Better Scarf It Down The Third Circuit Applies PACA to Restaurants

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May 2000

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Until recently, when a restaurant filed for bankruptcy, the case proceeded much as any other bankruptcy
case. However, in the past few years, several courts, most notably the Third Circuit, have altered the
distribution scheme to creditors dramatically. These courts have held that the Perishable Agricultural
Commodities Act of 1930 (PACA) applies to restaurants. As a result, creditors who supply produce to a
restaurant with a certain volume of business are eligible for "priority" claims secured by their produce or
its proceeds, and these claims are superior to most other secured and unsecured claims. PACA is thus a
powerful tool for produce suppliers to have their claims paid in full. Restaurants and their creditors,
especially secured creditors with blanket liens, must familiarize themselves with this new type of claim and
its treatment in a bankruptcy case.

<h3>Scope of PACA</h3>

PACA protects sellers of produce (essentially fresh fruits and vegetables) by imposing a floating,
non-segregated trust on produce sold to buyers for the benefit of the unpaid sellers. A PACA trust consists
of the produce itself, all food inventories derived from the produce and proceeds from the sale of the
produce. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §499e(c)(2)</a>. The imposition of a PACA trust also extends personal liability to individual
shareholders, officers or directors of the seller who are in a position to control PACA-trust assets and who
breach their fiduciary duty by failing to preserve those assets. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Growers Inc. v. Fisher, 104 F.3d
280, 283 (9th Cir. 1997)</a>. PACA also institutes licensing and other regulations of conduct in the produce
industry. The produce-seller's rights to the PACA trust are superior to other creditors' rights, including
secured creditors with blanket liens and after-acquired property clauses, because the corpus of the PACA
trust is not considered property of the bankruptcy estate. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Magic Restaurants Inc., 205 F.3d 108, 112
(3rd. Cir. 2000)</a>. The seller loses the protection of the trust unless it provides notice of its intent to preserve
the trust, usually within 30 days after payment is due. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §799e(c)(3)</a>.

However, PACA does not regulate all sales of produce. It is limited to sales to commission merchants,
brokers, and dealers. Commission merchants and brokers basically buy and sell on behalf of others. A
"dealer" is "any person engaged in the business of buying or selling in wholesale or jobbing quantities,"
which are quantities of at least a ton of produce shipped, received or contracted for shipment or receipt on
any given day. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §499a(b)(6)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… C.F.R. §46.2(x)</a>. A dealer is not otherwise exempted from PACA
just because it resells produce at retail, so long as its annual purchases of produce exceed $230,<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…. 7
U.S.C. §499a(b)(6)</a>.

For roughly 70 years, it has been assumed that even though a restaurant buys produce and sells some of
it in unaltered form, the restaurant is not a "dealer" under PACA. The U.S. Department of Agriculture
(USDA), which is responsible for administering PACA, has never licensed or attempted to regulate
restaurants under PACA, but instead has stated, "restaurants traditionally have not been considered subject
to the PACA by USDA or Congress unless the buying arm of the restaurant is a separate legal entity and
is buying for and/or reselling the product to another entity."<a href="#1" name="1a">1</a> Moreover, the House Committee on
Agriculture has stated that "it is not the intent of the committee that the definition of retailer (a subcategory
of dealer) be construed to include foodservice establishments such as restaurants or schools, hospitals and
other institutional cafeterias." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…. Rep. 104-207, 104th Cong., 1st Sess. (1995), 1995 WL 849090</a> at *22.
Therefore, since 1930, restaurant businesses have been spared regulation under PACA, and when those
restaurants have filed for bankruptcy, secured and unsecured claims have not been subordinated to the
PACA trust claims of fruit and vegetable suppliers.

