Physical Possession of Goods Is Required for an Administrative Expense Under § 503(b)(9)

The Third Circuit Court of Appeals recently issued an important opinion addressing the question of when goods are “received” for purposes of § 503(b)(9) of the Bankruptcy Code in In re World Imports Ltd.[1] Reversing two lower courts, the appellate court held that in determining whether a seller is entitled to an administrative expense under that section, goods are “received” when the debtor takes physical possession of the goods. Days later, the U.S. Bankruptcy Court for the District of Delaware relied on In re World Imports in holding that a vendor who “drop-shipped” goods to a customer of the debtor during the 20-day period was not entitled to an administrative expense in In re SRC Liquidation, LLC.[2]

Background

Section 503(b)(9) of the Bankruptcy Code grants an administrative expense priority 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]

This section, which was added to the Bankruptcy Code in 2005 as part of the BAPCPA,[4] elevates a group of trade creditors, who previously only held general unsecured claims, ahead of priority unsecured creditors and all other general unsecured creditors.

Section 503(b)(9) was intended to work in conjunction with § 546(c) of the Bankruptcy Code for sellers who have valid reclamation claims.[5] As one court stated, it “provides a supplemental remedy for those sellers who would be preferred reclamation sellers, but for a minor disqualification under section 546(a).”[6]

Litigation often arises regarding whether goods are “received” by a debtor within the 20 days prior to the petition date. While the term “received” is not defined in either the Bankruptcy Code or the Uniform Commercial Code (UCC), the term “receipt” is defined in § 2-103(1)(l) of the UCC as “taking physical possession.”^[7]

A number of courts have adopted this definition in order to determine whether goods were “received” within the scope of § 503(b)(9). For example, some courts have held that goods are “received” for purposes of § 503(b)(9) when the debtor takes possession of them, regardless of whether title to the goods has actually transferred.^[8] Courts have also held that the goods themselves must be received by the debtor, and thus, goods drop-shipped to the debtor’s customers at the request of a debtor do not fall within the scope of the statute.^[9]

In re World Imports Ltd.

In In re World Imports Ltd., two Chinese furniture manufacturers sold goods to the debtor in the ordinary course of business. The vendors shipped the goods from China FOB, or “free on board,” more than 20 days before the petition date, but the debtor took physical possession of the goods in the U.S. within the 20-day priority period. Post-petition, the vendors filed motions for allowance and payment of an administrative expense under § 503(b)(9) of the Bankruptcy Code. The parties disagreed about which action (shipment/transfer of title or physical acceptance) constituted receipt under § 503(b)(9).

The bankruptcy court concluded that the authority controlling the definition of the term “receive” was international commercial law, not nonbankruptcy state law such as the UCC.[10] Instead of looking to the UCC, the bankruptcy court looked to the Convention on Contracts for the International Sale of Goods (CISG) on the theory that a treaty preempts state law. The CISG does not define the term “received,” so the court looked to international commercial terms (“Incoterms”), which are incorporated into the CISG. And although no Incoterm defined “received,” the Incoterm governing FOB contracts makes clear that title and the risk of loss transfers to the buyer when the seller delivers the goods to the common carrier’s vessel.[11] Because the risk of loss transferred when the goods were shipped, the bankruptcy court concluded that the goods were “constructively received” when they left the port in China. Accordingly, the bankruptcy court denied the vendors’ motions, and the district court affirmed.[12]

On appeal, the Third Circuit began its analysis by noting that if the debtor “received” the goods when they were loaded onto the common carrier in China, then the vendors’ claims for administrative priority fail. Alternatively, if the goods were “received” only when the debtor took physical possession of them, then the vendors’ claims were entitled to priority in payment as an administrative expense under § 503(b)(9).

The court recited the principle from Supreme Court case law that Congress does not write on a clean slate and if a word incorporated in a statute “had at the time a well-known meaning … [it is] presumed to have been used in that sense unless the context compels to the contrary.”[13] The court then noted that although the term “received” is not defined in the Bankruptcy Code, although Black’s Law Dictionary and the Oxford English Dictionary both define the word as requiring physical possession. These definitions, the court continued, comport with the definition found in Article 2 of the UCC, which defines “receipt” of goods as “taking physical possession of them.”[14] The court therefore inferred that Congress meant to adopt that “well-known meaning” of the term.[15]

The court then found that there is ample evidence from the statutory context that Congress relied on the UCC definition of the word when it enacted BAPCPA. The court noted that § 503(b)(9) was enacted as part of a section of BAPCPA entitled “Reclamation,” which (1) amended § 546(c) of the Bankruptcy Code (dealing with the traditional reclamation remedy) to clarify the conditions placed on trustees and sellers that seek to reclaim goods sold to a debtor, and (2) created § 503(b)(9) to add an administrative expense “as an exemption from § 546(c)’s reclamation conditions.”[16] The court noted that the interrelationship between §§ 546(c) and 503(b)(9) is also explicit in the Bankruptcy Code, given that § 546(c)(2) expressly references and preserves a vendor’s rights under § 503(b)(9). “Because § 503(b)(9) provides ‘an alternative remedy to reclamation,’ it should be read and interpreted consistent with § 546(c).”[17]

The court then focused on the Third Circuit’s prior precedent dealing with reclamation rights under § 546(c). It noted that it had previously defined “receipt” for purposes of § 546(c) in a case called In re Marin Motor Oil to mean “taking physical possession.”[18] This definition, the court stated, like the reclamation provision itself, arose out of the UCC. Because Congress essentially borrowed the reclamation provision from the UCC, the Marin court had reasoned that “it also borrowed the standard definition of the term receipt.”[19]

