes a business reality and is a section which I support.

138 CONG. REC. S8266 (daily ed. July 16, 1992) (statement of Sen. Heflin).

There are significant incentives for a vendor to participate in a §546(h) return program. First, in many cases, the vendor is in a position to resell the goods for a far higher price than the debtor. Vendors often have access to much broader resale markets and, unlike the debtor, have the ability to sell the goods in a manner not driven by an immediate need for cash. Dumping of goods at "firesale" prices by a distressed debtor can send shock waves through a troubled industry, drastically depressing market prices for all players. Second, returns, which are payments in kind, get the vendor’s money out of the insolvent debtor immediately. This gives the creditor a substantial advantage over the position of the typical unsecured creditor who often must wait several years while the bankruptcy case winds its way through the system before getting any payment at all. Third, by virtue of §546(h)’s prefatory sentence, these returns are not subject to avoidance or setoff by the trustee under §§544(a), 545, 547, 549 or 553. Therefore, the unsecured vendor is at least guaranteed the "payment" it received on its unsecured debt through the return of the goods. This limits its risk that it could receive a lesser distribution in a chapter 11 plan or upon conversion to chapter 7. Fourth, §546(h) provides a creditor, who for whatever reason has missed the short deadlines for reclamation provided in §546(c), another bite at the apple. Section 546(h) gives creditors up to 120 days to convince the debtor to voluntarily return goods.


Section 546(h)is another arrow in a quiver of those "last in line" seeking to be come "first in line."

The debtor also can find significant benefits from the use of this relatively new statute. First, since the returns are credited to the estate at their purchase price, a return often can generate a far higher value for the estate than the amount that would be realized in a "firesale" or other liquidation basis. Troubled debtors or their trustees often find themselves unable to effectively dispose of perishable or hazardous inventory and supplies. Section 546(h) gives the debtor the new option of simply returning these to the vendor, thus relieving the estate of a major headache and the lost value to the estate. In industries where product becomes quickly dated, §546(h) allows debtors to exercise return rights, which are an essential part of normal marketing operations.2 Such effective inventory management enhances a debtor’s financial performance and improves the prospects of a successful reorganization.

Section 546(h) also offers strategic advantages in arranging for post-petition trade credit, by effectively allowing a trade creditor to exchange administrative claim priority status for its previous unsecured creditor status, without changing its net credit to the estate. For example, an unsecured supplier owed $1 million on a pre-petition shipment would normally stand at the end of the priority line with all other unsecured creditors where the distribution scraps are typically meager to recover payment for this shipment. However, under §546(h), this creditor could enter into an agreement with the debtor to accept return of its $1 million pre-petition shipment in exchange for $1 million in post-petition credit. Under §546(h), the return would represent an offset against the supplier’s pre-petition claims, thus eliminating its exposure for this $1 million pre-petition credit entirely. Under §364(a), the unsecured creditor’s $1 million extension of post-petition credit would receive administrative priority status. The net result is that the supplier has moved to the front of the line for this $1 million credit, while incurring no additional credit risk.3 The estate presumably benefits by being able to get rid of old inventory it cannot use by getting a post-petition line of credit for new inventory that it will be able to sell efficiently.

Given the utility of §546(h), an unsecured vendor who realizes it shipped goods to a debtor prior to its bankruptcy filing may want to seek to persuade the debtor of the advantages of this section. Not all debtors will focus on this section in the frantic first four months of a bankruptcy case.

While §546(h) provides powerful strategic possibilities, as might be expected, a number of legal difficulties often stand in the way of its use—difficulties for which there is little legal guidance. At the present time, there are no reported cases directly dealing with §546(h), and major treatises devote very little discussion to the subsection.4 However, the early articles and litigation have generally focused on the three issues described below.

First, can a §546(h) return be made in the face of a conflicting blanket security interest? While it seems unlikely that the courts would not uphold the rights of secured parties in inventory, the fact remains that the statute grants the debtor a right to return goods and makes no reference to the rights of secured parties in such goods. If returns are made of goods covered by a blanket security interest, does the supplier then take the returns subject to the security interest, or would the court make some other provision to satisfy the security interest holder through other estate assets?

Second, there are two competing views on the legal status of the returns to the unsecured supplier. Under the first view, §546(h) returns merely represent early distributions of dividends to a member of the pool of unsecured creditors. According to this theory, the participating supplier-creditor should then have to wait until all other unsecured creditors have received an equal percentage return (or have "caught up") before participating in additional estate distributions. Under the second view, which focuses on the text of §546(h), such returns represent "offsets," which, like secured interests, should be deducted first in order to determine the amount of the supplier’s allowed unsecured claim. Accordingly, the participating supplier-vendor would participate equally with all other unsecured creditors according to its pro rata share of unsecured debt in all distributions to unsecured debtors (after deducting all §546(h) set-offs).

Third, what should the judicial standard be for determining if a §546(h) return is in the "best interests" of the estate? One interpretation focuses on the interests of the unsecured creditors and suggests that before permitting a §546(h) return, a court would have to project that the net return to all unsecured creditors would be higher with the return than it would be if the product were sold directly by the estate and the proceeds made available for pro rata distribution. Some have suggested that it would be hard to meet such a standard except in cases where the debtor was nearly solvent. Other interpretations focus on the "best interests of the estate" language in the statute and would allow the judge to consider going concern factors such as whether the return would increase the availability of new financing or would permit more effective inventory manage-ment. Under this approach, an early projection of the effect on net distributions to unsecured creditors might not be required.

Conclusion

Section 546(h) is another arrow in a quiver of those "last in line" seeking to become "first in line." In the appropriate situation, it allows a vendor to retrieve goods it shipped to the debtor pre-petition as a payment on its pre-petition claim. Since chapter 11 payments on pre-petition claims are unpredictable and often are cents on the dollar, this preferential distribution can be quite valuable. In addition, §546(h) provides a needed tool for the debtor in inventory management and can yield a lever for obtaining post-petition trade credit.

Despite §546(h)’s promise, its use is not without some risk, especially to the trade creditor. Secured creditors or lien creditors (as defined in §9-301 of the Uniform Commercial Code) can be expected to assert their rights against the goods in an attempt to block the proposed return. This is most likely to happen when a lender (typically an asset-based lender with a lien on virtually all of the debtor’s assets) believes that the value of its collateral is insufficient to protect the debtor’s obligations to such creditor. Even if this hurdle is cleared, other unsecured creditors can be expected to challenge the trade creditor’s rights to participate fully in subsequent estate distributions or to challenge approval of the return if it would result in an unequal distribution to all class creditors.


Footnotes

1This section appears in current editions of the Bankruptcy Code as 546(g)*. Due to a drafting error in the 1994 Amendments, this new subsection was added as subsection (g) even though §546 already included a subsection (g). However, this section is referred to as 546(h) in §553(b)(1) and it is reasonable to expect that Congress will change the numbering to §546(h) in a subsequent amendment. Return to text.

2In certain industries, such as the music industry, return rights are critical to a debtor’s financial performance. Return to text.

3This analysis assumes that there is no competing secured or administrative priority claims, an issue which is addressed below. Return to text.

4See, e.g., 4 Collier On Bankruptcy, ô 546.LH[7], pg. 546-69 (15th ed. 1998) (containing only a two-line notice of the passage of the bill). Return to text.

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Wednesday, July 1, 1998

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