Seller Beware Is Your Reclamation Claim as Strong as You Think It Is

Journal Issue

Mar 2003

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Some things, like wine, improve with age. Vendors' reclamation
rights, however, are not among them. Even though vendor support is crucial to
every reorganization, and even though prompt payment of the vendor's
reclamation claim is important in garnering vendor support, case law has
evolved to expose several pitfalls that can eviscerate reclamation claims.

<h3>The Statute</h3>

The vendor's reclamation
remedy is a creature of state law—embodied in <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=U…
§2-702</a> as follows:

<blockquote>
(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... 
(3) The
seller's right to reclaim under subsection (2) is subject to the rights
of a buyer in the ordinary course or other good-faith purchaser under this
Article. Successful reclamation of goods excludes all other remedies with
respect to them.
</blockquote>

Because insolvent buyers often
wind up in bankruptcy, Bankruptcy Code §546(c) is designed to protect the
vendor's reclamation right against a buyer who becomes a debtor, so long
as the prerequisites of §546(c)(1) regarding the timely written
reclamation demand are fully satisfied. Vendors like to think that their
reclamation rights are sacrosanct in bankruptcy because §546(c)(2) seems to bar a court from denying a reclamation demand unless the vendor
gets a lien or an administrative expense claim, as follows:

<blockquote>
(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—
<blockquote>

(A) grants the claim of such seller priority as a claim of a kind specified
in §503(b) of this title; or 
(B) secures such claim by a lien.<a href="#1" name="1a">1</a>
</blockquote>
</blockquote>

By
its very language, however, §546(c)(2) applies only if the vendor has a right of
reclamation. Obviously, if the vendor has failed to satisfy any of the
statutory prerequisites, the vendor will not have a right of reclamation. For example, if the vendor fails to deliver
a timely or properly written reclamation demand to the debtor, then it has no
right of reclamation.<a href="#2" name="2a">2</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=U…
UCC §2-702(2)</a> makes reclamation available only
to vendors who discover that the buyer received
goods on credit while insolvent, a vendor who knows the buyer is insolvent but continues to sell goods to that buyer on
credit loses the right to reclamation.

<h3>Ordinary Course Purchaser</h3>

But even if the
vendor has satisfied all of the statutory prerequisites for reclamation, its
right of reclamation is not absolute. For example, it is subject to the rights of a buyer in the ordinary course of business or
other good-faith purchaser. The secured creditor with a perfected security
interest in after-acquired inventory qualifies as a "good faith
purchaser"<a href="#3" name="3a">3</a> unless the reclaiming vendor proves some misconduct by the
secured creditor. See, e.g., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Arlco, 239 B.R. 261, 271</a> (Bankr. S.D.N.Y.). However, courts are split on whether the
vendor's right of reclamation is extinguished by, or just subordinated
to, a perfected security interest in the buyer's/ debtor's
inventory. Some courts have held that the mere existence of a secured creditor
with a perfected security interest in after-acquired inventory extinguishes the
reclamation claim altogether. See, e.g., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=5…
re Lawrence Paperboard Corp., 52 B.R. 907, 911
(Bankr. D. Mass. 1985)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Shattuc Cable Corp., 138 B.R. 557, 563
(Bankr. N.D. Ill. 1992)</a>. Fortunately for
vendors, a majority of the decisions on this issue have held that the existence
of a creditor with a perfected security interest in after-acquired inventory
does not extinguish the vendor's reclamation remedy, but merely
subordinates it to the secured creditor's claim. See, e.g., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…
re Pester, 964 F.2d 842, 846 (8th Cir. 1992)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Arlco, 239 B.R. 261, 267 (Bankr. S.D.N.Y.
1999)</a>.

