The definitive source of CLAIMS TRADING How Claim Traders Can Pursue Reclamation and Administrative Expense Claims in Retail and Other Insolvencies By Darius J. Goldman, Matthew W. Olsen and Jessica P. Chue Katten Muchin Rosenman LLP As a result of changing consumer spending habits, numerous retailers including Sports Authority, Pacific Sunware, Aeropostale and, most recently, American Apparel have been forced to close down their storefronts or enter into bankruptcy. Others, such as Macy s, Sears, J.Crew and Toys-R-Us, are also reaching distressed levels. While these retail bankruptcies have negative implications for landlords, tenants and other stakeholders, they may offer great opportunities for claim traders in the secondary distressed trading market. The Bankruptcy Abuse Prevention and Customer Protection Act of 2005 (2005 Amendment) sought to strengthen vendor-creditor rights under the federal bankruptcy law through two key provisions: Federal Reclamation, which allows a vendor to reclaim goods delivered during the 45 days before the bankruptcy filing date (Petition Date); and Reclamation Administrative Expense Priority, which created the right to assert an administrative priority claim for goods received by the debtor during the 20 days prior to the Petition Date. Armed with the proper tools, a claims trader could find value in the recent influx of retail bankruptcies. This article outlines how a vendor-creditor s claim may qualify for reclamation or administrative expense priority under the 2005 Amendment. For additional insight from Goldman and Chue, see What the LSTA s Revised Delayed Compensation Requirements Mean for Loans Trading on Par/Near Par Documents (Oct. 27, 2016). For more on claims trading from Goldman, see How Hedge Fund Claim Traders Can Protect Their Interests in the Visa/MasterCard Litigation (Jun. 14, 2016); and What Hedge Fund Claim Traders Need to Know About the Visa/MasterCard Settlement (Jun. 25, 2015). Reclamation Rights Under Section 546(c) of the Bankruptcy Reform Act of 1978 (Bankruptcy Code),[1] a trade vendor (Vendor) has the right to recover unpaid physical goods sold to an insolvent tradecustomer (Debtor). Reclamation rights have always existed under state law, and the Bankruptcy Code recognizes the validity of such state laws. Upon the occurrence of a bankruptcy filing, however, Section 546(c) of the Bankruptcy Code serves as the exclusive remedy for a Vendor to recover possession of its goods from an insolvent Debtor. This means that a Vendor cannot rely on typical common law provisions such as Section 2-702(2) of the Uniform Commercial Code[2] (UCC), a state court replevin action[3] or other forms of self-help activities and must affirmatively prove all elements of its reclamation claim under the federal Bankruptcy Code. Elements of a Federal Reclamation Rights Claim To successfully assert a right of reclamation under Section 546(c)(2) of the Bankruptcy Code (Reclamation Rights), a Vendor must affirmatively prove the following statutory requirements by a preponderance of the evidence: 1. The Debtor was insolvent at the time it received the goods. The Debtor must be insolvent, as defined under 101(32) of the Bankruptcy Code, which states that the sum of [the Debtor s] debts is greater than all of such [Debtor s] property, at a fair valuation, exclusive of certain exempted property. Insolvency is determined by using a balance sheet test, which could lead to different results depending on which method is used. While it may be difficult (and possibly expensive) to
prove that a Debtor was actually insolvent at the time it received goods, most Debtors in bankruptcy are, in fact, insolvent, and that is not usually a disputed issue. 2. The goods were sold in the ordinary course of the Vendor s business. Courts generally use the UCC s definition of goods, which is defined, in relevant part, as all things (including specially manufactured goods) [that] are movable at the time of identification to the contract for sale other than the money in which the price is to be paid, investment securities and things in action. [4] 3. The Debtor received the goods within 45 days of bankruptcy. Courts generally use the UCC s definition of receipt, which is defined as taking physical possession. [5] Therefore, receipt of goods occurs when the Debtor takes physical possession of them or when the Debtor takes constructive possession through physical possession of the goods by its agent.[6] While this is generally a straightforward determination, it could be more difficult if the Vendor used a thirdparty common carrier, in which case, the Vendor may have difficulty providing evidence of actual delivery, especially if the Vendor s records differ from those of the Debtor. Obtaining a written receipt of that delivery from the Debtor or its agent is critical to proving that this element has been met. 4. The Vendor made a timely written reclamation demand. The Vendor must make a written demand for reclamation within 45 days of the Debtor s receipt of the goods. However, if the Debtor files for bankruptcy within this 45-day period, the Vendor is given an additional 20 days from the Petition Date within which to make the reclamation demand, thereby potentially giving the Vendor 65 days to recover its goods.[7] The demand must be made by the Vendor; a third party, such as an assignee or bailee of the Vendor, cannot make the demand on behalf of the Vendor.[8] The Bankruptcy Code does not specify at what point in time a reclamation demand is deemed to be made. Most courts apply the dispatch rule, under which a reclamation demand is made when it is sent by the Vendor, provided that the method of communication is commercially reasonable.