In re Family Christian: Michigan Bankruptcy Court Holds § 503(b)(9) Claims Are “Freight” that Must Be Paid in 363 Asset Sale

In June 2015, Bankruptcy Judge John T. Gregg ruled in In re Family Christian[1] that all administrative priority claims, including those arising under § 503(b)(9), must be paid as part of the price of a § 363 sale of the debtor’s assets.

Factual Background

The debtors in Family Christian operated one of the largest chains of Christian retail bookstores, with over 280 stores in 36 states and annual sales exceeding $200 million. Their assets were valued at about $28 million against secured debt totaling about $58 million. Administrative priority claims totaled about $14 million, $5.6 million of which were § 503(b)(9) claims.

The assets went to auction, which resulted in three disparate bids: The first bid guaranteed payment of all administrative priority claims in full; the second bid made no payment guarantee as to administrative priority claims; and the third bid guaranteed payment of only certain administrative priority claims (explicitly excluding § 503(b)(9) claims).[2]

Conflicting Case Law Backdrop

When Congress enacted the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), it amended the Bankruptcy Code to include § 503(b)(9), which granted administrative priority status to claims for “the value of any goods received by the debtor within 20 days before the date of commencement of a case under [title 11] in which the goods have been sold to the debtor in the ordinary course of such debtor’s business.”[3]

For retail debtors, these claims can be quite substantial. Family Christian, for example, received over $5 million in inventory from publishers within 20 days of its bankruptcy filing. Notably, however, unlike other administrative priority claims, which all arise post-petition, Section 503(b)(9) claims are based on goods received pre-petition. Accordingly, before BAPCPA’s passage, most of these claims would have been treated as run-of-the-mill unsecured claims that could be satisfied, if at all, by cents on the dollar.[4] After BAPCPA went into effect, however, these pre-petition claims were elevated to administrative priority status and thus were required to be paid in full as a condition to the confirmation of any plan of reorganization.[5]

What happens, however, when the debtor sells its assets instead of filing a plan and, after satisfying the undersecured lender, retains no proceeds to pay § 503(b)(9) claims?

Undersecured lenders have long accepted the “necessity of making some distribution available to other creditors as the price of a court-approved sale” of their collateral.[6] They have balked, however, at paying § 503(b)(9) claims, arguing that such pre-petition claims are not a cost of doing business in chapter 11 (i.e., are not “freight”) because they were not incurred in administering the bankruptcy estate, nor are they for post-petition shipment of goods that added value to the estate. Before Family Christian, these arguments had met with mixed results.

For example, in In re Allen Family Foods, Bankruptcy Judge Kevin J. Carey approved the sale of the debtors’ assets despite there being no assurance of full payment of allowed § 503(b)(9) claims. Although “troubled by the fact that all 503(b)(9) expenses are not covered,” the court articulated its justification for excluding them from “freight”: “[U]nlike other types of administrative expenses, there’s no ongoing contribution to the 11” by the § 503(b)(9) claimants, and they are not being “asked to do anything more than that which they’ve already done.”[7]

Similarly, in In re Real Mex Restaurants Inc., Bankruptcy Judge Brendan L. Shannon approved a § 363 sale despite the fact that the case was administratively insolvent, based on his conclusion that “the circumstances for all creditors would be much worse without this sale.”[8]

On the other hand, in In re Townsends Inc. and In re NEC Holdings Corp., Bankruptcy Judge Christopher S. Sontchi prohibited the lenders from treating § 503(b)(9) claims differently than other administrative priority claims. Judge Sontchi stated that a § 363 sale “can’t be done on the back of the 503(b)(9) admin claims”[9] and that “the freight is certainly an administratively solvent estate.”[10] These comments echo Bankruptcy Judge Paul W. Bonapfel’s observation: “I don't see that Congress says we can pay one administrative expense and not another.”[11]

A couple of years after Townsends and NEC, Judge Sontchi faced the § 503(b)(9) issue again in In re NE Opco Inc. This time, the court approved a settlement concerning a proposed debtor-in-possession (DIP) financing and contemplated asset sale that provided for a segregated escrow account to pay allowed § 503(b)(9) claims, based on evidence of a “reasonable likelihood, or more likelihood than not, that 503(b)(9) claims will be paid in full.”[12]

Holding

Judge Gregg declined to approve the sale to any of the bidders for reasons unrelated to the payment of administrative priority claims, but he explicitly disqualified the third bid for failure to guarantee payment of all administrative priority claims.[13] Taking the Townsends and NEC holdings one step further, Judge Gregg also entered an order specifying that if the auction were reopened, any qualifying bid must provide for payment in full of all administrative priority claims.[14]

In the end, the winning bid was embodied in a confirmed plan of reorganization, providing (as also required by § 1129(a)(9)(A)) for full payment of all administrative priority claims, including all § 503(b)(9) claims.

Case Implications

What lessons can § 503(b)(9) claimants take away to frame their response to a § 363 sale driven by an undersecured lender? Certainly, the Townsends, NEC, NE Opco, Blitz, AFA and Family Christian decisions all suggest that claimants, committees and other parties in interest should begin discussing payment of § 503(b)(9) claims as soon as they see that a § 363 asset sale is in the offing. This can be as early as the first-day motions for DIP financing or the use of cash collateral where an asset sale is a stated strategy.

By no means are the issues settled because, as noted, other decisions have treated § 503(b)(9) claims as administrative priority “lite.” Nevertheless, by putting payment of § 503(b)(9) claims on the table earlier – even if only to suggest an escrow to protect against administrative insolvency – the court and other parties will be sensitized to the issues. This awareness may well prevent debtors and their undersecured lenders from steamrolling over § 503(b)(9) claimants on the eve of a sale by arguing that the sale, though it leaves these claims unpaid, is the best possible outcome for all creditors.