An Argument for Adequate Protection of Reclamation Rights

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Mar 2003

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In the opening day(s) of many chapter 11 cases, the debtors will
request authority from the court to use cash collateral and to enter into
debtor-in-possession (DIP) financing. It is a rare situation when a trade vendor
is given sufficient notice of these "first-day pleadings," but in
the instances when a trade vendor does appear, the parties typically give
little, if any, credence to any issues raised by such a vendor. However, the
courts should give special credence to the reclamation rights of trade
creditors and, if appropriate, provide "adequate protection" to
trade creditors for their reclamation rights prior to approving the
debtors' use of cash collateral or the DIP financing.

<h3>Reclamation Rights</h3>

When
Congress enacted the Bankruptcy Code, it included <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
U.S.C. §546(c)</a> in order to recognize any right
of reclamation that a seller of goods may have under non-bankruptcy law. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Arlco Inc., 239 B.R. 261, 266 (Bankr.
S.D.N.Y. 1999)</a>. The Code does not create
any new right to reclaim goods, but merely affords a seller the opportunity to
take advantage of any reclamation right that may exist under state law. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…;

In almost every state, the
right of a seller of inventory to reclaim goods is derived from the Uniform
Commercial Code (UCC). For example, in <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=U…,
Tex. Bus & Comm. Code §2.702 (UCC §2-702</a>) states, in pertinent part:

<blockquote>
(b) 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... 
(c) 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 under this
Article...
</blockquote>

<a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=U….
§2-702(b)-(c)</a>. Based on the provisions of <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=U…
§2-702(b)</a>, courts generally require a
reclaiming creditor to show that (1) the seller sold the goods in the ordinary
course of its business, (2) the purchaser received the goods while insolvent,
(3) the seller demanded return of the goods in writing within 10 days after the
purchaser received the goods and (4) the purchaser was in possession of the
goods when it received the seller's reclamation demand. See, e.g., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…
re Pester Refining Co., 964 F.2d 842, 845 (8th
Cir. 1992)</a>.

<h3>The Rights of a Reclaiming Creditor Are Lien Rights</h3>

Reclamation
is the right of a seller to recover goods delivered by the seller to an
insolvent buyer. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…
re Pester Refining Co., 964 F.2d at 844</a>. The right to reclaim the goods is based on the theory that the
seller has been defrauded. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…; While most courts have not gone so far, the court in <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>, has stated that
the reclamation right is a property right that a seller has in the goods sold. See,
also, <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=5… the Matter of PFA Farmers Market Ass'n., 583 F.2d
992, 1001 (8th Cir. P. 1978)</a>

("most courts" have concluded that the right of reclamation is a
specific property right). <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=5…; Since the reclamation right is a property right in the inventory to
secure repayment, §101(37) defines such rights as a lien under the
Bankruptcy Code.

<blockquote><blockquote>
<hr>
<big><center>
[T]he
mere existence of a pre-petition lender's lien on the reclaimed goods
does not extinguish the seller's reclamation rights or the seller's
right to recover from the reclaimed goods.
</center></big>
<hr>
</blockquote></blockquote>

<h3>General Limitations on a Seller's Reclamation Rights</h3>

In
response to an argument that the reclaiming seller has a lien right in
inventory, the debtors, lenders and courts raise concerns that a pre-petition
floating lien on inventory destroys the reclamation rights. It is true that a
seller's reclamation rights can be diminished by <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=U…
§2-702(3)</a>, which provides that the
seller's reclamation right is "subject to the rights of a buyer in
ordinary course or other good-faith purchaser." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=U…
§2-702(3)</a>. Indeed, almost all the pre-petition
lenders will be a good-faith purchaser with lien rights in the reclaimed goods
that are superior to the seller's reclamation rights. However, the mere
existence of a pre-petition lender's lien on the reclaimed goods does not
extinguish the seller's reclamation rights or the seller's right to
recover from the reclaimed goods. For example, the Fifth Circuit has held that
when a seller of goods has met the requirements of <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=U…
§2-702</a>, and when all prior lienholders have
been satisfied through the proceeds of a foreclosure sale, the reclaiming
seller is entitled to the surplus proceeds. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=7…
States v. Westside Bank, 732 F.2d 1258, 1265
(5th Cir. 1984)</a>. See, also, <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Arlco Inc., 239 B.R. at 276-277</a> (citing Westside with approval).
Similarly, where a prior lienholder releases its security interests in goods
subject to reclamation, the seller is entitled to the reclaimed goods. Pester
Refining Company v. Ethyl Corp., 964 at 848. See,
also, <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Arlco Inc., 239 B.R. at 276-277</a> (citing Pester Refining with
approval).