[9] A minority of courts apply the receipt rule, under which a reclamation demand is made when it is received by the Debtor. Of note, the dispatch rule is more favorable to Vendors as it deems the reclamation demand to have been made at an earlier date. Although not as exacting as the four elements summarized above, the Vendor must also satisfy the following implicit requirements: 1. the goods are still in the Debtor s possession on the later of the Petition Date or reclamation demand date;[10] 2. the goods are identifiable on the later of the Petition Date or reclamation demand date and have not been incorporated into another product;[11] and 3. the Debtor has not sold the goods to another buyer in good faith. Indeed, a Vendor s right to recover its goods is subject to the right of other parties, particularly buyers in the ordinary course and good faith purchasers of the Debtor. As amended by the 2005 Amendment, Section 546(c) of the Bankruptcy Code provides that a Vendor s Reclamation Rights are subject to the prior rights of a holder of a security interest in such goods or the proceeds thereof. Therefore, to the extent one or more secured creditors of the Debtor have a blanket lien on all the Debtor s assets, including inventory, the Vendor s Reclamation Rights under Section 546(c) are subject, and subordinate, to the rights of those secured creditors. In fact, many courts take the viewpoint that the value of the specific good the Vendor seeks to reclaim must exceed the value of the Debtor s total secured indebtedness, which could also include post-petition debtor-in-possession financing. Given the prevalence of asset-based lending and other forms of commercial lending in the retail sector, this exception to Section 546(c) may make it difficult for a Vendor to exercise its Reclamation Rights. Finally, many Vendors may have little incentive to reclaim goods (for instance, if the goods are specific to the Debtor, if they are seasonal or if they have significantly lower resale value
once reclaimed) and will often prefer to receive cash as bargained. In some cases, where the goods subject to valid reclamation demands are essential to the Debtor s business, the Debtor may seek authority from the bankruptcy court to pay for the goods in cash, resulting in immediate and full payment to the Vendor without waiting for confirmation of a plan and the ordinary post-confirmation payment of claims.[12] Given the procedural shortcomings attendant to Reclamation Rights, more typically, Vendors may find that utilizing administrative expense priority as set forth in Section 503(b)(9) of the Bankruptcy Code, when applicable, offers a much better remedy when compared against reclamation. 503(b)(9) Administrative Expense Claims Within a Vendor s general Reclamation Rights, lies a subcategory under Section 503(b)(9) of the Bankruptcy Code that grants the Vendor an administrative priority expense (Admin Claim) for the value of goods received by the Debtor within 20 days prior to the Petition Date. This alternative remedy is available to Vendors of goods regardless of whether they meet the requirements of reclamation or fail to assert their Reclamation Rights. The effect of Section 503(b)(9) is to elevate the priority of a Vendor s claim for goods delivered within the 20-day period to an administrative expense priority claim from a non-priority general unsecured claim. Debtors are generally required to provide for the payment of all Admin Claims in full, in cash, on the effective date of their proposed chapter 11 plan of reorganization in order to obtain confirmation of the plan by the court.[13] In contrast, general unsecured creditors have no assurance of a recovery in chapter 11, and their claims typically receive only a fraction of the face amount in distributions. Unlike a Vendor s Reclamation Rights asserted under Section 546(c) of the Bankruptcy Code, Admin Claims are not reduced by a secured creditor s floating lien on the Debtor s existing and after-acquired inventory (provided a chapter 11 plan is confirmed).[14] Therefore, Admin Claims are often considered to be more valuable than Reclamation Rights under Section 546(c) of the Bankruptcy Code, even though the look-back period for Reclamation Rights is 25 days longer than for Admin Claims under Section 503(b)(9). Vendors must satisfy the following requirements to qualify for Section 503(b)(9) treatment: 1. The claim must apply only for goods as defined by Section 2-105(1) of the UCC. Services furnished to the Debtor do not qualify. 2. The goods must be sold to the Debtor in the ordinary course of the Debtor s business (in contrast to reclamation, which requires the goods to be sold in the ordinary course of the Vendor s business). 3. The goods must be received by the Debtor within 20 days prior to the date of commencement of the bankruptcy. In many cases, application of Section 503(b)(9) converts a substantial amount of a Debtor s trade claims from general unsecured claims receiving only partial recoveries to Admin Claims entitled to full payment under a plan. For claim traders, Admin Claims are highly sought after because they are likely to receive a full cash payment for these goods and must be paid in full in cash by the effective date of the plan of reorganization as a condition to confirmation. While an Admin Claim still has priority, however, it may not be entitled to full payment to the extent the Debtor is unable to confirm a plan and is forced to liquidate. Furthermore, because the Bankruptcy Code does not require immediate payment of Admin Claims, in most cases, Vendors holding these claims must wait until the plan effective date (or later) to receive payment. If the Debtor defers payment of Admin Claims and incurs excessive expenses including professional fees (which are also entitled to administrative priority) during the course of the bankruptcy case, there is a greater risk that the Debtor will be administratively insolvent. In that case, the other
