Section 546(h) Overcoming Conflicting Interests in Returned Goods Part II

Journal Issue

Oct 1998

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Cases Discussed

1998-10-15

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In Part I of this article published in the July/August edition of the ABI Journal, we highlighted the potential benefits

that §546(h)<a href="#1" name="1a">1</a> can provide for trade creditors and/or the debtor in appropriate circumstances including, inter alia: (i)

receipt of an indefeasible early in-kind payout on a pre-petition claim; (ii) avoiding a liquidation sale by the debtor of

the creditor's product; and (iii) the possible extension of post-petition trade credit to the debtor-in-possession (DIP).

In Part II, we examine the following legal issues that arise in the context of a §546(h) motion: (i) the effect of a

conflicting security interest on §546(h) returns; (ii) equality of distribution issues; and (iii) satisfaction of the "best

interests" test of §546(h).

<h3>The Legal Issues Addressed by Enactment of §546(h)</h3>

Prior to the enactment in 1994 of Bankruptcy Code §546(h), chapter 11 debtors with unsaleable seasonal or

perishable merchandise were faced with a predicament; while their suppliers were willing to accept return of the

product for full credit against pre-petition debt, returns could be subject to avoiding powers. See In re Pearson Industries Inc. 147 B.R. 914, 917, 929 (Bankr. C.D. Ill. 1992). Since returns would provide certain general

unsecured creditors payment prior to a plan and sometimes payment in-full, this raised allegations of treating similar

claims differently. While debtors tried to solve this problem by appealing to the "necessity of payment" doctrine, not

all courts accepted this controversial theory. Stephen B. Selbst, "Monitoring Retail Reorganization in an Era of

Consolidation," Com. Lending Rev. (Winter 1998) at 28 n.14.

Permitting return of inventory that would otherwise go to waste made so much sense that other courts authorized

such returns prior to the enactment of §546 notwithstanding the legal obstacles referenced above. In 1990, in In re

Federated Department Stores Inc., Consolidated Case No. 1-90-00130, 1990 Bankr. LEXIS 564, (Bankr. S.D. Ohio,

March 27, 1990), the bankruptcy judge permitted the "accommodation return" or "return to vendor" of some $25

million in seasonal inventory. The order, which was entered with the approval of the Official Committee of

Unsecured Creditors, provided for offset of pre-petition claims by $1.09 for each $1.00 of merchandise returned.

While the court documents do not reveal the negotiations behind this apparently unopposed motion, t

he extra 9 percent credit may well have been the price for the approval of the deal by the rest of the unsecured creditor

class.

The enactment of §546(h) created for the first time a solid legal basis for returns with protection from the debtor's

avoiding powers. While §546(h) directly resolves the avoiding power problem, significant issues still remain in

dealing with the holders of conflicting interests.

<h3>The Conflicting Security Interest Problem</h3>

Commentators on §546(h) suggest that a return of goods that are subject to a blanket security interest would be

severely limited by the requirements for using collateral without a lender's consent pursuant to §363. See, e.g.,

Theodore L. Freedman, et al., "Changes in the Landscape for Secured Creditors: New Strategies, New Powers and

New Problems (Part II)," ABI Journal (July/August 1995) at 22. Since, under UCC §9-203, a security interest

attaches to goods as soon as the debtor gains rights to them—usually upon its receipt or possession of the

goods—any goods slated for return would be encumbered. Generally under §36

3(f), a trustee can only sell encumbered property if the secured party consents or if the property can be sold for an

amount greater than all its liens. Since §546(h) permits returns to be credited at their purchase price, this would not

constitute a sale in excess of all liens, and thus could only be done with lender consent. However, §546(h) only

specifically requires consent from the court and the return-creditor.