<h3>Split of Authority</h3>

Although
§546(c)(2) is not ambiguous on its face, there is a split among the courts
regarding the scope of the relief to be given to the vendor that asserts a
reclamation claim when a secured creditor has a perfected security interest in
after-acquired inventory. One line of cases holds that once a vendor
establishes a valid right to reclaim,<a href="#4" name="4a">4</a> then, pursuant to §546(c)(2), the
vendor is entitled to a lien or an administrative priority claim for the amount
of the goods sought to be reclaimed (or the traceable proceeds therefrom),
regardless of whether the vendor's reclamation remedy would be worthless
under state law due to a secured creditor's perfected security interest
in after-acquired inventory. See, e.g., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Marko Electronics Inc., 145 B.R. 25, 29
(Bankr. N.D. Ohio 1992)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Sunstate Dairy and Food Products, 145 B.R.
341, 346 (Bankr. N.D. Fla. 1992)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
Food Service, 130 B.R. 427, 430 (Bankr.
S.D.N.Y. 1991)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Roberts, 103 B.R. 396, 399 (Bankr. N.D.N.Y.
1988)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=7…
re Bosler Supply Group, 74 B.R. 250, 254-255
(N.D. Ill. 1987)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3…
re Wathens Elevators Inc., 32 B.R. 912, 923
(Bankr. W.D. Ky. 1983)</a>. This approach
seems consistent with the wording of §546(c)(2), which neither limits the
property of the debtor's estate on which the lien or administrative claim
is granted, nor extinguishes the reclamation claim when there exists a
perfected security interest in inventory.

There is a second line of
cases, however, that observes that §546 is designed only to protect a vendor's reclamation rights, not enhance them. These courts
reject the notion that §546(c)(2) empowers them to grant a lien or
administrative claim on any property of the
debtor's estate. Instead, they conclude that the reclaiming
vendor's lien or administrative claim can be imposed only on the goods that the vendor seeks to reclaim, or the traceable
proceeds of those goods, as follows:

<blockquote>
When there are
goods or traceable proceeds available to reclaim, the alternative remedies in
§546(c)(2) provide needed flexibility. But when the secured creditors have
satisfied their claims out of the goods to be reclaimed, granting §546(c)(2) relief would afford the reclamation seller
something it does not have under the UCC—a priority interest in the
buyer's assets other than the goods to be reclaimed.
</blockquote>

<a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…
re Pester, 964 F.2d 842, 847 (8th Cir. 1992)</a>.

Consequently,
these bankruptcy courts are determined not to
give value (via a lien or an administrative expense claim) to a vendor whose
reclamation claim would be worthless in the non-bankruptcy context due to a
secured creditor with a perfected security interest in after-acquired
inventory. See, e.g., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Arlco, 239 B.R. 261 (Bankr. S.D.N.Y. 1999)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Steinberg's. Inc., 226 B.R. 8, 12
(Bankr. S.D. Ohio 1998)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Video King of Illinois, 100 B.R. 1008
(Bankr. N.D. Ill. 1989)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=6… B.R. 315, 322-323 (Bankr. E.D.N.C. 1986)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Leeds Building Products Inc., 141 B.R. 265
(Bankr. N.D. Ga. 1982)</a>. Under this line
of cases, it is only when (a) the secured creditor releases its lien on the
goods sought to be reclaimed (See, e.g., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…
re Pester, 964 F. 2d 842, 848 (8th Cir., 1992)</a>), or (b) the reclaiming vendor's goods (or traceable proceeds
therefrom) exceed the amount of senior secured claims in the goods sought to be reclaimed, that
the reclamation claim has value so as to entitle the vendor to an
administrative claim or lien. If the security interest in goods is released,
then the vendor is entitled to either reclaim the goods, or receive a lien or
administrative claim valued at the full invoice price of the goods sought to be
reclaimed. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…,
supra at 848</a>. If the secured creditor doesn't release its security
interest, but the value of the goods sought to be reclaimed exceeds the secured
claim thereon, then the vendor whose reclamation demand is denied is entitled
to a lien or an administrative claim in an amount equal to the surplus that
remains after payment of the secured creditor's claim in those
reclamation goods. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Houlihan's Restaurant Inc., 286 B.R.
137, 140 (Bankr. W.D. Mo. 2002)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Arlco Inc., 239 B.R. 261, 272 (Bankr.
S.D.N.Y. 1999)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Steinberg's Inc., 226 B.R. 8, 12
(Bankr. S.D. Ohio 1998)</a>.

