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A Short Series on Reclamation for Credit Managers

Part 1: RECLAMATION BASICS

After reading the answer to Anxious in Alaska about getting inventory back post-bankruptcy if the debtor agrees, a reader asked about the availability of a remedy without the debtorÕs consent. That raises the issues surrounding "reclamation." Since the rules governing reclamation are specific, it requires a bit of detail. Therefore, the next few issues of The Law will be devoted to it.

Reclamation is a means by which a seller may "reclaim" goods that were sold and shipped to a customer on credit prior to the seller learning that the customer was insolvent. For reclamation to be effective, the seller must make a demand on the customer for the return of the goods. The Uniform Commercial Code (U.C.C.) Section 2-702(2) states:

(2) 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 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.

Part 2: RECLAMATION AND BANKRUPTCY

I. RECLAMATION AND BANKRUPTCY

Sometimes, the reclamation demand is occasioned by the customer filing a Voluntary Petition for Relief under Chapter 11 of the U.S. Bankruptcy Code. Please note that once a bankruptcy case is initiated, Section 546(c) provides the exclusive remedy for a seller who is seeking to reclaim his goods. Therefore, once a debtor initiates a bankruptcy case, a seller must establish his right to reclaim the goods pursuant to 11 U.S.C. Section 546(c) of the Code.

A seller's reclamation rights arise under Section 546(c) of the Code only if the seller has a right to reclaim under the nonbankruptcy law (generally the U.C.C.) of the state where the goods were sold. In addition to the nonbankruptcy law requirements, a seller's failure to comply with the additional requirements of Section 546(c) will terminate his reclamation rights, regardless of compliance with more liberal requirements of the state's nonbankruptcy laws.

II. SECTION 546(C)

11 U.S.C. Section 546(c) states:

(c) Except as provided in subsection (d) of this section, the rights and powers of a trustee...are subject to any statutory or common-law right of a seller of goods that has sold goods to the debtor, in the ordinary course of such seller's business, to reclaim such goods if the debtor has received such goods while insolvent, but --

(1) such a seller may not reclaim any such goods unless such seller demands in writing reclamation of such goods --

(A) before 10 days after receipt of such goods by the debtor; or

(B) if such 10-day period expires after the commencement of the case, before 20 days after receipt of such goods by the debtor; and

(2) the court may deny reclamation to a seller with such right of reclamation that has made such a demand only if the court --

(A) grants the claim of such a seller priority as a claim of a kind specified in Section 503(b) of this title; or

(B) secures such claim by alien.

Section 546(c) is straightforward and is similar (although narrower) than Section 2-702(2) of the U.C.C. and the case law relating to Section 546(c) is well-defined. Case law reduced Section 546(c) into the five basic elements which give rise to a seller's reclamation rights. These elements are as follows:

1. The seller sold goods to the debtor on credit;

2. The sale of goods was in the ordinary course of business of both the debtor and the seller;

3. The seller delivered the goods at a time when the debtor was insolvent, as defined by the Bankruptcy Code;

4. The seller made a written demand for return of the goods within 10 days (or 20 days if the 10 day period had not yet expired when the Petition was filed) after the goods were delivered to the debtor;

5. The debtor had possession of the goods at time of the written demand or the goods were not in the debtor's possession in the ordinary course of business or the goods had been sold to a good-faith purchaser at the time of demand.

Part 3: HOW IT WORKS

III. HOW IT WORKS

The first thing a creditor should do when it learns of a bankruptcy (or other indication of insolvency) is look to see if it has any shipments which were received by the customer in the last 10 (or 20) days. If there are, sirens should go off, bells should ring and flares should shoot up into the sky! When in doubt, send the notice! Delaying, even a day, can cost your company valuable rights. If you are wrong, and a reclamation notice is inappropriate, there is no downside! The worst that happens is you wasted some time and some money. There is no penalty.

Unlike the UCC Section 2-701, which requires that a demand of unspecified form be made for reclamation, under the Bankruptcy Code, the demand must also be in writing. The written demand must explicitly state that it is "asserting the right of reclamation" and should probably also note that the reclamation is being claimed under 11 U.S.C. Section 546 and applicable state law, in furtherance of explicitly asserting the reclamation rights. In addition, the writing should reflect what items or shipments are the subject of the reclamation. That way, vagueness of the demand does not raise questions of whether items being reclaimed were within the window of reclamation.

The mailbox rule applies to this section. As long as the demand was made in a commercially reasonable manner, it is effective on dispatch. A Telex has been held to be sufficient as a writing and another case held that the demand need not be by registered or certified mail to be effective as a written demand, though for issues of proof, it may not be a bad idea to do so. A hand delivered written demand has been held to be sufficient. Although no reported case was found to discuss fax or e-mail notice under Section 546(c), faxes are generally considered to be sufficient as "writings" under the UCC. However, the use of these "instantaneous" methods is not relevant in terms of time restrictions for making the reclamation demand, because of the employment of the mailbox rule.

Part 4: CASH, LIEN OR CLAIM?

IV.CASH, LIEN OR CLAIM?

