United States: Reclamation Right Worthless Where Debtor’s Assets Fully Encumbered

Sellers dealing with a financially troubled company that may be on the brink of filing for bankruptcy ordinarily do so with the assurance that their state law right to reclaim goods sold in the ordinary course of business will either be honored in bankruptcy, or if not, protected by means of a priority administrative claim or a lien. However, the reclamation rights preserved by the Bankruptcy Code are limited. Sellers must be wary to ensure that they take all of the immediate steps prescribed by the statute to effectuate their reclamation rights. A recent decision handed down by the Sixth Circuit bankruptcy appellate panel illustrates that sellers must also ensure that ongoing developments during the case do not impair their reclamation rights. In In re Pittsburgh-Canfield Corp., the court affirmed the denial of administrative expense Corp. priority for a seller’s reclamation claim where the seller failed to preserve the validity of its claim during the case.

Under 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 the appropriate period of time, which varies depending upon whether or not the seller shipped the goods in reliance upon the buyer’s written (mis)representation of solvency. 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 in question. Therefore, if the buyer ignores a reclamation demand and sells the goods to a good faith purchaser, the seller’s rights will be subject to those of the good faith purchaser. Likewise, because the UCC defines good faith purchasers to include secured creditors, a seller’s reclamation rights are subject to a secured creditor’s rights, such as the rights of a creditor holding a floating lien on the debtor’s inventory. Thus, reclamation rights are inferior to the rights of a secured creditor holding a lien on the seller’s assets, but superior to the seller’s general unsecured creditors.

Section 546(c) of the Bankruptcy Code preserves a seller’s reclamation rights under non-bankruptcy law to a limited extent. It provides that the trustee’s strongarm and avoidance powers are "subject to any statutory or common law right of a seller of goods that has sold goods to the debtor, in the ordinary course of such seller’s business, to reclaim such goods if the debtor received such goods while insolvent." To effect reclamation of goods after the buyer files for bankruptcy, the seller must make written demand for reclamation before 10 days after the debtor received them or, if the 10-day period expires after the bankruptcy filing date, before 20 days after the debtor’s receipt of them. A bankruptcy court has the discretion to deny a seller’s legitimate reclamation demand only if it protects the seller by granting it an administrative priority claim or by securing the seller’s claim with a lien. As illustrated by the bankruptcy appellate panel’s ruling in In re Pittsburgh-Canfield Corp., the threshold inquiry that a court Corp. undertakes in determining whether a seller can rely on section 546(c) to reclaim goods, or obtain either administrative or secured status for its claims in lieu of such goods, is whether the seller has an enforceable reclamation right under applicable non-bankruptcy law.

Shortly before Wheeling-Pittsburgh Steel Corporation ("WPSC") and its subsidiaries filed for chapter 1 1, WPSC bought and received goods from several of its vendors, many of whom made proper reclamation demands in the days immediately preceding, as well as on, the bankruptcy filing date. During this time, WPSC’s obligations under a pre-petition credit agreement were secured by 100% of its inventory and all proceeds, but the value of the collateral significantly exceeded the debt outstanding.

On the petition date, WPSC sought approval of a DIP financing facility that provided for payment in full of the prepetition facility and assignment of the security interests under the pre-petition credit agreement to the lenders under the DIP financing facility. The DIP loan was significantly greater than the pre-petition facility, such that WPSC’s equity in its asset base was eradicated for all intents and purposes. The bankruptcy court approved the DIP financing facility in an order that, among other things, validated the DIP liens and security interests. The order also provided that challenges to the validity of the liens and security interests would be barred if not timely made. No party made a timely challenge to the validity of the DIP financing facility.

The bankruptcy court also approved a "reclamation procedures order" that prohibited third parties from interfering with WPSC’s receipt, use or disposition of goods and established procedures for determining the validity and amount of reclamation demands asserted against WPSC. That order reserved WPSC’s right to assert defenses to the reclamation demands, providing that the demands were subject to the superior liens granted to the DIP lenders.

At a hearing convened to establish the amount of reclamation demands made by four vendors, WPSC asserted that the goods in question had been processed, after which their proceeds were paid to the DIP lenders to pay down the DIP revolving loan. Reasoning that the DIP liens took precedence over the vendors’ reclamation rights, the bankruptcy court ruled that the vendors were not entitled to relief under section 546(c) of the Bankruptcy Code. Instead, the court determined that they held general unsecured claims in the amount of their reclamation demands.

The vendors appealed, contending that once a vendor meets the requirements of section 546(c), its right to reclaim the goods sold, or alternatively to an administrative expense claim or a lien, is absolute and not subject to state law defenses. The appellate panel rejected this argument. Noting that while the decisions of a minority of courts supported the vendors’ position, these decisions fail to recognize that there is no right of reclamation under section 546(c) without entitlement to reclamation under state law. Here, the court explained, the goods in question had been manufactured by WPSC, sold and their proceeds applied to pay down the DIP loan, which was secured by a lien on all of WSPC’s inventory and proceeds. Thus, because the vendors’ reclamation rights were subject to the superior rights of the secured lenders under applicable non-bankruptcy law, the vendors had no rights under section 546(c).

Although the appellate panel remarked that its decision in Pittsburgh-Canfield is in line with the majority of courts, the trend on this issue is less than clear. While certain decisions support the rationale of the court, other courts have concluded that the reclamation rights provided in section 546(c) are not subject to the liens of senior secured lenders. According to this minority view, in order to invoke the benefits of section 546(c), a reclaiming seller need only establish that it sold goods to the debtor in the ordinary course of business, the debtor received the goods while it was insolvent, the seller made a timely reclamation demand and the debtor still had the goods at the time of the demand. These courts do not inquire whether the seller’s reclamation claim has any value under state law. Instead, they grant reclamation rights ( i.e., an administrative claim or lien) regardless of whether the e. secured lender with superior rights is under or oversecured. They also give the reclaiming seller a lien on other assets of the bankruptcy estate in which the reclaiming seller originally had no interest.

Pittsburgh-Canfield is somewhat unusual in that, by wrap- ping up a pre-petition loan that was substantially oversecured into a DIP loan that was not, the selling vendors’ reclamation rights became valueless. Had the vendors objected to the DIP financing on the basis that it would have such an impact on their rights, instead of allowing the order approving the financing to become final and unappealable, the outcome of the case might have been different.

In a dissenting opinion, the bankruptcy appellate panel faulted the bankruptcy court for failing to adequately protect the vendors’ reclamation rights at the time that it approved the debtor’s post-petition financing. According to the dissent, the vendors’ reclamation rights clearly had value at the time that they made their reclamation demands because the debtor’s assets were not fully encumbered. Upon a showing of the validity of the reclaiming sellers’ claims, the dissenting judge wrote, "the bankruptcy court should have granted the reclaiming sellers an administrative claim or lien junior to the DIP Facility, while leaving the determination of the value of the claims to a later, meaningful time."

In re Pittsburgh-Canfield Corp., 309 B.R. 277 (B.A.P. 6 Corp. th Cir. 2004).

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