Yet even if a §546(h) return can be done without secured party consent, the returned goods presumably still

would be subject to the blanket security interest. After all, this is what happens when vendors attempt to reclaim

goods subject to a blanket security interest under §546(c). Section 546(c) is the Bankruptcy Code reflex of UCC

§2-702 (2), which gives a seller who discovers that it has sold to an insolvent buyer the right of rescission and

reclamation within 10 days of delivery. But there is a limit on this right of reclamation—§2-702(3) makes

reclamation "subject to" a subsequent purchaser's (e.g., secured party's) rights. So what happens if the seller seeks to

reclaim goods that are encumbered by a blanket security interest? Some courts permit the reclaiming party only to

claim the excess proceeds on sale by the secured party, if any. See In re Pester Refining Co., 964 F.2d 842, 846 (8th

Cir. 1992). Others permit reclamation but require the return vendor to take subject to the security interest. See In re

Blinn Wholesale Drug Co. Inc., 164 B.R. 440, 446 (Bankr. E.D.N.Y. 1994). So, if similar rules apply under

§546(h), the return vendor could accept return, but then would have to deliver the proceeds from disposal of the goods

to the secured party to the extent of its interest.

This result often would defeat the remedial purpose of §546. If a return vendor is required to take back inventory

subject to a security interest, what incentive would it have to accept such a return? Some have argued that the UCC

§2-702(3) limitations on the right of the reclaimer simply do not apply to §546(h) returns. See Freedman, et al.,

supra, at 22. These limitations were placed on the reclaiming seller because the law recognizes that it was in a

position to have better protected its rights by obtaining a purchase money security interest that would have defeated

all other security interests. See B & P Lumber Co. v. First National Bank of Atlanta, 250 S.E.2d 505, 507 (Ga. Ct.

App. 1978). However, this limitation should not be forced on the return vendor who is not exercising a right but

rather is creating a benefit to the estate by accepting its goods back. See discussion of benefits to the estate in

"Determining the Best Interests of the Estate" section, infra. Section 546(h) might be understood as an extension of

the broad equitable powers afforded to the courts pursuant to §105. Accordingly, the statute arguably looks to the

court to take conflicting interests into account when it permits a return.

To overcome the property rights of secured parties so easily would be inconsistent with the rest of the

Bankruptcy Code and relevant case law. A better approach, which takes into account both the rights of secured parties

and the rehabilitative goals of §546(h), is to read the provisions of §363(e) into §546(h) cases. This would permit a

court to order a return over the objections of a conflicting security interest holder by providing the secured party with

adequate protection and permitting the return vendor to accept return of the goods with no encumbering security

interest. In any case, a return vendor is well-counseled to seek to ascertain whether: (a) a secured creditor has a lien on

the goods to be returned; and (b) the secured creditor has any exposure for an unsecured (deficiency) claim. If the

answer to both of these questions is yes, the return vendor should seek protection in the court order approving the

return.

<h3>The Problem of Preferential Distributions</h3>

The chief objection raised in the House hearings by commercial lending industry groups against passage of

§546(h) was that it would erode the principle of equality of treatment for similarly situated general creditors. See,

e.g., "Bankruptcy Reform: Hearings on H.R. 2326 Before the Subcommittee on Economic and Commercial Law of

the House Judiciary Committee," 103rd Cong. (August 17, 1994) (statement of Philip S. Corwin, Director &

Counsel, Operations and Retail Banking, American Bankers Association). Section 546(h) does appear to give return

vendors an advantage (i.e., they receive a distribution in kind early not subject to avoidance). However, since return

vendors often must accept dated or perishing property at its original sale price as payment, the true value of this early

payment may be suspect. Furthermore, since many return vendors may be required to extend additional credit in

exchange for these returns, they may not be "similarly situated" with all other general creditors.

Litigation over the application of §546(h) has seen the old equality of treatment arguments recycled as a theory

that return setoffs should be counted as early distributions of dividends (the "Early Distribution Theory") rather than

as offsets to be deducted in computing an allowed claim (the "Offset Theory"). While the statute's anti-avoiding

power provisions make returns indefeasible, under the Early Distribution Theory a rough equity among the general

creditor class would be achieved by denying a return vendor any additional dividends until all other class members

have received the same percentage of their allowed claims (i.e., until other class members have "caught up.")

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...a more flexible standard should be applied, requiring only a showing that the return will further

the debtor's reorganization.

