B Bankruptcy Code Section 503(b)(9) was enacted in Hear Bruce as he - - PDF document

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Bruce NathaN, esq. THE PUBLICATION FOR CREDIT & FINANCE PROFESSIONALS $7.00 N AT I O N A L A S S O C I AT I O N O F C R E D I T M A N A G E M E N T FEBRUARY 2013

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Drop Shipment Claims Denied Section 503(b)(9) Priority Status

Bankruptcy Code Section 503(b)(9) was enacted in 2005 to provide additional protection for goods suppli-

• ers. Section 503(b)(9) grants these trade creditors an

administrative priority claim for the value of the goods they sold in the ordinary course of business to a fjnan- cially distressed customer that were received within 20 days of its bankruptcy fjling. Although Section 503(b)(9) ofgers goods suppliers a step up in priority and enhanced prospects for payment

• f their claims, the courts have had to grapple with

many questions about the meaning of this relatively short and ostensibly simple statute. One issue that has proven to be particularly nettlesome is whether goods that a creditor, upon the debtor’s instruction, delivers to a third party in a “drop shipment” transaction are deemed “received” by a debtor in determining whether the creditor has satisfjed Section 503(b)(9)’s require- ments for obtaining priority status. Tiis issue is particularly important to trade creditors who drop ship goods to their buyer’s customers. Unfor- tunately, the United States District Court in New Hamp- shire in Ningbo Chenglu Paper Products Manufacturing

• Co. Ltd. v. Momenta, Inc., denied Section 503(b)(9) pri-
• rity status to a trade creditor that drop shipped goods

to certain of the debtor’s customers within 20 days of the debtor’s bankruptcy fjling. Tie district court based its holding on the debtor’s lack of receipt of the drop shipped goods, which is one of the requirements for Section 503(b)(9) priority status. section 503(b)(9) “20-Day Goods” Priority claim Section 503(b)(9) grants goods sellers an administrative priority claim for: “...the value of any goods received by the debtor within 20 days before the date of commencement of a case under this title in which the goods have been

One issue that has proven to be particularly nettlesome is whether goods that a creditor, upon the debtor’s instruction, delivers to a third party in a “drop shipment” transaction are deemed “received” by a debtor in determining whether the creditor has satisfied section 503(b)(9)’s requirements for obtaining priority status.

Hear Bruce as he presents, or co-presents:

• 22048. Bankruptcy Rumblings:

Identifying and Mitigating Risk

• f a Financially Troubled

Customer Headed toward Bankruptcy 22062 & 22072. Bankruptcy Reform Town Hall from the Perspective of the Credit Executive and Other Constituencies

Learn more about this and other legal educational sessions on pp. 28-43.

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sold to the debtor in the ordinary course of such debtor’s business.” Debtors and trade creditors have been frequently litigating Section 503(b)(9)’s seemingly straightforward requirements. Tie stakes are huge here as debtors and their secured lenders have been litigating issues, such as what constitutes receipt of goods, in order to limit trade creditors’ recoveries in bank- ruptcy cases. Factual Background Momenta fjled for Chapter 11 on October 23, 2010 (the “peti- tion date”). Prior to the petition date, Momenta, Inc. ordered goods from Ningbo Chenglu Paper Products Manufacturing

• Co. Ltd. During the 20-day period preceding the petition

date, at Momenta’s direction (a) Ningbo delivered three ship- ments valued at approximately $23,000 to Momenta and (b) delivered four other shipments (the “drop shipped goods”) valued at in excess of $140,000, to Momenta’s customers in the United Kingdom and Canada. On December 6, 2010, Ningbo fjled a motion for relief under Bankruptcy Code Section 503(b)(9) for the allowance and payment of an administrative priority claim in the amount of $163,527.95. Ningbo’s motion included a request for payment

• f approximately $140,000 for the drop shipped goods.

Momenta conceded that all seven shipments were for goods that Ningbo had sold to Momenta in the ordinary course of

• business. Momenta also conceded that Ningbo was entitled to

Section 503(b)(9) priority status for Ningbo’s three shipments

• f goods directly to Momenta.

Momenta objected to Ningbo’s motion for Section 503(b)(9) priority status for the value of the drop shipped goods. Momenta argued that Section 503(b)(9) did not apply because Momenta had not received the drop shipped goods that were shipped directly to Momenta’s customers, which is