One case is particularly
troubling for vendors. In <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Arlco, 239 B.R. 261 (Bankr. S.D.N.Y. 1999)</a>, the lender held a perfected security interest in all of the
debtor's assets, but apparently the liquidation of the debtor resulted in
the inventory being sold first. Consequently, the inventory proceeds were paid
to the lender first, before the balance of the collateral was liquidated. The
debtor's liquidation continued, and the proceeds of the other collateral
were paid to the lender, satisfying the lender's claim. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…; 239 B.R. at 273</a>. Thus, the reclaiming vendor asked the bankruptcy court to invoke
the marshalling doctrine to create a basis for granting the vendor's
reclamation claim. In denying the vendor's request, the court noted that
marshalling would have been more expensive and time-consuming for the lender,
and was inapplicable anyway because marshalling requires two secured creditors. (In Arlco, the
court found that there was only one secured creditor—the
lender—because the right of reclamation does not create a security
interest in the goods at issue. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…; 239 B.R. at 274</a>). The court then held:

<blockquote>
In summary, in the
context of a secured creditor that qualifies as a good-faith purchaser, the
value of the reclaiming seller's reclamation claim will depend on whether
the goods or the proceeds from the goods have been used to satisfy the secured
creditor's claim. Once the goods or the proceeds from the sale of
those goods have been "paid" to the secured creditor, the
reclaiming seller's claim in those goods is valued at zero, regardless of
whether the secured creditor is ultimately paid in full and its lien released
as to the other collateral (emphasis added).
</blockquote>

<a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…; 239 B.R. at 276</a>.

The
holding in Arlco is insensitive to the reality
that inventory is often liquidated first and the proceeds paid to the secured
creditor, and ignores the protection that <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=U…
§2-702</a> and Code §546(c)(2) intended to
give to reclaiming vendors. Basically, Arlco

extinguishes a reclamation claim whenever the
inventory proceeds are paid to a secured creditor—even if the secured
creditor is ultimately oversecured when all of its collateral is liquidated. Fortunately for vendors, at least
one court seems troubled by Arlco. In In re
Suwanee Swifty Stores Inc., 2000 Bankr. LEXIS 2005,
p.1, p. 10 (Bankr. M.D. Ga. 2000), the court (in dicta) expressed its
disagreement with Arlco and its inclination to
allow marshalling so as to give vendors a reclamation remedy, citing <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8…
re Maddox, 84 B.R. 251, 258 (Bankr. N.D. Ga.
1987)</a>.

<h3>Realistic Expectations and Strategies</h3>

By
now, you must be wondering what vendors can do to protect themselves. At a
minimum, vendors need to adjust their expectations. They must understand that
case law has evolved to render the reclamation remedy of today more fragile
than before; consequently, vendors must fight harder than ever before to
protect their reclamation claims. First, vendors must know the customer's financial condition and watch for any sign that indicates a buyer's insolvency. Second, a vendor must exercise its reclamation rights as vigorously as possible, as soon
as it discovers the buyer's insolvency. If
the vendor discovers the buyer's insolvency while the goods are in
transit, it should use <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=U…
§2-705</a> to stop them in transit and require
cash in advance or COD payment for those goods. Obviously, once the vendor
stops goods in transit, it should also stop selling to this buyer on credit.