<h3>Recent Bankruptcy Cases Applying PACA</h3>

In the past several years, however, virtually every bankruptcy court to consider this issue has ignored
the long-standing position of the USDA and the apparent view of Congress, and has held that restaurants
are dealers under PACA and therefore subject to PACA trusts. The first case to consider PACA's
applicability to restaurants was <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Magic Restaurants Inc., 197 B.R. 455 (Bankr. D. Del. 1996)</a>. In Magic
Restaurants, a creditor who supplied the debtor with produce pre-petition sought the immediate payment
of its pre-petition claim or a turnover of the produce. The debtor claimed that a restaurant cannot be a dealer
under PACA, because under <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §499a(b)(6)</a>, a "dealer" includes a "retailer," which is defined in
USDA regulations as "a person engaged in the business of selling to consumers only." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… C.F.R. §46.2(j)</a>.
Therefore, the debtor argued, a restaurant cannot be a person selling to consumers because in this context,
a restaurant is the consumer. The court disagreed and held that under the plain language of PACA, a
restaurant with the requisite volume of business fits within the definition of both "retailer" and "dealer".
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Restaurants, 197 B.R. 455, 457-58</a>. The court refused to consider legislative history because
PACA's definition of "dealer" was unambiguous. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 458</a>.

The next case to consider this issue was <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Italian Oven Inc., 207 B.R. 839 (Bankr. W.D. Pa. 1997)</a>,
in which a pre-petition produce supplier sought relief from the automatic stay to bring an action to impose
a PACA trust on the debtor's assets. The debtor and the creditors' committee argued that PACA was
inapplicable because the debtor was not "engaged in the business of buying and selling produce," but
instead was a consumer that sold menu items to its patrons. The court first noted that PACA has been in
existence since 1930, and until recently no case had been considered PACA's applicability to restaurants.
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Oven, 207 B.R. at 843</a>. The court rejected the holding of Magic Restaurants and held that it was
unclear if PACA applied to restaurants. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 844</a>. The court deferred to the opinions of USDA and the
House Committee on Agriculture that PACA does not apply to restaurants. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;

Three courts in the Ninth Circuit next addressed this issue, and each found that PACA applied to
restaurants. In <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Produce Inc. v. Paragon Steakhouse Restaurants Inc., 70 F. Supp. 2d 1119, 1121-22
(E.D. Cal. 1999)</a>, the court held that PACA's definition of "dealer" unambiguously included a restaurant
that purchases the requisite volume of produce; therefore the court would not consider administrative
opinions or legislative history. The court also found that the opinions of the USDA and the House
Agriculture Committee related to license requirements rather than the imposition of PACA trusts. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; In
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Foods Co. v. L.R. Holdings Inc., 1999 WL 1051978 (N.D. Cal. Nov. 10, 1999)</a>, the district court
found that PACA unambiguously applied to restaurants. The court rejected the argument that PACA does
not apply to a restaurant because its "primary" business is not the buying and selling of produce, because
PACA never uses the qualifier "primary". <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Foods, 1999 WL 1051978</a> at *3. Although the court
refused to defer to the opinions of the USDA or the House Agriculture Committee, it was troubled by the
fact that the USDA has never licensed restaurants in 70 years of administering PACA. The court indicated
that it would be inclined to defer to the USDA's formal, considered opinion on the issue and believed that
the USDA should formally re-evaluate its "benign neglect of restaurant chains." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; The Ninth Circuit
Bankruptcy Appellate Panel (BAP) also applied PACA to restaurants in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Country Harvest Buffet
Restaurants Inc., 245 B.R. 650 (9th Cir. BAP 2000)</a>. The BAP rejected the argument that a restaurant is
engaged in the business of operating restaurants rather than buying or selling produce, because PACA does
not require a "dealer" to engage "primarily" in the buying and selling of produce. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Buffet, 245 B.R.
650, 654</a>. The BAP also rejected the debtor's argument that a "dealer" under PACA must buy and sell
produce, as opposed to buying or selling produce, because this interpretation would exclude from PACA
all large-scale purchasers of produce at the end of the distribution chain. Id.<a href="#2" name="2a">2</a>