• ne of the prerequisites for obtaining relief under Section

503(b)(9). Ningbo disputed this, arguing that a buyer’s “receipt” of goods is not limited to goods that the buyer phys- ically possesses and includes the drop shipped goods received by the buyer’s customers. Tie bankruptcy court refused to grant Ningbo an administra- tive priority claim under Section 503(b)(9) for the balance due on the drop shipped goods. Tie bankruptcy court noted that the Bankruptcy Code does not defjne the term “received.” Tie court narrowly defjned the term “received” to have the same meaning in Section 503(b)(9) as in Section 546(c) that deals with reclamation rights.1 Tie court also relied on the meaning of the term “receipt” in determining whether and when a debtor “received” goods. While the Bankruptcy Code does not defjne “receipt,” the Uniform Commercial Code (“UCC”) defjnes receipt of goods in UCC Section 2-103(c)(1) as taking physical possession of the goods. Tiat includes the buyer either having obtained actual physical possession of the goods or constructive possession of the goods in the posses- sion of a third party, such as a carrier. However, the court did not consider Momenta to be in constructive possession of goods that Ningbo, at the direction of Momenta, had deliv- ered to Momenta’s customers in drop shipment transactions. As such, the bankruptcy court denied Ningbo any priority status under Section 503(b)(9) for the drop shipped goods. Tie court concluded that Momenta had not received the goods that Ningbo had drop shipped directly to Momenta’s customers, and, therefore, Ningbo did not satisfy Section 503(b)(9). Ningbo appealed the bankruptcy court’s denial of Section 503(b)(9) priority status for its claim for payment of the drop shipped goods. Ningbo faulted the bankruptcy court for holding that the same defjnition of “received” is applicable to both reclamation and Section 503(b)(9) priority rights. Ningbo argued for a broad interpretation of the term “received” in Section 503(b)(9) to include a creditor’s drop shipment of goods to the debtor’s customers during the 20-day period prior to the bankruptcy fjling date. Ningbo relied on the preface to UCC Section 2-103(1) which states that its def- inition of “receipt,” taking physical possession of goods, does not apply if “the context otherwise requires.” According to Ningbo, in the typical drop shipment transaction, “received” should be defjned “in context” in a way that accounts for the commercial reality of the arrangement. Buyers and sellers fre- quently arrange for the sellers’ drop shipment of goods to the buyer’s customers and these arrangements ofuen call for fmexi-

• bility. A buyer should not be permitted to invoke its decision

to direct the seller’s delivery of goods to the buyer’s customer as the basis for opposing Section 503(b)(9) priority status for such goods because the buyer had not received the goods. Ningbo also claimed that neither Section 503(b)(9) nor Sec- tion 546(c)’s reclamation provision requires a seller to qualify for reclamation of its goods as a condition for invoking administrative expense status under Section 503(b)(9). Sec- tion 546(c) states that a seller who has not timely sent a writ- ten reclamation demand is still eligible for priority status under Section 503(b)(9). Neither Section 546(c) nor Section 503(b)(9) requires a creditor to satisfy the requirements for reclamation (such as the debtor’s continued possession of the delivered goods) as a condition for obtaining Section 503(b) (9) priority status. Momenta asserted a narrow interpretation of Section 503(b) (9). Momenta argued that Section 503(b)(9) is merely a sup- plemental remedy that is available only to reclamation credi- tors who, but for their failure to send a written reclamation notice required by Section 546(c), would be entitled to recla- mation of their goods. the District court’s Decision Tie district court agreed with Momenta’s narrow interpreta- tion of Section 503(b)(9) and denied administrative priority status for Ningbo’s drop shipped goods. Tie court found that Momenta had not received the drop shipped goods and, therefore, was not eligible for a Section 503(b)(9) priority claim for the drop shipped goods. Congress intended the

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administrative priority claim granted by Section 503(b)(9) to be only a “supplemental remedy” for reclamation sellers and not a priority claim for all sellers who delivered goods within the 20 days of the debtor’s bankruptcy fjling. Consistent with this narrow view, the court noted that Congress intended the term “received” to have the same meaning in both Sections 503(b)(9) and 546(c). Tie Momenta court also relied on policy grounds to support its narrow interpretation of Section 503(b)(9). A broad inter- pretation of Section 503(b)(9) would create a new and poten- tially very large class of priority sellers that risks distorting, if not completely undermining, the Bankruptcy Code’s general equitable principle that all unsecured creditors should be treated fairly and in the same manner. Tie court also rejected any broad interpretation of Section 503(b)(9) priority rights as detrimental to the policy favoring

• reorganization. Since the debtor must set aside cash to pay all

administrative priority claims, the court was concerned that a debtor’s prospects for confjrming a Chapter 11 plan and reor- ganizing would be diminished by an expanded class of credi- tors entitled to Section 503(b)(9) priority status. Tiis concern trumps any competing policy of encouraging trade creditors to continue extending credit to fjnancially distressed custom- ers that would be encouraged by the priority status granted by Section 503(b)(9) to the claims of all creditors who deliver goods within 20 days of their customer’s bankruptcy. Did the Momenta court err in Denying section 503(b)(9) Priority status to a trade creditor that Drop ships Goods to a Debtor’s customers? Tie Momenta court’s narrow view of “received” in a drop shipment of goods to the debtor’s customers is not supported by various provisions of UCC Article 2 dealing with the sale of

• goods. For example, according to UCC Section 2-705 that

deals with a goods seller’s right to stop delivery of goods to an insolvent buyer, the seller’s stoppage of delivery rights termi- nate and reclamation rights arise when the buyer receives the

