Floating Inventory Liens Can Wipe Out Reclamation Claims

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Feb 2000

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Unsecured creditors situated near the bottom of the creditor ladder face grim prospects for
recovery on their claims. The Bankruptcy Code's priority rules require that senior secured and
priority claims be paid first from the debtor's assets before the general unsecured creditors
realize any recovery.

This pessimistic scenario is abated somewhat by an unsecured creditor's right of reclamation. If
successful, the creditor will receive the goods back, payment as a reclamation claim, a
replacement lien or an administrative claim. Any of these alternatives usually yield more than
the creditor would otherwise realize on its general unsecured claim. Recent decisions from the
bankruptcy courts in the Southern District of New York and Middle District of Florida threaten
to drastically limit a reclamation recovery when the debtor's inventory is encumbered.

<h3>Grounds for Reclamation Relief</h3>

Section 2-702 of the Uniform Commercial Code and §546(c) of the Bankruptcy Code list what
must be shown for a reclamation claim. Briefly stated, a reclaiming creditor must satisfy the
following four requirements:
<ol>
<li>The creditor must send a written reclamation demand to the debtor within 10 days of the
debtor's receipt of the goods, and where the debtor received the goods within 10 days of the
filing of the bankruptcy petition, within 20 days of receipt.
</li><li>The sale to the debtor must have been in the ordinary course of the creditor's business and on
credit terms.
</li><li>The debtor must have been insolvent when it received the goods.
</li><li>The debtor must have possessed the goods when it received the demand.
</li></ol>

A buyer in the ordinary course of business or other good faith purchaser may defeat a creditor's
reclamation rights. Lenders with perfected security interests in inventory have been held to be
good-faith purchasers. Also, courts have almost universally held that an inventory lender's
interest in inventory is superior to a creditor's reclamation claim.

Some courts hold that a floating inventory lien extinguishes reclamation claims in bankruptcy
cases. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Shattuc Cable Corp., 138 B.R. 557 (Bankr. N.D. Ill. 1992)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Lawrence
Paperboard Corp., 52 B.R. 907 (Bankr. D. Mass. 1985)</a>. These courts reason that under state
law, a creditor is not entitled to recovery on its reclamation claim when the debtor's inventory
is encumbered and the reclaiming creditor should not have greater rights (an administrative
claim or replacement lien) in a bankruptcy case.

Other courts merely hold that reclaiming creditors cannot recover their goods. These courts
grant an administrative claim or replacement lien for the reclamation claim. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Bosler
Supply Group, 74 B.R. 250 (N.D. Ill. 1987)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Sunstate Dairy & Food Products Co., 145
B.R. 341 (Bankr. M.D. Fla. 1992)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Diversified Food Service Distributors Inc., 130 B.R.
427 (Bankr. S.D.N.Y. 1991)</a>. They reason that reclamation claims are subject to, but not cut off
by, a floating inventory lien. When a creditor is otherwise entitled to relief on its reclamation
claim, the court must grant alternative relief in the form of an administrative claim or
replacement lien.

Other courts condition relief on the creditor's showing that there is equity in the lender's
collateral. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Reliable Drug Stores Inc., 70 F.3d 948 (7th Cir. 1995)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Refining
Co. v. Ethyl Corp., 964 F.2d 842 (8th Cir. 1992)</a>. Under state law, a creditor's reclamation
claim would be denied where the debtor's lender is undersecured. The creditor should not realize
any greater recovery in bankruptcy where the creditor would not be entitled to any recovery
under state law.

Courts following this third "equity" view have only recently considered how to calculate equity
in the lender's collateral justifying a reclamation claim. Two bankruptcy courts recently
rejected reclamation claims where the secured lender received all of the proceeds from the sale
of the inventory, leaving no surplus proceeds to justify an administrative claim or replacement
lien. These holdings, if followed by other courts, would effectively extinguish reclamation
claims in most cases with an inventory lender.

In <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Arlco Inc., 239 B.R. 261 (Bankr. S.D.N.Y. 1999)</a>, Galey and Lord sold textiles on credit
to the debtor. On May 16, 1997, Galey made a reclamation demand for goods invoiced at
approximately $760,000. CIT Group/Business Credit Inc. had a security interest in all of the
debtor's assets, including Galey's reclamation goods, to secure its multimillion-dollar secured
claim.