Even though Section 546(c) entitles a seller to reclamation rights, a seller does not automatically get the goods back from the debtor. The Court has discretion to "balance the equities" between the debtor's needs for the goods in order to continue its business operations and the seller's interest in the value of the goods. If the Court determines that the debtor's needs for the goods outweighs the sellers need to resell the goods for cash, the Bankruptcy Court is required to grant the seller an administrative expense priority or a secured claim by lien on the assets of the estate.

If the Bankruptcy Court grants a seller a lien or an administrative priority in lieu of returning the goods, the reclaiming seller is entitled to the full invoice price for the goods. However, return of the goods is the preferred remedy for sellers, since an administrative claim may only be paid from the estate after all secured claims. If the secured creditors' claims amount to the entire value of the goods, the seller's administrative expense claim or lien is worthless. Reclaiming creditors may consider filing a motion directing payment of that administrative claim, especially when there is a post-petition lender. If the creditors await the end of the case (and the case is liquidated), all of the money may go to the administrative creditors.

V. RECLAMATION RIGHTS VS. SECURED CREDITORS AND/OR GOOD FAITH PURCHASERS

A seller seeking reclamation must contend with two common hurdles to recovery. One is a prior secured creditor with a floating lien on the assets of the debtor. The second hurdle is the good faith purchaser, where a debtor no longer has the goods because they were sold to a good faith purchaser prior to the reclamation demand. Even Section 2-702(3) of the U.C.C. provides that a seller's reclamation rights are "subject to the rights of a buyer in the ordinary course or other good faith purchaser..." Since secured creditors are considered good-faith purchasers pursuant to Sections 1-201(32) and (33) of the U.C.C., a seller is unable to reclaim the physical possession of the goods against either a secured creditor or a good faith purchaser.

It is important to note that the presence of one or both of these barriers does not extinguish a seller's reclamation rights. The seller's reclamation rights are merely subordinated to the rights of the secured creditors or the good faith creditors, and the seller will be granted an administrative priority or subordinated secured lien on the assets of the debtor.

Part 5: CODE V. CODE

VI. CODE V. CODE

While the U.C.C. and Section 546(c) reclamation provisions are similar, they are not identical. There are several common risks for the unwary seller, arising from the differences between the U.C.C. and Section 546(c). Since Section 546(c) requires a seller to comply with nonbankruptcy law (usually the U.C.C.) as well as its own provisions, it is important to note the differences between the two provisions. The differences are as follows:

A. DEFINITION OF INSOLVENT

A debtor is "insolvent" under the U.C.C. if the debtor has ceased to pay his debts in the ordinary course of business or cannot pay his debts as they become due. A debtor is "insolvent" under the Bankruptcy Code if he meets the Code's "balance sheet" test, which requires that "the sum of the entity's debt is greater that all of the entity's property, as fair valuation..."

In a recent case, the seller sought reclamation pursuant of Section 546(c) for cotton which it had delivered to the debtor pre-petition. The Court held that, even though the seller complied with the U.C.C.'s reclamation requirements, the seller's request for reclamation must be denied because the seller offered no evidence that the debtor's liabilities exceeded its assets at the time the seller demanded the return of the cotton, as required under Section 546(c) of the Code.
In another case the Court held that the debtor's poor financial condition which was evidenced by its Schedules and the fact that the debtor filed its Petition in the Bankruptcy Court within one week after it received the goods, provided the seller with strong probative evidence that the debtor's liabilities exceeded its assets at the time the seller demanded the return of his goods.

B. WRITTEN NOTICE WITHIN 10-DAYS AFTER THE DEBTOR'S RECEIPT OF THE GOODS

Unlike some states' nonbankruptcy laws which allow for oral demand by the seller for return of goods, Section 546(c) requires the demand to be in writing. Also, while some states' nonbankruptcy laws provide that a seller's reclamation rights are extinguished 10 days after receipt of the goods. Section 546(c) has recently been modified to extend a seller's reclamation rights to 20 days after receipt of the goods if the regular 10 day expiration period ends after the Petition date.

Part 6: RECEIPT, STOPPAGE IN TRANSIT & CONCLUSION

VII. THE DEFINITION OF RECEIPT

The date of "receipt" is crucial in determining when the 10 day (or 20 day) reclamation demand period expires. Section 2-103 of the U.C.C. defines "receipt" of goods as "taking physical control of them." U.C.C. Section 2-103(1)(c). Case law has set forth a general test to determine if goods were received pursuant to the Bankruptcy Code. Generally, goods are "received" when the seller can no longer stop delivery of goods and is left with only the remedy of reclamation.

VIII. STOPPAGE IN TRANSIT

In some cases, a seller may discover that the buyer is insolvent when the goods are "in transit", i.e. after the buyer places an order but before the buyer receives actual physical possession of the goods. The U.C.C. provides a mechanism by which a seller may stop goods in that circumstance. Although there is no specific language in the Bankruptcy Code which permits a seller to stop shipment of the goods in transit, the reclamation section of the Code includes, by implication, the seller's prior right to stop goods in transit.

CONCLUSION

It is essential that creditors who have a right to reclaim act expeditiously and in conformity with the Uniform Commercial Code and the Bankruptcy Code. Without such a practice, the rights of a seller to reclaim his goods will be extinguished, and the seller loses a valuable remedy and must take its place with the rest of the unsecured creditors.