A guide to sellers’ protections when a customer declares bankruptcy
A reality of business is the risk that a customer that has purchased goods does not pay for such goods. When that customer files bankruptcy, the seller may believe that the risk of non-payment has become a reality. However, there are legal protections that greatly increase a seller’s chances of collecting for such goods in the event of a customer bankruptcy.
One of the protections provided to a seller of goods in the event of a customer bankruptcy is reclamation. Section 546(c) of the Bankruptcy Code permits a seller to reclaim goods sold to an insolvent debtor in the ordinary course of the seller’s business, which were received by the debtor within the 45 days prior to the commencement of the bankruptcy case. This section limits certain avoidance powers granted to a bankruptcy trustee or debtor in possession as against the reclaimed goods.
In order to exercise its reclamation rights, a seller must make a written demand for the goods within 45 days from the date the debtor has received such goods. This time period is adjusted to 20 days from the commencement of the bankruptcy case if the 45-day period to demand goods expires after the commencement of the bankruptcy case. In other words, if a debtor files for bankruptcy less than 45 days after receiving goods, a supplier has 20 days from the bankruptcy filing date to make a written demand for reclamation. The written demand must clearly demand reclamation of the goods, identify the goods subject to reclamation, and be sent to the debtor.
A seller’s right to reclamation may be limited in a number of instances. Goods that are no longer in the debtor’s possession or identifiable at the time of the demand are not subject to reclamation. This means that raw goods that have been converted to finished products at the time of the demand are not subject to recovery through reclamation. Additionally, a seller’s reclamation rights are subject to the rights of other creditors in such goods. Therefore, if the debtor has sold the goods to a third party in the ordinary course of business and in good faith, then the seller cannot recover those goods from the third party purchaser. The reclamation claim to goods will also be subordinate to a secured creditor’s claim in such goods, such as a secured creditor with a floating lien in inventory.
If a debtor does not voluntarily return the goods subject to a reclamation claim, then the seller will be required to take action in the bankruptcy case to enforce its reclamation claim by filing a motion for relief from stay or an adversary proceeding.
Given that a claim for reclamation requires affirmative action (a written demand) within a certain period of time (20 days after the debtor files for bankruptcy), it is important for a seller to be vigilant to a customer’s bankruptcy filing and react quickly in making a written demand so that the reclamation claim is preserved.
Administrative priority claim under Section 503(b)(9) of the Bankruptcy Code
To the extent that a seller fails to make a timely demand for reclamation (or the reclamation demand is ineffective because the goods have been sold by the debtor or are not identifiable), the seller may not be completely out of luck.
The Bankruptcy Code provides for special protection for a claim for payment of goods delivered to a debtor within 20 days of a bankruptcy filing. Section 503(b)(9) of the Bankruptcy Code provides a seller with an administrative priority claim for the value of goods received by the debtor within 20 days prior to the bankruptcy filing date, if the goods were sold to the debtor in the ordinary course of business. Such an administrative priority claim will have higher priority than a general unsecured claim and, generally, must be paid in order for a debtor to confirm a Chapter 11 Plan.
A claim under Section 503(b)(9) has a number of advantages over a reclamation claim. For one, no notice to the debtor is required for a claim under this section. Additionally, a Section 503(b)(9) claim does not require that the goods remain in the debtor’s possession or identifiable. Also, a prior security interest in the goods subject to the claim in favor of secured creditor will not eliminate the seller’s administrative claim provided under Section 503(b)(9).
Accordingly, given the limitations on recovery for a reclamation claim, a claim under Section 503(b)(9) will often offer the best chance for recovery for a pre-bankruptcy shipment.
Whether a seller continues to do business with a customer that files bankruptcy will depend in part on whether there is a contractual obligation to continue to ship to such customer. If there is such a contract, the seller is obligated to continue to ship to the customer until that contract is rejected in the bankruptcy case, which would constitute a breach of the contact by the debtor, or the contract is assumed, which would require the debtor to cure any outstanding amounts, including pre-bankruptcy amounts, that may be due under the contract. If there is no contractual obligation to ship, then the seller would not be required to continue to ship to the debtor after a bankruptcy filing.
To the extent that the seller continues to ship, either voluntarily or pursuant to contractual obligation, then a debtor that continues to operate in a Chapter 11 bankruptcy will typically pay for such post-bankruptcy shipments in the ordinary course of business. If the debtor does not pay for such goods shipped after the bankruptcy filing, then the seller can assert a right to payment for such goods as an administrative expense priority claim and may seek to compel payment of such claim by filing a motion in the bankruptcy case.
Republished with permission. This article first appeared in Inside Counsel on June 2, 2015.