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Proponents of the Early Distribution Theory argue that the general policy behind the Bankruptcy Code is

equality of distribution. This is the basis for the position of many courts that §1122(a) requires that all

similarly situated creditors be placed in the same class and given equal distributions. See 7, Collier on Bankruptcy ¶

1122.03, at 1122-4-5 (Lawrence P. King, ed., 15th ed. rev. 1998). Congress has specifically mandated a priority

scheme in §507, and where Congress intends to permit deviation from this scheme, it says so specifically, as in the

case of pre-confirmation retirement benefits pursuant to §1114(e)(2). See In re Roth American Inc., 975 F.2d 949,

954-58 (3rd Cir. 1992).

Whenever Congress does not specifically grant a higher priority status, interim payments to a portion of a class

constitute pre-payments with which all other class members are permitted to catch up. For example, professionals

who receive progress payments under §331 and landlords who receive regular rental payments under §365(d)(3)

generally have been required by most courts to disgorge such amounts to the extent that insufficient funds remain at

the end of a case to pay all administrative expenses. See, e.g., In re IML Freight Inc., 52 B.R. 124, 137 (Bankr.

Utah 1985); In re Dieckhaus Stationers of King of Prussia Inc. 73 B.R. 969, 973 (Bankr. E.D. Pa. 1987). Finally,

proponents of the "catch up" position point out that there is nothing in §546(h) to indicate that Congress intended

return vendors to receive an elevated priority distribution. Congress must have viewed the fact that these creditors

would receive an early return on account of their debt as sufficient incentive for them to participate in a return

program.

These premises of the Early Distribution Theory are questionable. Deviations from the Code's priority structure

are not always explicitly stated. Implied rights and obligations are often recognized by courts. Even deviations from

the Bankruptcy Code's priority scheme have been implied by courts. See In re Leisure Time Sports Inc., 189 B.R.

511, 513 (Bankr. S.D. Cal. 1995) (noting "clear Congressional mandate that commercial lenders be given special

protection" codified in §365(d)(3). It would be virtually impossible for a DIP to have any return program if every

trading partner believed that any payments it received were made on an interim basis only and were subject to

disgorgement. For analogous reasons, operating expense payments made by a DIP under §1108 are final when paid,

even if at the end of the case others go unpaid. In re Telesphere Communications Inc., 148 B.R. 525, 530-31 (Bankr.

N.D. Ill. 1992). Accordingly, while the majority of courts traditionally have held that interim payments made to

professionals or to lessors are defeasible, some recent courts have rejected this notion as not being required by the

Code or at least finding that such disgorgement is within the discretion of the court. See In re New Almacs Inc., 196

B.R. 244, 248-51 (Bankr. N.D.N.Y. 1996) (granting superpriority status for pre-rejection lease payments); In re

Unitcast Inc., 219 B.R. 741, 752-54 (B.A.P. 6th Cir. 1998) (holding that even §726(b) disgorgement is

discretionary).

The best argument for the Offset Theory is that the language of §546(h) plainly states that returns are to be

counted as offsets against the creditor's claims. "Offset" is a term of art referring to a party's right to deduct claims it

has against a party from obligations that it owes in return. According to §§506(a) and 553, pre-petition offset rights

are treated as security interests and are deducted in order to determine the creditor's allowed unsecured claim. Since

returns are to be considered offsets, they should be deducted to compute a net allowed unsecured claim that would

then share fully in all dividends to the unsecured creditor class.<a href="#2" name="2a">2</a>

Why would Congress wish to give return vendor claims a higher priority? First, return vendors are, at least

theoretically, doing the estate a favor. While the interim payment provisions of §331 are designed to accommodate

the special needs of professionals who have the burden of financing bankruptcy litigation, §546(h) is designed to

help the debtor, not the creditor. As explained by Senator Heflin, the goal of the offset procedure was to "relieve the

bankruptcy estate of the burden of keeping unwanted or unsaleable goods..." 138 Cong. Rec. S8266 (daily ed. July

16, 1992). Second, return vendors are taking risks and responsibilities that other creditors do not take—not only

must they accept payment in kind, instead of in cash, but they also must accept this in-kind payment at the original

purchase price instead of its often much lower current value. Third, many vendors would be unwilling to accept

returns if they realized that it would prevent them from recovering a significant amount of their remaining claim.

