Getting Paid: Climbing the Claim Priority Ladder

In bankruptcy cases, general unsecured claims can be found near the back of the line and are often paid pennies on the dollar. Having a perfected first lien on valuable collateral is certainly preferable to a mere general unsecured creditor, but if a creditor does not have such security, is it always regulated to waiting months for its pro rata share of whatever crumbs are left after paying other claimants? Not necessarily. This article discusses how the law provides certain unsecured claimants with several options for clawing their way up the ladder of claim priority and positioning themselves ahead of their fellow unsecured creditors.

Trust Funds
Intuitively, it makes sense that secured creditors come first in the order of priority. However, there are certain circumstances when creditors without any security can position themselves ahead even of secured creditors. Federal and state laws mandate trust fund rights to particular creditors. These statutes are generally designed to protect the interests of a narrow group of claimants. An example of such a trust fund statute is the Perishable Agricultural Commodities Act (PACA),[1] which provides that the funds owed to suppliers of fresh produce are, under certain circumstances, held in trust by the debtor for the benefit of suppliers. A trust-fund claim is one of the best types of claims possible because, in the strictest sense of the word, it is not even a “claim.” Rather, trust fund claimants assert that the debtor is holding its property (i.e., the dollars owed on account of the product supplied) and therefore may demand its return. This is in contrast to a secured claim, for example, which typically is viewed as having an interest in the collateral, but not title to the collateral (depending on state property law). Additional examples of trust fund statutes include the Packers and Stockyards Act[2] for suppliers of certain types of meat, and § 181 of the Texas Agriculture Code, for suppliers of dairy products. In bankruptcy cases with the potential for a large number of trust-fund claims, the debtor will often seek to quantify such claims by requesting a special bar date. Holders of these claims should be aware of any deadlines to assert trust-fund claims to avoid losing valuable rights.
In addition to statutory trusts, a “constructive” trust may exist under certain limited circumstances. A constructive trust is generally a state law concept whereby a trust is deemed created as a remedy to the inequitable conduct of the debtor. Bankruptcy courts will enforce constructive trusts under these circumstances.[3] Cases have also relied on federal common-law in applying a constructive trust where the debtor “acts as a conduit, collecting money from one source and forwarding it to its intended recipient.”[4] Constructive trusts provide creditors with another route for jumping ahead of secured creditors.

Section 503(b)(9) Priority Claims
The next-best option for unsecured claimants is to assert an administrative-expense claim. In 2005, the Bankruptcy Code was amended to introduce a new concept: an automatic pre-petition administrative-expense claim. Under § 503(b)(9), suppliers of “goods” delivered to the debtor within 20 days prior to the petition date are entitled to an administrative-expense claim, and has had a significant impact on chapter 11 cases. In fact, at a 2009 House of Representatives subcommittee hearing entitled “Circuit City Unplugged: Why Did Chapter 11 Fail to Save 34,000 Jobs?,” multiple witnesses testified that § 503(b)(9) contributed to Circuit City’s inability to reorganize. Whether or not § 503(b)(9) actually doomed Circuit City to liquidation, the case that the section has imposed a new and significant administrative expense burden on debtors.
Case law and procedures have developed that somewhat blunts the impact of this statute. For example, as with trust-fund claims, debtors are seeking special bar dates for § 503(b)(9) claims, which allows the debtor to quantify such claims and exclude claimants who sit on their rights. In addition, courts have ruled against requests by § 503(b)(9) claimants to be paid prior to confirmation of a plan. This delay allows debtors to punt the issue to the end of the case. Moreover, certain case law has limited the applicability of the section. [5] Section 503(b)(9) remains a significant issue for reorganizing debtors, as well as a relatively easy method for suppliers of goods to have some—or all—of their claim paid in full.
While the enactment of § 503(b)(9) was generally a boon to creditors, the section has indirectly benefited debtors in at least one way. Since the enactment of § 503(b)(9), it is much less common for a creditor to demand, or a court to grant, payment of a claim as a “critical vendor” claim. The concept of a critical vendor was not based in the Code, but is an equity remedy allowing for the payment of the pre-petition claims of a limited number of creditors in order to ensure that these creditors continue to do business with the debtor, thereby preserving the value of the estate. While this concept was designed to be limited, courts and commentators began to express concerns that it was being applied too broadly, thereby allowing funds to flow out of the estate early in the case in contravention of Code policies. Case law prior to the enactment of § 503(b)(9) had already developed to clamp down on the broad application of the concept. [6] However, since the enactment § 503(b)(9), a court is likely to point out to the creditor that much—or perhaps all—of the creditor's claim will already be paid pursuant to
§ 503(b)(9) and avoid granting critical vendor status.

Reclamation Rights
Section 503(b)(9) is not the only change from the 2005 legislation that has affected trade creditors. Congress changed the law to make reclamation rights much less valuable. The Code had always recognized a creditor’s rights under state law to demand the reclamation of goods supplied to the debtor within a limited time period prior to the reclamation demand being made. Prior to 2005, the Code permitted a creditor to make a reclamation demand for goods supplied up to 10 days prior to the petition date. In the common situation where a debtor was unable to return the goods, the creditor would often receive an administrative-expense claim for the value of the goods. In 2005, the 10-day period was lengthened to 45 days. However, the law also was changed to explicitly state that a reclamation claim is “subject to” a previously existing lien on the goods.[7] Because a senior secured creditor often has a floating inventory and equipment lien, reclamation claims are sometimes not an effective a tool for bumping an unsecured claim up the priority latter.

Priority Claims
A final method for placing an unsecured claim above general unsecured claims is the old fashion one: Assert that the claim is entitled to priority under § 507 of the Code. Aside from specific creditors receiving special protection (e.g., tax authorities, grain producers, fishermen, etc.), most unsecured creditors will not qualify for priority-claim treatment. Nevertheless, unsecured claimants should scour the Bankruptcy Code, and the case law, for any possible method for positioning themselves ahead of their fellow unsecured creditors. Diligence can make the difference in increasing recovery on a claim.