If
the vendor discovers the buyer's insolvency after the goods have already been delivered, the vendor should
immediately (a) deliver the reclamation demand
by hand, fax or some other expedited method that provides proof of delivery,
(b) start a state court action (or an adversary proceeding, if the buyer is in
bankruptcy) seeking a temporary restraining order and preliminary and permanent
injunction to prevent the insolvent buyer from altering, processing or
disposing of the goods, plus an order that grants the vendor both the right to
inspect the goods (and the buyer's records regarding the goods) and a
turnover of the goods sought to be reclaimed, and (c) contact other vendors to
coordinate their reclamation efforts. Reclamation lawsuits filed by several
vendors (or by a coordinated group of vendors) might give the vendors valuable
leverage. Debtors (and their lenders) often respond to a flock of these actions
with a global reclamation program to maintain vendor goodwill and to avoid the
possibility that the debtor's shelves could become bare. Reclaiming
vendors should try to participate actively in the negotiation of any global
reclamation program and should not be afraid to remind the debtor and its
lenders that prompt payment of reclamation claims is a prerequisite to vendor
support, and that without vendor support there may be no inventory and hence no
business to reorganize.

Anything
is possible in negotiation. If there is no secured creditor, vendors whose
reclamation demand is denied may want to seek a lien because payment of a lien
is not dependent on the solvency of the bankruptcy estate. If the debtor
already has one or more secured creditors, then the reclaiming vendors will
probably have to settle for an administrative claim rather than a junior lien.
In this situation, vendors should try to negotiate for the quickest, fullest
payment of their reclamation claims. If the partial payment is significant
enough, then vendors need to weigh whether quick partial payment of reclamation
claims is more advantageous than delayed fuller payments, because a debtor can
become administratively insolvent and unable to pay even the negotiated
reclamation claims. The caselaw teaches vendors that they should ask the
secured creditor for a "carve out" or release of its security interest
in the goods that are subject to valid, timely reclamation demands, or should
push to have the secured creditor with an all-asset security interest agree
that it will look first to non-inventory assets for collection. Although the
evolution of case law has not been kind to reclamation claims, these strategies
might help vendors get the protection that <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=U…
§2-702</a> and Code §546(c)(2) intended, and
might keep reclamation claims from falling to "last in line."

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> The right to a lien or administrative
priority claim is in lieu of, not in addition to, any right to reclaim. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Leeds Building Products Inc., 141 B.R. 265,
268. (Bankr. N.D. Ga. 1992.)</a>. <a href="#1a">Return to article</a>

<a name="2">2</a> Under <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=U…
§2-702</a>, the seller must make the reclamation demand within 10 days
after the buyer receives the goods. Pursuant to Code §546(c)(1)(B), if the
10-day period has not expired when the buyer files bankruptcy, the seller has
an additional 10 days within which to make the demand. <a href="#2a">Return to article</a>

<a name="3">3</a> See, e.g., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=6…
Angeles Paper Bag Co. v. James Talcott, 604
F.2d 38 (9th Cir. 1979)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=5…
re Samuels & Co. Inc., 526 F.2d 1238 (5th
Cir. 1976), cert. denied, 429 U.S. 834
(1976)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=7…
re Griffin Retreading Co., 795 F.2d 676 (8th
Cir. 1976)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3…
re Haywood Woolen Co., 3 UCC Rep. 1103 (Bankr.
D. Mass. 1967)</a>. Indeed, the only case to hold otherwise is <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re American Food Purveyors Inc., 17 UCC Rep.
Serv. 436 (Bankr. N.D. Ga. 1974)</a>, but that decision is
rather old and has not generally been followed. See, e.g., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3…
re Melvin Liquid Fertilizer Inc., 37 B.R. at
589</a>. <a href="#3a">Return to article</a>

<a name="4">4</a> Bankruptcy Code §546(c) requires the
vendor to establish that (1) it has a statutory or common law right to reclaim
the goods; (2) the goods were sold to the buyer on credit; (3) the goods were
sold in the ordinary course of the seller's business; (4) the debtor was
insolvent when the goods were received; (5) the vendor made a written demand
for reclamation within the statutory time limit after the debtor received the
goods; (6) the buyer was still in possession or control of the goods when the
reclamation demand was made; and (7) the goods are identifiable as those sold
to the debtor. <a href="#4a">Return to article</a>

Journal Authors

Lisa Sommers Gretchko

Journal Date

Saturday, March 1, 2003 - 12:00

Bankruptcy Rule

2003