administrative expenses of equal priority will be paid on a pro rata basis under 100 percent. An important consideration for claim traders is that the right to an Admin Claim is not automatic. Instead, a Vendor s Admin Claim will only be allowed after notice and hearing, and the Debtor will likely dispute the merits of the Vendor s claim (e.g., the value of the goods, the date of receipt and whether the goods were sold in the ordinary course of business). As with a Vendor s assertion of Reclamation Rights under Section 546(c) of the Bankruptcy Code, it is critical that the Vendor obtain written documentation confirming the delivery dates of its delivered goods. Thus, while Section 503(b)(9) provides Vendors with a useful tool in a retail bankruptcy case, it is not entirely without cost to file, prove and defend the Admin Claim. This raises the need for proper legal diligence and review of a purported Admin Claim prior to acquisition thereof. Conclusion Vendors regularly supply goods on credit to their customers, but as retailers increasingly face chapter 11, Vendors must understand their options under the Bankruptcy Code to mitigate the risk of non-payment. Although the 2005 Amendment provided Vendors with greater protections under the Bankruptcy Code, the rules are not without their intricacies and complications. To protect their rights, Vendors and claim traders must be knowledgeable of applicable bankruptcy protections, their rules and their shortcomings, so they may properly exercise and assess the rights of a Vendor against a retailer in bankruptcy. Claim traders should engage legal counsel familiar with not only the intricacies of the Bankruptcy Code, but also their practical application when diligencing Reclamation and Admin Claims for purchase. Similarly, any transfer documentation should be carefully negotiated to identify and carve out these risks so that the Vendor-claim seller bears the burden of proper categorization. Darius J. Goldman is head of Katten s distressed debt and claims trading practice. Goldman provides transactional guidance to clients who originate, restructure and invest in or trade distressed assets in both domestic and foreign jurisdictions. He represents financial institutions, hedge funds and sophisticated investors engaged in the purchase and sale of bank debt, trade claims, private securities and other investments in companies undergoing financial distress and has settled countless transactions for the transfer of secured, administrative expense, general unsecured and customer claims. Matthew W. Olsen is a partner in Katten s Insolvency and Restructuring practice and represents secured and unsecured lenders, municipal bond issuers and investors, asset purchasers, distressed debt investors and intellectual property licensors and licensees in all aspects of bankruptcy proceedings and workouts, including a broad range of transactional and litigation matters. His experience covers a wide array of industries with an emphasis on manufacturing, real estate, fashion and retail, entertainment and media and municipal finance. Jessica Chue is a senior associate in Katten s distressed debt and claims trading practice. [1] 11 U.S.C. 101 et seq. [2] Section 2-702 of the UCC states that Where the seller discovers that the buyer has received goods on credit while insolvent he may reclaim the goods upon demand made within ten days after the receipt, but if misrepresentation of solvency has been made to the particular seller in writing within three months before delivery the ten day limitation does not apply. Except as provided in this subsection the seller may not base a right to reclaim goods on the buyer s fraudulent or innocent misrepresentation of solvency or of intent to pay. [3] A replevin action is an action seeking return of personal property wrongfully taken or held by the defendant. [4] UCC 2-105(1) [5] UCC 2-103(1)(c) [6] See Montello Oil Corp. v. Marin Motor Oil, Inc. (In re Marin Motor Oil, Co.), 740 F.2d 220, 224-25 (3d Cir. 1984).
[7] However, in cases where the 45-day period following the Debtor s receipt of goods would expire later than 20 days after the Petition Date, the more prudent approach is to assume that the reclamation demand still must be made within 20 days after the Petition Date. [8] See Oakland Gin Co., Inc. v. Marlow (In re Julien Co.), 44 F.3d 426, 432 n.4 (6th Cir. 1995). [9] See In re Marin Motor Oil, Co., 740 F.2d at 228. [10] See, e.g., In re Adventist Living Ctrs., Inc., 52 F.3d 159, 163 (7th Cir. 1995); In re Pester Refining Co., 964 F.2d 842, 845 (8th Cir. 1992); In re Rawson Food Serv., Inc., 846 F.2d 1343, 1347 (11th Cir. 1988) [11] See Galey & Lord Inc. v. Arley Corp. (In re Arlco, Inc.), 239 B.R. 261, 266-67 (Bankr. S.D.N.Y. 1999) (citing Party Packing Corp. v. Rosenberg (In re Landy Beef Co., Inc.), 30 B.R. 19, 21 (Bankr. D. Mass. 1983)). [12] One (non-retail) example of where such reclamations procedures were approved was in the American Airlines chapter 11 cases, in which the court authorized the debtors to elect whether to return goods subject to reclamation or pay for them in cash. See In re AMR Corp., et al. (Bankr. S.D.N.Y, Chapter 11 Case No. 11-15463 (SHL) (Jointly Administered)) (ECF Doc. Nos. 283 and 3388). [13] 11 U.S.C 1129(a)(9)(A). [14] In the event the Debtor is unable to confirm a plan of reorganization and its case is converted to a liquidation under chapter 7, administrative expense claims have a diminished priority and would be subject to the prior rights of secured creditors. Thus, when a Debtor is unable to pay even its administrative expense claims, let alone its general unsecured claims, it is referred to as being administratively insolvent.