The two theories can yield drastically different results. By way of illustration, if one assumes a final net cash

plan distribution of 50 cents on the dollar, a vendor owed $200,000 that accepts return of $100,000 of dated goods

would receive only the value of the dated goods from the estate under the Early Distribution Theory but would

receive the goods plus $50,000 cash under the Offset Theory. Of course, every bankruptcy case is different, and

creditors must review the circumstances of each case for the benefit(s) and recovery possibilities available.

<h3>Determining the Best Interests of the Estate</h3>

Some commentators have assumed that the "best interests of the estate" standard of §546(h) means that the

debtor must prove that the dividend available for the unsecured creditors would be greater after the return than before

it—like the standard §1129 "best interests" calculation. How could such a computation be done in the first 120 days

of a bankruptcy—before a plan has even been filed? See Freedman, supra at 22.

Actually, the phrase "best interests of the estate" does not have such a technical meaning. In fact, the phrase is

used in a wide variety of contexts in the Code, governing, in §§327(e), 721 and 1170(a)(1)(A), decisions as

wide-ranging as the hiring of bankruptcy counsel to the operation of a business in chapter 7 to the abandonment of a

railroad line—decisions not involving the net dividend to unsecured creditors.

According to the Senate's explanation of the statute, the best-interest standard of §546(h) was intended to require

only a general determination that a return would help the reorganization of the company: "such an action may only

take place when it is in the best interests of the reorganizing company...[by relieving] the bankruptcy estate of the

burden of keeping unwanted or unsaleable goods." 138 Cong. Red. S8266 (daily ed. July 16, 1992).

A finding of "best interests of the estate" should be established by simply alleging factors that show that a return

program would aid in the debtor's reorganization. The factors cited in the Federated Department Stores motion are

illustrative. Granting the proposed return policy was asserted to be in the best interests of the estate because it

would: (i) get rid of unsaleable seasonal or perishable merchandise, (ii) open up credit lines with vendors, (iii)

provide access to fresh merchandise, (iv) free shelf space for more profitable lines, (v) maintain the up-to-date image

of the company, (vi) prevent stigmatizing the company as a discounter, (vii) obviate the need to rent storage space,

(viii) prevent violation of restrictive debt covenants regarding volume of inventory, and (ix) allow maintenance of

internal buying policies. In re Federated Department Stores Inc., Consolidated Case No. 1-90-00130, 1990 Bankr.

LEXIS 458 (Bankr. S.D. Ohio, March 14, 1990).

<h3>Conclusion</h3>

While §546(h) provides strategic advantages to trade creditors, its use is not without legal obstacles. It seems

unlikely that a court would permit return of goods that are subject to a security interest without protecting the

security interest. However, this should not prevent the court from ordering returns if it offers adequate protection to

the secured party in exchange as provided in §363(e). The classification of the payment in kind represented by the

returned goods was specifically defined in the statute as an offset to the creditor's claim and should be treated as such.

The "best interests of the estate" standard contemplated in the statute should not be a §1129-like creditor-oriented

calculation. Rather, since the goal of §546(h) is to assist in the debtor's rehabilitation, a more flexible standard

should be applied, requiring only a showing that the return will further the debtor's reorganization.

Section 546(h) provides creditors with another mechanism to recover from insolvent estates. Its use should be

reviewed where creditors have goods in the debtor's inventory at the time of the filing.

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<h3>Footnotes</h3>

<a name="1">1</a> This 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. <a href="#1a">Return to article</a>

<a name="2">2</a> The language used in §546(h) closely tracks that used in §553: Section 546(h)'s "...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" is almost an exact copy of §553's "...the creditor to offset a mutual debt...against a claim of such creditor against the debtor that arose before the commencement of the case..." <a href="#2a">Return to article</a>

Journal Authors

Geoffrey L. Berman

Peter M. Gilhuly

Journal Date

Thursday, October 1, 1998 - 12:00