The Trade Creditors First Remedies

Journal Issue

Jun 2001

Column Name

It happens all the time. A client calls, complaining that his company recently shipped a large volume of products to
a customer, and now he has learned that the buyer is insolvent and might file for bankruptcy protection. Your client
is nervous, and asks for your help.

If the Goods Have Not Yet Been Delivered, Your Client May Be Able to Stop Them in
Mid-transit

Uniform Commercial Code §2-705 (1) states:

The seller may stop delivery of goods in the possession of a carrier or other bailee when he discovers the
buyer to be insolvent...

In order to stop delivery in transit, your client must notify the carrier in sufficient time to prevent the carrier,
exercising reasonable diligence, from delivering the goods to the buyer. See UCC §2-705(3)(a). Although UCC
§2-705(3)(a) does not require the seller's notification to be in writing, it is good practice for the seller to send (by
telegram or facsimile, if possible) written confirmation of any oral request for stoppage in transit. Your client should
also advise the customer that it is stopping the goods in transit.¹

Once the carrier receives notification from the seller to stop the goods in transit, that carrier must hold the goods
and deliver them according to the seller's instructions, but the seller is liable to the carrier for any ensuing charges or
damages. UCC §2-705(3)(b).

The seller may stop goods in transit irrespective of whether the goods are in the hands of a carrier, or a
warehouseman for shipment or for storage: The right of stoppage in transit exists as long as the buyer has not
"received" or taken physical possession of the goods.² That said, if the buyer sends its own company truck to pick
up the goods from the seller, then the buyer has taken possession of the goods, thereby terminating the seller's right
of stoppage in transit. In other words, even though the goods may technically be "in transit," if they are on a truck
owned by the buyer, then the buyer has possession of the goods and the seller has no right to stop in transit.

In In re Bill's Dollar Stores, 164 B.R. 471 (Bankr. D. Del. 1994), the court was forced to determine exactly
when goods were no longer "in transit," and when they were deemed "received." The court found that once the carrier
disengaged the trailer in the buyer's yard and left the buyer's yard with a signed bill of lading, the goods had been
"received" by the buyer and the seller could no longer stop them in transit. (The court rejected the argument that the
goods were received only when they were unloaded from the trailer.)

UCC §2-705(2) sets forth the four circumstances under which the seller loses the right to stop goods in transit as
follows: (a) the buyer receives the goods (this "receipt" may be by a third party on behalf of the buyer);³ (b) a bailee
other than a carrier acknowledges that it is holding the goods for the buyer's account;⁴ (c) a carrier acknowledges to
the buyer that it holds the goods for the buyer, either by reshipping the goods according to the buyer's instructions
or by the carrier's acknowledgment to the buyer that it is holding the buyer's goods as a warehouseman for the
buyer;⁵ or (d) a negotiable document of title, such as a bill of lading or a warehouse receipt, is negotiated to the
buyer.⁶

One frequently asked question is whether the seller loses the right to stop goods in transit if title to those goods
has passed to the buyer. Because the right to stop in transit depends on who has possession of the goods, the seller
does not lose the right of stoppage in transit simply because title to the goods may have passed to the buyer.⁷

Fortunately, case law has evolved to clarify that a seller's stoppage in transit does not violate the automatic stay
embodied in 11 U.S.C. §362(a), nor does it result in an avoidable statutory lien.⁸ Therefore, if a seller learns that the
buyer filed bankruptcy before the buyer received the seller's product, the seller may still exercise the right of
stoppage in transit.

If the Buyer has Already Received the Goods, Your Client May Be Able to Reclaim Them

The Uniform Commercial Code (§2-702) and the Bankruptcy Code (§546(c)) enable a seller to reclaim goods
when the seller learns of the buyer's insolvency. Obviously, UCC §2-702 governs before the buyer files a
bankruptcy petition, and §546(c) governs post-petition. Under UCC §2-702, the seller has the right to reclaim goods
upon learning of the buyer's insolvency; the seller does not have to wait and see if the buyer files a bankruptcy
petition.