• goods. Receipt occurs either by the buyer obtaining actual

physical possession of the goods, according to UCC Section 2-705(2)(a), or constructive possession of the goods through the buyer’s designee in any one of three ways listed in UCC Section 2-705(2)(b), (c) or (d). Tiis is accomplished through either “(b) acknowledgment to the buyer by any bailee of the goods except a carrier that the bailee holds the goods for the buyer; (c) such acknowledgment to the buyer by a carrier by reshipment or as warehouseman; or (d) negotiating to the buyer of any negotiable document of title covering the goods.” Tie Momenta court recognized that a buyer is in constructive receipt of goods upon their receipt by a third party in certain

• circumstances. However, the court held that Momenta did not

have constructive possession of goods that Ningbo had drop shipped for delivery to Momenta’s customers. Tie Momenta court ignored Offjcial Comment 2 to UCC Sec- tion 2-705 which states as follows: “Receipt by the buyer” includes received by the buyer’s designated representative, the subpurchaser, when shipment is made direct to him and the buyer himself never receives the goods. It is entirely proper under this Article that the seller, by making such direct shipment to the subpurchaser, be regarded as acquiescing in the latter’s purchase and as thus barred from stoppage of the goods as against him. If the UCC’s drafuers concluded that a buyer received goods through receipt by a subpurchaser, then why shouldn’t Momenta be deemed to have received goods upon Ningbo’s drop shipment of goods that are received by Momenta’s cus- tomers? Tiat would have enabled Ningbo to satisfy Section 503(b)(9)’s receipt requirement and thereby obtain an admin- istrative priority claim for the drop shipped goods. Tie Momenta court also disregarded UCC Section 2-310(a), which deals with payment terms in a sale transaction and states “payment is due at the time and place at which the buyer is to receive the goods…” Applying the narrow defjnition of “received” that the Momenta court relied upon to deny Ning- bo Section 503(b)(9) relief for the drop shipped goods to Momenta’s customers would lead to the ridiculous conclusion that Momenta had no obligation under UCC Section 2-310(a) to pay for goods that it had not received because they were purchased and resold through drop shipment to its custom-

• ers. Tiat makes no sense and supports an expanded interpre-

tation of “received” to include delivery to Momenta’s custom- ers and thereby grant Ningbo Section 503(b)(9) priority status for the drop shipped goods. Tie Momenta court was also mistaken in limiting Section 503(b)(9) priority status to goods that were otherwise subject to reclamation by Ningbo. Neither Section 546(c) dealing with reclamation rights nor Section 503(b)(9) contains any such limitation. Section 503(b)(9) applies to all goods that the debtor received within 20 days of the commencement of its bankruptcy case, regardless of whether the buyer exercises its reclamation rights or otherwise satisfjes Section 546(c)’s rec- lamation requirements. Tius, a trade creditor retains its Sec- tion 503(b)(9) claim for goods that are no longer in the debt-

• r’s possession on and afuer the bankruptcy fjling date and are

not otherwise subject to reclamation. A trade creditor should similarly retain its Section 503(b)(9) priority status for goods that the trade creditor had drop shipped to the buyer’s cus- tomers within 20 days of the bankruptcy that would otherwise not be subject to the buyer’s reclamation rights because the buyer had resold those goods. conclusion Tie availability of Section 503(b)(9)’s protection to trade cred- itors would be curtailed if other courts follow Momenta’s hold- ing denying Section 503(b)(9) priority status to trade creditors that drop ship goods to their buyer’s customers. However,

the Momenta court ignored Official Comment 2 to uCC section 2-705.

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• ther courts might opt for a broader interpretation of Section

503(b)(9) that includes drop shipment transactions.

• 1. Bankruptcy Code Section 546(c) states as follows: (1) …[S]ubject to

the prior rights of a holder of a security interest in such goods or the proceeds thereof, the rights and powers of the trustee under Sections 544(a), 545, 547, and 549 are subject to the 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, within 45 days of the commencement of a case under this title, but such a seller may not reclaim such goods unless such seller demands in writing reclamation of such goods (A) not later than 45 days afuer the date of receipt of such goods by the debtor; or (B) not later than 20 days afuer the date of the commencement of the case, if the 45-day period expires afuer the commencement of the case. (2) If a seller of goods fails to provide notice in the manner described in paragraph (1), the seller may still assert the rights contained in Section 503(b)(9). Bruce Nathan, Esq. is a partner in the New York City offjce of the law fjrm of Lowenstein Sandler PC. He is a member of NACM and is on the Board of Directors of the American Bankruptcy Institute and is a former co-chair of ABI’s Unsecured Trade Creditors Committee. Bruce is also the co-chair of the Avoiding Powers Advisory Committee working with ABI’s commission to study the reform of Chapter 11. He can be reached via email at bnathan@lowenstein.com. *Tiis is reprinted from Business Credit magazine, a publication of the National Association of Credit Management. Tiis article may not be forwarded electronically or reproduced in any way without written permission from the Editor of Business Credit magazine.