Most recently, this controversy has come full circle in the Third Circuit's disposition of the Magic
Restaurants appeal. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Magic Restaurants Inc., 205 F.3d 108, 112 (3rd Cir. 2000)</a>. Although the
bankruptcy court held that PACA applied to restaurants, the district court reversed, apparently following
Italian Oven. The Third Circuit reversed the district court because it found that PACA unambiguously
applied to restaurants, and this result was not contrary to PACA's purpose, absurd or demonstrably at odds
with the drafters' intentions. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 116</a>. Therefore, the court would not look beyond the statute to the
USDA's regulations or the House Agriculture Committee's 1995 report, which, even if relevant, was not
evidence of what Congress intended when it enacted PACA in 1930. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; The court recognized that although
it felt constrained by the PACA's plain language, its interpretation probably meant that thousands of
restaurants across the country had been in violation of PACA for 70 years. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; Circuit Judge Rendell filed
a dissenting opinion and stated that she would defer to the House Agriculture Committee's opinion because
PACA was susceptible to different meanings. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 118</a>. According to Judge Rendell, "the majority reading
would make most prisons 'dealers,' yet prisons are not engaged in the perishable commodity-buying
business." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;

<h3>Conclusion</h3>

The Third Circuit and other cases applying PACA to restaurants appear to be correct in their
plain-language interpretation of PACA, even though this interpretation is contrary to those of the USDA
and the House Agriculture Committee. PACA's definition of "dealer" does in fact include those restaurants
doing a requisite volume of business, despite the deleterious effect that definition will have on the restaurant
industry. Whether right or wrong, these court decisions have enormous implications in any bankruptcy case
involving a restaurant business. If PACA applies to restaurants, then those restaurants with enough business
are subject to PACA's license requirements and other conduct regulations. Moreover, if the restaurant does
not timely pay its produce suppliers, those suppliers will become PACA trust beneficiaries with rights
superior to all of the restaurant's other creditors, secured and unsecured alike. This will dramatically alter
the distribution scheme if the restaurant files for bankruptcy. In or out of bankruptcy, the restaurant's
officers, directors or shareholders may be impressed with the duty to maintain a PACA trust for the benefit
of the produce supplier, and may be personally liable for any deficiency. Finally, if PACA applies to
restaurants, then it seems that PACA should also apply to other institutional foodservice providers like
hospitals, schools, prisons and sports and entertainment arenas. Congress and the USDA should act quickly
to clarify definitively whether PACA and its trust scheme applies to restaurants and other foodservice
providers so that creditors can govern themselves accordingly.<a href="#3" name="3a">3</a>

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Rule, "Regulations (Other Than Rules of Practice) Under the Perishable Agricultural Commodities Act, 1930 (PACA)," 61
Fed. Reg. 13385, 1386 (March 27, 1996)</a>. <a href="#1a">Return to article</a>

<a name="2">2</a> Since Italian Oven, only one other court has found PACA inapplicable to restaurants. In <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Old Fashioned Enterprises Inc.,
2000 WL 250755 (D. Neb. Feb. 4, 2000)</a>, the court found that PACA was ambiguous because PACA's definition of "dealer"
("...buying or selling in wholesale or jobbing quantities...") did not define "wholesale or jobbing quantities." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C.
§499a(b)(6)</a>. Instead, "wholesale or jobbing quantities" was defined only in the USDA's regulations. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… C.F.R. §46.2(x)</a>. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Fashioned, 2000 WL 250755</a> at *4. The court reasoned that if it had to look to the USDA's interpretation of PACA to
complete the definition of "dealer," then it should also defer to the USDA's opinion that restaurants are not subject to PACA. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; <a href="#2a">Return to article</a>

<a name="3">3</a> The author's opinions are not necessarily those of Kirkland & Ellis or its clients and do not constitute the rendition of legal advice. <a href="#3a">Return to article</a>

Journal Authors

David Richard Seligman

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Monday, May 1, 2000 - 12:00