The court summarized its analysis by stating:

The context of § 503(b)(9) is clear; it is an exemption to the general bankruptcy reclamation scheme established by § 546(c). See § 546(c)(2). Given the interrelationship between these two provisions and our holding that Congress meant for terms used in § 546(c) to bear the definition used in the UCC at the time of BAPCPA’s enactment, if follows that the UCC definitions also apply to the § 503(b)(9) exception. It follows that since we have already held in Marin that the term “receipt” used in § 546(c) means “taking physical possession,” “received” means the same thing in § 503(b)(9).[20]

The statutory scheme, the court concluded, “warrants a consistent interpretation of the term” in both statutory provisions.[21]

Notwithstanding the foregoing, the debtor argued that the goods in this case were constructively received upon delivery because they were delivered FOB to a common carrier. The court rejected this argument, stating: “While it is true that a buyer may be deemed to have received goods when his agent takes physical possession of them, common carriers are not agents.”[22] Moreover, the court explained, while delivery may occur when title and risk of loss transfers, delivery is distinguishable from actual receipt of goods by the buyer both under the UCC and in the case law.[23] Put another way, a seller may deliver goods to a common carrier — thereby relinquishing title and risk of loss — long before the goods are actually received by the buyer or its agent.[24]

Accordingly, the court held that receipt as used in § 503(b)(9) requires physical possession by the buyer or his agent. Because the debtor didn’t take physical possession of the goods until the 20-day period prior to the petition date, the court reversed the order of the district court denying the vendors’ requests for allowance of an administrative expense.

In re SRC Liquidation

Days later, in In re SRC Liquidation LLC,[25] Hon. Brendan Linehan Shannon of the U.S. Bankruptcy Court for the District of Delaware relied on In re World Imports in holding that a vendor who “drop-shipped” goods to a customer of the debtor during the 20-day period was not entitled to an administrative expense under § 503(b)(9).

In SRC Liquidation, the debtor purchased goods from a vendor. While some goods were delivered to the debtor, others, totaling $44,439.78, were shipped directly to the debtor’s customers. The shipments to the debtor’s customers were made at the debtor’s direction and utilizing the debtor’s account with United Parcel Service. The vendor sought an administrative expense for the goods shipped to the debtor’s customers. The purchaser of substantially all of the debtor’s assets, who was responsible for paying all administrative expenses under the debtor’s confirmed plan, objected to the request alleging, among other things, that the drop-shipped goods were not “received” by the debtor during the 20 days prior to the petition date.

The court began its analysis by noting that although the phrase “received by the debtor” is not defined in the Bankruptcy Code, “case law teaches that courts may look to Article 2 of the U.C.C. when analyzing section 503(b)(9) claims.”[26] Turning to the UCC, the court stated:

The U.C.C. defines receipt of goods as “taking physical possession of them,” “unless the context clearly requires otherwise.” U.C.C. § 2-103(1)(c). An example of a “context [that] clearly requires otherwise” includes stoppage and reclamation rights. See U.C.C. §§ 2-702, -705. Section 2-705 of the U.C.C. specifies four situations in which a buyer “receives” goods such that the stoppage provisions of section 2-705 no longer apply and the reclamation provisions of section 2–702 come into play: one situation involves physical possession of the goods by the buyer and the other three situations include “constructive receipt,” each of which require physical possession of the goods through an agent. See U.C.C. § 2–705(2). Accordingly, the U.C.C. recognizes “receipt” in both its actual and constructive forms. See U.C.C. §§ 2-103(1)(c), -705(2).[27]

Digging deeper, the court noted that § 2-705 of the UCC contemplates actual, physical receipt of goods along with three forms of constructive receipt, specifically: (1) acknowledgement to the buyer by any bailee of the goods; (2) acknowledgment to the buyer by a carrier by reshipment or as warehouseman; and (3) negotiation to the buyer of any negotiable document of title covering the goods.[28]

The purchaser, relying on Marin, argued that receipt under § 503(b)(9) should be restricted to the four situations listed in § 2-705 of the UCC, none of which existed in the present case. Conversely, the vendor sought to distinguish Marin and its reliance on the UCC because Marin was a reclamation case and did not address § 503(b)(9).

The court rejected the argument of the vendor, holding that despite the different remedies provided in §§ 503(b)(9) and 546(c), the word “received” in both provisions “should and does hold the same meaning,” particularly given the aforementioned similarities and links between the statutory provisions.[29]

Moreover, the court held that its hands were tied as the In re World Imports opinion directly governed this matter. As stipulated by the parties, the court explained, the goods at issue “were delivered … to a common carrier (UPS) for shipping via the Debtor’s account to a third party customer” of the debtor.[30] The debtor never physically possessed the goods. “Only UPS possessed the goods,” the court found, “and as a carrier UPS does not qualify as an agent” under World Imports.[31]

Accordingly, the court held that the goods were never received by the debtor within the meaning of § 503(b)(9), thus the vendor’s request for an administrative expense was denied.

Conclusion

In the decade since its enactment, litigation has arisen regarding nearly every word in the text of § 503(b)(9). A great deal of this litigation has focused on the meaning of the term “received.” As evidenced by the court’s opinion in SRC Liquidation, the ruling in World Imports goes a long ways toward resolving such disputes. At least in the Third Circuit, it is now clear that “receipt” for purposes of § 503(b)(9) requires that the debtor take physical possession of the goods at issue.