Reclamation Rights vs. DIP Financers

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Mar 2004

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Toward the end of last year, two cases were published on virtually identical facts that addressed the impact of
debtor-in-possession (DIP)financing on reclamation rights. See In re Phar-Mor Inc., 301 B.R. 482 (Bankr. N.D.
Ohio 2003); In re Dairy Mart Convenience Stores Inc., 302 B.R. 128 (Bankr. S.D.N.Y. 2003). However, the
results are inconsistent. The net result is that in certain circumstances, the reclamation rights have value and may
even have priority over the lien rights granted to the DIP lender.

<h3>Substantially Identical Facts</h3>

In both cases, the debtors had pre-petition lenders with liens on all or substantially all the assets of the debtors
including inventory and accounts receivable. Upon filing, certain pre-petition trade creditors made valid reclamation
demands. Further, upon filing, the debtors each filed a motion (DIP motion) for authority to enter into DIP
financing (DIP loan) with a new lender (DIP lender). The DIP motion of each provided that (1) the DIP loan would
be used to repay the pre-petition loan, (2) the liens of the pre-petition lender would be extinguished, and (3) the DIP
loan would be secured by new liens. It is notable that the DIP motions did not request the assignment of the
pre-petition lender's liens to the DIP lender. Finally, each debtor filed motions to establish procedures for
reclamation claims that included a prohibition on returning goods to vendors.

In each case, the debtor was liquidated, the DIP lender was repaid in full and certain sale proceeds remained. In each
case, the debtor filed motions to reclassify the reclamation claims from administrative priority claims to general
unsecured claims. The rationale for the motion in each case is that since the inventory was subject to a pre-petition
lien, the reclamation claim had no value.

<h3>Reclamation Rights Generally</h3>

When Congress enacted the Bankruptcy Code, it included 11 U.S.C. §546(c) to recognize any right of reclamation
that a seller of goods may have under non-bankruptcy law. In re Arlco Inc., 239 B.R. 261, 266 (Bankr. S.D.N.Y.
1999). The Bankruptcy 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. Id.

In every or almost every state, the right of a seller of inventory to reclaim goods is derived from the
Uniform Commercial Code (UCC). For example, in Texas, Tex. Bus & Comm. Code §2.702 (UCC
§2-702) 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>

U.C.C. §2-702(b)-(c). Based on the provisions of UCC §2-702(b), 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., In re Pester Refining Co., 964 F.2d 842, 845 (8th Cir. 1992).

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

Reclamation is the right of a seller to recover goods delivered by the seller to an insolvent buyer. See In re Pester
Refining Co., 964 F.2d at 844. The right to reclaim the goods is based on the theory that the seller has been
defrauded. See Id. While most courts have not gone so far, the court in In re Shattuc Cable Corp., 138 B.R. 557,
563 (Bankr. N.D. Ill. 1992), has stated that the reclamation right is a property right that a seller has in the goods
sold. See, also, In the Matter of PFA Farmers Market Ass'n., 583 F.2d 992, 1001 (8th Cir. P. 1978) ("most
courts" have concluded that the right of reclamation is a specific property right). 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.

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

A seller's reclamation rights can be diminished by UCC §2-702(3), which provides that the seller's reclamation
right is "subject to the rights of a buyer in ordinary course or other good-faith purchaser." UCC §2-702(3). Indeed,
almost all 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 UCC
§2-702, and when all prior lienholders have been satisfied through the proceeds of a foreclosure sale, the reclaiming
seller is entitled to the surplus proceeds. United States v. Westside Bank, 732 F.2d 1258, 1265 (5th Cir. 1984). See
also, In re Arlco Inc., 239 B.R. at 276-277 (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, In re Arlco Inc., 239 B.R. at 276-277 (citing Pester
Refining with approval).