UCC §2-702 provides, in pertinent part:

(2) 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, but if misrepresentation of solvency has been
made to the particular seller in writing within three months before delivery, the 10-day limitation does not
apply...

(3) 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 or lien creditor under this article (§2403). Successful reclamation of goods
excludes all other remedies with respect to them.

11 U.S.C. §546(c) states in pertinent part:

Except as provided in subsection (d) of this section, the rights and powers of a trustee under §§544(a), 545,
547 and 549 of this title 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 has
received such goods while insolvent, but

(1) such a seller may not reclaim any such goods unless such seller demands in writing reclamation
of such goods—

(A) before 10 days after receipt of such goods by the debtor, or

(B) if such 10-day period expires after the commencement of the case, before 20 days after
receipt of such goods by the debtor, and

(2) the court may deny reclamation to a seller with such a right of reclamation that has made such a
demand only if the court—

(A) grants the claim of such a seller priority as a claim of a kind specified in §503 (b) of this
title, or

(B) secures such claim by a lien.

Although UCC §2-702 and Bankruptcy Code §546(c) are similar, there are important differences between them.
For example, UCC §2-702 is silent on whether the seller's reclamation demand needs to be in writing, but 11
U.S.C. §546(c) requires a written reclamation demand. Like UCC §2-702, 11 U.S.C. §546(c) requires the
reclamation demand within 10 days after delivery of the goods but, unlike UCC §2-702, if that 10-day period expires
after the buyer is in bankruptcy, then (and only then) the seller has a total of 20 days from the buyer's receipt of the
goods in which to make the reclamation demand. Unlike UCC §2-702, 11 U.S.C. §546(c) gives no special rights to
reclaiming sellers if the buyer gave that seller a written misrepresentation of solvency. Moreover, the test of
insolvency (which is a "balance sheet test") as set forth in the Bankruptcy Code⁹ may be much more difficult and
expensive to prove than the test of insolvency under the Uniform Commercial Code (which is inability to pay debts
as they become due).

Although UCC §2-702 and 11 U.S.C. §546(c) seem straightforward, questions often arise in their practical
application, as follows:

How should a written demand be delivered? Although UCC §2-702 is silent on whether the reclamation demand
needs to be in writing (and although two courts have held that an oral demand was sufficient¹⁰) the safest
reclamation demand is a written one because (1) it avoids future proof problems; (2) insolvent buyers often file for
bankruptcy protection and then argue that 11 U.S.C. §546(c) is the sole reclamation remedy; and (3) §546(c) requires
a written reclamation demand.

The most effective method of delivery is by facsimile or hand delivery, with the seller retaining the fax
confirmation sheet or a proof of delivery. Telegrams or mailgrams might also work, but only if the seller insists on
receiving written confirmation of the time and date that the reclamation demand was delivered to the buyer.

Sending the reclamation demand by regular, certified or even registered mail can be disastrous due to the typical
delays in mail service: Sellers who send reclamation demands using regular mail often find that many of the goods
delivered fall outside the 10-day reclamation period simply because the reclamation demand was delivered so late.

How should the reclamation demand be worded? The wording of the reclamation demand should be broad
enough to include deliveries made by all divisions of the seller's corporation to all divisions of the buyer's
corporation. The demand should also be as specific as possible (i.e., list as many invoices as possible), and should
also include a "catch-all" in case the seller misses an invoice or two. For example, the seller can "demand all goods
delivered within the applicable period under UCC §2-702 and/or 11 U.S.C. §546(c) including, but not limited to..."
After the reclamation demand is delivered, the seller should follow it up with a letter that details all of the specific
invoices.

