Do Hybrid Claims Qualify for § 503(b)(9) Administrative Expense Treatment?

Although a claim involving only goods sold to the debtor qualifies as an administrative expense under § 503(b)(9)[1] of the Bankruptcy Code, courts are split as to whether, and to what extent, this section covers so-called “hybrid” claims—those involving both goods and services transactions. Ultimately, courts must decide whether goods transactions within hybrid claims can be allocated as individual § 503(b)(9) expenses or whether hybrid claims should be considered indivisible for qualification under § 503(b)(9) and analyzed wholesale. Recently, in In re Circuit City Stores Inc.,[2] the court took the indivisible view, holding that the statutory language of goods “sold to the debtor in the ordinary course of such debtor’s business” required a determination of whether a claim “predominantly” involves goods sold. [3] The court’s purported adoption of the “predominant-purpose test” signals a split over how to apply § 503(b)(9) to hybrid claims. This article discusses the current split in analyzing hybrid claims under § 503(b)(9) and explains how these different analyses could lead to vastly different outcomes for creditors.

Relevant Statutory Provisions and Legal Doctrines
Allowance of Administrative Expenses
Section 503(b)(9) creates a specific type of administrative expense priority under the Code’s repayment hierarchy. Enacted as part of the BAPCPA,[4] § 503(b)(9) provides that “the value of any goods received by the debtor within 20 days . . . in which the goods have been sold to the debtor in the ordinary course of such debtor's business” may qualify as an administrative expense.[5] This section is a blessing for sellers because it protects those that were unable to secure liens on their goods and provides them with an additional remedy in case they failed to exercise their right to reclaim the goods under § 546(c). [6]

Since creditors ultimately benefit from having their claims classified as an administrative expenses, they bear the initial burden of proof to establish a prima facie § 503(b)(9) claim.[7]   While the exact requirements of a prima facie § 503(b)(9) claim are still being delineated, at least one jurisdiction requires the claimant to show that it (1) “sold ‘goods’ to the debtor; (2) the goods were received within 20 days prior to the bankruptcy filing; and (3) the goods were sold ‘in the ordinary course of business.’”[8]

Definition of “Goods” under UCC § 2-105(1)
As a threshold matter, determining where § 503(b)(9) might govern a claim depends on how a court defines “goods.” Neither § 503(b)(9) nor the Code defines “goods,”[9] but courts are in general agreement that the UCC definition under § 2-105(1) applies.[10] However, even this definition requires a degree of interpretation by courts, for example, where claimants argue that certain utilities provided to the debtor qualify as goods.[11] Consequently, if a court is willing to stretch the UCC “goods” definition to cover greater types of commercial transactions, there is a greater likelihood that the court will determine that a claim partially involves goods. Moreover, holding that a claim partially involves goods, creates a de facto hybrid claim.

The Predominant-Purpose Test
After a court defines the goods involved in a hybrid claim, it then must consider how the claim’s service elements affect its standing under § 503(b)(9). Some courts use the predominant-purpose test, which is a legal doctrine traditionally used to determine whether hybrid contracts are “transactions in goods, and therefore covered by the UCC, or transactions in services, and therefore excluded.”[12] When applying this test to hybrid claims, if a hybrid claim is predominantly for goods, the entire claim qualifies as an administrative expense under § 503(b)(9). [13] Conversely, if the claim primarily involves services or something other than goods, then the entire claim is excluded and classified as an unsecured claim. [14] Under § 503(b)(9), a hybrid claim’s predominant purpose will usually be predominantly for goods where the quantity or value of the goods provided are greater than the services rendered. [15]

The Differing Approaches to Evaluate Hybrid Claims
The predominant-purpose test is one of two approaches used to determine whether hybrid claims qualify as administrative expenses under § 503(b)(9). Other courts have used what may be called the “allocation approach” where hybrid claims are bifurcated into their goods and services elements with only the goods elements being entitled to § 503(b)(9) classification. This section examines the different ways courts have justified their treatment of hybrid claims under § 503(b)(9).

Adoption of the Predominant-Purpose Test
The bankruptcy court in Circuit City became the first jurisdiction to adopt the predominant-purpose test outright when determining § 503(b)(9)’s applicability to hybrid claims. [16] The debtor-retailer faced an array of hybrid claims from security system installation fees and construction costs to lease obligations and utility bills. [17] In questioning whether these claims truly arose from goods transactions, [18] the debtor moved for partial summary judgment urging that the court adopt the predominant-purpose test to determine when hybrid claims could qualify under § 503(b)(9). [19] The court held that the predominant-purpose test would be used when analyzing claims under § 503(b)(9) and granted the debtor’s partial summary-judgment motion. [20] Moreover, the court qualified hybrid claims by holding that § 503(b)(9) did not cover “any materials [i.e., goods] provided to the debtor incident to the performance of certain services.” [21]

The court’s determination that the predominant-purpose test applied rested on three arguments. First, the court determined that since the UCC definition of “goods” applied under § 503(b)(9) “it ma[de] sense” to also adopt the UCC-derived predominant-purpose test. [22] Second, the court relied on § 503(b)(9)’s statutory language: “in which the goods have been sold to the debtor in the ordinary course of such debtor’s business.” [23] The court held that the term “sold” required that a claim primarily stem from the sale of goods as opposed to covering any goods given in an otherwise service-related transaction. [24] Lastly, despite reserving a final decision for the retailer’s claims at issue, the court lauded its approach for avoiding the “fact-intensive evidentiary hearings” [25] that would accompany a ruling that every goods transaction encompassed within a hybrid claim qualified under § 503(b)(9). [26]