<h3>Impact of DIP Loan on Reclamation Rights</h3>

Dairy Mart: In Dairy Mart, the court acknowledged that the reclaiming creditors' rights in inventory were
not extinguished by the mere existence of the pre-petition lien on inventory. Thus, the court held that in
order to determine whether any goods or traceable proceeds remained, it had to consider the disposition of
the collateral and the use of the proceeds therefrom. The court concluded that since the inventory was used
to secure the post-petition loan that was used to repay the pre-petition lender, the inventory was used to
satisfy the pre-petition lender. As the court noted:

<blockquote>
the only way the debtors could get a post-petition loan was if they afforded the debtor-in-possession lender a lien on
all the pre-petition lender's collateral. In effect, that was the disposition of the collateral—the lien was given to the
new lender in exchange for payment to [pre-petition lender] or in effect "sold" to the new lender. The transaction of
releasing [pre-petition lender's] lien and simultaneously granting the lien to the post-petition lender [DIP lender],
must be viewed as an integrated transaction. [DIP lender] took a lien on everything for the purpose of securing its
loan. There was a direct nexus between the release of the liens on the pre-petition collateral and the payment on the
pre-petition secured loan. To agree to provide the post-petition revolving credit funding, which funding, in part was
used to pay [pre-petition lender's] loan, [DIP lender], as the post-petition lender, required that a lien be placed on
the very same pre-petition inventory and its proceeds that had secured [pre-petition lender's] loan, as well as any
additional post-petition inventory. These steps must be treated as an integrated transaction because, otherwise,
financing of debtors-in-possession would be impeded as post-petition lenders would be disinclined to lend on a
smaller collateral based than that afforded the pre-petition creditor.
</blockquote>

In re Dairy Mart, 302 B.R. at 135. Consequently, the court concluded that the reclamation rights were junior to
the DIP lender and had no value.

Phar-Mor: The court in Phar-Mor began with the same premise relied on by Dairy Mart; i.e., the mere existence of
a lien does not eliminate the reclamation rights of the debtor's vendors. Thus, the pre-petition secured creditor's
decisions with regard to its lien on inventory determines the value of the right to reclaim. Phar-Mor, 301 B.R. at 497.

The Phar Mor court noted that rather than liquidate the collateral for repayment, the pre-petition lenders were paid in full from the proceeds of the DIP loans, and upon repayment, the pre-petition liens were released. Thus, the vendor's rights to reclaim were not affected by the interests of the pre-petition lenders. Id.

Further, the Phar Mor court emphasized that rather than being assigned the pre-petition liens, the DIP lenders were
given new liens on inventory. Thus, the debtor's decision to grant a lien on inventory to a subsequent secured
lender cannot defeat a seller's reclamation rights if the seller's reclamation rights were asserted before the lien was
granted. Id. Moreover, once the DIP lender has knowledge of reclamation rights, it cannot qualify as a good-faith
purchaser under UCC §2-702(c). Id. Thus, the reclamation rights had value and, potentially, a lien position senior
to the DIP loan.

<h3>Conclusion</h3>

The difference in the two decisions relates to the court's interpretation of whether the DIP lender is a good-faith
purchaser. The Phar-Mor court concluded that a DIP lender who has knowledge of reclamation rights is not a
good-faith purchaser pursuant to UCC §2-702. Consequently, the DIP lender's liens will be subordinate to the
reclamation rights of pre-petition vendors. The Dairy Mart court, however, did not reach the issues of the DIP
lender being a good-faith purchaser under the UCC. But the better reasoning is that the DIP lender cannot be a
good-faith purchaser because it and the debtor have knowledge of reclamation rights.

Since neither case addressed priming liens, the courts did not address whether a vendor with reclamation rights is
entitled to adequate protection before a court can grant a post-petition lender a priming lien pursuant to 11 U.S.C.
§364(d). As I have previously argued, since vendors with reclamation rights have an interest in inventory, they
should in fact be given adequate protection in post-petition financing orders. See Hesse, "An Argument for Adequate
Protection of Reclamation Rights?," 22 ABI Journal 28 (March 2003). But adequate protection is an issue for
another day.

Journal Authors

Gregory G. Hesse

Journal Date

Monday, March 1, 2004 - 12:00

Bankruptcy Rule

2004