If the goods are fungible, then the reclamation demand must identify the goods as to which reclamation is
sought.¹¹

To whom should the reclamation demand be sent? It is also important that the reclamation demand properly
identify both the seller and the buyer of the goods in question. This issue often arises in the context of corporate
parents and subsidiaries. Although a reclamation demand issued by a corporation would include all deliveries made
by divisions of that corporation, it probably does not include deliveries made by subsidiary corporations. Similarly, a
reclamation demand served upon a corporation is sufficient to reclaim all goods delivered to divisions of that
corporation, but probably won't include deliveries made to subsidiaries and/or affiliate corporations. If a seller is
uncertain as to the buyer's identity, the seller should serve the reclamation demand upon all possible entities.
What is the procedure after the reclamation demand? What can be reclaimed? Section 2-702(3) of the Uniform
Commercial Code states that the seller's reclamation rights are subject to the rights of a buyer in the ordinary course,
other good faith purchaser or lien creditors. Thus, as a practical matter, under the Uniform Commercial Code a
secured creditor with a perfected lien in after-acquired inventory will defeat the claim of any reclaiming seller. If there
are no lien creditors, buyers in the ordinary course or good-faith purchasers, then generally a reclamation demand is
effective to reclaim only the goods that (a) were received by the buyer from the reclaiming seller within 10 days
before the reclamation demand, and (b) the buyer still has in its possession when the reclamation demand is made.
Courts have held that goods are "received by the buyer" when the buyer obtains physical possession of them.¹² A
reclamation demand does not cover the proceeds of goods already sold.¹³ If the buyer has processed the seller's goods
before the buyer received the reclamation demand, then they are non-identifiable and consequently not subject to
reclamation.¹⁴ Fungible goods can be reclaimed only if they can be traced to an identifiable mass.¹⁵

Thus, once the reclamation demand is delivered to the buyer, the seller should quickly send its representative to
the buyer's place of business (preferably with an objective third party) to inventory the seller's goods that the buyer
still has on hand when the reclamation demand was delivered. Alternatively, the seller can obtain a stipulation from
the buyer itemizing the seller's goods that the buyer still has on hand.

The seller should also speak to the buyer to determine its intentions regarding return of the goods. Usually
buyers refuse to return the goods; in this scenario, the seller should immediately file a state court action (or an
adversary proceeding in bankruptcy court if the buyer is now in bankruptcy) seeking a temporary restraining order and
preliminary injunction prohibiting the buyer from selling or processing the goods, and ultimately seek a court order
directing the buyer to return the reclaimed goods to the seller. It is important for the reclaiming seller to promptly
commence a lawsuit or an adversary proceeding in order to preserve reclamation rights: At least one bankruptcy court
has held that a seller who did not file the reclamation adversary proceeding until eight months after the reclamation
demand lost its reclamation rights.¹⁶ The reclaiming seller has the burden of establishing each element of the
reclamation claim.¹⁷

A majority of cases have held that a secured creditor with a
perfected security interest in after-acquired inventory is a
good-faith purchaser with rights superior to those of the
reclaiming seller...

What if the buyer gave the seller a written misrepresentation of solvency within three months before the goods
were delivered? Although the buyer's written misrepresentation of solvency is irrelevant under 11 U.S.C. §546(c),
UCC §2-702(2) expands the seller's reclamation rights if there has been written misrepresentation of the buyer's
solvency made to the particular seller, within three months before delivery of the goods. In this scenario, the 10-day
limit does not apply, and (subject to UCC §2-702(3)) the seller can reclaim any goods that (a) the buyer received
from the seller on credit and (b) the buyer still has on hand. Although UCC §2-702(2) requires the misrepresentation
of solvency to be in writing, the UCC is conspicuously silent on the type of writing, and there is no requirement
that the document be signed by the buyer. Generally, any form of writing given to that particular seller will suffice.
Courts have held, however, that a check returned for insufficient funds is not a sufficient writing under UCC
§2-702(2).¹⁸

UCC §2-702(2) requires that the buyer's misrepresentation of solvency be made to a particular seller—this
means that a general representation made to a credit association or reporting service will not suffice. Although the
written misrepresentation has to have been made to the seller within three months before the goods were delivered to
the buyer, the three-month period has been held to commence from the date the writing is presented to the seller,
rather than on the date of the writing itself.¹⁹

Although UCC §2-702 (2) relaxes the time limit on the seller's reclamation demand for sellers who received a
written misrepresentation of solvency from the buyer, it remains good practice for the seller to act as quickly as possible because the longer the seller waits, the fewer goods the buyer will have on hand for the seller to reclaim.

