Dealing with a customer's bankruptcy:
Recovering goods sold to an insolvent customer
(Part III of a series)

In recent issues of Legal Insights, we outlined some considerations if a customer was heading for, or had actually filed, a bankruptcy case. In this issue, we examine two related remedies that a seller of goods may pursue in a customer's bankruptcy to increase its chances of getting paid.

RECOVERING YOUR GOODS UNDER THE RIGHT OF RECLAMATION

Section 546 of the U.S. Bankruptcy Code permits a seller of goods, under certain circumstances, to recover those goods from a buyer that went into bankruptcy shortly after the sale. By this provision, the Bankruptcy Code leaves intact, with minor modifications, a seller's state law rights found in the Uniform Commercial Code (UCC) to recover goods sold to an insolvent customer.

A seller that wishes to recover goods from a debtor in bankruptcy may file a reclamation claim. In order to recover, the seller must meet a number of strict requirements:

  • First, the seller must show that it is in the business of selling the goods in question and that the goods were sold in the ordinary course of the seller's business. It makes no difference if the transaction was a cash or a credit sale.
  • The seller must also show that the buyer was insolvent at the time the goods were received. Insolvency for purposes of Section 546 means an excess of liabilities over assets at fair value. The schedules of assets and liabilities filed by the debtor at the outset of the bankruptcy case can provide strong evidence of insolvency for this purpose.
  • The seller must act quickly: A demand for reclamation must be made within 45 days after the debtor receives the goods, or not later than 20 days after the commencement of the case, if the 45-day period expires after the commencement of the case. For purposes of these deadlines, the courts have held that goods are "received" when the debtor takes actual physical possession of them.

    Further, the demand must be in writing (the oral demand allowed under state UCC law is insufficient to satisfy Section 546). A written demand made on the debtor's legal counsel has been held to be sufficient.

    The courts are split as to whether a reclamation demand is made when it is mailed, the so-called "mailbox" rule, or when it is actually received by the debtor.

    In addition, a demand merely for payment will not qualify as a demand for reclamation; the writing should expressly state that the seller is asserting the right of reclamation. A seller also should be as specific as possible in describing the goods to be reclaimed, such as by invoice date and number, bills of lading, shipping and receiving dates and kinds and quantities of the goods.

    As described in Part I of this series, the filing of a bankruptcy case triggers the automatic stay, a court-ordered injunction in every bankruptcy case that prohibits creditors from starting or continuing any action against the debtor to collect a debt. Courts have held, however, that sending a reclamation demand is not a violation of the automatic stay.
  • The debtor must still hold the goods. In order to be effective, the goods must still be in the debtor's possession and identifiable at the time the reclamation demand is received.

    While at first blush this might seem easy to determine, it has given rise to more than its share of litigation—for example, when the claimant's product (jet fuel) was comingled with that of other suppliers. In such cases, claimants are often required to prove not only the amount in the comingled pool at the beginning of the relevant reclamation period and the quantity delivered by the claimant but also the quantities delivered by other suppliers and how much of the total remained in the pool at the end of the period. If the goods are incorporated into a permanent product (such as steel beams at a building construction site), they may not be reclaimed.
  • The seller must follow procedure: A seller's right to reclamation under Section 546 is enforced by commencing a special proceeding in Bankruptcy Court. Because a reclamation demand merely preserves the seller's right of reclamation, the seller must initiate a lawsuit before the goods are disposed of in the ordinary course of the debtor's business.

    Further, the reclaiming seller should consider filing a motion for a preliminary injunction to preserve the goods at the time that it files its case for reclamation.

Successfully asserting a reclamation claim is not a slam dunk. Because each element of the case must be proved with sufficient evidence, the seller should carefully weigh the likely costs against the potential benefit to ensure that the value of the goods sought to be reclaimed justifies the expense of pursuing the claim.

Another critical factor is whether a superior security interest has attached to the goods in favor of a lender under a customary "after-acquired property" clause. If such a prior security interest exists, the seller must carefully evaluate its validity and scope and determine whether the debtor has other assets sufficient to pay the secured creditor in full, thereby freeing the goods in question to satisfy the reclamation claim.

GETTING PAID FOR YOUR GOODS WITH AN ADMINISTRATIVE CLAIM

In recognition of the fact that a lender often has a blanket security interest in all of the debtor's assets, and therefore that a seller will not be able to reclaim sold goods, Congress enacted Section 507(c) of the Bankruptcy Code. This section gives a seller the right to assert an administrative claim for goods delivered to the debtor in the ordinary course of business within the 20 days before the bankruptcy petition is filed. In a bankruptcy case, an administrative claim is paid before any of the unsecured claims of general creditors. A seller with an administrative claim therefore has a much higher chance of receiving payment in the case.

EXPERIENCED COUNSEL IS A MUST

Requirements for successful reclamation and administrative claims are numerous and complex. A competent creditor's rights attorney will be able to navigate the requirements and, in a reclamation case, help the seller analyze whether a secured lender's security interest might be defeated or satisfied from other assets.

Watch future issues of Legal Insights for other ways to maximize your recovery if your customer files for bankruptcy, including requesting to be treated as a critical vendor in a Chapter 11 bankruptcy case and filing a timely and effective proof of claim.

—Bruce L. Waterhouse Jr.
waterhouse@nicola.com

This is the third in a series of articles by Bruce L. Waterhouse Jr. on how businesses can deal with customer bankruptcies. The first article, which appeared in the Summer 2012 issue of Legal Insights, examined options if a customer is about to file, or has recently filed, a bankruptcy case. Next, in the Spring 2013 issue, Waterhouse examined how to defend against an attempt to force a business to return a payment it has received from the debtor.

For information on how to deal with delinquent customers who are financially troubled but have not filed for bankruptcy, read Waterhouse's advice in the Winter 2011-2012 issue and the Spring 2012 issue of
Legal Insights.