Rejection of the Predominant-Purpose Test: The Allocation Approaches of Plastech and Pilgrim’s Pride
Contrary to the Circuit City decision, at least two courts explicitly rejected using the predominant-purpose test. Instead, these courts held that goods transactions within hybrid claims may be allocated as individual § 503(b)(9) expenses, whereas the service transactions cannot. First, in In re Plastech Engineered Prod. Inc., [27] the court held that because § 503(b)(9)’s statutory language placed the modifier “any” before “goods,” goods within hybrid transactions may be classified as administrative expenses so long as their value could “be ascertained.” [28] Second, unlike the situation in Circuit City where the court feared protracted evidentiary hearings, this court had creditor invoices clearly delineating the value of goods rendered to the debtors, [29] thereby alleviating the efficiency concerns raised in Circuit City.

The court also sharply criticized using the predominant-purpose test as an alternative approach. The court recognized that there may be “sound policy reasons” [30] for using the test, including its ability to eliminate evidentiary hearings, [31] but held that it was overall an “unnecessary…winner-take-all approach” at least where the value of goods could be determined. [32] The court further lamented that the test is traditionally used when there is a “need to categorize” a transaction as a contract for goods or services to determine whether a particular body of law applies, similar to how the UCC governs the sale of goods. [33]

A second decision, In re Pilgrim’s Pride, [34] is equally critical of the predominant-purpose test and arguably more accommodating to creditors. In that case, the court held that using the predominant-purpose test “would go beyond…construing the Code” [35] and that § 503(b)(9) provided no congressional basis for excluding claims predominantly involving services. [36] The court held that where hybrid claims “even if minimally” involved goods, a § 503(b)(9) claim would arise. [37] The court’s lenient approach to creditors’ claims also extended to its permissible standards for valuing goods provided to the debtor. Unlike Plastech,where creditor invoices established the cost of goods provided to the debtors, [38] the creditors were unable to establish the independent value of the goods from billing information in Pilgrim’s Pride. [39] However, the court went so far as to say that it would allow the market-commodity price as sufficient proof of value. [40]

Reconciling the Predominant-Purpose and Allocation Approaches
The different approaches taken by the courts suggest a sharp divide over policy and highlight the factual sensitivity of individual cases. First, the Circuit City court was clearly concerned about the prospect of protracted litigation (as in Pilgrim’s Pride) spent parsing claims to determine the value of incidental goods. Large debtors like Circuit City would have been inundated with § 503(b)(9) claims if the court took the Plastech or Pilgrim’s Pride approach, which could have ultimately thwarted a successful chapter 11 reorganization. However, in applying the predominant-purpose test, the court made a conscious choice to tailor the scope of § 503(b)(9) to specific goods claims that were not necessarily supported by the statutory language. Moreover, the predominant-purpose test can also potentially lead to a creditor windfall.

Conversely, the allocation approach taken in Plastech and Pilgrim’s Pride more closely follows the statutory text, but imposes its own costs on debtors and the courts. The approach expands creditor protection—in some cases, irrespective of whether the main transaction within the hybrid claim was contemplated as a sale of goods. Thus, the allocation approach may be so accommodating as to include service providers with minute goods expenses where § 503(b)(9) was meant to benefit mainly vendors of goods. [41] Ultimately, an artfully framed claim under § 503(b)(9) lets a creditor cut to the front of the repayment line.

Another influence on the decisions seems to be the evidentiary record supporting the value of the goods transactions. The Circuit City court opposed the allocation approach in part because it feared wading through the morass of discovery to find the value of goods within hybrid claims. Yet the Plastech court already had invoices stating the value of goods provided to the debtor, making it a no-brainer for the court to allocate the goods as § 503(b)(9) expenses. While the Pilgrim’s Pride decision does cut against this theory because the court lacked billing records, the court essentially equated the proven market commodity price of a good to an invoice for valuation purposes.

What Effect Do the Different Approaches Have on Hybrid Claims?
Notwithstanding the current jurisdictional split, attorneys should advise clients that the value of goods within their hybrid claim will dictate how much, if any, of the claim can qualify under § 503(b)(9). Two simple hypothetical scenarios help illustrate this point.

In the first scenario, a creditor has a $100,000 claim with invoices clearly establishing a breakdown of $40,000 worth of goods and $60,000 worth of services. Under the predominant-purpose approach, the entire claim would be rejected as a § 503(b)(9) expense because the claim is not predominantly for goods.

In the second scenario, under the allocation approach, the $40,000 worth of goods would be classified as a § 503(b)(9) expense. Assume that the creditor has the same $100,000 claim with invoices establishing that $60,000 worth of goods were sold to the debtor. Under the predominant-purpose test, the entire claim could qualify as a § 503(b)(9) expense because it now “predominantly” involves goods. Using the allocation approach, only the $60,000 worth of goods would qualify.

Conclusion
Despite the drastically different outcomes under the two approaches, some general observations may be gleaned. First, sellers of goods must be vigilant in maintaining and retaining sales records. If a court has clear evidence establishing the price of goods sold to the debtor within a hybrid claim, a court may be all the more likely to follow the allocation approach. Second, even if the court follows the predominant-purpose approach rather than the allocation approach, those claimants whose business truly involves selling goods should find themselves protected under either approach. Section 503(b)(9) clearly does benefit sellers of goods, however, the problem is how far courts are willing to extend this benefit.