Galey commenced a lawsuit on its reclamation claim, and the trustee alleged, among other
defenses, that CIT's secured claim defeated Galey's reclamation claim. The U.S. Bankruptcy
Court for the Southern District of New York refused to grant Galey any relief on its reclamation
claim because the inventory lien rendered valueless Galey's reclamation claim, which precluded
an administrative claim or replacement lien.

Since CIT had a security interest in all of the existing and after-acquired inventory, it was a
good-faith purchaser with a superior interest in Galey's reclamation goods. While CIT's secured
claim did not automatically extinguish the reclamation claim, the reclamation claim was
rendered valueless under state law when the reclamation goods were sold and the proceeds were
paid to CIT. According to the law, Galey should have no greater rights in the debtor's bankruptcy
case, and therefore the company was denied any relief on its reclamation claim.

The court rejected Galey's argument to apply the equitable principle of marshaling.
Marshaling works this way: When a secured creditor has a claim against more than one property
or fund, and a junior lienholder can proceed against only one of them, the junior creditor can
compel the senior creditor to first liquidate the property or fund in which the junior secured
creditor has no interest. This enables the junior secured creditor to maximize its recovery
from the property or fund securing its claim.

Galey argued that CIT was fully secured and there was surplus collateral to justify granting
Galey an administrative claim or replacement lien. Galey argued that CIT should be required to
marshal its collateral to first liquidate its non-reclamation collateral. Since a surplus was
generated from CIT's other collateral, Galey argued that it was entitled to relief on its
reclamation claim.

The court rejected Galey's marshaling argument because a reclamation claim is not a secured or
lien claim—a requisite for asserting a marshaling claim. Even assuming that the court was
willing to grant lien status to Galey's reclamation claim, the court refused to apply marshaling
in a way that would inconvenience and delay CIT by compelling CIT to look to other collateral
before selling and recovering the proceeds of Galey's reclamation goods.

<h3>The Florida Case</h3>

In <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Affiliated of Florida Inc., 237 B.R. 495 (Bankr. M.D. Fla. 1998)</a>, Quaker Oats Co. sold
food products to the debtor on credit for $34,016.85. Following the debtor's bankruptcy
petition, Quaker Oats sent a written reclamation demand for these goods. Quaker Oats then
commenced a lawsuit directing either a turnover of the goods or granting Quaker Oats an
administrative claim or replacement lien in an amount equal to $34,016.85.

The debtor asserted, among other defenses, that its lenders' prior perfected security interest in
accounts and inventory extinguished Quaker Oats's reclamation claim. The lenders were owed in
excess of $19 million and received partial payment of their claim from the sale of the
reclamation goods.

The U.S. Bankruptcy Court for the Middle District of Florida denied Quaker Oats's reclamation
claim. The court similarly acknowledged that the lenders' floating inventory lien did not cut off
Quaker Oats's reclamation claim. Nevertheless, the court held that Quaker Oats's reclamation
claim had no value since the lenders' secured claims exceeded the value of the reclamation goods.

The court analyzed the treatment of Quaker Oats's reclamation claim under state law in the
absence of the debtor's bankruptcy filing. Quaker Oats's reclamation goods, together with all of
the debtor's other inventory, were sold for $4 million during the bankruptcy case. All of the
proceeds were paid to one of the lenders. There were no surplus proceeds from the sale of
Quaker Oats's reclamation goods to pay Quaker Oats's reclamation claim. Consequently, a state
court relying on Florida law would have denied Quaker Oats any recovery on its reclamation
claim; Quaker Oats should not be entitled to any greater rights in the debtor's bankruptcy case,
and was therefore not entitled to alternative relief in the form of an administrative claim or
replacement lien.

<h3>Conclusion</h3>

In view of these recent decisions, an unsecured reclaiming creditor satisfying all of the
reclamation requirements may be denied relief where the debtor's inventory is subject to a
prior perfected floating inventory, the amount of the secured claim exceeds the value of the
reclamation goods, and the secured creditor received all proceeds from the sale of the
reclamation goods. This scenario occurs in many bankruptcy cases. Unsecured creditors, faced
with a potentially valueless reclamation claim when the debtor has a secured lender with a large
unpaid claim and a floating inventory lien, may wish to seek additional protection in the form of
a letter of credit or a purchase money security interest in the inventory they are selling to the
debtor.

Journal Authors

Bruce S. Nathan

Journal Date

Tuesday, February 1, 2000 - 12:00