Seventh Circuit: Reclamation Claims Are Subordinate to DIP Financing

If there was any doubt before the 2005 amendments, it is now perfectly clear that the lien of a so-called DIP lender in a chapter 11 case comes ahead of valid reclamation claims, according to the Seventh Circuit.

Because amended Section 546(c) created a federal priority rule for disputes between a reclamation creditor and a lienholder, any question about a lender’s good faith under Section 2-702 of the Uniform Commercial Code is no longer an issue, the appeals court ruled.

Typical Facts for a Chapter 11 Reclamation Claim

The facts were typical, but the numbers were big.

Before bankruptcy, bank lenders had a lien on all of an appliance retailer’s assets, including inventory, proceeds, and after-acquired property. Preceding bankruptcy, a manufacturer had delivered $16 million in goods on unsecured credit. The lenders were owed $66 million on the filing date.

The retailer filed a chapter 11 petition. The same day, the bankruptcy court approved a so-called DIP loan for $80 million, giving the lenders a lien on all assets, proceeds, and after-acquired property. The DIP financing was a “priming lien,” granting the lenders a first-priority lien over existing security interests. As usual, the arrangement was a so-called rollup, where prepetition debt was converted to DIP debt over time as the debtor’s receipts were applied first to pay off the pre-bankruptcy secured credit.

Three days after filing, the manufacturer filed an otherwise valid reclamation notice. Later, the manufacturer filed an adversary proceeding against the DIP lenders to resolve a dispute about the priority of the reclamation claim.

The reorganization effort was a failure. The debtor ran going-out-of-business sales that apparently did not pay the secured lenders in full.

Bankruptcy Judge Jeffrey J. Graham of Indianapolis granted summary judgment in favor of the lenders, ruling that the DIP lien came ahead of the manufacturer’s reclamation rights under Section 546(c). He also found no reason for investigating the lender’s good faith under UCC § 2-702. The district court affirmed, largely adopting Judge Graham’s reasoning. The manufacturer appealed to the circuit, to no avail.

Reclamation Priority Is Now a Federal Question

In her February 11 opinion for the three-judge panel, Circuit Judge Diane S. Sykes explained how a DIP loan is “crucial to a Chapter 11 debtor because it provides desperately needed operating cash.” Because lending in chapter 11 “necessarily carries high risk,” she said that “a bankruptcy judge can authorize a debtor to grant a DIP lender a priming, first-priority lien—a lien that leapfrogs over preexisting liens to top priority,” citing Section 364(d).

Before the 2005 amendments, Section 546(c) did not prescribe the priority, if any, afforded to a reclamation creditor. Judge Sykes explained how courts typically resolved the priority of reclamation claimants by reference to UCC § 2-702(3), which made a reclamation claim “subject to the rights of a buyer in ordinary course or other good faith purchaser.”

Under prior law, Judge Sykes said the “prevailing view” held secured lenders to be good faith purchasers, placing them ahead of reclamation creditors.

Judge Sykes noted that UCC § 2-702, a rescissional remedy, is contained in Article 2, governing sales, not in Article 9, dealing with security interests.

The 2005 amendments “substantially reworked” Section 546(c), but the language remains “clunky,” Judge Sykes said. Subsection (c)(1) now provides that, “subject to the prior rights of a holder of a security interest in such goods or proceeds,” the rights of a trustee or DIP “are subject to the right of a seller of goods . . . to reclaim such goods if the debtor has received such goods while insolvent, within 45 days” before filing.

Judge Sykes laid out the changes wrought by the 2005 amendments. New Section 546(c)(1) omits reference to statutory or common law rights; (2) enlarged the reclamation period to 45 days; (3) imposed a 20-day deadline for filing reclamation demands; (4) made the rights of a reclamation creditor subject to the prior rights of a secured creditor; and (5) added a cross reference to Section 503(b)(9), which gives administrative status for claims arising from “goods” sold within 20 days of filing, even if the seller lacks reclamation rights.

According to Judge Sykes, the new law adopted “a federal priority rule” to resolve disputes between lienholders and reclamation creditors. It is now “crystal clear,” she said, that reclamation rights are subordinate to “the prior rights of a holder of a security interest.” In other words, the reclamation claim is worthless if the secured lenders are undersecured.

Alternatively, the manufacturer wanted the appeals court to remand for the bankruptcy judge to rule on whether the lenders were in good faith, as required by UCC § 2-702(3).

Because Section 546(c) “expressly subordinates a seller’s reclamation claim to the prior rights of a lienholder,” Judge Sykes said there was no “reason to import a state-law good-faith purchaser inquiry.” She therefore said that Bankruptcy Judge Graham “correctly concluded that [the manufacturer’s] allegations of bad faith are irrelevant to the priority determination under § 546(c).”

Judge Sykes upheld the lower courts because the manufacturer’s reclamation rights were subject to the lenders’ prepetition and DIP financing liens.