The
Pester Refining case is quite instructive in its
evaluation of the rights of a reclaiming seller vis-à-vis a secured
lender with a floating lien on inventory. In Pester Refining, Ethyl Corp. sold approximately $127,000 of goods in the ordinary
course of its business to Pester on credit. Shortly after delivery, Pester
filed for bankruptcy, and Ethyl made a timely reclamation demand. Though the
goods were on hand as of the petition date, the goods were also subject to a
floating inventory lien securing a $42 million loan. Since the secured lender
was undersecured, the parties agreed that pursuant to <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=U…
§2-702(3)</a>, the secured lender, as of the
petition date, had priority in the inventory as a good-faith purchaser over
Ethyl. However, since the secured lender ultimately released its lien on the
goods, Ethyl prosecuted its right to reclaim the goods. The bankruptcy court,
district court and ultimately Eighth Circuit Court of Appeals upheld
Ethyl's right of reclamation.

In the case, Pester argued that
the mere existence of the floating inventory lien extinguished Ethyl's
right to reclaim the goods. The Eighth Circuit disagreed:

<blockquote>
This contention
does obvious violence to the statutory language. In the UCC context, when the
right to reclaim is "subject to" the rights of secured creditors,
that means the right is subordinate or inferior to the security interests, not
that it is automatically and totally extinguished... Therefore, after the
secured creditor's superior interests have been satisfied or released,
the reclaiming seller retains a priority interest in the remaining goods, and in
any surplus proceeds from the secured creditor's foreclosure sale.
</blockquote>

<a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…
Refining, 964 F.2d at 846</a> (citations omitted). Thus, the court concluded that the right to
reclaim goods survives the existence of a floating lien.

The Pester Refining court noted that concluding that a right to reclaim exists is far
easier to determine than the value of such right. Pester argued that since the
secured lender was undersecured as of the petition date, Ethyl's right to
reclaim the goods had no value. The court disagreed, noting that the contention
was inconsistent with §546(c) of the Code:

<blockquote>
Once again, our
§546(c) analysis must begin with state law. Under the UCC, if an
undersecured secured creditor forecloses on the goods to be reclaimed and uses
the entire proceeds to pay down its secured debt, the seller's
reclamation right is extinguished. Even if the buyer has additional assets,
the seller's right to reclaim affords it no priority interest in those
assets; it is relegated to its unsecured claim for the purchase price. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=U…
§2-504(4)</a>. On the other hand, if the secured
creditor releases its security interest in the goods to be reclaimed, the
seller may enforce its right to reclaim, even if the resulting reduction in the
buyer's assets impairs the secured creditor's position. In other
words, in the non-bankruptcy context, the secured creditor's decision
with respect to its security interest in the goods will determine the value of
the seller's right to reclaim.
</blockquote>

<a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…
Refining, 964 F.2d at 847</a>. Consequently, the court concluded that the value of a
seller's rights to reclaim goods depended on the actions of the secured
lender with the superior rights in the goods. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…
Refining, 964 F.2d at 847-848</a>.

Finally,
the Eighth Circuit turned to the disposition of the reclaimed goods. Pester
confirmed a plan of reorganization in which (1) Pester transferred its refining
assets, including the reclaimed goods, to Derby Refining; (2) Derby Refining
transferred to Pester 54 service stations; (3) the secured lender released its
liens on Pester's refining assets, including the reclaimed goods; (4) the
secured lender agreed to accept payment over time from Pester with the plan
payments secured by the assets Derby Refining transferred to Pester; and (5)
the secured lender's pre-petition claims were deemed satisfied by the
plan. The court noted that it was apparent that the secured lender released its
security interest in the goods that Ethyl sought to reclaim in exchange for
payment from other sources. Consequently, the Eighth Circuit held that Ethyl's
right to reclaim the goods moved from a subordinate position to the senior
position on the reclaimed goods and affirmed the lower courts' order that
Pester pay Ethyl in full. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…
Refining, 964 F.2d at 848</a>.

<h3>Reclaiming Sellers Entitled to "Adequate Protection"</h3>

Since
reclaiming sellers have "lien" rights in inventory, §§363
and 364 require the courts to provide "adequate protection" to the
reclaiming creditors before authorizing the use of inventory or authorizing
post-petition financing secured by liens on the inventory. In the event the
court "denies" the reclaiming seller the right to recover the
goods, the "adequate protection" rights of reclaiming sellers is
limited by §546 to administrative claims or liens. However, §546 does
not relieve the court of the obligation to provide "adequate
protection" to reclaiming sellers.

Journal Authors

Gregory G. Hesse

Journal Date

Saturday, March 1, 2003 - 12:00

Bankruptcy Rule

2003