The following article appeared in the Fall 2009 issue Blakeley & Blakeley's Trade Creditor's Quarterly.

Ronald R. Clifford, Esq.

A topic of growing importance to trade vendors is that of reclamation in the bankruptcy setting. With the record number of bankruptcy filings in the last year, and the predictions by most of the pundits on news outlets that the trend will continue at least in the short term, trade vendors have to look towards the Bankruptcy Code to determine their collection rights against their customers more often than in the past.

A trade vendor's ability to reclaim its goods under state laws provide it with the opportunity to physically take back its goods should the customer have the inability to pay for those goods if certain criteria are met. This has proven to be a useful tool for trade vendors wishing to minimize losses. However, in recent times, those same customers are increasingly filing for bankruptcy protection, and trade vendors must at that point look towards, among other things, their reclamation rights in the realm of bankruptcy.

Most trade vendors have become familiar with Bankruptcy Code section 503 (b)(9). This Bankruptcy Code section first appeared in 2005 with the implementation of the Bankruptcy Reform Act. Essentially, any goods sold and received by a debtor in the ordinary course of the debtor's business within the twenty days preceding the date of the filing of the petition entitle the trade vendor that sold and delivered those goods to an administrative expense priority claim, which claims receive priority in payment over other general unsecured non-priority claims. This is a powerful tool given to trade vendors under the Bankruptcy Code. However, a question arises as to goods that are delivered to customers that file for bankruptcy prior to that twenty day period.

Do those goods simply make up a general unsecured claim for trade vendors? This is where the lesser known and utilized Bankruptcy Code section 546 is triggered.

Bankruptcy Code section 546 is a holdover from the days prior to the Bankruptcy Reform Act. It is essentially the Bankruptcy Code's reclamation statute. Under section 546, a trade vendor may reclaim goods delivered to a customer who has filed bankruptcy for all goods sold to that customer within the 45 days prior to the filing of the bankruptcy petition, if those goods were sold in the ordinary course of the customer's business, and written demand for their return is made within 45 days of receipt of the goods by the customer, or not later than twenty days after the filing of the bankruptcy petition. If the trade vendor is denied their right to reclaim the goods, the creditor is entitled to an administrative expense priority claim for the value of those goods.

Courts have interpreted section 546 to include some of the Uniform Commercial Code's reclamation requirement.

First, the goods must still be in the now bankrupt customer's possession when the written demand is made. If the goods have been sold prior to the written demand, the reclamation rights of the trade vendor are extinguished. The reclamation rights of the trade vendor are also lost if the goods have been incorporated into the customer's inventories, such that identification of specific goods is not feasible.

The typical case here is where the trade vendor provides a part of a finished product, and that part has been incorporated into the finished product so that it cannot now be segregated. For instance, envision a vendor that provides raw wood to Rolls Royce, which raw wood has already been milled, lacquered and installed as a dashboard prior to written demand for reclamation by the trade vendor. The trade vendor's reclamation rights are probably extinguished because its raw wood has been incorporated into the car, and the trade vendor is now unable to be segregate its raw wood from the rest of the car, or even the lacquer used to finish the wood for that matter.

Lastly, and sometimes most importantly, the reclaiming trade vendor's rights to reclaim their goods are subject to the rights of a buyer in the ordinary course or a good faith purchaser.

This last requirement is important in the bankruptcy side of the world, because often there is a pre-petition secured lender involved. That lender's liens often extend to the inventory of the trade vendor's now bankrupt customer. It has been well established by bankruptcy courts that a reclaiming trade vendor's rights to reclaim are subject to the existing rights of a secured creditor in that a secured creditor has been held to qualify as a good faith purchaser under the reclamation statutes. Therefore, even if the trade vendor meets its requirements under section 546, they must always look to whether or not a pre-petition secured creditor exists that has a lien on the now bankrupt customer's inventory. If so, the trade vendor's rights to reclaim under section 546 are probably extinguished.

An interesting case on the topic of prepetition secured creditors, and their ability to extinguish the reclamation rights of trade vendors under section 546 is the Phar-Mor, Inc. case. (301 B. R. 482 (2003)). Although there has been criticism of the case in legal publications and the like, it is still persuasive law in some jurisdictions. In Phar-Mor, a pre-petition secured lender had its pre-petition claim paid in full through proceeds from a post-petition secured lender. The trade vendors argued that their reclamation rights under section 546 could not be extinguished when the pre-petition secured lender is paid in full with proceeds from a postpetition secured lender. The court agreed. The court held that the prepetition secured creditor's lien rights over reclamation creditors are not preserved to post-petition secured lenders.

The court went on to state that "[a] debtor's decision to grant a security interest in inventory to a subsequent secured lender cannot defeat a seller's reclamation rights if the seller asserted its rights before the security interest is granted." The court essentially allowed the reclaiming trade vendors in the case, who made all the proper demands for the goods, and qualified otherwise under section 546 with the exception that the goods were no longer available to be reclaimed under the post-petition financing agreement, an administrative expense claim for the value of the goods sold and delivered within the requisite time periods.

With the ever evolving reclamation rights of trade vendors under statutory and case law, it is hard to gauge the impact and longevity of the Phar-Mor holding. However it proves to be a learning ground for trade vendors for two reasons. First, it shows that trade vendors should not simply give up on accounts receivables for customers that have filed for bankruptcy. Depending on the situation there may be a chance for a greater recovery than one would expect. Secondly, it is proof of the necessity that trade vendors become familiar with the Bankruptcy Code's reclamation statutes. These can be very powerful statutes for trade vendors, and having a fundamental understanding of them can prevent trade vendors from allowing valuable rights to pass them by.

The above article originally appeared in the Fall 2009 issue of Blakeley & Blakeley's Trade Credit Quarterly.

Ron Clifford, Esq. can be reached at rclifford @ blakeleyllp.com.