Is 11 U.S.C. §546(c) the exclusive remedy once the buyer files a bankruptcy petition? The vast majority of
courts have determined that Bankruptcy Code §546(c) is the exclusive remedy once the buyer is in bankruptcy;²⁰
however, at least one court seems to have held that 11 U.S.C. §546(c) is not the exclusive remedy.²¹ Consequently,
it is still advisable for a seller's written reclamation demand to include a reference to both Uniform Commercial Code
§2-702 and Bankruptcy Code §546(c), just in case the seller is litigating in a jurisdiction that holds that §546(c) is
not the exclusive remedy.
Does service of the reclamation demand violate bankruptcy's automatic stay? Service of a reclamation demand
after the buyer is in bankruptcy has been held not to violate the automatic stay embodied in 11 U.S.C. §362(a).²² If
the buyer sells the goods after receiving a reclamation demand, the majority of cases have awarded liens to reclaiming
sellers (rather than determining their reclamation rights unenforceable).²³
How often does the reclaiming seller actually get goods back from a bankrupt buyer? In bankruptcy cases, few
reclaiming sellers actually get their goods back, in part because so many bankruptcy cases involve secured creditors
with liens on after-acquired inventory. A majority of cases have held that a secured creditor with a perfected security
interest in after-acquired inventory is a good-faith purchaser with rights superior to those of the reclaiming seller, and
that the right of reclamation continues to exist but it is subject or subordinate to the perfected security interest. In
this scenario, many courts have granted the reclaiming seller a second lien or an administrative expense claim.²⁴
Other courts have held, however, that a security interest in after-acquired inventory extinguishes the reclamation
claim.²⁵

Even if there is no perfected security interest in the goods sought to be reclaimed, and even if the reclaiming
seller has fully complied with §546(c) of the Bankruptcy Code and has proven every element of its reclamation claim
in the adversary proceeding, the seller still might not get the goods back: 11 U.S.C. §546(c)(2) empowers the
bankruptcy court to deny the seller's right to physically reclaim the goods, but only if the court grants the seller an
administrative expense claim or secures the seller's claim by a lien on property. This statutory provision recognizes
that any debtor attempting to reorganize in bankruptcy needs all of its inventory, and as much cash as possible.
Consequently, most bankruptcy courts are loathe to allow a reclaiming seller to physically repossess its goods
(which could result in reclaiming sellers literally pulling their goods off the debtor's shelves), because that would
disrupt the debtor's business and would likely injure the debtor's chances of a successful reorganization.

Often, bankruptcy courts grant administrative expense claim status to the reclaiming seller's claim, which means
that the seller's reclamation claim is placed relatively high on the priority ladder and is much more likely to be paid
than unsecured claims. However, this is still an unsatisfactory remedy for the seller because if the buyer's
bankruptcy case is converted from a chapter 11 reorganization to a chapter 7 liquidation, and if there are insufficient
assets to fully pay all administrative priority claimants, then the reclaiming seller would only receive partial
payment even on its administrative expense claim. Consequently, it is preferable for reclaiming sellers to attempt to
negotiate for a junior lien on all property of the estate, or to seek cash payment (perhaps on a deferred basis) during
the administration of the bankruptcy case so that the unpaid portion of the seller's reclamation claim is quickly
reduced.

Conclusion

Though trade creditors often feel anxious and powerless when learning of their customer's insolvency or
bankruptcy, the trade creditor's right to stop goods in transit and reclaim them after delivery can be helpful tools, yet
they must be used quickly and properly for the creditor to reap the maximum benefit and avoid being "last in line."